U NIVERSITY

W ESTMINSTER

OF W ESTMINSTER
B USINESS S CHOOL

EXAMINATION PAPER
SEMESTER NINE
January 2012

MODULE CODE:

4FIN7E2

MODULE TITLE:

FINANCIAL MARKETS & INSTITUTIONS

DATE:
TIME:

January 11th 2012

10.00 am

INSTRUCTIONS TO CANDIDATES:
Answer THREE questions. Answer at least ONE question
from Section A and ONE question from Section B.
All questions carry equal marks.
1 mark is allocated for presentation.
All calculations, assumptions, underlying financial theory
and rough work must be done in your answer booklet.
Only silent non-programmable calculators are allowed.
Closed-book exam.

TIME ALLOWED: 3 HOURS

PLEASE DO NOT TURN OVER THIS PAGE UNTIL

INSTRUCTED TO DO SO BY THE INVIGILATOR
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Section A [Answer at least one question from this section]

Question 1. Answer all parts. Use graphs when necessary.
a) Under the expectations hypothesis, if the yield curve is upward sloping,
the market must expect an increase in short term interest rates.
True/False/Uncertain? Why?
(6 marks)
b) Under the liquidity preference theory, if inflation is expected to be falling
over the next years, long-term interest rates will be higher than short term
interest rates. True/False/Uncertain? Why?
(6 marks)
c) If the segmented markets theory causes an upward-sloping yield curve,
what does this imply? If markets are not completely segmented, should we
dismiss the segmented markets theory as even a partial explanation for
the term structure of interest rates? Explain.
(6 marks)
d) The yield to maturity of one year zero coupon bond is 2%. The yield to
maturity on two year zero coupon bond is 3%.
i)
ii)
iii)

What is the forward rate of interest for the second year?

If you believe in the expectations hypothesis, what is the best guess
as to the expected value of the short term interest rate next year?
If you believe in the liquidity preference theory, is your best guess at
to next years short term interest rate higher or lower than in (ii)?
(15 marks)
(Total: 33 marks)

Question 2. Answer all parts. Use graphs when necessary.

a) You are the treasurer of a UK manufacturing company and you plan to
borrow funds and may use the forecast of interest rates to determine
whether you should obtain a loan with a fixed interest rate or a floating
interest rate. The following information from the Bank of England (BoE)
Inflation Report can be considered when assessing the future direction of
interest rates:

Economic growth has been very low: The UK grew by 0.4% in the first
quarter of 2011 and by 0.1% in the second quarter and there are fears of
double deep recession.
The CPI inflation rate is likely to pick up to between 4% and 5% in the
near term and to remain well above the BoEs 2% target over the next
year.

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The Monetary Policy Committee (MPC) of the BoE has maintained the
Bank Rate at 0.5% and it has announced a new program of Quantitative
Easing by ejecting 75 billion to the UK economy.
The new government has followed a program of fiscal consolidation
aiming at the reduction of public debt but the continuation of this program
is uncertain.
i)

Given the above information determine how the demand and supply
of loanable funds will be affected and determine the future direction
of interest rates.
(16 marks)

ii)

You can obtain a one-year loan at a fixed-rate of 5 percent or a

floating-rate loan that is currently at 4 percent but would be revised
every month in accordance with general interest rate movements.
Which type of loan is more appropriate based on the information
provided?
(10 marks)

iii)

Assume that European Central Banks (ECBs) interest rates have

abruptly risen just as you have completed your forecast of future
U.K. interest rates. Consequently, ECBs interest rates are now 1
percentage point above U.K. interest rates. How might this specific
situation place pressure on U.K. interest rates? Considering this
situation along with the other information provided, would you
change your forecast of the future direction of U.K. interest rates?
(11 marks)
(Total: 33 marks)

Question 3. Answer all parts. Use graphs when necessary.

a) The Bank of England is facing an economy with low growth and high
unemployment rate.
i)
How can the Central Bank correct a weak economy by using open
market operations?
ii)
What is the impact of a stimulative monetary policy on expected
inflation?
(22 marks)
b) Why monetary policy may not achieve the desired effects? Discuss the
lagged effects of monetary policy.
(11 marks)
(Total: 33 marks)

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Section B [Answer at least one question from this section]

Question 4. Answer all parts.
a) Hankla Company plans to purchase either (1) zero-coupon bonds that
have ten years to maturity, a par value of $100 million, and a purchase
price of $40 million, or (2) bonds with similar default risk that have five
years to maturity, a 9 percent coupon rate, a par value of $40 million, and
a purchase price of $40 million. Hankla can invest $40 million for five
years. Assume that the markets required return in five years is forecasted
to be 11 percent. Which alternative would offer Hankla a higher expected
return (or yield) over the five-year investment horizon?
(12 marks)
b) A 10-year bond has a par value of $1,000 and a coupon rate of 5 percent.
During the first six months after the bond was issued, the inflation rate
was 4.5 percent. By how much does the principal of the bond increase?
What is the coupon payment after six months?
(5 marks)
c) The required rate of return on a bond is primarily determined by the
prevailing risk free rate and the credit risk premium on the bond. Which
are the factors that affect the risk free rate ? Discuss each one of them
separately and how they affect the required rate of return and the price of
the bond
(16 marks)
(Total: 33 marks)
Question 5. Answer all parts.
a) Describe the Capital Asset Pricing Model (CAPM) as a model used to
derive the required rate of return for stocks and its limitations.
(17 marks)
b) AT company just paid a dividend of $2.5 per share on its stock and that
the dividend will continue to grow at a rate of 3 percent per year. If the
required return on this stock is 5 percent, what is the current share price?
(8 marks)
c) IBM has a beta of 1.11.
i)
If you assume that the stock market has a maximum expected loss
of 5.2 percent on a daily basis (based on a 95 percent confidence
level), what is the maximum daily loss for the IBM stock?
ii)
If you have $50,000 invested in IBM stock, what is your maximum
daily dollar loss?
(8 marks)
(Total: 33 marks)

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Question 6. Answer all parts.

a) Open-end Fund A has 100 shares of ATT valued at $100 each and 50
shares of Toro valued at $50 each. Closed end Fund B has 75 shares of
ATT and 100 shares of Toro. Both funds have 100 shares outstanding.
i)
Determine the NAV of each fund.
ii)
Assume another 100 shares of ATT valued at $100 are added to
Fund A. Determine the NAV of the fund if the underlying share
prices remain unchanged?
iii)
If the price of ATT rises to $110 and price of TORO falls to $40, how
does this impact on the NAV of both funds. Assume Fund A only has
100 shares on ATT.
(12 marks)
b) A hedge fund charges 2 plus 30%. Investors require a return of 25%. How
much the hedge fund must earn before fees to provide investors with
these fees?
(6 marks)
c) Describe a defined benefit pension plan. Describe a defined-contribution
plan, and explain how it differs from a defined-benefit plan.
(15 marks)
(Total: 33 marks)
[End of Examination Paper]

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