Section A
Answer 1
The four main activities of financial intermediaries are as follows –
1. Channelize the savings to investment through financial instruments like saving
account, commercial paper, stocks, bonds etc.
2. Facilitates the credit from lender to borrower through banks and other financial
institutions.
3. Helps in settlement of financial obligation in foreign currency through discovering the
appropriate exchange rate by forward or swaps.
4. Providing better interest rate to the bond holders through matching of durations with
similar kind of cash flows.
Answer 2
The four functions of foreign exchange market are as follows –
1. Provide credit facility to both national and international traders to facilitate the cross-
border trade and settlement.
2. Transfer of fund from one nation to another through wire transfer, electronic bill etc.
3. Facilitates fund flow in the form of FPIs and FDIs across the countries.
4. Provide hedging facilities against the exchange rate risk.
Answer 3
The international money market has several advantages. In facilitates the trade between two
parities from different countries. Since, currencies are exchanges through out the times, there
is no scope of any arbitraging and hence, a stability in currency is achieved. Interest rate in
international market is also generally lower than domestic market and hence, capital can be
raised at low cost. Risk is also comparatively low because any fluctuation in currencies and
the local markets are balanced out by others. Greater flexibility is also provided due to no
restriction on capitalization. As a result, the financial institutions can lend at 100% of their
deposits. The diagram of advantages of international money market is given as below.
Answer 4
Bond being offered at discount rate means the bond price is 10% less than its face value.
Suppose, the face value of bond is $100 and if it is offered at 10% discount, the market price
of the bond would be $90. Bond is at discount when the coupon rate offered on the bond is
less than the required rate of return i.e., YTM. It is due to the reason that bond’s market price
is sum of all the PV of cash flows associated with the bond. Here, the cash flows are in the
form of coupons that are paid either annually or semi-annually and the redemption amount of
the bond paid at maturity. So, if the discount rate i.e., interest rate turns to be higher than
coupon rate, the PV of all such cash flows would be less than face value. Hence, if the
interest rate is likely to go up, the bond is issued at discount.
Answer 5
I don’t agree with the given statement. For corporates, the secondary market is as important
as the primary market. Yes, it is true that capital fund can’t be raised in the secondary market
but corporates can buyback their shares in secondary market only. Bonus shares issued to the
existing shareholders are also carried on in the secondary market. Share split is also carried
on in secondary market. Apart from these, secondary market shows the stock performance of
the company and the stock performance is the yardstick of business performance. Therefore,
by capturing the trend of stock price, one can estimate the business performance in future.
Price discovery of company’s share and bond are conducted in secondary market that not
only serve the investment purpose of investors but also helps the corporate to rebalance its
capital structure
Answer 6
I am an UK exporter and the amount receivable is in US dollar. Therefore, I am exposed to
exchange rate risk. Any adverse change in exchange rate between Pound and USD may
significantly reduce the actual money received in pound. Hence, to hedge my position, I may
forward/future contract on currency to lock up the exchange rate. Alternatively, options can
also be used, although it is generally costlier than forward contract. Money market hedge can
also be used to hedge the USD receivables. By either way, the USD receivable can be
hedged. However, all such hedging attracts cost and the appropriate selection of hedging
technique can be decided by determining the cost involved in the hedging.
Answer 7
The future market is an organized exchange unlike the over-the-counter market. There are
standard norms and terms regarding the underlying assets such as its quality, price, delivery
time etc. Therefore, there is no scope of delivery of any sub-standard assets or at price
different from agreed upon and any delay in exchange of underlying asset. Such
standardization is made for both the parties and hence, there is no scope of default.
Clearing house executes the contract on the behalf of both the parties. The exchange holds
delivery of asset until maturity and protect itself by imposing the margin on traders through
the system called “marking to market”. Margin money is deposited by the parties with the
clearing house and as per the fluctuation in price of underlying asset, the margin money is
adjusted or asked from the respective parties. On the date of maturity, the final settlement is
done by the clearing house and thus, interest of both the parties is protected.
Answer 8
The four main factors that affect the time value of the option contract are as follows –
1. Time remaining until expiration. Higher is the time remaining to expiration, higher
would be the time value of option and vice versa.
2. Volatility in the price of underlying asset. Higher would be the volatility in the price
of underlying asset, higher would be the time value of option contract and vice versa.
3. The delta of the option that describes the relationship between option’s strike price
and price of underlying asset. At-the-money option has greater time value of money
than out-the-money option because of higher chance of at-the money option to
worthwhile to exercise.
4. Interest rate has inverse relation with the option premium and hence, higher is the
interest rate, lower would be the time value of option and vice versa.
Answer 9
The differences between Interest rate swap and currency swap are as below.
Interest rate swap Currency swap
Cash flows are exchanged between two Cash flows generated in order to hedge the
parties at different interest rates on the exchange rate between two currencies are
notional amount. swapped between two parties.
The main focus is exchanging of interest The main focus is exchange of any amount
rate payment obligation between two in one currency to another currency.
parties.
Currency swaps are foreign exchange
Interest rate swaps are contracts of financial agreement between two parties.
derivatives between two parties.
Answer 10
The three types of embedded options that can be applied to bonds are as follows –
1. Call option – The call option embedded with bond enforces the bondholders to sell the
call option to the issuer of the bond whether they realize it or not. The callable bonds are
generally used at the time of high interest rate in the market. It allows the issuer to buyback
or redeem the bond at some time in future when the interest rate will be low.
2. Put option – Put option embedded with the option provides more control to the
bondholders where he essentially purchases the put option. In the case of high interest rate,
the bond holder can sell the bond to the issuer and invest the proceed in other high yielding
assets.
3. Conversion option- This option allows the bond holder to convert the bond into equity
at the predetermined price and time in future. Thus, it provides the benefit of both bond and
equity to the bondholders.
