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 ASSIGNMENT SOLUTIONS GUIDE (2017-2018)
M.E.C.E.-4
Financial Institutions and Markets
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the
Assignments. These Sample Answers/Solutions are prepared by Private Teacher/Tutors/Authors for the help and guidance
of the student to get an idea of how he/she can answer the Questions given the Assignments. We do not claim 100%
accuracy of these sample answers as these are based on the knowledge and capability of Private Teacher/Tutor. Sample
answers may be seen as the Guide/Help for the reference to prepare the answers of the Questions given in the assignment.
As these solutions and answers are prepared by the private Teacher/Tutor so the chances of error or mistake cannot be
denied. Any Omission or Error is highly regretted though every care has been taken while preparing these Sample
Answers/Solutions. Please consult your own Teacher/Tutor before you prepare a Particular Answer and for up-to-date
and exact information, data and solution. Student should must read and refer the official study material provided by the
university.
Note: Answer all the questions. While questions in Section A carry 20 marks each (to be answered in
about 500 words each) those in Section B carry 12 marks each (to be answered in about 300 words each).
In the case of numerical questions word limits do not apply.
SECTION-A
Q. 1. Describe the nature of the financial system in a modern economy giving the important types of
constituent institutions, markets and instruments. Explain the concept of flow of-funds in the financial
markets
Ans. Nature of Financial System: A financial system is a set of complex, and inter-connected institutions, agents,
practices, markets, transactions and claims and liabilities in the economy.
It has four constituents:
(a) Financial Institutions (b) Financial Markets
(c) Financial Instruments (d) Financial Services
Financial Institutions
Financial institutions are mobilizers and depositors of savings and providers of credit and loans. Financial institutions
can be classified into:
(a) Banking institutions and Non-Banking Institutions.
(b) Intermediaries and Non-Intermediaries.
Banking Institutions and Non-Banking Institutions
Basis Banking Institutions Non-Banking Institutions
Meaning Banking institutions accept demand Non-Banking institutions do not accept
deposits i.e., they accept deposits demand deposits i.e., they do not accept
that can be used for payments and payments and trans-deposits that can be used for
actions motive. transactions motive.
Share in Money Deposits of banking are a major They provide a minor source of money supply.
Supply source of money supply in the
economy.
Credit Banking institutions are creators of Non-Banking institutions are purveyors of
credit. credit.
Intermediaries They are always financial interme- They may be financial intermediaries or non-
diaries. financial intermediaries.

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 Intermediaries and Non-Intermediaries
Basis Intermediaries Non-Intermediaries
Meaning They mediate between investors These institutions do the loan business but
and savers. their money is not directly savers.
received from
Function They lend money as well as They only lend money.
mobilize savings.
Assets and Their liabilities are towards the Their liabilities are not specifically known but
Liabilities ultimate savers and their assets their assets are investors.
are from borrowers.
Who are who All banking institutions are Non-Banking institutions may be in interme-
financial intermediaries. diaries or non-intermediaries. When they are
non-intermediaries, they are called non-
banking financial intermediaries.
Financial Markets
It is a market in which people deal in financial securities like shares, debentures etc. Demand and supply of such
securities determine their price.
Financial markets can be classified into:
(a) Primary and Secondary Markets
(b) Money Market and Capital Market
However, financial markets are also classified into:
(i) Organized and unorganized,
(ii) Formal and informal,
(iii) Official and parallels,
(iv) Domestic and foreign.
Primary Market and Secondary Market
Basis Primary Market Secondary Market
Meaning It deals in new financial claims or new It deals in securities which are already
securities issued or existing or outstanding.
Function It mobilizes savings and savings supply Secondary markets do not directly
fresh or additional capital to business units. contribute to the supply of additional
markets liquid. capital. Their role is to making primary
Other nameThey are also called They are also called “Old Markets”.
“New Issue Markets”

Money Market and Capital Market

Basis Money Market Capita Market
Meaning Money market is a short-term market for Capital market is a market for long-term
short-term securities with a maturity of securities which have maturity period of
less than one year. one year or more.
Purpose It provides funds for working capital. It provides funds for long-term.
Financial Instruments
A financial instrument can be defined as a claim against either a person or an institution for the payment on a
future date. Payment may be a lump sum amount or a periodic amount like interest or dividend. Financial securities
vary from each other in terms of:
(i) Marketability liquidity reversibility,
(ii) Types of options,

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 (iii) Returns,
(iv) Risks involved, and
(v) Transaction costs
These instruments can be primary securities or secondary securities.
Primary Securities and Secondary Securities
Basis Primary Securities Secondary Securities
Meaning These are directly issued by the ultimate Secondary securities are securities issued
borrowers of funds to ultimate user. by intermediaries.
Other name These are also called direct securities. They are also called indirect securities.
Financial Services
Financial services include merchant banking, leasing, hire purchase, credit rating, etc. these are performed by
financial intermediaries. They bridge the gap between knowledge of investors.
FLOW OF FUNDS IN THE FINANCIAL MARKET
A concept is a flow concept when it is measured over a period of time. In a modern economy, income is not
entirely spent. Some part of it is saved and converted into investment using financial system. These markets provide
funds to borrowers and return to savers on their investment. Financial investment has varied degrees of risks, returns
and liquidity. When investment is made in physical assets, it is called real investment. It is saving that ultimately gets
converted into real investment.
Savings & Investment and National Income Accounts
National income is the sum total of final expenditure by households, firms, government and foreigners. From
income view point, it is sum total of wages, rent interest, profit received by the residents of a country. This income
may be used either as consumption or as savings. Savings can be invested directly in real assets or in financial
instruments.
Financial investments can take place directly or via financial intermediaries. These institutions then invest the
funds received by them either in securities or consumer loans. In both cases, these funds will be used for buying real
assets or consumer goods. It will increase national income.
Flow-of-Funds Accounts
It includes all the sources and uses of funds for the various sectors of the economy and by summation of all
sectors. These are financial counterparts of the national income accounts of the real sector of the economy. Therefore,
it is very important for a financial analyst to understand flow of funds accounts. It is flow of funds account that brings
real and financial sectors together.
In an economy ex-post saving is equal to ex-post investment. Saving is one source of funds and investment is one
use of funds. But it is not necessary practically that saving and investment are equal.
Data for Flow-of-Funds Accounts
For obtaining data for flow of funds accounts, we need to follow following steps:
(i) Classify the economy into sectors;
(ii) Preparing a statement showing inflow and outflow of funds in each sector;
(iii) Summing these sources (inflow) and uses (outflows),
(iv) Placing the sector accounts side-by-side to form a table matrix.
Firstly, we develop a matrix wherein the economy is classified into few sectors like households, firms, government
and rest of the world. If we can handle complex matrix, these sectors may be given sub-sectors. But too complex
matrix will not be able to serve the purpose. The ideal number of group will depend on the purpose of the analysis and
the degree of segregation necessary.
Thereafter, we collect information on sources and uses of funds in each sector. It is done by examining the
balance sheets of different sectors in the beginning and end of a quarter. The relative importance of different items
might have undergone change. It is necessary that uses are equal to sources.
It is to be noted that inter-sectoral flows are not included and only net increases in assets are treated as use of
funds. Debt repayments are dissavings and they are treated as negative sources of funds. For a given sector, the
following equality is obtained:

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 Change in net worth + change in liabilities = change in real assets + change in financial liabilities.
It is extended by summing up all sectors. It makes it clear that if in one sector savings exceeds investment then
lending will exceed borrowing and it will be a surplus sector and vice versa.
We have given a hypothetical matrix below in table given below.
Flow of funds account for 1 April, 2011 to 31 March 2012
(Rs. Crores)
(SECTORS)
Households Business Government Financial All Sectors
Intermediaries
U S U S U S U S U S
Savings 600 400 –100 900
Real Investment 100 800 900
Net change in 500 500 1000
financial assets
Net change in 400 100 500 1000
financial
liabilities
Total 600 600 800 800 100 900 1900 1900
Sector Surplus 500 –400 –100
or deficit
U: Uses of funds
S: Surplus of funds
In the above table the uses and surplus of funds has been shown by each sector. It is to be noticed that for each
sector, use and surplus is equal. Households saved Rs. 600 crores and out of it invested 100 crores in real assets and
500 crores in financial assets. Business units invested 800 in real assets of which 400 crores were arranged from their
own savings and 400 were taken as loans from financial institutions. Government sector is a deficit sector as it has
done dissaving of Rs. 800 crores. Overall, financial assets increased by Rs. 100 crores and the total of all sectors is
1900 crores.
From the figures obtained in the matrix we can form a credit market summary table as below:
Credit Market Summary
(Rs. In 000)
Funds Raised by sectors

Households 0
Business 400
Government 100
Financial Institutions 500
Total 1000
Funds Advanced by sectors
Households 500
Business 0
Government 0
Financial Institutions 500

Total 1000
We have not allowed for the fact that government borrows funds directly from the government sector and from
each other. It is further assumed that non-financial sector acquired financial assets and financial liabilities. It is a
simplifying assumption.

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Significance of Flow of Funds Accounts
l It provides useful framework for classifying and measuring the sources and uses of both internal and external
funds.
l It reflects the relationship among different sectors of the economy.
l It provides historical data that can be used to draw trend line and thereby helps in forecasting.
l It provides statistics on relation on credit flows to total spending goods and services.
l It is used to test hypothesis concerning the portfolio behaviour of consumers and firms.
Q. 2 Discuss the Markowitz theory of efficient portfolio selection. How does the CAPM theory build
on it?
Ans. Portfolio Theory: Markowitz’s work on Portfolio theory explains the behaviour of an optimum investor.
An investor is ready to take a given risk and aims to maximize his expected return from his investment on portfolio
assets. Those portfolios that satisfy his maximization condition at given risk level are called efficient portfolios. He
explains its working.
Assumption of Markowitz Portfolio Theory:
(i) While deciding about investment. Investors consider expected mean and variance of return.
(ii) Investors are risk averse utility maximizers.
(iii) All investors have a single period time horizon.
(iv) For all risky assets Investors expectations are identical about expected returns, variances and covariance.
Based on above assumptions, Markowitz suggested following steps for optimum investment allocation:
(i) Mark out the set of efficient portfolio.
(ii) Find indifference curves of investors between risk and return.
(iii) Choose the optimum portfolio.
It can be shown on a diagram with expected return on Y-axis and risk and variance on X-axis. Since risk gives
negative utility to an investor and return gives positive utility, indifference curves of risk and returns will be upward
sloping. But they will be convex because investors are assumed to be risk averse. It is shown with the help of a
diagram given below:

10 11 12

Return

Risk

An investor is indifferent between all combinations on an indifference curve. Stepper is the IC, risk avert is the
investor and vice versa. An indifference curve 10 gives higher utility than IC 12. Assuming that all portfolios have
equal risk, different portfolios will have different returns. A rational investor will choose that portfolio which gives
maximum returns with minimum risk. We use quadratic programming to attain this combination. It is beyond our
curriculum. We are giving a common sense explanation called intuitive explanation. All those portfolios that an investor
can afford are called feasible portfolio. A collection all those combinations which are feasible for investor are called
feasible set of portfolios. However, optimum portfolio will be one which is tangent to indifference curves and satisfies
the mathematical conditions of maximization that first derivative is zero and second derivative is negative. Therefore,
an investor will choose that point where the Markowitz efficient set of portfolio is tangent to IC. It will be a subset of
the feasible set of portfolios.
Capital Asset Pricing Model
When all individual investors attain their equilibrium as given by Markowitz, there must be an overall economic
level equilibrium. The works of Sharpe, Lerner and Mossin is concerned with this equilibrium. CAPM is an equilibrium

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model of asset pricing which provides an understanding of the behavior of prices of securities, the risk return relationship,
and the appropriate measure of risk for securities.
All Markowitz’s assumptions apply to this model as well but there are some additional assumptions too. These
are:
(a) Unrestricted borrowing and lending can occur at risk free rate of interest.
(b) There are no imperfections in the capital market such as transaction costs.
(c) There are no taxes.
It is to be noted that there are some risk free assets in the market which Markowitz did not talk about. When risk
free assets enter the market scene and it is known that investor can lend or borrow any amount at risk free rate then
it can be shown that the investor’s equilibrium will be attained at a level higher than what it was under Markowitz
theory. The investor will select a portfolio on an upward sloping line in the curve were expected return is taken on X-
axis and risk on Y-axis. It starts from origin showing that there are some assets which are risk free. It is upward
sloping and is tangent to Markowitz efficiency curve at some point. This line is called capital market line. If we move
on to the left of capital market line, to the Markowitz efficiency portfolio curve, one can find points on the line
vertically above on the Markov Efficiency Frontier. In such a case, two-fund separation theorem will work. It says
that all risk-averse investors will hold a combination of the risk free asset and market portfolio.
SECTION-B
Q. 3. Critically examine the major theories that have been put forward to explain the term structure of
interest rates.
Ans. Term Structure of Interest Rates: The theories of the determination of interest rates basically are giving
us a measure of explanation of the average rate of interest and natural rate of interest. These don’t get into detailed
vast away. In this section we shall explain the gap in interest rate in short run and long run interest rate. What factors
determine the structure of interest rate. In different situations default risk of different assets varies, for e.g. shares
are more risky investment than debentures. There is a rule that more risky investment give high returns. When we
say ‘term structure of interest rates’ we mean that returns on interest bearing investments like debentures, bonds etc.,
which are exactly equal with one difference that their maturity dates are different.
Let us consider two types of bonds with same rate of interest but one with 5 years maturity and other with 10 year
maturity, when a difference in yield of an asset is closed due to gap in maturity dates, it is called ‘term structure of
interest rates.When this relation is shown with the help of a curve in which x-axis shows the maturity period and y-
axis shows the rates of yield of the debt instrument, it is called yield curve. It summarised the yields that one can get
if he invested in different instruments of varied maturity. In a yield curve, the date at which we are studying yield
curve is taken as given and kept unchanged. This one upward sloping curves become more will be the maturity period,
more will be yield. In exceptional situations, it can be downward sloping when short-term investment give less return
than long-term investment.
Some theories have been proposed to give an explanation for the term structure of interest rates. These theories
are discussed below:
1. The Expectation Hypothesis: It claims that on an average, long-term investments give better return than
short-term investment. The theory assumes that:
(a) Short-term and long-term investments are substitutes of each other.
(b) There is only one factor that influences investor’s decision and it is expected ROI. He will invest in that
avenue that gives a larger return.
(c) Investors are risk neutral.
(d) There are no transaction costs.
(e) Cost of buying an asset is same–irrespective of its maturity period.
The theory claims that an investor should expect that he can get equal return by investing in an either 5 years bond
or 10 years bond. We can write it as follows:
(1 + r1, t)t = (1 + r1) + (1 + Er2) ... (1 + Ert)
where r is expected yield to maturity. On the left hand side we have shown the value of rupee one invested in an
r-year bond, while RHS of equation shows the future value of rupee that an investor has invested in a series of 1-year
bonds over a period of years.

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 2. The Segmented Market Hypothesis: Theoretically speaking, it is opposite of expected theory. It says that
an investors can substitute bonds with different maturity periods and their yields are not dependent on each other. It
assumes that market for bonds with different maturity dates are operating separately, independently of each other. In
each market, yield is determined by the market forces of demand and supply for a particular type of bond.
When an investor wishes to invest in a market, he wants to invest in such a market where yield and maturity both
suit him. If I have some extra cash, I’ll think for how long, I am not in a need of it. Suppose, I am not expecting its need
for next 5 years. In that case I’ll neither prefer investing in longer duration bond as it’ll have my liquidity not in shorter
duration bond because it’ll involve transaction cost. This hypothesis implies that the shape of yield curve is determined
by the supply of and demand for bonds and other financial instruments which have different maturity periods.
However, this theory also is not free from criticism. It has been criticised on two grounds.
(a) It is not very useful in predicting changes in yields.
(b) The theory did not establish any relation between short-term and long-term rates of interest.
3. The Preferred Habitat Hypothesis: It has make an effort to combine the features of the expectations
hypothesis and the segmented market hypothesis. It claims that investors always prefer lonable funds of specific
terms to maturity. According to this theory, investors are interested in substituting away from their preferred terms
provided they compensated as per their expectation. The term premium is a word used to refer to the compensation
that must be offered to investors to convince them for purchasing different term to maturity than their preferred
terms. Therefore, this theory has also been called ‘liquidity premium theory.’
This theory assumes that an investor will choose bonds on two considerations.
(a) Expected return on investment.
(b) Investor’s preference for bonds with a particular maturity.
An investor, if given ‘term premium’ can be convinced to buy an investment with maturity different from his
desired one. The expectations and segmented market hypothesis are extreme forms of this theory. In expectation
hypothesis, there is zero term premium effectively. On the other hand, in segmented market hypothesis, it is effectively
infinite.
Comparison between three theories and interpetations
1. The preferred habitat hypothesis is a combination of expectations hypothesis and segmented market hypothesis.
Therefore, it is in a better position to explain yield curve.
2. Yield curve in the preferred habitat hypothesis can be upward sloping, downward sloping or flat.
3. There is empirical evidence of the fact that with the increase in short run interest rate, long run interest rate
also increases and vice-verca.
Q. 4. Explain the need for and role of depository systems in secondary markets. Explain the concept
of custodial services.
Ans. Depository System: In the post-liberalization period there took place a tremendous increase in the volume
of activity as the capital markets matured. There emerged a need to replace this traditional system with a new system
called ‘Depository system’. The depository system revolves around the concept of paperless or scrip less trading
because the shares in a depository are held in the form of electronic accounts, i.e., in a dematerialized form.
‘Depository means a place where something is deposited for safekeeping. A depository is an organization which
holds securities of a shareholder in an electronic form and facilities the transfer of ownership of securities on the
settlement dates.
As cash deposits and withdrawals are made in a bank, in lieu of which a receipt and a passbook are given,
similarly, in depositories, scrips are debited and credited and an account statement is issued to the investors from time
to time. An investor in a bank deals directly with a bank while in a depository, an investor deals through a depository
participant.
Following factors created the need for depository system:
l Delays in transfer of securities, in getting duplicate shares/debentures, certificates.
l Delay in the receipt /non-receipt of securities after allotment /refund orders to those who are not allotted
shares.
l Inadequate infrastructure in banking and postal segments to handle a large volume of application and storage
of share certificates.

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 l Return of share certificate as bad deliveries on account of forged signatures /mismatch of signatures or face
certificate /forged transfer deed.
With increase in the number of investors and volume of trading in securities drawbacks of the system were more
visible. In response to it following steps were taken:
(a) Depositories Act 1996 was enacted. The Act vests SEBI with the powers of registration of depositories and
participants to approve or amend the bye-laws of a depository.
(b) The National Securities Depository Limited (NSDL) was set-up in 1996. It was sponsored by the IDBI, the
UTI and the NSE
The system of depositories has the following features:
l Existing security holders have choice of either continuing with the existing share certificate or opt for the
depository mode.
l Investors are given an option by Issuers of new securities to opt for physical delivery of share certificates or
join the depository mode.
l The investors opting for depository mode continue to enjoy the economic benefits from the shares and the
voting rights.
l The shares in depositories do not have distinct number or distinct identity.
l Investors are allowed exist from the depository and they can claim share certificate from the company by
getting their names substituted as the registered shareholder in place of the depository.
l Once investors opt for depository mode, the share certificate of the investors get dematerialized and their
names are entered in the books of participants as beneficial owners in the register of the name of the depository
as registered owner of securities.
l The investors joining the depository system have to register with or more participants who are agents of the
depositories. Such participants are custodial agencies, such as banks, financial institutions, etc.
Benefits of depositories to various interest groups are as follows:
Interest group Benefits
Investor l Speedy transfer of shares
l Avoidance of risk
l Dematerialization and rematerialization facility;
l Loss indemnification;
l Safety from fake and stolen shares;
l No refusal of share transfer;
l Low brokerage cost;
l Availability of periodic information.
Issuer l Reduction in volume of paper work;
l Ease in distributing benefits to actual beneficiaries;
l Facilitates wider spread of shareholding over a geographical area.
Intermediaries l Elimination of the problem of bad or fake shares;
l Easier to get loans on dematerialized securities;
l Reduction in brokerage rate.
Lending Banks l No headache of replacing securities in case of book closures;
l Makes switching of portfolio convenient;
l Shares can be easily transferred to bank in case borrower defaults in payment;
l Reduces paper cost;
l Frees the bank from the problems of transfer deed and other related matter by simplifying
creation of bank charges.
Custodial Services
A custodian is an intermediary who keeps the accounts of his clients. He maintains the scraps of clients in
custody. He performs following functions:
(a) Safe keeping of share certificates and trustee for the same.

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 (b) Providing ancillary services like physical transfer of share certificates.
(c) Collecting dividends and investment warrants.
(d) Confirming to transfer regulations.
(e) Updating clients on their investment status.
(f) Claiming benefits on behalf of its clients like bonus issue or right shares.
The provision of efficient custodial services is an important element of a mature stock market system.
SEBI Custodian of Securities Regulation, 1996 for their proper conduct and functioning. SEBI has defined custodial
services as
(a) Safe keeping of securities of a client who enters into such an agreement to avail of these services, and
(b) Providing services incidental thereto.
Q. 5. Discuss the Black Scholes formula on derivative pricing.
Ans. The Black-Scholes Formula: The Black Scholes Model is one of the most important concepts in modern
financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used
today, and regarded as one of the best ways of determining fair prices of options.
The original formula for calculating the theoretical Option Price (OP) is as follows:
OP = SN(d1)–Xe–rt(d2)
Where:
 S v2 
ln    r +  t
 X  2
d1 =
v t

d 2 = d1 –v t
The variables are:
S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one year). See
below for how to estimate volatility.
ln = natural logarithm
N(X) = standard normal cumulative distribution function
e = the exponential function.
Q. 6. Compare the impact of monetary policy under fixed exchange rates with those under flexible
exchange rates.
Ans. Fixed Versus Floating Exchange Rates: BOP account of a country gives a record of the transactions
of a country with the rest of the world. It is divided into current account transactions and capital account transactions.
The former includes import and export of goods and services and unilateral transfers like remittances, grants, gifts
etc. It includes income related inflow.
Capital account includes transactions which affect assets and liabilities of a nation. It includes financial investments
and direct investment. Portfolio investment (financial investment) net purchases of Indian securities and lending to
Indian residents and net purchases of foreign securities and net lending to foreigners.
Two exchange rate systems are prevalent in exchange rate markets at extremes however there are many pegged
systems as well. These are: fixed exchange rate system and floating exchange rate system.
(a) Fixed Exchange Rate System: Under this system, the government of a nation announces the exchange
rate in terms of their currency or some other commodity like gold. It also announces “rules of exchange”. If the value
of a currency is given in terms of gold, it is called gold standard system. If the price of a currency is determined to a
fixed amount of other currency it is called reserve currency standard.
(b) Floating Exchange Rate: Under this system, the currency rate is determined by the intersection of demand
and supply for that currency in terms of other currency. Therefore, demand and supply will determine equilibrium
exchange rate and therefore, there will be fluctuations in due to changes in these forces which are quite uncertain.
Therefore, it has been called flexible exchange rate.

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 Some countries like China, Mexico, Brazil etc. do not allow their exchange rate to be so fluctuating as per market
forces. Rather they peg the value of the foreign exchange rate to a fixed parity. It is said to adopt fixed exchange rate
system. It is not sufficient to simply announce a peg. It also has to buy or sell foreign exchange in order to maintain
that fixed parity value depending on the situation. If there is excess supply, it has to sell the securities and in case there
is excess supply, it has to buy it.
Fluctuation in flexible exchange rate system occurs when banks buy or sell forex to correct their stock. But this
buying and selling is an outcome of modifications in demand and supply and therefore, at the core level, it is demand
and supply that are bringing fluctuations.
Forex market developed in 1971, when fixed exchange rate system of Bretton Woods System started to abandon.
Under fixed exchange rate regime, there were hardly any inter-bank markets for different currencies. Speculations
were prohibited in Bretton Woods System. BW agreement was set-up in 1945. It aimed at bringing stability in
international currencies and preventing money fleeing across nations.
Case for and against flexible exchange rate regime
Flexible exchange rate system gained popularity amongst economists during 1960s in western countries. It is a
system in which there is no interference of government or central bank in fixing rates. Its merits are as follows:
(a) There is monetary autonomy. When central banks are freed from balancing exchange rates, it can concentrate
on reaching internal and external balances.
(b) No country will be able to export its inflation on to others.
(c) There are some currencies which start dominating in fixed exchange rate regimes. It will vanish with introduction
of flexible exchange rate system.
(d) Flexible exchange rates act as automatic stabilizers. Without any intervention, things get back to equilibrium
in this system.
But it is not an unmixed blessing. It has its limitations too.
(a) Some skepticism has arisen about this system as it has increased uncertainty in the market.
(b) Some indiscipline may creep in due to non- interference of central bank.
(c) It makes speculators to enter the market who further increase uncertainty. Flexible exchange rate can cause
more disruptions to a country’s home money markets than exchange markets.
(d) International trade gets adversely affected due to lack of pre-dictability in the market.
Overall, it is accepted by many economists that flexible exchange rates will increase instability and uncertainty
without giving greater freedom for macro economic policies.
How does the central bank intervene in FEM under fixed exchange rate?
It intervenes by buying and selling securities depending on demand and supply levels. A country can maintain a
fixed exchange rate parity which is different from the one that will exist if markets are allowed to act freely only till
a point when it can fill the gaps of excess demand and excess supply. In this sense, foreign exchange intervention will
either increase money supply or decrease money supply. When sale of foreign reserves occur it reduces money
supply and vice versa.
Open market operations are a standard instrument way in which of controlling money supply and exchange rates
in a country. The effects of open market operations vary a great deal in fixed and flexible exchange rate systems. Let
us discuss them in detail.
When there is an open market purchase of government bonds under flexible exchange rate regime, it does not
affect currency rates directly. It leads to increase in money supply. This increase in money supply decreases interest
rate in the country. With the decrease in interest rate, people prefer investing abroad and therefore, they will sell
Indian bonds and buy foreign bonds. It will increase demand for foreign exchange and decrease supply of foreign
exchange and exchange rates will depreciate.
When there is an open market sale of government bonds under flexible exchange rate regime, it also does not
affect currency rates directly. It leads to decrease in money supply. This decrease in money supply increases interest
rate in the country. With the increase in interest rate, people prefer investing in India and therefore, they will buy
Indian bonds and sell foreign bonds. It will decrease demand for foreign exchange and increase supply of foreign
exchange and exchange rates will appreciate.
Fixed exchange rate regime reduces the risk element of uncertainty. This certainty promotes international trade
and FDI. Moreover, discipline of fixed exchange rate reduces the rate of inflation in internal economy.

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 Some economists claim that it is not possible to attain three objectives simultaneously: Full capital account
convertibility; domestic monetary policy independence and stability in currency. These goals are contradictory in
nature. Therefore, some systems have been developed which have tried to make a balance between fixed and
flexible regimes. It includes:
(a) Crawling peg (fluctuations up to 1% are allowed);
(b) Target Zone or Managed floating;
(c) Wider band system (Fluctuations up to 2.5% are allowed).
At resent, there is hardly any economy which follows fixed or fluctuating exchange rate systems. They opt for
crawling pegs, managed floating and wider band systems. When floating is used for disadvantage of other country, it
is called dirty floating.
Q. 7. Discuss the concept of leverage for a firm. Discuss the important financial and leverage ratios
used. Explain the Merton-Miller theorem.
Ans. Leverage refers to the substitution of fixed-charge financing mainly debt. Financial leverage affects expected
earning per share and return on investment. If the entire capital is arranged through equity, then fluctuations in
earnings per share arise entirely through the firm’s business risk. Leverage has both positive as well as negative
effects. Questions arises if there is an optimal level of leverage then. Traditional answer to this was that since
leverage substitutes debt for equity, with increase in debt, the proportion of cheaper credit increases, it reduces the
form’s weighted average cost of capital. It implies an increase in total value of the firm.
This view was challenged by Franco Modigliani and Merton Miller in 1958. They showed that under the assumptions,
that there are no taxes, transaction costs and other capital distortions, the capital structure does not matter. Modigliani-
Miller’s propositions are as follows:
(i) First proposition is that the value of the firm is independent of its capital structure. It is based on arbitrage
kind of argument. It suggests that in equilibrium identical assets must sell for identical prices regardless of
how they are financed. This arbitration assumption with an assumption of firm’s operating cash flow is
independent of its capital structure gives birth to second proposition.
(ii) Cost of capital of a leveraged firm is equal to overall cost of capital plus a risk premium.
(iii) Risk premium itself is the difference between the overall cost of capital and cost of debt multiplied by debt-
equity ratio.
Symbolically, it is equal to:
Ke = K0 + (K0 – Kd) D/E
Where, Ke is cost of equity capital;
K0 is cost of overall capital
Kd is cost of debt capital
D/E is debt equity ratio.
n n

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