Review Questions Flashcards
Define the financial system.
The financial system consists of the financial markets, financial intermediaries and other financial institutions that execute financial decisions of households, firms/businesses, and governments.
What are the 4 elements of the financial system.
The 4 elements of the financial system are:
- Lenders and borrowers
- Financial institutions
- Financial instruments
- Financial markets
Name the categories that lenders and borrowers can be grouped into.
Lenders and borrowers can be categorised into:
- Household sector
- Business or corporate
- Government sector
- Foreign sector
Differentiate between direct and indirect financing
In direct financing process, funds are raised directly by borrower from lenders usually through a financial market broker.
In indirect financing, funds are raised from lenders by financial intermediaries and then lent to borrowers
Describe how pension funds expedite the flow of funds from lenders to borrowers
Pension funds expedite the flow of funds from lenders to borrowers by receiving contractual savings from households and re-investing the funds in shares and other securities such as bonds
Describe how banks expedite the flow of funds from lenders to borrowers
Banks expedite the flow of funds from lender to borrowers by accepting deposits from lenders and on-lending the funds to borrowers
List 3 marketable primary securities and 3 non-marketable indirect securities
3 marketable primary securities: T-bills, promissory notes and debentures.
3 Non-marketable indirect securities: Savings accounts, fixed deposits, retirement annuities
Explain the difference between primary and secondary markets
The primary market is the market for the original sale or new issue of financial instruments while the secondary market is a market in which previously-issued financial instruments are resold
What are the core functions of the financial system
The core functions of the financial system are to channel savings to investments, pool savings, clear and settle payments, manage risks and provide information
What is the 1-year rate of return for a share that was bought for R100 paid no dividend during the year and had a market price of R102 at the end of the year?
2%
Explain how centrally-planned and free-market economies approach the assignment of scarce resources to the production of goods and services
In a centrally planned(command) economy, most key decisions on the assignment of scarce resources to the production of goods and services are taken by a central planning authority.
In a free-market economy firms and households interact in free markets through the price system to determine the allocation of resources to the production of goods and services.
Describe a mixed economy
A mixed economy is an economy in which the state provides some goods and services such as postal and education services with privately-owned firms providing the other goods and services
Name the leakages from and injections into the circular flow of income
Leakages:
- Savings
- Imports
- Taxes
Injections:
- Government spending
- Exports
- Investment spending
In terms of which objectives is the performance of an economy judged?
High-rate of non-inflationary economic growth. High and steady level of employment. Stable general price level. Stable balance of payments and equitable distribution of income.
Define fiscal policy
It is the policy the use of government spending and taxation policies to influence the overall level of economic activity
What is a business cycle and name its 4 phases?
The business cycles are recurring intervals of economic expansion followed by times of recession. The 4 phases are:
- Expansion
- Upper turning point
- Contraction
- Lower turning point
Outline the behaviour of production capacity during the 4 phases of the business cycle
At the lower turning point there is idle production capacity.
During the expansion phase the idle capacity is absorbed and a need arises for additional production capacity.
At the upper turning point production capacity is fully utilised
Describe the likely impact of high GDP growth on interest rates
If the economy is close to full capacity, high GDP growth could be inflationary. In this case, high GDP growth will lead to rising interest rates as market participants expect the central banks to raise interest rates to curb higher inflation
Define the globalisation of financial markets
Globalisation of financial markets refers to the increasing integration of financial markets around the world
An investor deposits R1500 today and R1500 one year from today into a deposit account. The deposits earn 10% compounded annually. What will the total amount in the deposit account be two years from today?
R3465
An investor decides to spend an inheritance of R100000 on an overseas trip rather than invest it at 10% p.a. What is the opportunity cost of this course of action?
10% p.a. i.e., the value the investor foregoes by choosing to spend the money on an overseas trip
What is a yield curve?
A yield curve plots yields against the term to maturity of similar quality bonds.
If short-term rates are higher than long-term rates, the yield curve is ….
Inverse
What impact will a restrictive monetary policy have on the yield curve?
Restrictive monetary policies drive short-term interest rates higher than long-term rates.
Which theory states that the shape of the yield curve reflects the market’s current expectations of future short-term rates?
The expectations theory
An investor is setting up a charitable trust for victims of natural disasters. The trust must provide 6 annual payments of R20 000. The 1st payment is to be made today. How much money must the investor invest today at 10%p.a compounded annually to meet the required obligations?
R95815.74
An investor has an opportunity to invest in a property development. The investor’s required rate of return is 12%. The net present value of the investment is -R26341. Will the investor accept the investment?
The investor will not accept the investment
An investor has an opportunity to invest in a private equity investment. The investor’s required rate of return is 1%. The estimated internal return of the private equity investment is 24%. Will the investor accept the investment?
The investor will accept the investment
What is the difference between a population and a sample?
A sample is a subset or pat of a population. A population is the entirety of objects of a specified group.
What is the mean annual rate of return for a share having the following annual rates of return?
2009 : 12%
2008: 4%
2007: -10%
2006: 30%
9%
What is the annual rates of return?
2009 : 12%
2008: 4%
2007: -10%
2006: 30%
40%
What is the MAD of the annual rates of return?
2009 : 12%
2008: 4%
2007: -10%
2006: 30%
12%
What is the standard deviation of the sample of annual rates of return?
2009 : 12%
2008: 4%
2007: -10%
2006: 30%
16.69%
What is the standard deviation of the population of annual rates of return?
2009 : 12%
2008: 4%
2007: -10%
2006: 30%
14.46%
True or False. A normal distribution is skewed.
False
True or false. If the distribution of an investment’s returns has a positive skew, it has many small losses and few substantial gains.
True
True or False. The positive correlation coefficient between the change in the share price of an industrial
bakery and the wheat price is 0.82. So a change in the wheat price causes an 82% change in the
share price.
False
Define the foreign exchange market
The foreign exchange market is the financial market where currencies are bought and sold.
What is a foreign exchange rate
The foreign exchange rate is the price of one currency in terms of another currency.
What are 2 important roles of the foreign exchange market?
1) Facilitating international trade
2) Facilitating financial transactions
Name the primary vehicle currency.
USD
Describe the 2 spot exchange rates for a currency
Bid rate - the rate at which one currency can be purchased in exchange for another
Offer rate - the rate at which one currency can be sold in exchange for another
Assume a South African importer wants to buy dollars from a bank and the bank quotes the following rates R10.5230 - R10.5280. Which of the 2 rates apply
R10.5280
Assume a South African exporter wants to sell dollars to a bank and the bank quotes the following rates R10.5230 - R10.5280. Which of the 2 rates apply
R10.523
If the US dollar / rand is R10.4340 - R10.4350. and the 3-month forward premium is 601-611 points. what is the forward rate?
10.4941 - 10.4961
What is a foreign exchange swap transaction?
It is the simultaneous exchange of 2 currencies on a specific date at a rate agreed at the time of the contract and a reverse exchange of the same 2 currencies at a date further in the future.
How do commercial banks participate in the foreign exchange market?
1) Offer to buy and sell foreign exchange on behalf of their customers
2) Trade in foreign exchange as intermediaries and market makers
What is the most common maturity of money market transactions?
3 months
Differentiate between the primary and secondary money market
The primary money market is the market for the issue of new money market instruments.
The secondary market is the market in which previously issued money market instruments are traded.
Define a Bankers’ Acceptance
It is a bill of exchange drawn on and accepted by a bank
What is the quality of a bankers’ acceptance?
High quality since the accepting bank and the drawer are obligated to pay the holder on maturity (How likely the bank is to pay at maturity)
What is the disadvantage of investing in promissory notes?
Credit risk
What are the advantages of investing in NCDs?
There is an active secondary market. Thus liquidity. Maturities can be tailored.
Name 2 money market instruments issued by banks.
NCDs and call bonds
Why would corporations rather use promissory notes than bank overdrafts to access funding?
Promissory notes are cheaper to issue than using a bank overdraft
Why would pension funds invest in treasury bills?
Because they are considered risk free. And there exists a liquid secondary market
Describe the uses of repurchase agreements.
RAs are used by large companies including banks to borrow short-term funds. They are also used between central banks and banks as part of the central banks’ open-market operations.
What is the capital market?
The capital market is the market in which businesses and governments raise long-term funds to finance capital investments and expansion projects. The capital market includes the bond and long-term debt market as well as the equity market.
Describe the secondary market in bonds and long-term debt
The secondary market is the market in which previously issued bond and long-term debt instruments are traded.
What is a bond?
It is an fixed-interest bearing security sold by the issuer promising the investor interest at future dates and the nominal value at maturity
What is the marketability of floating rate notes?
Certain issues of floating rate notes have an active secondary market.
Describe the credit risk inherent in bonds.
The quality of a bond depends on its issuer. Government bonds are essentially risk-free within a country as they constitute evidence of debt of the government. Semi-gilt stock may have a degree of credit risk.
List 5 types of debentures
Debentures can be secured, redeemable, convertible, callable and profit-sharing
What is the maturity of debentures?
5 - 30 years
When investing in bonds, do investors have an opportunity for capital gains in times of falling or rising interest rates
In times of falling interest rates.
Name the issuers of and investors in debentures.
Issuers: corporations. Investors: institutional investors (insurance companies, hedge, mutual and pension funds)
When would the issuing of a debenture be unattractive to an issuer?
It may be unattractive to an issuer if the terms and conditions restrained the freedom of the management of the company in their operations
What does equity represent?
A residual claim against the assets of a company after obligations to creditors and bondholders have been met.
Discuss the 2 types of new share issues
SPOs - For companies that already have publicly traded shares
IPOs - For companies wishing to sell shares to the public for the 1st time
Describe the secondary equity market
It is where previously issued shares are bought and sold. It can either be stock exchanges or OTC markets
Define dematerialisation.
It is the dispensing of paper-based instruments and certificates by replacing them with an electronic record of ownership of securities
List the most important characteristics of ordinary shares
They represent perpetual claim, residual claim, pre-emptive rights, and have limited liability
List 6 types of equity investors
Individual investors, companies, asset or investment management firms, insurance companies, pension funds and mutual funds
Explain the statement “ Preference shares are hybrid securities in that they have features of ordinary shares and debt “
Like debt, preference shares pay their holder a fixed amount per year, have no voting rights and in event of non-payment of dividends may have a cumulative dividend feature that requires all dividends to be paid before any payment to common shareholders. Like ordinary shares, preference shares are perpetual claims and subordinate to bonds in terms of seniority.
Name 5 types of preference shares
Cumulative, non-cumulative, participating, convertible and redeemable preference shares
Define a depository receipt
It is a type of negotiable financial security traded on a local stock exchange, representing a security, usually in the form of equity that is issued by a foreign public listed company. Depository Receipts allow investors to hold shares in equity of other countries
What do the returns to ordinary shareholders consist of?
It consists of dividends and capital gains
What is the difference between real assets and financial assets?
A real asset is a tangible asset that has intrinsic value while a financial asset is an ownership claim on a real asset.
Name 2 physical commodities.
Gold and coffee
In which commodities market are commodities transactions tailor-made to meet the needs of participants?
In OTC markets
True or False. The majority of trading on commodities exchanges is physical commodities trading?
False. Majority of trading on commodities exchanges is in derivatives
What are the differences between commodities and financial assets such as bonds and equity?
Commodities are investable assets not capital assets.
Commodities dont generate dividends, interest payments or other income
Commodities are valued because they can be consumed or changed into something else. Their value is determined by supply and demand.
List 6 ways of investing in commodities
Directly, shares of commodity producers, commodity futures, commodity index funds, ETF and ETNs
What is a spot commodity contract?
It is a contract for the immediate delivery of the commodity to the seller by the buyer.
Differentiate between producers and consumers of commodities
Producers make, grow and supply the commodities for sale while consumers buy and use commodities
True or false. Spot market traders connect producers and consumers. They will sometimes buy commodities to clear the market.
True
Name 3 types of investors in commodities
Institutional investors, private investors and retail investors
What is a derivative?
It is a financial instrument that derives its value from the value of another underlying variable
Name and describe 2 organisations in SA that make up the organised derivatives market.
The exchange: The 4 JSE derivatives markets
The CCP processes all the trades executed on the exchange.
What are the 2 opposing forces that influence the design of derivatives contract by derivatives exchanges?
Standardisation and market depth and liquidity
Differentiate between forward and futures contracts
Futures are traded on exchanges. Forwards are traded OTC
Futures contracts are based on a standard quality/quantity. Forwards are custom made
Futures contracts performance is guaranteed by CCP. Forwards have default risk
Define an option contract and describe its characteristics.
An option contract gives the right to buy or sell a specific quantity of an underlying asset or derivative at a specific price at/before a known date in the future
What is a swap?
A contractual agreement by which 2 parties agree to swap a series of cash flows at specific intervals over a certain period of time.
What is the primary use of currency swaps?
To hedge against exchange rate risk
Define credit derivatives
They are instruments that derive their value from the credit quality of an obligation such as a loan or bond of a reference entity.
What does the value of insurance derivatives depend on?
It depends on expectations of the amount of catastrophic losses from events such as hurricanes and earthquakes
Name the participants in the derivatives market
Hedgers
Speculators
Arbitrageurs
Investors
What is a collective investment scheme?
It is a generic term for any scheme where funds from various investors are pooled for investment purposes with each investor entitled to a proportional share of the net benefits of ownership of the underlying assets
True or false. There are no disadvantages of holding cash in notes and coins.
False. No real interest is earned, and value will be eroded by inflation. Secondly cash may attract criminals
What factors should an investor consider when choosing a bank deposit account?
Interest rate, term to maturity, period of notice and risk of bank default
True or false. An investor may invest R10 million in a retail saving bond
False, retail bonds have a max limit of R5 million
Name 3 classifications of life policies
Term insurance, whole-life insurance and endowment policies
What is immediate annuity?
In return for a single premium, it provides an annual payment starting immediately and continuing for the rest of the annuitant’s life
Name 4 types of annuities.
CPA, VPA, living annuity and composite annuity
What is a retirement fund?
It is an independent non-profit legal entity that collects, invests and administers funds contributed to them by individuals and companies in order to finance retirement plan benefits
Name 3 types of retirement funds.
Government pension schemes, personal retirement funds, occupational retirement funds
Why in general do investors invest in private equity
Investors invest in private equity because the risk-adjusted return on private equity is expected to be higher than that on other investments and there are potential diversification benefits.
Name and describe 2 distinct sources of risk as classified by the single-index model.
- Systematic risk: Cannot be eliminated by diversification
- Unsystematic risk: Can be diversified away
True or false. Sharpe asserted that in an efficient market, investors are only compensated for bearing systematic risk as it cannot be diversified away
True
Describe the ways in which superior portfolio can be achieved with the single-index model.
1) Forecast market accurately and adjust the beta of the portfolio accordingly
2) Achieve a positive alpha or excess return
List the assumptions underlying the capital asset pricing model (CAPM)
- Investors have homogeneous expectations
- Investors have identical time horizons
- Perfect competition exists
- Investors are able to lend or borrow unlimited funds at the risk-free market interest rate
- Assets are infinitely divisible
- All investors attempt to hold Markowitz-efficient portfolios
List the 2 important differences between the capital market line and the security market line
Capital market line: measures risk by standard deviation of the investment
Security market line: considers only systematic component of an investment
Calculate the required rate of return on a share, given:
- Share beta = 2.1
- The current treasury bill rate is 7.2%
- The return on the market is 12.5%
18.33%
Calculate the required rate of return on a share, given:
- Share beta = 1.4
- The current treasury bill rate is 7.7%
- The risk premium is 10.9%
18.6%
Share A with a beta of 1.5 is currently priced at R46. A year ago the share was trading at R40. The market rate was 12% in the past year and the risk free rate at 6.0%. Is the share priced correctly?
Yes
What is the major difference between a multi-factor model and the CAPM?
Multi-factor models specify several risk factors to explain expected return
CAPM specifies one (beta or variance)
Briefly describe the arbitrage pricing theory.
It starts with a multi-factor model in that it suggests that there are a number of systematic influences on the long-term average return on shares
What is portfolio management?
It is the process of putting together and maintaining the proper set of assets to meet the objectives of the investor given any restrictions imposed
Name the steps in the portfolio management process
1) Plan portfolio
2) Develop and implement
3) Monitor
4) Adjust
Why is it important to have a portfolio perspective of an investor’s asset holdings?
When added to a portfolio of assets, the risk of an individual asset may be diversified away.
To appeciate the risk and return prospects of an investor’s total position.
What is an investor’s risk objective a function of?
It is a function of both the investor’s ability and willingness to assume risk
Why is it important to draw up an investment portfolio statement for an investor?
- Investors are better able to recognise the appropriateness of any investment strategy
- It ensures investment continuity because it is portable
- It is a document of understanding that protects both the investor and investment manager
Briefly describe the phase of the portfolio management process that aims to construct a portfolio
The development and implementation of the portfolio strategy is the phase of the investment management process that aims to construct a portfolio with with appropriate asset composition that is within the guidelines of the strategic asset allocation.
Define investor constraints and preferences
Liquidity, time horizon, taxes and regulatory issues.
Name 2 portfolio strategies
Active or passive
Monitoring a portfolio has 2 components. Name these
Performance measurement and performance evaluation
What could motivate revising the portfolio once the desired portfolio has been constructed?
Changes in investor’s objectives, circumstances or change in market expectations
Name the main taxes that impact investments and securities trading
Income tax, capital gain tax, dividends tax and securities transfer tax
True or false. Income tax is payable on the amount received from the sale of securities held by an investor as investments
False. The amount received from the sale of securities held by an investor as investments is not included in income. However sale of assets held by a trader for trading will be
Name 3 statutory charges relating to trading and investing
Fees for the electronic settlement of share transactions
FSCA Investor Protection Levy
Securities Transfer Tax
Define asset management fees
Asset management fees are fees associated with the management of the assets underlying an investment
Define performance-based fees
It is fees linked to the performance of the investment. Performance fees are charged if the investment exceeds a given relevant benchmark, such as the JSE All Share Index, by a defined percentage
