CFA Exam on Financial Markets and
Institutions - Answers
Question 1
Functions of Central Banks such as the Bank of England
Central banks serve multiple key functions, including:
1. **Monetary Policy Implementation**: Central banks control money supply and interest
rates to achieve macroeconomic objectives like controlling inflation, managing employment
levels, and stabilizing the currency.
2. **Financial Stability**: They act to maintain financial system stability by monitoring and
addressing systemic risks, providing emergency liquidity support, and implementing
regulatory measures.
3. **Currency Issuance**: Central banks have the exclusive authority to issue and regulate
the nation’s currency, ensuring confidence in the monetary system.
4. **Government Banking Services**: They manage the country’s foreign reserves, handle
government accounts, and facilitate government borrowing through bond issuance.
5. **Lender of Last Resort**: Central banks provide financial institutions with emergency
funds during liquidity crises to prevent bank failures and broader financial panic.
6. **Regulation and Supervision**: They oversee financial institutions to ensure compliance
with laws and regulations, promoting safe and sound banking practices.
Main Elements of Repo’s and Reverse Repo’s
Repos (Repurchase Agreements) and Reverse Repos are short-term borrowing and lending
instruments used predominantly by central banks.
- **Repo**: A seller (typically a financial institution) agrees to sell securities to a buyer
(often the central bank) with a commitment to repurchase them at a higher price on a
future date. This transaction temporarily increases the money supply.
- **Reverse Repo**: The central bank sells securities with an agreement to repurchase them
later. This transaction temporarily decreases the money supply.
**Use by Central Banks**:
- **Liquidity Management**: Central banks use repos to inject liquidity into the banking
system and reverse repos to withdraw liquidity, thus managing short-term interest rates
and overall monetary policy.
- **Interest Rate Control**: By setting repo and reverse repo rates, central banks influence
other interest rates across the economy.
Question 2
Below is a snapshot of Twitter Inc from 28th March 2022 to 19th April 2022.
On the 4th April 2022 an offer was made at $54.20 per share to purchase all shares in the
company.
Three Forms of Market Efficiency
1. **Weak-form Efficiency**: Asset prices reflect all past trading information. In such
markets, technical analysis cannot provide consistent excess returns.
2. **Semi-strong-form Efficiency**: Prices reflect all publicly available information.
Fundamental analysis cannot provide consistent excess returns as any new information is
quickly incorporated into asset prices.
3. **Strong-form Efficiency**: Prices reflect all information, both public and private. Even
insider information cannot provide consistent excess returns.
Pricing Efficiency of Twitter Inc
The offer of $54.20 per share on April 4, 2022, for Twitter Inc reflects a scenario where the
market did not sustain the offer price. This can be explained through:
- **Semi-strong Efficiency**: The market quickly incorporates public information (the
offer), but the price not sustaining suggests market skepticism about the deal’s completion,
reflecting potential risks or expected delays.
- **Informational Efficiency**: Not all information about the deal (like regulatory hurdles or
internal company issues) may be fully reflected immediately, leading to a lower sustained
price.
- **Allocational Efficiency**: This efficiency is challenged if the market believes resources
(capital, management) will not be optimally allocated post-acquisition, affecting the
perceived value.
Question 3
Saul Ltd is considering a listing on the stock market, the company has a market
capitalisation of 850,000, sufficient working capital and a two-year trading record.
Full Market vs. Alternative Market Listing for Saul Ltd
Given Saul Ltd’s market capitalization of 850,000, sufficient working capital, and a two-year
trading record:
- **Full Market Listing**: More suitable for larger companies due to stringent requirements,
higher regulatory burden, and greater visibility.
- **Alternative Market Listing (AIM)**: More appropriate for smaller companies like Saul
Ltd, offering more flexible regulatory requirements, lower costs, and easier access to capital
markets.
Qualified Investors
Qualified investors refer to individuals or entities with the financial knowledge and
resources to understand complex investment products. These investors are exempt from
certain protections provided to retail investors, simplifying the regulatory process for
issuing entities.
Principal-Agent Problem and Agency Issues
The principal-agent problem arises when management (agents) prioritizes personal goals
over shareholder (principals) interests. Signs include:
- **Excessive Executive Compensation**: Misalignment of management’s compensation
with company performance.
- **Empire Building**: Managers expanding the company unnecessarily to increase their
power and resources.
- **Underperformance**: Poor financial results despite high executive rewards.
Question 4
Main Features of Securitisation and Credit Enhancement
- **Securitisation**: Pooling various financial assets (e.g., loans) and selling them as
securities to investors. This process converts illiquid assets into liquid marketable
securities.
- **Credit Enhancement**: Techniques to improve the credit profile of a securitised asset,
making it more attractive to investors. Methods include over-collateralization, insurance,
and third-party guarantees.
Impact of Securitisation on Bank Lending and Risk Taking
- **Pre-financial Crisis**: Securitisation like CDOs and CLOs expanded lending by offloading
risk from bank balance sheets to investors. However, it also led to higher risk-taking and
poor underwriting standards, contributing to the financial crisis.
- **Post-financial Crisis**: Regulations tightened, improving transparency and risk
management. Banks continue using securitisation for capital efficiency but with more
stringent oversight to mitigate excessive risk-taking.
