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FINANCIAL MARKETS AND INSTITUTIONS

(19BSP422)

January 2020 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 in the box above.

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. Which statement about empirical research on market efficiency is false?

A. A failure of the hypothesis of strong market efficiency implies a failure of

weak market efficiency CORRECT
B. A failure of weak market efficiency implies a failure of semi-strong market
efficiency.
C. A failure of semi-strong market efficiency implies a failure of strong market
efficiency?
D. A failure of weak market efficiency implies a failure of strong market
efficiency?

2. Which of the following is a buy-side institution?

A. Bookbuilder/ underwriter
B. Central counterparty
C. Sovereign wealth fund CORRECT
D. Interdealer broker

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3. Which of these is a reason why in the past smaller companies have typically
borrowed from banks, rather than issuing securities or borrowing directly from
investors?
A. Banks can diversify the risks of lending to small business
borrowers
B. Banks benefit from deposit insurance, so have lower cost of funds
C. Regulation prevents small companies borrowing privately from wealthy
investors
D. Banks have systems in place for dealing with the legal and
administrative costs of small business lending CORRECT

4. What is NOT a feature distinguishing a hedge fund?

A. A hedge fund is active, seek to do better than an index

B. A hedge fund is listed on an exchange and traded like an equity CORRECT
C. A hedge fund is only open to sophisticated and professional investors, not
retail investors
D. A hedge fund can freely use derivatives for both increasing and reducing risk
exposure.

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 5. There is now considerable talk about a slowdown in global growth and possible
recession. What impact would you expect this to have on corporate bond credit
spreads and liquidity?

A. Credit spreads increase, liquidity increases

B. Credit spreads increase, liquidity decreases CORRECT
C. Credit spreads decrease, liquidity increases
D. Credit spreads decrease, liquidity decreases

6. A young graduate, setting up a self-manged pension scheme, is deciding in which

investment fund to place their contributions so as to provide for their retirement forty
years from now. On past experience, which choice would give them the lowest
pension?

A. An active global equity fund

B. A passive global equity fund
C. An active global bond fund CORRECT
D. A passive global bond fund

7. The Hong Kong Stock Exchange HKSE recently offered $36.6bn to purchase the
London Stock Exchange LSE. If this proposal had gone ahead, what impact on
share prices would be typical of a large merger of this kind.

A. Share price of HKSE rises, Share price of LSE falls.

B. Share price of HKSE falls, Share price of LSE falls.
C. Share price of HKSE rises, Share price of LSE rises.
D. Share price of HKSE falls, Share price of LSE rises. CORRECT

8. What is the investment opportunity pursued by venture capital funds?

A. Financing young companies and then selling for a profit as they mature.
CORRECT
B. Investing in private companies when they are publicly floated
C. Buying under-priced companies on the public market whose value is likely to
rise
D. Selling or “going short” over-priced companies on the public market whose
value is likely to fall

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9. Which statement is true?

A. A dark pool is better than a limit-order book for investors who want to conduct
illegal insider trading
B. A limit order book is better than a dark pool for investors for investors who
want to conduct illegal insider trading
C. A dark pool is better than a limit-order book for investors who want to make a
large purchase or sale and are willing to wait to achieve best execution
CORRECT
D. A limit order book is better than a dark pool for investors who want to make a
large purchase or sale and are willing to wait to achieve best execution

10. Which of the following is an economic benefit of having a market for corporate
control?

A. It allows family owners to realise return through a stock market listing

B. It limits political interference in corporate decision making
C. It provides a discipline on underperforming managers who do not act in the
best interests of dispersed investors CORRECT
D. It prevents private equity investors engaging in asset stripping

11. A dealer has built up a short position of £10mn in five-year government bonds and
wishes to hedge against the resulting market risk. How can they most directly do
this?

A. Reducing both their ‘bid’ and ‘ask’ prices for bonds, so clients buy more from
the dealer and sell them less.
B. Taking a long position (i.e. an agreement to future purchase) of £10mn in
five-year bond futures in one year’s time CORRECT
C. Taking a short position (i.e. an agreement to a future sale) of £10mn in five-
year bond futures in one year’s time
D. Widening the spread between ‘bid’ and ‘ask’ prices

12. Which of the following intermediaries is responsible for keeping the ultimate records
of the issue of securiites?

A. Central counterparty
B. Central securities depository CORRECT
C. Central bank
D. Custodian bank

13. Which two central bank actions both reduce market rates of interest?

A. Selling bonds on open market; increasing reserves using repo with

commercial banks
B. Buying bonds on the open market; increasing reserves using repo with
commercial banks CORRECT
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 C. Selling bonds on open market; reducing reserves using reverse repo with
commercial banks
D. Buying bonds on the open market; reducing reserves using reverse repo with
commercial banks

14. The interest rate on which money market instrument is least affected by increased
concern about counterparty risk?

A. Treasury bill CORRECT

B. Repo (on ‘good collateral’)
C. Bank wholesale deposit
D. Commercial paper

15. You believe an equity is fundamentally undervalued. Which trade allows you to
profit with least risk from this belief?

A. Borrowing the equity, then selling it

B. Buying the equity, then lending it
C. Borrowing the equity and hedging with a short position on an equity index
future
D. Buying the equity and hedging with a short position on an equity index future
CORRECT

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 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

(a) Explain what Fama meant by “market efficiency”, distinguishing this concept from that
of market pricing based on economic fundamentals.
[20 marks]
Expecting students to distinguish the three forms of market efficiency, weak form, semi-
strong and strong, and to define the notion of economic fundamentals as pricing based on
a present discounted value of expected future cash flows (or similar). Deeper answers will
relate Fama’s market efficiency to predictability , is it possible using this information set to
obtain a superior risk adjusted return than investment in the market, and note the inherent
subjectivity of fundamental pricing because of uncertainty of future cash flows and difficulty
of assessing an appropriate risk premium.

(b) Is the historical volatitliy of equity prices consistent with Fama’s market efficiency or
with pricing based on economic fundamentals? [15 marks]
Students should be aware and provide examples of large changes in the prices of financial
assets -- both sharp declines at times of economic downturn and stress and lack of
liquidity in markets & strong recoveries when conditions reverse -- and that these are
difficult to explain based just on economic fundamentals. It is less clear that these are
violations of Fama’s market efficiency – it is still difficult to do better than the market based
just on available public information. The best arguments will clearly communicate both
theoretical understanding and supporting examples and evidence.

17. Bonds and bond risks

(a) Explain how changes in inflation and in interest rates affect the price and yield on
government bonds. What other risks can also affect the price and yield on corporate
bonds? [20 marks]

Answering from lecture material, I expect clear discussion of the how inflation and market
yields are related to bond prices (increases in inflation increases required returns i.e.
yields and reduces prices); and how monetary policy tightening raises interest rate/ bond
yields and lowers bond prices (and loosening has the opposite impact) but this is a smaller
and temporary affect if inflation remains under control. The final part of the answer should
discuss both default risk and liquidity risk and also note how changes in perceived default
risk can reduce prices/ increase credit spreads
.
(b) How are these risks best managed?
[15 marks]

The obvious answer is diversification. More credit for discussing in greater depth e.g.
matching of risks to liabilities and to the possibility of active portfolio management e.g.
selling bonds that of declining credit quality, but noting that this reduces expected returns
as well as risk.

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18. Corporate governance
(a) Outline the different arrangements used by equity investors to finance and control
companies.

The first part of the question can be answered directly from lecture material, and should
cover ownership by families or original founders; public firms with dispersed stock holding,
and variations such as controlling shares or keeping a large proportion of shares with
major holders; finally private equity funds deserve mention.. It should also briefly cover
corporate governance arrangements in public firms (independent directors, board
arrangements). The word “finance” invites mention of IPOs/ retention of earnings, but must
not go too far off main task of outline arrangements.

(a) Is family ownership superior to other forms of corporate ownership and control?

The second part of question, there is a supporting research article, they should be able to
demonstrate both awareness of the challenge of separation of ownership and control, that
this can be overcome by family ownership, on average evidence does suggest better
performance, but there are obvious problems and disadvantages as well (difficult to raise
outside finance, possibility of disputes etc.)

19. Computer based trading and financial market stability.

(a) Explain how ‘limit order books’ are used to help the matching of buyers and sellers
in in equity market trading. Why do large orders have a large impact on market price
and how can computerised ‘algorithmic trading programs’ help limit this impact?.
[20
marks]
Answered from lecture material, should give an example of a limit order book (two were
given in lectures/ lecture notes) showing how limit order are placed for a range of
relatively low buying orders and relatively high selling prices. Traders who are impatient
and want to transact immediately can place a market order, buying/ selling what is
available on the order book, but this will be at a higher price for purchase/ lower price
for case than they can get by placing a further buy/ sell order in addition to those
already on the order book. A large market order will use up all the available best price
on the limit order book and move the price. A large limit order will alert traders to the
presence of buying/ selling pressure and lead to limit orders being withdrawn and a
move in the price. A computer program can feed an order gradually into the market,
using anaysis of past market behaviour to work out how to minimise market movement/
obtain a better trade-off between price and risk.

(b) Has computerised trading improved the operation of equity markets?

An open-ended question where students can demonstrate deeper understanding. Good

marks either for a well argued conventional answer (yes, computers provide greater
market liquidity , allow investors to adjust their portfolios with less market impact) and/
or discuss potential problems, including the instability of flash crashes and concerns
that fast moving ‘hi frequency’ traders can take advantage of naïve slow moving
investors.
[15 marks]

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20. Benchmark Fixing and Bank Ethics.

(a) Describe the role of dealers in the OTC foreign exchange market and the resulting
conflicts of interest that led to manipulation of the 4pm foreign exchange fix?

The first part of the question can be answered directly from lecture material. It should
descvibe the role of dealers in making bids and offers for purchase of foreign exchange
and managing the resulting risks (a strong and detailed answer may also discus role of
interdealer brokers in exchange the risks between dealers). They can then explain the
calculation of benchmark FX rates London at 4pm, and that dealers could alter this market
rate with large transactions over a short time period, benefitting themselves because this
increased their profits on other larger offsetting client transactions based on the 4pm
benchmark. . Can also describe practice of ‘front running’ in foreign exchange markets
although this is a different problem, reflecting similar ethical problems.

(b) What measures have been taken to deal with these problems and will they be
effective?

The second part of the question needs critical awareness both of the technical measures
taken to improve the calculation of the benchmark and of the ethical and management
measures taken (for example those highlighted in the Bank of England “fair and effective
markets” review). Strongest answers will adopt a critical perspective on effectiveness e.g.
pointing out costs of compliance and difficulties of monitoring.

21. Active versus Passive Fund Management.

(a) Explain the operation of an index tracking exchange traded funds (ETFs) and how
they are able to offer low-cost easily-traded investment in liquid asset classes.
[20 marks]

Answers should explain index tracking, how this can be undertaken on a mechanical basis
with relatively few transactions and no need to pay expensive performance bonuses. Beter
answers will properly explain the difference between ETFs and passive mutual funds, with
ETFs market makers buying and selling the ETF against underlying assets to maintain a
stable market price, something possible today because of low cost computer based
trading. Some credit for mentioning the possibiluity of ‘smart beta strategies’ and the
limitations/ risks of operatin an ETFs when underlying asset markets are or could become
illiquid.

(b) In your view, should long-term retail investors limit their investments to ETFs; or
should they consider other forms of investment in a fully diversified portfolio?
[15 marks]

As the question is phrased, looking for understanding and insight. A basic argument will
point out that low cost exposure to most asset classes can nowadays be achieved using
ETFs. No need to lose money on active investment that underperforms the market after
fees. A deeper answer may point out counterarguments e.g. that ETFs do not provide
exposure to important illiquid asset classes, e.g. private equity, emerging markets (though
there are some emerging market ETFs), property; so there is an case for holding a
proportion of a long-term investment portfolio in other less liquid assets.

A.K.L. MILNE

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