SHORT ANSWER QUESTIONS

I. Week 9 – Money & Bond market:

1. Describe the features and functions of money markets.
- Functions:
Banks and financial institutions usually have timing differences between cash
collections and disbursements. For example, a sovereign fund needs to borrow cash
with low risk to invest in long-term investment-grade corporate bonds, but cannot
find banks that can provide such a huge loan amount in a short time period. The
money market, consisting of short-dated liquid securities that closely resemble cash,
was created to help these institutions adjust their liquidity positions efficiently.

For corporations, it allows them to easily borrow funds for short-term cash flow needs
such as a temporary increase in working capital. For central banks, it allows them to
implement monetary policies and provides the banking system with low-risk liquid
reserves. The money market, as the most liquid market in the financial world, also
represents the prevailing conditions in the industry as well as market expectations of
central bank movements. For commercial banks, they can borrow from or invest in
the money market with many different players, not just among themselves or the
central bank, which makes it easier to handle short-term liquidity problems.
- Features:
No central marketplace, most of the activities are OTC and take place via dealers.
Exclusive wholesale markets, not available to retail investors.
2. What are the characteristics of money market instruments. How are Australian T-
notes issued?
Characteristics:
- Low risk: very low default risk (low risk but not risk-free) and no price risk. Money
market instruments should be issued by institutions of the highest quality (AAA
investment grade).
- Highly liquid: As investors are looking for close substitutes to cash, money market
instruments should be as marketable to cash as possible.
- Available in large denominations: To minimise transaction costs.
T-notes issuance:
- T-notes are pure discount securities, which means there is no coupon paid, profits are
made by the difference between purchase price and face value at maturity.
- Issued by AOFM in Australia.
- Has virtually no default risk, and is as close to risk-free as it can get. Major users
include investment and commercial banks.
- From 2003 – 2009, because of persistent government budget surplus, Australian T-
notes were not issued (there was no need for additional funding). After the GFC, they
came back as government needed to increase spending to push the economy to
recovery.
3. Distinguish between negotiable CDs, commercial papers, and Bank Accepted Bill
(BAB).
Commercial papers:
- Most issuers are very large and have high credit quality. Investors include banks,
MMFs, mutual funds, insurance and non-financial corporations.
- Are purely discount securities like T-notes, with no coupon paid in between.
- Cheaper source of funding for companies than bank loans, and usually backed by
bank lines of credit.
- Can be in unsecured or secured form (ABCP). If secured, the collateral can be trade
receiveables and credit card receivables (short maturity and predictable cash flows),
and recently also includes auto loans, commercial loans, student loans, MBS, etc.
Negotiable CDs;
- Bank deposits that are tradeable => Large secondary market. Most have a maturity of
3 months, but can be issued for up to 33 months.
- Purchasers are companies looking for high-yield short-term returns. The rates paid on
CDs are negotiated between the bank and its customers. Long-term customers may
have a preferred rate lower available.
- Yield: T-notes < Neogtiable CDs < Commercial Papers
Bank Accepted Bills:
- Identical to Commercial Paper, but has an endorsement/acceptance from a bank that
guarantees payment to the buyer.
- Today, bank accepted bills are the most popular instrument in money markets.
Players include banks, non-financial corporations and especially the RBA and the
government. The former determines liquidity positions generally in the short term
money market, the latter can also do so when it is a demander and/or supplier of
funds.
- Because ultimately, the bank is the payer, the rates on bank-accepted bills closely
mirror those of negotiable CDs.
4. Present a story of money markets proximately pre- and post-GFC
5. Explain the key features of the ‘Hamiltonian system’ which contributed to nation-
building
- The Continental dollars issued for the war dropped in value and became worthless,
while the states were also heavily indebted. This puts the new government in a dire
financial situation, unable to borrow funds effectively.
- Hamilton sought to solve this problem by funding the Federal Government fully in
debt, which means the government has to honor all of its outstanding obligations. Up
until then, the bonds issued by Continental Congress had been distrusted, and the
holders of these bonds (those who fought in the war was paid by bonds) sold them to
speculators at a significant discount.
- Many critics opposed Hamilton’s plan would heavily reward speculators and not the
people who fought in the war. Hamilton acknowledged this but argued that a
fundraising mechanism was desperately needed to establish the nation’s credibility.
 The plan was approved of and a sinking fund and a central bank were established to
help ensure US obligations to be honored.
- Finally, tariffs on foreign imports and taxes on booze were established to further raise
funds for the government and to protect the nascent industrial base of the nation.

II. Week 10 – Bond & Stock market:

1. According to Ferguson (2008), the birth of the bond was the second greatest
revolution in the ascent of money. Explain why.

2. Outline how bonds began in Italian-city states, especially Florence, and then in
England.
3. Discuss alternative types of bonds a corporation can issue to raise capital.
Hybrid securities (convertible bonds):
- Convertible bonds are unsecured bonds that can be converted into common stocks at
the behest of its holder or at a predetermined time agreed upon by both parties =>
Have characteristics of both debt and equity, allow investors to benefit if the stock
price rises, while also paying lower interest payments than the usual bonds if option is
not exercised.
- Many bonds have a call feature and give the issuers the right to force conversion.
Junk bonds:
- Bonds with credit ratings below investment grade or BBB rating by S&P.
- Most junk bonds are not issued as junk (distressed companies issuing more debt), but
are fallen angels, companies that previously were investment grade but fell below that
 rating. Those below investment grade ratings tend to borrow from banks as it is
generally cheaper.
- Australian market does not have a lot of junk bonds compared to the US due to
cultural differences (lower risk tolerance). Junk bond issuance has been rising in
Australia, offering 4 – 6% above the government bond yields.
Covered bonds:
- Typically issued by banks and backed by a pool of assets called cover pool. Enjoy
AAA credit ratings
- Value of cover pool assets have to be bigger (103%) face value of the covered bonds.
- Have lower yield than similar unsecured bonds, but may not reduce a bank’s overall
borrowing costs.
4. Briefly present the evolution of stock market since the establishment of the VOC
17th – 18th century: VOC established, traded in Amsterdam exchange – the world’s first
stock exchange. The Amsterdam bank accepted VOC shares as collateral =>
Crucial link between credit and stock markets.
Corporate governance reform at VOC led to the establishment of a Board of
Directors.
th
19 century: VOC model is replicated in England.
The London Stock Exchange and New York Stock Exchange were
established.
Ticker tape brought stock prices to the exchange and the birth of DJIA
index.
th
20 century: Great bull market ended with the stock market crash of 1929 because of
speculations driving prices.
SEC was established to regulate securities trading.
Black Monday stock crash of 1987
Dot com bubble bursts in 2000
2008-2009 GFC
5. Preference shares can be issued in many different varieties. What are they?
III. Week 12 – Derivatives & Behavioural Finance:
1. Discuss the use of credit default swaps in the years leading to the Global Financial
Crisis of 2008-2009.
Credit Default Swap is an insurance contract that guarantees the payment of the
underlying security, for example, the insurer must pay the face value of a bond to the
counterparty in the event of solvency issues from bond issuers. CDS swaps the default
risk from the holder of the bond to another party, hence the name. Like other derivatives,
CDS can be used as a tool for speculation if one anticipates a default from the issuers of
underlying securities.
However, before the GFC, a buyer of CDS does not need to own the underlying security,
making it function similarly to a naked option. This means CDS could be issued in
greater quantities than the assets they are derived from. The CDS market was also
unregulated, so there were a lot more sellers than buyers (market does not expect the
bonds to default), making the price of CDS low. After the collapse of Bear Sterns and
Lehman Brothers, insurers such as AIG, who were CDS sellers were unable to guarantee
payments as they themselves were insolvent. This led to the collapse of the whole system,
and required the Feds and the government to bail out these corporations.
2. Explain how interest rate swaps can help firms to obtain cheaper financing and to
service debt in the way they prefer.
3. Recently Air New Zealand announced its order to purchase eight B787-10 aircrafts, at
the value of US$2.7bn. Assume that, to finance this purchase, the Airline takes out a 10-
year US$ loan, at the interest rate of Libor+2.5%, from Bank of America. It has to
make yearly interest payment to the bank. Discuss how Air New Zealand can use a
swap contract to hedge against exchange rate risk and interest rate risk.
4. Discuss three stylized facts, which were inconsistent with the theory of expected utility
maximizing representative agent.
Dividend puzzle:
- Dividend policies should be completely irrelevant to its share price if financial agents
are rational. Companies that pay a high dividend will see its retained earnings fall and
vice versa, but the capitalised equity value should stay the same.
- In the real world, companies that pay a large dividend unexpectedly will see its share
price rising.
Market volatility:
- In a world with rational agents, prices of financial assets should only change when the
company’s fundamentals change. However, it has been proven that share price can
change based on factors completely irrelevant to fundamentals, such as momentum.
Extrapolation:
- People extrapolate on patterns from past events, such as a continuation of past price
changes. Therefore, they are optimistic in bull markets and pessimistic in bear
markets.
5. Some of those stylized facts above (in question 3) can be explained by heuristic decision
processes or rules of thumb. What are they? Examine in detail any two of these rules.
 Heuristics are ‘rules of thumb’ that we employ when faced with complex tasks. Such
shortcuts may not be rational processes but are often used when speed is of the essence.
Gambler’s fallacy:
- Occurs when people predict that a trend will reverse because it has happened too
many times or for way too long. For example, when tossing a coin 5 times gives 5
heads, people will generally expect the next one to be tail.
- In finance, this manifests in some investor’s belief that the end of a bull or bear run is
near. This can be because they felt the run has gone on for too long instead of a
rational look at the characteristics of the market.
- Gambler’s fallacy has been found to be more likely to happen to experienced
investors than novices.
Anchoring:
- Occurs when an individual relies too heavily on a piece of information they first
received to make a decision. For example, a sell-side research report that publishes a
target price of a stock may provide an anchor for an investor to hang on to. The
investor’s valuation may arrive at a result closer to that of the sell-side researcher than
if he/she did not read the report.

IV. Week 13 – Cryptocurrencies & Behavioural Finance:

1. Describe the Prospect theory of behavioural finance
Prospect theory states that people make decisions based on how they perceive losses and
gains, rather than rational evaluation of possible outcomes when confronted with complexity
and uncertainty. There are 4 aspects that are important to financial market participants:
Myopic Loss Aversion:
- People view losses and gains disproportionately, a loss will be more painful than a
gain of the same magnitude => Investors are loss averse. This results in myopic
behaviour such as holding losing stocks for a long period while selling winning
stocks quickly.
Regret Aversion:
- People generally try to avoid the pain of regret from making a bad decision. It’s more
than the pain of loss, it’s the pain of being responsible for the loss. Investors refuse to
cut losses to avoid recognition that a loss has been made.
- It can also explain herding behaviour where people invest and stick to respected
stocks as they provide an implicit insurance against regret.
Mental Accounting:
- People organise the world by separating it into mental accounts. An example would
be most people tend to separate budgets into one for discretionary spending and the
other only used for long-term savings.
- This can explain inconsistencies in individuals’ decision making process. For
example, people will borrow at a high interest rate to buy an expensive item, while
trying to pay off interests from a mortgage loan they took.
Self-control:
 - Traditional finance theory assumes people have complete control over their emotions,
but in reality, this is not true. Mental accounting is a method that humans employ to
keep their emotions in control.
2. Is Bitcoin a currency or commodity?
Answer the same way as essay question
3. Discuss some issues associated with the rise of Bitcoin.
Crypto money-laundering:
- Because of its anonymous features, Bitcoin provides a great way for criminals to
launder money. For example, Bitcoin can be transferred and exchanged for other
digital currency, such as online game currency, and converted back to traditional
currencies like the USD.
- There is evidence of growing money laundering activities through cryptocurrencies.
Costs of mining:
- Mining costs an enormous amount of electricity, and so miners try to find locations
with cheapest eletricity costs, which can unexpectedly drive up usage in those
countries and cause outage or increase utilities expenses.
ICOs and Regulations:
- ICO is a form of capital raising in which investors in young companies are offered
cryptocurrencies/virtual tokens. Some of these were scams and there were no
regulation framework to solve these problems.
- However, regulators are building a legal framework, for example in Aus and South
Korea, crypto exchanges are required to have ID documents of all customers and keep
a record of transactions. The SEC is thinking of treating tokens issued through ICOs
as securities.
Probable threat to financial stability: Too soon to say anything.