D33/135523/2019.

DFI224 CAT.
COURSE INSTRUCTOR: MRS. HELLEN KINYUA.
QUESTION 1
A) The roles of the securities market in:

1. Price discovery.
Price discovery is the process by which buyers and sellers in the securities market agree on a
price in executing their transactions. The securities market takes into consideration a couple of
factors in assigning suitable prices to all the securities traded in that market. The following are the
factors considered.

a) Demand and Supply.

These two forces are involved in any pricing activity. When the demand of a certain
security is higher than supply, its price increases in response. The increase in demand of a
security is usually attributed to an increase in its intrinsic value and scarcity of the
security as well.
On the other hand, when the supply of a security is higher than the demand, prices fall
because of the widespread availability of the security. When demand is equal to supply
then securities are sold at the equilibrium price which is said to be fair to both buyers and
seller. Demand and supply helps traders in the securities market to know who between
the buyers and sellers are dominant in the market.

b) Available information.
Buyers and sellers may be hesitant when they’re in await of an important piece of
information to be released. This is usually the case when the information has a great
effect on the price of a security. The securities market, however, reflects all information
available so that no investor suffers because of an information not incorporated in the
price of the security. This is in accordance with the market efficiency principle.

c) Volatility.
When the price of a security is highly volatile, it poses a risk to both sellers and buyers.
Buyers fear the price might fall drastically and thus make a loss or they may anticipate a
spike in price which can give them huge capital gains. However, when it comes to price
volatility, it depends on the risk profiles of buyers or sellers, that is, whether they’re are
risk tolerant, neutral or averse.

2. Provision of Liquidity.
Liquidity refers to the ease with which an asset or a security can be to turned into cash. The
securities market offers the following services to traders to ensure high liquidity of the securities
they possess.
a) Round the clock trading.
 The securities market conducts its buying and selling activities 24 hours a day, 7 days a
week and 365 days a year. This enables buyers or sellers to make a transaction anytime
they find convenient.

b) Brings together large number of traders.

The securities market brings together thousands of potential buyers and sellers together.
This means that those who want to sell their securities can quickly and easily find
someone to sell to thus improving the liquidity of the security.

c) Offers proper pricing.

The securities markets adjust prices frequently to accommodate all available information.
This helps traders to be at ease when they are selling securities because they know the
prices are truly fair considering the prevailing market conditions.

3) Minimization of trading costs.

The securities markets in a bid to maximize traders’ gains, is trying to reduce trading costs in the
following ways:
a) Elimination of middlemen.
There are no middle men who could inflate the price through their markup. Brokers are the only
medium between the traders and the market. The brokers simply place orders for their client
traders at a fee but they do not make a profit like traditional middlemen who buy low and sell
high.

b) Adoption of online trading.

Traders no longer have to go to a physical office of a broker in order to make a transaction in the
securities market. Reduced rental costs for brokers have allowed them to also charge a fraction
of the fee they used to charge before online trading was embraced.

c) Increasing awareness of the securities market.

This is done in order to attract more and more traders by the thousands. When more traders are
in the market, trading fees can be reduced greatly as opposed to when few traders are present.

B) The financial system in Kenya comprises of all the different financial institutions such as banks,
insurance companies, SACCOs among others. Each of these institutions in the financial system
contributes in its own unique way in achieving the vision 2030 as discussed below.
1) Banks provide loans to investors with ambitious projects but lacking the capital to start it.
Through the banking sector many huge capital outlay investments have been and will be made
possible.
2) Insurance companies ensure continuity of the economy by protecting individuals and businesses
from risks. For example, the transport industry is prone to road accidents through which many
revenue generating vehicles are lost. Insurance companies replace or repair such vehicles to
 ensure they continue generating revenue which can help the government achieve the set goals in
the vision 2030.
3) Investment companies encourage a culture of investing among Kenyans. Investing is a better
option compared to a savings account where the money is eroded by inflation. When more
Kenyans embrace investing, the overall per capita of the country improves which is a good
economic indicator of progress towards the achievement of the vision 2030.
4) Mortgage Companies help in realizing the goal of affordable housing quicker for all Kenyans.
They provide packages to suit any level of income. When more people are residing in good
descent homes, the living standards of the common “mwananch" improves which is a sub-goal of
the vision 2030.
5) Brokerage firms have helped the easy access of the Kenyan and international securities. This has
seen more Kenyans no longer being dependent on 9- 5 jobs but have become full time traders.
Income through investing in the securities market Is fulfilling the financial freedom dreams many
Kenyans hope to achieve. Increased income for the people translates to increased national
income, one of the goals of the vision 2030.
6) Savings and credit cooperatives encourage a saving culture and they also extend loans thus
encouraging the entrepreneurial spirit of its members. Many Kenyans have started successful
businesses with the help of their SACCOs. They also offer financial education to members.
SACCOs help in achieving the vision 2030 by empowering Kenyans both financially and
educationally.
7) Pension funds are some of the most important financial institutions when it comes to dealing with
the biggest economic problem of many nations; dependency. Pension funds provide security to
Kenyans in their retirement so that they don’t become a burden to their children in old age.
Pension funds help in achieving the vision 2030 by reducing dependency ratio a major ingredient
in high poverty levels.

QUESTION 2
A) A stock market is secondary securities market that consists of buyers and sellers who trade in
shares of listed companies. Bonds, derivatives and mutual funds are also traded in a stock
market. The following is an overview and major characteristics of the financial instruments
traded in a stock market.

a) Stocks
Stocks or shares represent partial ownership of a company and belong to to equity
category of securities. Companies issue stocks to raise capital from the public. There
are two main types of stock namely, common and preferred stocks.
Preferred Stock Characteristics.
 It guarantees perpetual dividend payments.
 It has no voting rights
 Preferred stock holders have priority over common stock holders on
company’s assets during liquidation.
Common stock characteristics.
 Dividends are not guaranteed and are paid occasionally.
 It gives voting rights to its holder.
  Common stock holders come after preferred stock holders and other debt
obligations have been met during liquidation.

b) Bonds.
Bonds are debt obligations that offer periodic interest payments to the holder. Bonds
are also used to raise capital by both companies and the government. Bonds can be
corporate bonds, municipal bonds or treasury bonds.

Bond characteristics.
 Par value- This is the face value of the bond that is paid back when the bond
matures.
 Coupon rate- This is the fixed rate at which the bond pays interest until the
maturity of the bond.
 Maturity date- This is the time specified in the contract and in which the
bondholders are paid back the par value.
 Call option- This is the alternative of selling a bond and getting a capital gain
at the expense of the periodic interest payments.

c) Derivatives
These are financial instruments that obtain their value from an underlying assets and
thus their prices are affected by fluctuations in the price of the underlying asset.
Some common examples of derivatives are options, forwards, futures and swaps
contracts.
Derivatives characteristics.
 They obtain their value from an underlying asset.
 Their prices are subject to fluctuations in the price of the underlying asset.
 They require little initial investment.
 It must be settled at a future date from the time the contract is initiated.

d) Mutual Funds
This is a professionally managed fund where investors funds are pooled together and
invested across a wide range of securities for the purpose of portfolio diversification.
Characteristics of Mutual funds.
 It is managed by a team of professional investment managers who make the
decisions of ensuring a return for the investors.
 The investors have the ownership of the pooled resources.
 An investor cannot sell his mutual fund share directly to another investor but
has to sell it back to the firm directly or through a broker.
 It has a low risk because the funds are diversified into many asset categories.
 The investors’ shares are denominated in units known as net asset value that
change on a daily basis with the prevailing market conditions.
B) Quite major challenges have made the mortgage market of Kenya not to make a progress
as other markets. The following are some of the challenges pulling down the mortgage
market in Kenya.

1) Low levels of income

Many Kenyans have either an income of less Ksh. 30,0000 per month or lead a life
of hand to mouth. This makes a high percentage of Kenyans not to even dream of
owning a home and keep on struggling with more urgent needs such as food, school
fees and rent.

2) High Credit risks.

Most mortgage offering institutions face high levels of credit risk due to poor
documentation of credit histories of most Kenyans. This makes mortgage companies
to be conservative by giving mortgage to few individuals thus impeding their growth
and penetration in the Kenyan financial market.

3) High interest rates.

This is a major challenge that puts off the dream of owning a home by many
Kenyans. Most don’t want to take a mortgage because of the high interest they
would end up paying in the long-run.

4) Lack of financial education.

Many Kenyans don’t understand how the financial markets nor the products work.
Due to many people not knowing what a mortgage is and how it works, it has led
them to being unaware of the whole mortgage industry.

5) Under developed banking sector.

The banking sector in Kenya lacks the know-how in coming up with innovative
products and mortgage packages to meet the unique needs and situations of the
Kenyan people.

6) Inaccessibility to long-term funds.

Most Kenyans don’t meet bank's requirements to extending long-term loans to its
customers. This has made mortgage loans to be out of reach for many Kenyans.

7) Cumbersome process of registering real estate.

It takes a lot of time and procedure for a single property to obtain a title deed in
Kenya. This has made b mortgage companies not to grow at the pace they would like
because of such delayances in closing a deal.

8) High costs incurred in foreclosure.

Since Kenya is still a third world country, many Kenyans run out funds in
maintaining a mortgage loan. This exposes too many foreclosures to mortgage
companies and hence make them lose value of some investments.
 9) Strict regulations-.
Some regulations are too tough for mortgage companies to abide by. The result of
this is usually concentrating more on not breaking the law than achieving the
business goals. Regulations are placed to encourage ethical growth of a company but
some may actually impede the growth of some industries like the mortgage industry
of Kenya.

10) Diminishing supply of land for housing.

Due to urbanization land is becoming more expensive by the day. This makes many
small mortgage companies not to meet the capital requirements for the expensive real
estate of this times.

11) HIV/AIDS and other debilitating diseases.

People suffering from diseases that question their long-term productivity usually
have no access to long- term loans because banks are uncertain as whether such a
person will live that long. As a result, many people get declined for a mortgage loan
even though they’re currently financially able but not in the long-run.

QUESTION 3
A) These are financial instruments that obtain their value from an underlying assets and thus their
prices are affected by fluctuations in the price of the underlying asset. Some common examples
of derivatives are options, forwards, futures and swaps contracts.

The following are the key distinguishing elements between forward and future contracts.

i. Forward contracts are highly customizable to suit the private needs of the parties
involved while future contracts have their terms standardized to meet the needs
of not just two parties, but a large number of buyers and sellers in the market.

ii. Forward contracts are traded in the over the counter market(OTC) since they are
private. While future contracts are on the stock market because they’re
standardized and public contracts.

iii. Forward contracts can only be executed at the maturity date agreed upon initially
while future contracts can be executed any time the holder desires to because the
stock market runs trades 24 hours a day.

iv. Forward contracts are regulated by the parties involved since it is a private
contract while future contracts are regulated by the stock market in which they
are traded.
 v. Forward contracts carry a high level of counterparty risk because of their private
nature while future contracts carry virtually no counterparty risks because they
are legally binding contracts.

A)
I. No. of Semi-annual periods Using this Information, P.V is calculated
12*2 =24 periods

Semi-annual coupon rates PV OF THE BOND= 30PVIFA 5%,24 +1000PVIF5%,24

6%/2= 3% semi-annually. = SH. 724.07

Semi-annual coupon payments ( The 10% required rate of return is divided by 2

3% of sh.1000= sh.30 since the discounting is done semi-annually)

II. No. of Semi-annual periods Using this Information, P.V is calculated

12*2 =24 periods

Semi-annual coupon rates PV OF THE BOND= 60PVIFA 5%,24 +1000PVIF5%,24

12%/2= 6% semi-annually. = SH. 1,138.04

Semi-annual coupon payments ( The 10% required rate of return is divided by 2

6% of sh.1000= sh.60 since the discounting is done semi-annually)

III. The present value of a bond increases with an increase in the coupon rates as shown
above. When the coupon rate increases from 6% to 12%, the present value of the bond
rises in value from sh.724.07 to sh.1,138.04.

IV. Repeating (I) and (II) Using 8% required rate of return.

(i) No. of Semi-annual periods Using this Information, P.V is calculated

12*2 =24 periods

Semi-annual coupon rates PV OF THE BOND= 30PVIFA 4%,24 +1000PVIF4%,24

6%/2= 3% semi-annually. = SH. 847.51

 Semi-annual coupon payments ( The 8% required rate of return is divided by 2
3% of sh.1000= sh.30 since the discounting is done semi-annually)

(ii) No. of Semi-annual periods Using this Information, P.V is calculated

12*2 =24 periods

Semi-annual coupon rates PV OF THE BOND= 60PVIFA 4%,24 +1000PVIF4%,24

12%/2= 6% semi-annually. = SH. 1,304.92

Semi-annual coupon payments ( The 8% required rate of return is divided by 2

6% of sh.1000= sh.60 since the discounting is done semi-annually)

Relationship between Coupon rates and bond price volatility.

When Coupon rates are higher than the required rate of return (market interest
rates), which are the cause of the bond price volatility, bond price volatility is
low. This is because investors will be more willing to invest in bonds since bonds
pay higher interest payments as opposed to a savings account with a low
interest rates.