Assignment- Financial Markets (APC 313) – January 2015.

Q1. (a) Explain what you understand by each of the following terms. In each case give an example relating to the financial markets to illustrate your answer.
• asymmetric information
• moral hazard
• quantitative easing (QE)
Asymmetric information
– Please refer to page 196 of chapter 9. Define and explain the term “asymmetric information” related to financial market. Let say, relationghip between supplier and end-users of capital. ….
– The connection between asymmetric information and market faiure lines with risk. Please clarify this issue.
– Take examples from financial market supporting for above explainations

Moral hazard
Definition and explaination come from page 197 of chapter 9. Please clarify some main points:
– Moral hazrd refers to the situation whereby end-users obtain and use fund in different way or risker than expectation of lenders.
– Moral hazard is a very troublesome issue for regulators.
– Take example from financial market.
Quantitative easing
– Please refer to handout slides for definition, objective of QE, how does it work, ….
– Take examples.
(b) With close reference to your answer in part (a) above, discuss why there is a need to regulate financial markets.
– Please refer to page 7 & 8 of chapter 1 and 201 of chapter 9 to explain that regulation is the best way to protect participants of financial market.
– Please refer to page 8 of chapter 1 to explain that regulation is also understand the tool to achieve of financial stability of financial system because of contagion of dominic effect in financial market.
– Other reason should be supposed…..
Q.2 Distinguish between the spot and the forward foreign exchange rates. How are these rates related and determined in the foreign exchange markets ?
Spot rate
– refer to page 127 of chapter 6 for definition and explaination
Forward rate
– refer to page 128&129 of chapter 6 for difinition and explaination
– refer to page 129&130 of chapter 6
– exchange rate risk in attached file
– Others…
How these rate related and determined ….
– Please refer to chapter 7: page 146 – 150

Q3(a) Explain the operations and activities of the London Stock Exchange (LSE) market.
– page 86-89 of chapter 4
– …
(b) With close reference to the relevant theoretical and the empirical literature and your own financial data analysis critically assess the efficiency of this stock exchange market.
– Theory of EMH
– Literature review of EMH research in LSE
– Collecting share price of some stock listed in LSE: explain how information are affected on share price. Please refer to page 68-71 of chapter 4, understanding share price date to know how to explain
(c) How might recent upward surges in the FTSE 100 share price index be explained?
– Reference: part 4.3 The pricing of company shares page 72 – 77

Q (4) (a) Explain the operation and activities of the Money Market. Why is there a need for such a market?
Basic concepts & definition
• The term money market is a bit confusing , because money or currencies are not actually traded in Money Markets.
• Securities (eg treasury bills, government bonds) that are traded, are short –term and highly liquid , that is, they are close to being like money and can easily being converted into money.
• The Money Markets can therefore be characterised as having securities that trade in one year or less , are of large denomination and are very liquid.
• Note that Money market transaction are not taking place in any one particular locations/building- they are normally done electronically from various locations
• Money Markets securities have three basic characteristics in common:
• They are usually bought and sold in large volumes- usually in excess of $1million or frequently about $100 million (wholesale markets)
• They have low default risk and therefore low interest rates.
• They mature in less than a year- usually in less than 120 days.
The purpose of Money market
• Money Market provides a means to invest(warehouse) funds and to borrow large sums over a short period of time, at slightly better interest rates compared to banks, but without losing liquidity and fear of default. The only condition is that the transactions have to be large. This in turn limits the number of key participants in this markets to only a few .
Key players
• Governments/Central Banks- For example US Treasury, Bank of England- Sell Treasury/Government bills to fund national debts- Also buy /sell to control money supply.
• Large Businesses- Buy and sell securities( T-Bills) to manage finance/cash.
• Commercial Banks-Buy/sell (T-Bills) for their operations and for clients.
• Investment companies(brokerage firms)-trade on behalf of clients (normally lend)
• Finance companies- buy/sell to lend money to individuals ( normally borrow)
• Insurance companies-Maintain liquidity needed to meet unexpected demand.
• Pension funds- Maintain funds to buy stock/shares .
• Individuals – Via Money Markets Mutual funds.
The primary and secondary of money market
The need for and the purpose of The Money Market
• The Money Market essentially complement the banking industry. They exists because they can provide cost advantage over the banking industry.
• The banking industry primary exists so that savers-lenders could lend to borrowers- spenders. Banks earn profits by capturing economies of scale while providing this service.
• Cost advantage: Banks must put aside a portion of their deposits ( usually between 3-10% )in the form of reserves that are held without interest at the central banks (reserve ratio) . This means that it must pay a lower interest to the depositors compared to having the full deposit to lend.
• Also due to lack of competition in the banking industry ,interest rates are not normally subject to variations .
The Key function of Money Markets
• The key function of the money markets is the provision of a framework for the conduct
of monetary policy by the central banks/ bank
of England.
• Monetary policy normally consists of setting interest rate by the central bank in order to control inflation rate via reduction in demand; also setting interest rate in order to stimulate demand and employment.

(b) Explain how a central bank might use the Money Market to conduct monetary policy in order to target the rate of inflation.
Monetary policy
• Monetary policy Instrument – Policy rate of interest- determined in the UK by the Monetary Policy Committee on a monthly basis – they set the policy rate of interest to control the rate of inflation- Monetary policy Target. (Inflation Targeting).
• Mechanism: Changes in the policy rate are transmitted quickly to all other rates of return and quickly changes the short –term rates of interests for borrowing and lending and therefore ultimately influencing level of aggregate demand and rate of inflation in the economy.
Example: Conduct of Monetary policy in Practice via London Inter-Bank Offer Rate (LIBOR)
• Key players :
1. Central Bank/Bank of England (MPC) determines the Policy rate of interest.
2. Commercial Banks operate on the basis of fractional reserve ratio and must maintain these ratios(3-10% of liabilities/deposits) with the Central bank/BOE at all times.
IF there is a shortage in their ratio . They can borrow either
(a) from the BOE at MPC+ 1%
(b) from other commercial bank at the London Inter-Bank Offer Rate (LIBOR).
If they have surplus in the reserve, they can leave it in the BOE getting MPC-1% , or deposit it with other banks at LIBOR.
• Changes in MPC rate influences the demand and supply of interbank transactions, this in turn changes the LIBOR and return on all other instruments via arbitrage activities leading to a change in the short-run rates of interest in the market, which is the target of the central bank in this monetary policy operation.
• A rise in the Policy rate
• Suppose Central bank/BOE raises the Policy rate to reduce the inflationary pressures.
• This rise in policy rate will quickly rises the LIBOR via interbank transactions-
• The rise in the LIBOR will quickly increase the interest rates offered by the commercial banks/building societies in the market.
• The rise in the market rates of interest will reduce demand for loans /borrowing leading to fall in consumers’ spending and ultimately to fall in the rate of inflation.
Here is the way to explain how money market is used to conduct monetary policy to achieve target of inflation. BUT PLEASE DON’T COPY IN YOUR ASSIGNMENT

Guidance and Preparation Note:

1.Each question should be answered with reference to the key published academic literature and relevant financial data and evidence. Each part , excluding Q .3 (b) requires a focused answer within 500-600 word limit.

2.For Q.3(b) you need to review carefully key academic literature and published supporting empirical evidence , combine theory with evidence and your own financial data analysis ( including data on the traded share prices within the framework of the LSE market), to arrive at a conclusion. Normally this process can be done within a 1500 word limit plus an appropriate data appendix if required.

Assessment Criteria

1.Evidence of background reading and relevance of the material to the question posed.

2.Appropriate use of Harvard referencing system .

3.Depth of analysis based on relevant academic literature and empirical evidence.

4. Appropriate conclusion based on relevant analysis and
empirical evidence/ financial data provided.

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