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UNIVERSITY OF BOTSWANA

DEPARTMENT OF ECONOMICS

ECO 473 2009-10 ACADEMIC YEAR

TUTORIAL SET 1

1. Why is it important to understand how global financial system operates? In


what ways is the financial system linked to the economy as a whole?

2. What are the principal functions of the global financial system? How do the
financial markets fulfill those functions?

3. Distinguish between:
a. money market and capital markets
b. open and negotiated markets
c. primary and secondary markets
d. spot, forward and futures markets
e. perfect and efficient markets

4. What is asymmetric information?

5. Classify the following transactions as to where they fit in question 3 above.


a. You visit a local bank and secure a 3-year loan to finance the purchase
of a new car
b. You buy a new P10 000 Bank of Botswana bond for delivery today
c. Concerned about recent trends in the price of Rand, you contact a
large money center bank in the region and purchase R10 000 at
today’s Pula/Rand exchange rate for delivery in 6 months, when you
plan to fly to Pretoria.

6. Define the following:


f. Risk, probability distribution
g. Expected rate of return
h. Standard deviation, variance, coefficient of variation
i. Risk aversion
j. Risk premium for stock k, market risk premium
k. Correlation, correlation coefficient
l. Market risk, diversifiable risk, relevant risk

7. Which is the riskier claim, equity or debt, issued by a company? What are the
implications for required rate of return on the 2 types of claims?

8. Explain the difference between maturity transformation and risk


transformation.
9. What is meant by the term ‘liquidity’ when applied to financial markets?

10. What is the difference between ‘life insurance’ and ‘general insurance’?

11. What is the difference between an investment trust and a mutual trust?

12. Briefly explain the main roles played by venture capitalists in the financial
system.

13. Outline four types of risk that commercial banks face

14. Explain some of the advantages to an employee of joining a company


pension scheme, over investing in the stock-market directly.

15. Suppose 2 assets A and B. RA=20%, RB=10%, σA = 80%, σB = 30%,

WA WB ρAB=0.5 ρAB=0 ρAB=-0.5 Return


1 0
0.8 0.2
0.6 0.4
0.4 0.6
0.2 0.8
0 1

16. You have the following 6 years of data covering share A and the market
portfolio:

Year Share A Market portfolio Weighted yearly


return
2000 7% 9%
2001 4% 2%
2002 6% 15%
2003 1% 5%
2004 -3% -4%
2005 4% 15%

i. Calculate the yearly returns of a portfolio created by allocating your money


30% in share A and 70% in the market portfolio
ii. Calculate the expected return and standard deviation of stock A
iii. Calculate the expected return and standard deviation (use population N)
of the market.
iv. Calculate the expected return and standard deviation (use population N)
of a portfolio made up of 30% investment in share A and 70% in the
market.
PART 2

17. A market portfolio is made up entirely of the following 4 securities:


Total Standard Correlation matrix
value deviation
A B C D
Security P100 20% A 1 0 0 0
A
Security P40 30% B 0 1 0 0
B
Security P60 40% C 0 0 1 0
C
Security P80 50% D 0 0 0 1
D

(i) Calculate the standard deviation of the market portfolio.


(ii) If the risk-free rate of interest is 5% and the expected rate of return on the
market portfolio is 12%, draw a diagram to depict the relevant capital
market line.

8. Security A has an expected return of 7 %, a standard deviation of 35 %, a


correlation coefficient with the market of -0.3, and a beta coefficient of -1.5.
Security B has an expected return of 12 %, a standard deviation of returns of 10
%, a correlation with the market of 0.7 and a beta coefficient of 1.0. Which
security is riskier? Why?

8. Stocks A and B have following historical returns:

Year Stock A Returns Stock B’s Returns

1997 10 % 3%
1998 18.5 21.29
1999 38.67 44.25
2000 14.33 3.67
2001 33 28.3

a. Calculate the average rate of return for each stock during the period
1997 through 2001. Assume that someone held a portfolio consisting
of 50% of stock A and 50% of stock B. What would have been the
realized rate of return on the portfolio in each year from 1997 through
2001? What would have been the average return on the portfolio
during this period?
b. Calculate the standard deviation of returns for each stock and for the
portfolio.

9. If a firm sells securities for cash to investors through an investment banker,


that transaction is classified in what market?

10. If a risky asset trades at a higher price than a riskless asset, then

A. the risky assets must offer investors higher future cash flows than
the riskless asset
B. the risky asset must offer investors lower future cash flows than the
riskless asset
C. the risky asset must have a discount rate that is lower than the
riskless asset
D. none of the above
11. What is the main characteristic of a well-diversified portfolio?

12. A financial adviser claims that a particular stock earned a total return of 10%
last year. During the year, the stock price rose from P30 to P32.50. What
dividend did the stock pay?

13. What is the purpose of financial markets?

14. One difference between a forward exchange contract and a futures contract
in foreign exchange is:

15. The standard deviation of an asset’s return is a measure of what?

16. The difference between the expected return on the market and the risk free
rate is called____________

17. Explain the principles underlying the Markowitz diversification of portfolios of


securities. (12 marks)

18. You are planning to invest P300 000 in either security A or B or both.
Following probability distributions are applicable:

SECURITY A SECURITY B
Probability A Return A Probability B Return B
0.1 -10% 0.1 -30%
0.2 5 0.2 0
0.4 15 0.4 20
0.2 25 0.2 40
0.1 40 0.1 70

A. Calculate expected return and risk for securities A and B.


B. What weight gives the minimum risk portfolio?
C. Will introduction of risk free return of 10% change your portfolio? If so
how?

19. Market portfolio is made of 4 securities

Total Std Correlatio


value Deviation n Matrix
A B C D
A P100 20% A 1 0 0 0
B 40 30 B 0 1 0 0
C 60 40 C 0 0 1 0
D 80 50 D 0 0 0 1

(i) Calculate standard deviation of market portfolio.


(ii) If the risk free rate is 5% and expected rate of return is 12%, draw the
capital market line.