TERM 2 AY2007-08

Mid-Term Test
8th Mar 2008

FNCE102

FINANCIAL INSTRUMENTS, INSTITUTIONS AND MARKETS

INSTRUCTIONS TO CANDIDATES

1 The time allowed for this test paper is 2 hours.

2 This test paper contains 2 sections.

Section 1: 20 MCQ questions (1 mark each)

Section 2: 5 Short answer questions (5 marks each)

There are a total of Ten (10) pages including this instruction sheet.

3 You are required to answer ALL questions.

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SECTION 1: MCQ

Please choose the correct answer from choices (A) to (E). (1 mark each)

Question 1

A zero-coupon T-bill has a face value of US$55,000. Assume today (July 5, 2006) you invest in
this bill, which will mature on Nov 6, 2006, how much are you paying for it?

Its bid quote is 2.8% pa, with a bid-ask spread of 25 bp. (bp = basis points)

A) S$54,422.19
B) US$54,469.56
C) S$54,516.92
D) US$54,523.53
E) None of the above.

Solution: E

Bid quote = 2.8%

Ask quote = 2.8% - 0.25% = 2.55%

Use Discount Yield formula.

Id = [(P1 – P0) / P1] x 360/h

Where:

Id = 2.55%
P1 = US$55,000
P0 = ask price = US$54,516.92
h = 124 days to maturity = 26 + 31 + 30 + 31 + 6 = 124
360 calendar days is used because US$ denominated T-bills

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Question 2

A Financial Institution is going to liquidate some of its assets (listed below) at short notice, due to
an internal crisis. The sale values are listed in the table below. Calculate the 1 year liquidity index
for these assets.

Asset Face Value ($) 1 year sale value ($) Current sale value ($)
Stock A 25 million 30 million 20 million
Bond B 25 million 35 million 22 million
Loan C 60 million 65 million 45 million
Fixed asset D 20 million 30 million 15 million

A) 0.15
B) 0.65
C) 0.89
D) 1.57
E) 1.92

Solution: B

Liquidity Index
= (25/130)(20/30) + (25/130)(22/35) + (60/130)(45/65) + (20/130)(15/30)
= 0.6455

Question 3

If fluctuations in interest rates become smaller, then, other things equal, the demand for stocks
________ and the demand for long-term bonds ________ relatively.

A) increases: increases
B) increases: decreases
C) decreases; decreases
D) decreases; increases
E) stabilises; stabilises

Solution: D

When there are smaller i/r fluctuations, bond prices also fluctuate lesser, hence, demand for LT
bonds increases while demand for stocks decreases relatively.

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Question 4

Which of the following is false?

A) Additional funds can be raised through rights issues, in which existing shareholders can
purchase new shares at the subscription price.
B) In a rights offering, the existing shareholder can reject the rights offer within a time period.
C) After employees of the firm are paid, shareholders are entitled to a claim on the firm’s
liquidated assets.
D) Raising funds through a private placement is faster than a public offering.
E) Shareholders must vote in proxy so as to ensure the firm is managed by capable personnel.

Solution: E

E is false because:
Voting can be done in person too.

Question 5

Figure (a) Figure (b)

Which of the following is true?

A) A reversal pattern is shown in Figure (a).

B) Figure (b) shows a head and shoulders continuous pattern.
C) Figure (a) shows a bear flag.
D) Figure (b) shows a wedge continuous pattern.
E) A downtrend breakout is shown in Figure (b).

Solution: C

The rest are false because:

A) Figure (a) is a continuous pattern.
B) Figure (b) shows a head and shoulders reversal pattern.
D) There is no wedge pattern here.
E) There is no downtrend breakout pattern here. A downtrend breakout is when the share price
penetrates the resistance line, showing the end of a downtrend.

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Question 6

Which of the following is false?

A) Singapore corporate bonds are actively traded in the secondary market.

B) Offshore corporate bonds, on the other hand, are thinly traded in the Asian Dollar
Bond secondary market.
C) Singapore companies would rather rely on the stock market and private placement of
bonds for capital expenditure programs, than public offering of bonds.
D) Treasury bills are quoted as discounts from par value.
E) In a competitive bid for SGS, the applicant wants to be allotted the yield specified in the
application.

Solution: A

A is false because:
Singapore corporate bonds are also inactively traded, as most are held till maturity.

The rest are true because:

C) More well-informed of the stock market and private placement of bonds is faster for
raising funds.

Question 7

Happy Plant company announces a rights offering, under which it hopes to sell another 3 million
shares. Each shareholder will receive 0.5 right for each share owned. Share price of the company
before the rights offering is $20. If the right allows purchase of a share at a 30% discount after the
rights offering, what is the value of all your rights? (Assume 1 right can be exchanged for 1 share
in the new issue, your stake in the company is 0.5%. Company initially has 6 million shares
outstanding.)

A) $4
B) $20
C) $60,000
D) $90,000
E) None of the above

Solution: C

You own = 0.5% x 6mil = 30,000 shares

After rights offering: you receive = 0.5 x 30,000 = 15,000 rights to buy 15,000 new shares

Total Market Value of Company before rights = $20 x 6 mil shares = $120 mil
Total Market Value of Company after rights
= ($20 x 6 mil old shares) + ($14 x 3 mil new shares) = $120 mil + $42 mil = $162 mil

Share price after rights issue = $162mil/9mil shares = $18/share

Your Right allows you to buy new share (worth $18) at $14.
Hence, value of 1 Right = $4

Your ownership interest is unchanged:

Before (30,000/6mil) = 0.5%
After (45,000/9mil) =0.5%

Value of all your rights for 15,000 rights x $4 = $60,000

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Question 8

Risk sharing is one of the major functions of a Financial Institution.

Risk sharing is:

(i) Asset Transformation

(ii) Transferring risks to the shareholders and employees
(iii) Diversifying risks done through holding LT & ST assets & liabilities
(iv) Possible even when assets are perfectly positively correlated

A) i, ii only
B) i, iii only
C) i, iv only
D) i, iii, iv only
E) All (i) to (iv)

Solution: B

(iv) is false because:

Provided that assets are not perfectly positively correlated, significant amount of risks can be
diversified.

Question 9

Which of the following is false regarding the revamp of SGX’s listing rules?

(A) SESDAQ is transformed into a sponsor-supervised board.

(B) The Main Board’s focus will be both “Size” and “Quality”.
(C) A Full Sponsor may engage in both Introducing Activities as well as Continuing Activities.
(D) After the Sponsor determines suitability for listing, there is another minimum quantitative
requirement on the listing applicant for Catalist.
(E) Catalist aims to attract both local and foreign growing companies to list.

Solution: D

Given that the Sponsor determines suitability for listing, there will be no minimum quantitative
requirement on the listing applicant.

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Question 10

The major types of Money market instruments traded in Singapore include:

(i) Treasury Bills

(ii) Singapore Govt securities (SGS)
(iii) Negotiable certificates of deposits
(iv) LT convertible bond
(v) Bills of exchange

A) i, ii only
B) i, ii, iii only
C) i, ii, iii, v only
D) i, iv, v only
E) All the instruments listed.

Solution: C

(iv) LT convertible bond is a LT capital market instrument.

Question 11

Which of the following is described as direct finance?

A) You set up a credit line with a finance company.

B) You borrow $20,000 from a new-found friend.
C) You buy shares of common stock in the secondary market.
D) You invest in a mutual fund.
E) You take out a mortgage loan from your local bank.

Solution: B

Only B has direct contact between deficit and surplus units.

For secondary markets, mutual funds, finance companies and local banks, there is no direct
contact.

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Question 12

Which of the following is false?

(A) When a board lot has 500 shares, trading 300 shares is an odd lot trading.
(B) Shares on the former SESDAQ of SGX have high price volatility because they are majority of
small companies in the electronics sector.
(C) Former SESDAQ was set up to help small companies (SMEs) raise funds.
(D) One of the criteria for listing on SGX’s Main Board is minimum 5 years Operating Track
Record.
(E) In Singapore, share transactions can be conducted without a broker.

Solution: D

D is false because:

(D) One of the criteria for listing on SGX’s Main Board is minimum 3 years Operating Track
Record.

E is true because:

In Singapore, investors in shares can walk into any authorized trading centre located in selected
branches of local banks, and special counters operated by SGX stock brokerage firms to buy and
sell shares without going through a broker.

Question 13

Mr. Tan has existing financial liabilities in the form of a bank loan. Interest period on this loan is 3
months. Today (Mar 7, 2008), he invested in a bond with 5 years to maturity. The coupons match
the periodic instalments he has to pay on his bank loan. If he bought the bond for S$8mil, which
of the following is true? (Assume bond coupon rate is 6% pa and par value is S$10mil).

(A) The cost of borrowings for Mr Tan is 29% pa.

(B) The bond yields 2.82% pa.
(C) The bond is a premium bond.
(D) The yield on the bond is smaller than its coupon rate.
(E) None of the above.

Solution: E

Quarterly Coupon payment = (6%/4) x S$10mil = S$150,000

Current market price = S$8mil = S$150,000 (PVIFA i%, 20) + S$10mil (PVIF i%, 20)

i% = 2.82% (for 1 quarter)

YTM = 2.82% x 4 = 11.28% pa

(A) Wrong. Not enough information to calculate cost of borrowings on loan.

(B) Wrong. Should be 11.28% pa.
(C) Wrong. The bond is a discount bond. (PV < Face value; Coupon rate < YTM)
(D) Wrong. YTM = 11.28% pa > 6% pa coupon rate

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Question 14

A bond with a sinking fund provision is:

(i) Safer for investors

(ii) Pays a lower interest rate
(iii) Where the bondholder is required to retire a portion of its bonds periodically
(iv) One which protects bondholders by assuring that the issue is retired in an orderly manner.

A) i, ii only
B) i, ii, iv only
C) i, iii only
D) i, iii, iv only
E) All (i) to (iv)

Solution: B

(iii) Where the bond issuer is required to retire a portion of its bonds periodically

Question 15

Which of the following can complete the following sentence?

Liquidity risk exposure _________________ .

(i) May lead to insolvency problems.

(ii) Is the risk of having insufficient cash on hand for a bank to meet deposit withdrawals & loan
demand.
(iii) Is the risk of obtaining additional borrowings at low cost.
(iv) Can be measured by ratio comparisons.

A) i, ii only
B) i, ii, iii only
C) ii, iii only
D) i, ii, iv only
E) All (i) to (iv)

Solution: D

(iii) is incorrect because:

(iii) Is the risk of obtaining additional borrowings at high cost.

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Question 16

For the next 2 years, ABC company’s dividends are expected to grow at a rate of 10% pa. In the
3rd year, the growth is 15% pa. Thereafter, a constant growth rate of 8% pa is expected. The
company has just paid dividends of $1.10. Find the stock price today if we assume a required rate
of return of 12% pa.

A) $32.60
B) $60.32
C) $92.60
D) $100.32
E) $150.32

Solution: A

Step 1: Calculate the sum of the PVs of the dividends in the supernormal growth period.

D0 = $1.10
D1 = $1.10 (1.10) = $1.21
D2 = $1.21 (1.10) = $1.33
D3 = $1.33 (1.15) = $1.53

Sum of all PVs = PV (D1, D2, D3)

= $3.23 (A)

Step 2: Find the PV of the stock price at the end of Year 3.

P3 = D4 / (r – g) = [D3 (1 + g)] / (r – g)
= [$1.53 (1 + 8%)] / (12% - 8%)
= $41.25

PV of P3 = $29.36 (B)

Step 3: Sum (A) and (B)

Stock price today = $3.23 + $29.36 = $32.59

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Question 17

In 1 year’s time, nominal interest rate in Britain is 8% pa, while that in US is 14% pa. Which of the
following is true, if we assume real interest rates are the same in both countries and purchasing
power parity holds. Spot exchange rate: US$1.6728/GBP1

A) Nominal interest rate spread between Britain & US is 8% pa.

B) GBP depreciates in 1 year’s time.
C) 1 year forward rate is GBP0.5640/US$1
D) Both GBP and US$ appreciates in 1 year’s time
E) 1 year forward rate is US$1.5724/GBP1

Solution: C

Spot exchange rate: US$1.6728/GBP1

Int (US) – Int (Britain) = 6% = Inflation (US) – Inflation (Britain)

= Change in Exchange rate/Spot Exchange rate
Change in Exchange rate = 6% x US$1.6728 = US$0.1004
New Exchange rate = US$1.6728 + US$0.1004 = US$1.7732/GBP1
= GBP0.5640/US$1

GBP appreciates, US$ depreciates.

Question 18

You have recently invested in a bond maturing in 6 years, during when it will pay $10,000. Annual
coupons are paid at 8% pa and the bond is priced to yield 10% pa. What is the duration?

A) 3.22 years
B) 3.95 years
C) 4.08 years
D) 4.94 years
E) 5.85 years

Solution: D

Cashflow No. Time Cashflow Amt PVCF PVCF x t

1 1.0 800 727.27 727.27
2 2.0 800 661.16 1,322.32
3 3.0 800 601.05 1,803.15
4 4.0 800 546.41 2,185.64
5 5.0 800 496.74 2,483.7
6 6.0 10,800 6,096.32 36,577.92
Total = 9,128.95 Total = 45,100

Duration = 45,100 / 9,128.95 = 4.94 years

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Question 19

Which of the following is false?

A) The beta of a security or portfolio is an index of the systematic risk.

B) It is best to hold a portfolio with an infinite number of stocks because the riskiness of a
portfolio declines as the number of stocks increases.
C) Diversification reduces risk, but it does not eliminate risk.
D) A law suit in one firm is an example of unsystematic risk.
E) The systematic risk of a portfolio is the market value-weighted average of the
systematic risk of the individual securities.

Solution: B

Although the riskiness of a portfolio declines as the number of stocks increases, too many stocks
is not good because it is difficult to monitor their performance.

The rest are true because:

A) The beta of a security or portfolio is an index of the systematic risk.
It is a measure of how sensitive the security’s return is to changes in the market level.
C) Diversification reduces risk (firm-specific risk), but it does not eliminate (systematic) risk.
D) A law suit in one firm is an example of unsystematic (firm-specific) risk.

Question 20

Mr Tanaka Yukimoto plans to invest in either Japanese or British deposits. Assume British
deposits pay 13% pa and spot exchange rate is JPY206.21/GBP1. 3 months forward rate is
JPY200.00/GBP1. If we assume interest rate parity holds and his investment horizon is 3 months,
how much should the Japanese deposits be paying?

A) 0.56% pa
B) 0.98% pa
C) 1.89% pa
D) 2.66% pa
E) 3% pa

Solution: A

Return on Japanese investment = Return on GBP (foreign) investment

1+IJPY = (1/Spot ex. Rate) x (1+IGBP) x (Forward ex. Rate)
1+IJPY = (1/206.21) x (1+3.25%) x (200) = 1.0014

IJPY = 0.14% for 3 months

IJPY = 0.56% for 1 year

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SECTION 2: Short Answer Qns

Please write your answers in the answer booklets provided. (5 marks each)

Question 1

Elaborate on the different classifications of financial markets.

Solution

1. Primary & Secondary

Primary
• Where new issues are sold
• Public offering /
Pte Placement

Secondary
• Where securities which have been issued can be resold
• Brokers & Dealers
• Exchanges & Over The Counter (OTC) markets
• Stock Exchange of Singapore

2. Money & Capital

Money
• Where ST debt instruments are traded
• ST debt: maturity < 1 year
• Smaller price fluctuations than LT securities
• Banks use money markets to earn interest on surplus funds which they hold only
temporarily.

Capital
• Where LT debt & Equity are traded
• LT debt: maturity ≥ 1 year
• Major players: Large Corps & Govts

3. Debt & Equity

Debt
• A contractual agreement by Borrower to pay Lender fixed amounts periodically until
maturity when final payment is made.
• Maturity: ST, MT, LT

Equity
• Claims to share in a co.’s income & assets
• Periodic payments: dividends
• Maturity: LT (no maturity)
• Claims are subordinated

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Question 2

a) What is a convertible bond?

Solution:

A bond, which under specified terms and conditions can be exchanged for common stock at the
option of the holder. Conversion of such bonds does not bring in additional funds (debt is simply
replaced by common stock on the balance sheet).

b) A 20 year convertible bond has the following terms:

Periodic Coupon $35

Coupon rate 7% pa
Quality Rating Baa
Current stock price $35
Conversion Price $50
Par value $1,000
The bonds would be non-callable for 5 years.

Additional Market information

5-year Risk-free rate 11% pa
10-year Baa non-convertible bond rate 13% pa
10-year Risk-free rate 9% pa
20-year Baa non-convertible bond rate 12% pa
20-year Risk-free rate 8% pa

Calculate the floor value of the convertible bond at time 0.

Solution:

Step 1:

Periodic Coupon payment = $35 = 3.5% x Par value

Par value = $1,000
Straight bond value = $35 (PVIFA 6%, 40) + $1,000 (PVIF 6%, 40)
= $623.84

Step 2:

Conversion value at time 0 = CR x prevailing stock price

= $1,000/$50 x $35
= $700

Step 3:

Floor value of bond = higher of (straight bond value, conversion value)

= $700

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Question 3

a) By way of graphs, show how is the Security Market Line different from the Characteristic Line.

Solution:

Refer to Lecture 5.
Must explain that the slope of CL is Beta, but the x-axis of SML is Beta.

b) Assume the following information:

Risk-free rate: 10% pa

Return on market portfolio (kM): 14% pa
Beta of ABC stock: 1.4
Required return on ABC stock: kA

Suppose kM decreases by 200bp and the slope of the Security Market Line remains constant,
how will this affect kA? (bp = basis points)

Solution:

Before change in kM
SML: ki = kRF + (kM – kRF) bi
kA = 10% + (14% - 10%) 1.4 = 15.6%

After change in kM
SML: ki = kRF + (kM – kRF) bi
kA = 8% + (12% - 8%) 1.4 = 13.6%

kA will decrease by 2% to 13.6%.

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Question 4

A 3 year par value bond pays 16% pa coupons every 3 months. Its face value is $10,000. If yields
increase by 5% pa, use both the Duration model and the bond valuation model to calculate the
change in bond price. Explain why there is a difference in using the 2 models.

Solution:

Cashflow No. Time Cashflow Amt PVCF PVCF x t

1 0.25 400 384.62 96.16
2 0.50 400 369.82 184.91
3 0.75 400 355.60 266.70
4 1.00 400 341.92 341.92
5 1.25 400 328.77 410.96
6 1.50 400 316.13 474.20
7 1.75 400 303.97 531.95
8 2.00 400 292.28 584.56
9 2.25 400 281.03 632.32
10 2.50 400 270.23 675.58
11 2.75 400 259.83 714.53
12 3.00 10,400 6,495.81 19,487.43
Total = 10,000 Total = 24,401.22

For bonds selling at par, YTM = Coupon rate = 4% quarterly

Duration = 24,401.22 / 10,000 = 2.44 years

When interest rate increases by 5% pa: new YTM = 21% pa

(1) Using Duration model

Change in Price/Initial Price = -2.44 [(Change in R) / (1+R)]

= -2.44 (0.05/1.04) = -11.73%
New Price = $10,000 x (100% - 11.73%)
= $8,827

(2) Using Bond Valuation model

Old price = $400 (PVIFA4%,12) + $10,000 (PVIF4%,12) = $10,000

New price = $400 (PVIFA5.25%,12) + $10,000 (PVIF5.25%,12) = $8,907.55

Difference in using 2 models = $8,907.55 - $8,827= $80.55

Duration model overpredicts the fall in price by $80.55.

Why 2 models produce different answers?

Duration model is a good prediction of the actual price changes only for small changes in interest
rates. Duration is a tangent to the actual Price/rates curve.

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Question 5

a) Explain Foreign exchange risk and how it is managed.

Solution:

 Risk that exchange rates will move unfavourably

 Risk that the value of the foreign currency will change relative to the domestic currency
 Risk that the changes in the exchange rates will affect the assets & liabilities of a
company
 Risk that the exchange rates will affect the cashflows & ultimately the profitability &
returns of a company

Managed through Hedging either (i) On Balance sheet (ii) Off Balance sheet.

b)

On Nov 18, 2005, you invested in a Yen denominated CD of equivalent US$12mil at JPYUSD:
0.0075/80, yielding 15% pa. What is your US$ gain from the investment today, May 18, 2007?

Table: Exchange Rates on May 18, 2007

Rate A Rate B
EURUSD 1.0980 1.0990
USDJPY 122.10 122.25
GBPUSD 1.6723 1.6733
USDSGD 1.3960 1.3970

Solution:

Step 1

Convert US$8mil to Yen (Sell US$, buy Yen) = US$12mil / US$0.0080/JPY1 = JPY1,500mil

Step 2

Earn interest of 15% pa, 18 months earn = 22.5%.

P+I = JPY1,500mil (1.225) = JPY1,837.5mil

Step 3

On May 18, 2007, Convert Yen back to US$

(sell Yen, buy US$ at USDJPY ask rate 122.25)
= JPY1,837.5mil / JPY122.25 per US$1 = US$15.03mil

Gain = US$15.03mil – US$12mil = US$3.03mil

- End -

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