ASM 1

Q1.

a. Distinguish between different levels of market efficiency. Give examples to illustrate your
answer.

Market efficiency refers to the degree to which market prices reflect all available, relevant
information. If markets are efficient, then all information is already incorporated into prices, and
so there is no way to "beat" the market because there are no undervalued or overvalued securities
available. (Boyle, 2022)

There are three levels of market efficiency.

● Weak Form

The weak form of market efficiency is that past price movements are not useful for predicting
future prices. If all available, relevant information is incorporated into current prices, then any
information relevant information that can be gleaned from past prices is already incorporated
into current prices. Therefore future price changes can only be the result of new information
becoming available.

For example, Ajao and Osayuwu (2012) analyzed and tested the weak form of efficient market
hypothesis in the Nigerian capital market. The scope of the study consists of all securities traded
on the floor of the Nigerian Stock Exchange and the month-end value of the all share index from
2001 to 2010 constitute the data analyzed. Based on these findings, the study concluded that
successive price changes of stocks traded on the floor of the Nigerian Capital Market are
independent and random, therefore, the Nigerian Capital Market is efficient in the weak form.

● Semi-Strong Form

The semi-strong form of market efficiency assumes that stocks adjust quickly to absorb new
public information so that an investor cannot benefit over and above the market by trading on
that new information. This implies that neither technical analysis nor fundamental analysis
would be reliable strategies to achieve superior returns because any information gained through
fundamental analysis will already be available and thus already incorporated into current prices.

For example, Gupta (2003) examined the semi-strong efficiency of the Indian Stock market over
the period from 1995 to 2000 by employing an event study. The study involved a sample of 145
bonus issues, to examine the announcement effects of bonus issues on equity share prices in
India. The study concluded that the Indian Stock market was semi-strong form efficient.

● Strong Form

The strong form of market efficiency says that market prices reflect all information both public
and private, building on and incorporating the weak form and the semi-strong form. Given the
assumption that stock prices reflect all information (public as well as private), no investor,
including a corporate insider, would be able to profit above the average investor even if he were
privy to new insider information.

b. With close reference to the efficient market hypothesis literature and by using relevant
empirical evidence and data, critically assess the” efficiency” of an emerging stock
exchange market of your own choice.

Q.2

a. Compare and contrast the key roles and functions of the capital markets with those of
the money markets.

Definition:

- The capital market is a type of financial market where long-term financial products like stocks,
bonds, and debentures are traded for a long time. They serve the purpose of long-term financing
and long-term capital requirements. The capital market is a dealer and an auction market and
consists of two categories:
 ● Primary market: A primary market where the fresh issue of securities is offered to the

public.

● Secondary market: A secondary market where securities are traded between the investors.

- Money market: It is the part of the financial market where lending and borrowing take place for
a short period of up to one year. Money markets generally deal in promissory notes, bills of
exchange, commercial paper, T bills, call money, etc.

(Srivastav, 2023).

* Similarities

- Both are important components of the international finance market.

- Both the money and capital markets facilitate participants to buy debt instruments securities.
Debt securities are financial products where the borrower promises the lender to pay back the
debt amount. Other types of money markets and securities are also exchanged in the capital
market.

- The expanded activities of the government or any business activity are paid for through lending
money from both types of markets. Even the capital needed for government or business
operations is sometimes borrowed from both types of markets depending on the time.

- Both the markets do not exchange stocks and bonds offline or hand to hand. These usually
exchange money through some particular online platforms.

* Differences

Basis for Capital Market Money market

Comparison

Types of It involves stockbrokers, mutual funds, The money market contains financial
investors underwriters, individual investors, banks, the central bank, commercial banks,
commercial banks, stock exchanges, financial companies, chit funds, etc.
Insurance Companies

Nature of Capital markets are more formal Money markets are informal
Market

Liquidity of Capital Markets are comparatively less Money markets are liquid
the market liquid

Maturity The maturity of capital markets instruments The maturity of financial instruments
period is longer and they do not have a stipulated
time frame

Risk factor Due to its less liquid nature and long Since the market is liquid and the maturity
maturity, the risk is comparatively high is less than one year, the Risk involved is
low

Purpose The capital market fulfills the long-term The market fulfills the short-term credit
credit needs of the business needs of the business

Functional The capital market stabilizes the economy The money markets increase the liquidity
merit due to long-term savings of funds in the economy

Return on The returns in capital markets are high The return in money markets is usually low
investment because of higher duration

b. Critically explain how money markets’ activities might influence asset prices in the
capital markets. Give examples to illustrate your answer.

Q.3

Distinguish between a fixed and a floating exchange rate system and critically discuss why
developing/emerging countries tend to favor a fixed exchange rate system in practice. Give
examples to illustrate your answer.
A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official
exchange rate. A set price will be determined against a major world currency (usually the U.S.
dollar, but also other major currencies such as the euro, the yen, or a basket of currencies).

A floating exchange rate is determined by the private market through supply and demand. A
floating rate is often termed "self-correcting," as any differences in supply and demand will
automatically be corrected in the market. (Boyle, 2022)

Fixed Rate Exchange Rate

Deciding authority The fixed rate is determined by the Flexible rate is determined by
central government demand and supply forces

Impact on Currency is devalued and if any Currency appreciates and

Currency changes take place in the currency, depreciates in a flexible
it is revalued. exchange rate

Involvement of Government bank determines the No such involvement of

Government Bank rate of exchange government bank

Need for Foreign reserves need to be No need to maintain the foreign

maintaining foreign maintained reserve
reserve

Impact on BOP This can cause a deficit in BOP that A deficit or surplus in BOP is
(Balance of cannot be adjusted automatically corrected
Payment)

● Developing/emerging countries tend to favor a fixed exchange rate system:

Developing economies often use a fixed-rate system to limit speculation and provide a stable
system. A stable system allows importers, exporters, and investors to plan without worrying
about currency moves. Countries prefer a fixed exchange rate regime for export and trade. By
controlling its domestic currency a country can—and will more often than not—keep its
exchange rate low. This helps to support the competitiveness of its goods as they are sold abroad.
For example, let's assume a euro (EUR)/Vietnamese dong (VND) exchange rate. Given that the
euro is much stronger than the Vietnamese currency, a T-shirt can cost a company five times
more to manufacture in a European Union country, compared to Vietnam.

The choice of exchange rate regime by developing countries is of crucial importance to their
self-protection from speculative attacks and currency crises as well as the achievement of long-
term growth. The choice of exchange rate regime in developing countries means which regime
would be most appropriate not only for preventing massive capital inflows and currency crises
but also for better facilitation of trade, FDI, and economic growth. The fixed exchange rate
dynamic not only adds to a company's earnings outlook, it also supports a rising standard of
living and overall economic growth. For example, China decided during the global financial
crisis of 2008 to revert to a fixed exchange rate regime. The decision helped the Chinese
economy to emerge two years later relatively unscathed.

Q.4

Explain what you understand by each one of the following terms:

a. Euro-dollar and Asian-dollar markets.

● Euro-dollar market

Eurodollars refer to dollar-denominated accounts at foreign banks or overseas branches of

American banks. The eurodollar market is one of the world's biggest capital markets and consists
of sophisticated financial instruments.

The origins of the eurodollar can be traced back to the 1960s when Eastern European countries
initially wanted to keep U.S. dollar deposits outside the U.S. and hence deposited them into
European banks. Such a dramatic acceleration of foreign capital paved the way for financial
innovation in the form of the Eurocurrency market.

The Euro-dollar market attracts funds because it offers higher rates of interest, greater flexibility
of maturities, and a wider range of investment qualities than other short-term capital markets;
and the market can attract borrowers because it lends funds at relatively low rates of interest. It
thus renders the financial service of intermediating between owners of funds and would-be
borrowers. The market operates with low costs because the banks and other firms that use it are
well known, because the transactions are for substantial sums, and because dealings are highly
competitive. The low costs are reflected in competitive advantages to both depositors and
borrowers. (Vazquez, 2020)

For example, someone deposits $5,000 into an account in Brazil. That money is considered
eurodollars. It’s also eurocurrency because it is money issued by one government and deposited
into an account located in a different country. Were someone to deposit 5,000 Mexican pesos in
that same Brazilian bank, that money also would be considered eurocurrency but not eurodollars.
“Dollar” is the nickname of U.S. currency, and as such, eurodollars refer only to dollars from the
U.S. that have been deposited in another country.

● Asian-dollar market

The Asian Dollar Market functions as a regional center for Eurodollars in Asia-Pacific. From its
establishment in 1968, it mobilized the surplus US dollars in the region and then served the
demand for capital from developing countries and national and multinational corporations in
Asia. In October 1968, the Asian Dollar market, centred in Singapore, was established as an
offshoot of the European counterpart. Since its initiation by the Bank of America to fund the
latter's corporate financing activities in this region, the Asian Dollar market has developed and
expanded substantially.

b. Forward foreign exchange markets.

Interbank forward foreign exchange markets are priced and executed as swaps. This means that
currency A is purchased vs. currency B for delivery on the spot date at the spot rate in the market
at the time the transaction is executed. At maturity, currency A is sold vs. currency B at the
original spot rate plus or minus the forward points; this price is set when the swap is initiated.

The interbank market usually trades for straight dates, such as a week or a month from the spot
date. Three- and six-month maturities are among the most common, while the market is less
liquid beyond 12 months. Amounts are commonly $25 million or more and can range into the
billions. (Potter, 2022)

For example, you could sign a forward contract with a local bank for a payment in Japanese yen
that you'll receive in six months. You agree on an exchange rate of 115 yen per dollar, so either
if the exchange rate goes up to 125 or down to 105, you will receive the same amount of dollars
at 115 yen per dollar.

c. Adverse selection.

Adverse selection is a term used in economics and insurance to describe a market process in
which buyers or sellers of a product or service are able to use their private knowledge of the risk
factors involved in the transaction to maximize their outcomes, at the expense of the other parties
to the transaction. Adverse selection is most likely to occur in transactions in which there is an
asymmetry of information—that is, where one party has more or better information than the
other party. Asymmetry of information impacts both buyers and sellers:

Asymmetry of information tends to favor the buyer in markets such as the insurance industry,
where the buyer knows much more about their personal needs and risks than the insurance
provider. For example, a person might lower the deductible on their health insurance policy,
knowing that they expect to file a major claim within the next few months.

The seller usually has better information than the buyer in markets such as used cars, stocks, and
real estate, where they have more knowledge of the products. For example, a homeowner may
know of a home’s history of basement flooding, but not fully disclose the information to a
potential buyer. (Alston, 2023)

A prime example of adverse selection in regard to life or health insurance coverage is a smoker
who successfully manages to obtain insurance coverage as a nonsmoker. Smoking is a key
identified risk factor for life insurance or health insurance, so a smoker must pay higher
premiums to obtain the same coverage level as a nonsmoker. By concealing their behavioral
choice to smoke, an applicant is leading the insurance company to make decisions on coverage
or premium costs that are adverse to the insurance company's management of financial risk.
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