FINANCIAL MARKETS AND INSTITUTIONS

(17BSP422)
January 2018 2 Hours
Answer the ALL questions in Part A and any TWO other questions from Part B.
Questions 1 to 15 should be answered by circling
the correct answer (A, B, C or D) on the exam paper.
Answers to Part B should be in the separate pink answer booklet.
You must write your answers in ink.
Answers written in pencil may receive a zero mark.
Please ensure you write your Student ID Number and
Exam Seat Number in the boxes below.

Student ID Number: Exam Seat Number:

PART A

This part of the exam is worth 30 of the total available marks.

Place a circle around the correct answer (A, B, C or D) for questions 1 to 15. Each
question is worth 2 out of the available 100 marks.

1. What portfolio reallocation is typical, as an investor gets closer to retirement?

A. From equities into bonds and from older mature firms into young start-up
firms
B. From bonds into equities and from older mature firms into young start-up
firms
C. From equities into bonds and from young start-up firms into older mature
firms CORRECT
D. From bonds into equities and from young start-up firms into older mature
firms

2. Which of the following is not always an advantage of indirect investment by a retail

investor through a mutual fund, rather than owning financial assets directly?

A. A mutual fund provides convenient diversified exposure to an asset class

B. A mutual fund avoids the higher fees of active management CORRECT
C. A mutual fund reduces the costs of collecting, taxing and reinvesting income
D. A mutual fund lowers transaction costs for retail investors

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3. Which of the following does not violate ‘semi-strong’ market efficiency?

A. Profitable insider trading, based on unpublished company information

CORRECT
B. Arbitrage trading, risk-free profit from inconsistencies in market pricing
C. High frequency trading, profiting from very short-term price movements
D. Long-run fundamental based trading, obtaining better than market returns

4. How does the ongoing tightening of US monetary policy affect emerging market
bonds?

A. Increases bond prices, increases expected returns

B. Reduces bond prices, reduces expected returns
C. Increases bond prices, reduces expected returns
D. Reduces bond prices, increases expected returns CORRECT

5. Which statement about credit spreads on corporate bonds is correct?

A. BB bond spreads are higher and rise more in recessions than AA bond
spreads CORRECT
B. BB bond spreads are lower and rise less in recessions than AA bond spreads
C. BB bond spreads are higher and rise less in recessions than AA bond
spreads
D. BB bond spreads are lower and rise more in recessions than AA bond
spreads

6. Which of these statements is true of all limited liability companies?

A. Ownership is separated from control

B. They must publish quarterly financial statements
C. The market value of their equity exceeds the book value of their equity
D. To protect creditors, they are not allowed to trade while insolvent
CORRECT

7. What best explains the high fees for an IPO book building (7% of market value)?

A. The high costs of marketing to global investors

B. A high required return because of the high risk associated with public listing
C. The costs and risk of market-making after the IPO
D. Information on how much investors are willing to pay, allows higher pricing
CORRECT

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8. Which statement is true?

A. A limit order provides liquidity to other market participants; a market order

removes uncertainty about the trading price and time needed for execution
CORRECT
B. A market order provides liquidity to other market participants; a limit order
removes uncertainty about the trading price and time needed for execution
C. A limit order provides liquidity to other market participants and removes
uncertainty about the trading price and time needed for execution
D. A market order provides liquidity to other market participants and removes
uncertainty about the trading price and time needed for execution

9. What is the common feature of equity trading venues with no public prices (dark
pools) and of inter-dealer brokers (such as the world’s largest TP-ICAP)?

A. They reduce the impact on market prices of large financial market trades
CORRECT
B. They reduce regulatory oversight over financial market trades
C. They are used by the large investment banks to trade with each other
D. Their lack of public pricing increases trading costs for final investors

10. A client sells $1mn of 10-year US government bonds to a dealer in government

bonds, increasing the dealer’s bond holdings (inventory) to $5mn. Which action will
protect the dealer from the risk of a fall in the market price of these bonds?

A. Increasing (‘tilting’) their bid and ask prices, so clients sell them more bonds
B. Taking a long position (i.e. a purchase) of £1mn in one-year bond futures
C. Taking a short position (i.e. a sale) of £1mn in one-year bond futures
CORRECT
D. A wider spread between its ‘bid’ and ‘ask’ prices to increase its profit margins

11. Which of the following is NOT a reason why financial market speculators, such as
hedge funds, often prefer transacting in derivative rather than spot markets?

A. Derivatives require relatively low upfront cash payments (inherent leverage)

B. Using derivatives rather than spot markets avoids delivery of the underlying
assets
C. Concern about ‘counterparty risk’ in spot markets (where there is no CCP
guarantee) CORRECT
D. Derivative markets have more buyers and sellers and lower transaction costs

12. Which of the following intermediaries maintains the ultimate record of security
ownership, ensuring total securities held match the number issued to the market?

A. Central counterparty
B. Central securities depository CORRECT
C. Central bank
D. Custodian bank
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13. What characteristic distinguishes a closed-end fund from an open-ended fund?

A. It is protected from market risks

B. It is traded on an exchange CORRECT
C. It is passively managed instead of being actively managed
D. A sponsor creates/extinguishes units to match market price to a benchmark.

14. Which is the safest money market instrument, with the lowest market interest rate?

A. Repo (on ‘good collateral’) CORRECT

B. Bank wholesale deposit
C. Commercial paper
D. Foreign exchange swap

15. In 2008-2009 the Federal Reserve provided ‘swap lines’ to other central banks.
Why?

A. To help finance world-wide fiscal expansion (higher government spending)

B. To protect the Fed from exchange rate volatility
C. To provide dollar liquidity to overseas institutions, unable to obtain
collateralised loans directly from the Federal Reserve CORRECT
D. As a form of monetary expansion, lowering money and bond interest rates.

PART B

(use the separate pink answer booklet to answer questions from this section)

Answer any TWO of the questions in this part of the exam. Each question is worth 35
marks.

16. Irrational Exuberance

What is meant by ‘efficiency’ in Eugene Fama’s statement of the efficient markets

hypothesis? US stock prices fell by around fifty per cent between March 2000 and Dec
2002 and again between Dec 2007 and March 2009. Are such sharp declines in stock
prices consistent with market efficiency?

First part of question can be answered fairly directly from lecture notes, explaining the
different concepts of market efficiency. The best answers will discuss the empirical testing
of market efficiency, not just the statement that prices incorporate information (from past
prices, from public domain). A violation of market efficiency is the opportunity, using a
stated information set, to predict future market prices sufficiently well to achieve superior
risk-adjusted returns.

The second part of the question is a bit more open ended, requiring discussion of the
volatility of market prices, not just their efficiency. I expect to students to be aware that
market crashes are only a violation of the efficient market’s hypothesis if they create an
opportunity to make superior investment returns. They may contrast the concepts of
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market efficiency and economic efficiency, noting that market crashes indicate
misallocated investment.

17. Bonds and bond risks

Who are the major holders of US government bonds and why do they purchase them?
Explain the following two statements: ‘Expansionary monetary policy lowers interest rates
and increases bond prices’; ‘Expansionary monetary policy increases inflation and reduces
bond prices’; and discuss if it is possible for both statements to be true.

The first part of the question has been discussed at length in lecture notes and in group
work. They should be aware that bonds appeal to investors, such as life insurers, with
predictable future cash outflows, the predictability of bond returns allows them to match
assets and liabilities. They should also be aware that bonds appeal for investors with
comparatively short investment horizons. Finally any investor who is very averse to risk
(for example central banks or government agencies investing public money) are likely to
hold a major part of their investment portfolio in the form of government bonds. I would
also expect some discussion of holding of US government bonds, noting that a large
proportion are held by overseas investors e.g. from China.

The second part of the question requires them to explain how both interest rate and
inflation risk and how thee affect the value of bond portfolios. A lowering of interest rates,
especially if this has a substantial impact on long term interest rates, reduces required
returns and increases bond prices. Higher inflation lowers the real value of bond
repayments and hence increases required (nominal) returns and lowers bond prices.
Better students will be able to reconcile the two statements, noting that expansionary
monetary policy which allows inflation to get out of control will result in higher interest rates
and lower bond prices; but that a temporary monetary expansion to ensure inflation and
output do not fall well below a target or desired level need not result in a large increase in
inflation and hence can increase rather than reduce bond prices.

18. Corporate governance

Outline the role of outside equity investors in the development of young start-up
companies. Does separation of ownership and control discourage further innovation once
successful start-up companies ‘go public’ through an IPO?

Lectures and classes have focused on various aspects of equity ownership, including the
provision of risk bearing risk finance, strategic control and the development of young firms.
Answers to the first part of this question can be based largely on lecture and cass material,
but should focus on the role of family members, business angels and venture capital funds
in supporting start-up firms. Good answers will point out the advantages of these forms of
finance, from having relatively little separation of ownership and control and allowing
managers of start-up firms to benefit from the experience and advice of experienced
entrepreneurs, e.g. in dealing with marketing, cash flow management, supply chains etc. .
Other forms of outside investment, e.g. equity crowdfunding (although this does not
overcome problem of separation of ownership and control), might be mentioned.

Second part of question goes well beyond lectures, asking for a balanced discussion of the
relationship between ownership and control and innovation. Potential points to be made
include (a) the need to focus on the long term when conducting research and development
of new products and services, which may be difficult with dispersed ownership (b)
differences in sectors and in cluture of firms. Some firms especially in technology sectors
e.g. Google, Telsa are putting substantial resources into research and development (c) in
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this context makes sense to distinguish new technological breakthroughs that develop
entirely new products and markets (may not get much support from incumbent firms) &
incremental innovation, reducing costs, which can be encouraged by large publicly listed
firms. Better answers will refer to examples and illustrations, because there is no simple
relationship between ownership and innovation.

19. Computer based trading and financial market stability.

Describe the operation of ‘order driven’ and ‘quote driven’ trading systems explaining the
difference between them. Nowadays a large proportion of equity trading is carried out by
computer programs executing trades in multiple trading venues. Has this development
benefited investors in global equity markets?

First part of question can be answered fairly directly from lecture notes. The two systems
should be clearly explained. Fuller answers will discuss the reasons why quote driven is
preferred, including insufficient liquidity to support a publicly visible order book, hence
need for market maker, the possibility now quite common of hybrid systems that combine a
visible order book with a market maker with an obligation to contribute limit orders, also
important role of regulation (e.g. in terms of rules for pre- and post-trade transparency).

Second question is fairly open-ended, problems in terms of the occurrence of a number of

flash crashes should be discussed, possibility that some investors and market participants
may be getting better pricing than others, but best answers will be balanced and consider
also benefits to final investors in terms of narrow bid-ask spreads and greater market
‘depth’ i.e. prices not moving so much when relatively large orders are placed. In equity
markets especially broker dealers must operate with narrower margins, and so make less
money on client trading than before, but clients are benefiting from lower charges. .

20. Benchmark Fixing and Bank Ethics.

Describe the profit opportunities and risk management of a foreign exchange dealer who
offers clients the opportunity to buy and sell Euros for dollars. Discuss, with reference to
recent cases, the concern that these dealers have sometimes behaved unethically, making
excessive profits when clients have come to them to make large foreign exchange
transactions.

The first part of the question asks for a description of the risk and return for dealers in the
most liquid forex market, that between Euros and dollars, and how these are managed.
Following lecture notes, the profits come from the ‘bid’/’ask’ spread, the risks arise
because following the acceptance of a client order the trader then acquires a position from
the client (short – borrowing Euros or long holding Euros) and is then exposed to risk of
adverse exchange rate changes. The risks rise at times of greater exchange rate volatility,
e.g. when there is significant economic or political news. Dealers are especially concerned
about the reaction appropriately to new market information (news or changes in market
prices). If they are too slow to adjust their ‘bid-ask’ spreads then can lose money on client
trades; if they over- or under- react then they can still face lower margins or possibly
losses on client trades and/or start taking on more risk than they prefer. So new
information e.g. economic news, is followed by very active trading by clients and by
dealers with each other (through ‘interdealer brokers’) which establishes new pricing. The
most profitable dealers are those who attract the largest client flows and use the
information from client flows to their advantage during such episodes of price-
readjustment.

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The second part of the question is more focused on recent concerns about exploitation of
clients, particularly front running (when traders have operated separate non-client
accounts, trading ahead of large client orders to benefit themselves from predictable price
movements) and benchmark manipulation. Benchmark manipulation is the practice of
accepting client orders on the dealer’s balance sheet during the middle of the day,
agreeing to price at an end-day benchmark rate (the 4pm fix), trading out of the acquired
position during the day, then finally executing trades in the small window (originally plus/
minus 30secs) in order to move the benchmark to benefit the dealer at the clients expense
(so if the client were buying Euro pays a high rate say 1.17, if they were selling Euro gets
only $1.15 but the dealer has already laid off the client order at 1.16 earlier in the day). A
full discussion will address the problems of culture and governance that have supported
these malpractices and the responses by regulators and firms.

21. Active versus Passive Fund Management.

Describe the source of funds and the determination of fund manager remuneration in (i) an
actively traded mutual fund; (ii) a hedge fund. Are the exceptionally high remuneration of
successful hedge fund managers justified by the returns offered to investors?

The first part of this question can be answered largely from lecture notes and class
material. They should be aware that hedge funds can use extensive leverage while
borrowing by an actively traded mutual fund is limited. They should also be aware that
managers of mutual funds are paid on a salary + bonus basis but this gives them only
limited direct exposure to the risks of fund returns. Hedge fund managers on the other
hand are also owners, holding a fairly large proportion of invested equity in the fund, 20%
or 30% not uncommon, giving them direct financial exposure in addition to a management
fee. Mutual funds also have more onerous disclosure requirements. Better answers can
explore a bit further the governance of these two types of funds and how these vary with
the targeted investor base. Retail mutual funds whose investors have little understanding
of fund risk and returns and little time to monitor performance, can be cavalier about
engagement with investors, the focus is on marketing rather than analysis of risk and
return. Funds targeted as professional investors, whether hedge funds or mutual funds,
will have to put more effort into disclosure and analysis of risk and returns, to persuade
professional investors to place money with them.

The second part of the question is open-ended and goes a bit beyond lecture and class
material. I expect better answers to provide examples of successful hedge funds, noting
that while high returns are not achieved consistently, on occasion these funds can achieve
very substantial returns that greatly exceed conventional market investment. In this case
high levels of returns justify the resulting high levels of remuneration. On the other hand,
hedge funds can also make substantial losses, and while some management fee is still
paid, returns to owenrs fall a great deal. So incentives provided for managers to make
effective investment decisions are stronger in hedge funds than in mutual funds. A deeper
answer might also discuss the benefits of ‘price discovery’ for all investors, active or
passive, and offer this as a justification of high returns to hedge fund managers.

A.K.L. MILNE

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