Answer to Question #166154 in Finance for BISHEM

Question

 QUESTION ONE

(a)  What are derivative instruments?                                                                  

(b)  Explain the types of derivative instruments.                                                

(c)  What are the advantages and disadvantages of using derivative instruments?                  

    

QUESTION TWO

Discuss the significance of stock markets like the Lusaka Stock Exchange (LuSE) in financial markets and the economy in general. What was the motivation for the Zambian Government to set up the LuSE?

Outline the securities and companies’ listing processes at the LuSE. What factors are taken into account when listing securities and companies on the LuSE?

                               

QUESTION THREE

(a)  Discuss in detail the roles played by financial institutions (FIs) in the economy with particular reference to Zambia citing particular examples of financial institutions that you are familiar with in Zambia.                                                                                  

(b)  List and explain the major risks that financial institutions in general face? How do these risks manifest or affect the FIs?                                                                   

QUESTION FOUR

 Using appropriate illustrations discuss in detail the factors that affect demand for loanable funds according to the Loanable Funds Theory of interest rate determination.

What impact would these have on demand and supply of funds and on the interest rate?                                                                                                                                     

QUESTION FIVE

(a) Discuss the term Monetary Policy in relation to the Zambian economy.       

 (b)  Zambia as a developing country may have problems in establishing an effective operating Monetary Policy.

 

(i). Explain at least five major problems which may prevent Zambia from establishing an effective Monetary Policy.                                                                         

(ii).Describe the main Monetary Policy tools which Zambia may use to influence economic growth. 

                                                                                 

QUESTION SIX

 (a)  What is risk management? Discuss the two major ways in which exposure can be managed and/or reduced.                                                                              

 (b)  Financial institutions face a number of risks in their operations. How are these risks mitigated or managed? What techniques are used to mitigate each type of risk you have identified?                                                                                                       

 

Answer 1

Derivatives instruments are instruments that derive their value in response to changes in interest rates, financial instrument prices, commodity prices, foreign exchange rates, credit risk and indices.

b) Call option. Is an agreement that gives the holder the right, but not the obligation, to buy shares, bonds, commodities, or other assets at a predetermined price within a predefined time period.

Put option. Is an agreement that gives the holder the right, but not the obligation, to sell shares, bonds, commodities, or other assets at a predetermined price within a predefined time period.

Forward. Is an agreement to buy or sell an asset at a predetermined price as of a future date. This is a highly customizable derivative, which is not traded on an exchange.

Future. It is an agreement to buy or sell an asset at a predetermined price as of a future date. This is a standardized agreement, so that they can be more easily traded on a futures exchange.

 

c) Advantages

Underlying asset price determination

Derivate are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.

Market efficiency

It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.

Disadvantages

High risk

The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.

Speculative features

Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.

2.i) The LuSE's core mandate is to provide a fair and efficient platform through transparent and equitable trading of the listed securities.

ii) LuSE contributes to wealth development, financial services and a platform for investment for foreign and local investors.

The Zambian Government was motivated by the need to deepen awareness and understanding of financial and capital markets in support of the emerging private sector.

Listing means the admission of securities of a company to trading on a stock exchange. When securities are listed in a stock exchange, the company has to comply with the requirements of the exchange.

3.(a)

There are different roles played by both bank and non-bank financial institutions in Zambia. They act as a channel between borrowers and lenders, they pull funds from those individuals and organizations with excess in form of deposits and lend to those in need of funds. Financial institutions thrive on these intermediation abilities as they take funds in form of deposits at lower interest and then lend out as loans at much higher interest.

For instance, the Bank of Zambia ensures efficient allocation of resources by taking resources from where they are least needed to where they are required. This results in economic development.

Financial institutions such as Business Partners International Zambia SME Fund Limited provide information on investment opportunities as well as channeling funds to those investments.

Generally, financial institutions in Zambia manage financial risks, provide loans, encourage saving and control the flow of money and liquidity.

(b)

Credit risks –Occurs when the borrowers fail to honor their contractual obligations. This may bring great loss to financial institutions.

Operational risk- This comes mainly from internal employees mainly with intent to defraud the financial institution

Market risk- Given that interest rates, equity markets and asset markets are unpredictable, it sometimes sinks the funds of financial institutions when they invest in such markets.

Liquidity risk- occurs when financial institutions fail to meet the cash demand of customers in time. This leads to a snowball problem.

These risks manifest when there are changes in technology and regulations, the financial institution is affected by cybercrimes, if the reputation of the financial institution is damaged, when there is a decline in the general economy and when they are affected negatively by competition.

4.

a)

Investments

Low-interest rate causes demand for loan able funds for investment to be high and vice versa.

Hoarding

When the rate of interest is low the demand for loan able funds for hoarding will be high and when the rate of interest is high the demand for loan able funds for hoarding is low.

Disserving

When the rate of interest is low the demand for loan able funds for disserving is high. That is, disserving is a decreasing function of the interest rate.

b)

Individuals will save more with high-interest rates. At higher interest rates; idle cash of the past becomes active balances of today, therefore, increasing investments.

Disinvestments will be high when present interest rates provide better returns in comparison to present earnings and therefore the demand for funds will be high.

5.

(a)

The Bank of Zambia has a role to implement the main objective of monetary policy which is the regulation of monetary supply. Often as an attempt to reduce inflation (price stability) and general trust of value and stability of Zambia's currency.

b) i)

Developing countries such as Zambia struggle to maximize the output and employment levels hence the amount in the banks is a small fraction of the money in the economy which makes monetary policies ineffective.

The difference in consumer prices and aggregate monetary prices is a great challenge in developing countries like Zambia.

The volatile interest rates also affect the monetary policy-making as it affects both output and inflation.

Inflation also affects the efficiency of the Monetary policy in Zambia as it affects prices and money supply in the economy hence adjusting to inflationary monetary policy can be a challenge.

Fiscal factors such as technology also pose a challenge to monetary policy in Zambia.

(ii)

Open market operations

The Bank of Zambia sells government securities in these markets to ensure price stability and control liquidity by manipulating the short-term interest rate and the supply of base money in an economy.

The discount rate

The Bank of Zambia regulates the interest rates favorably to sets the floor for the interest rate which in turn determines saving and investments.

Reserve requirements

The Bank of Zambia requires the other banks in the country to hold a certain percentage of money to regulate loans and therefore limiting the money supply in the economy.

6.a)

Risk management is the procedure of identifying potential risks early enough, analyzing them and taking measures to minimize or avoid the risks.

Ways of reducing risks include;

Taking insurance covers to cover financial risks such that in the event of the risk occurring an insurance firm takes up some or all the responsibility of the losses incurred.

Diversifying investments

This involves investing in different portfolios to maximize returns and minimize risks.

(b)

Risks are mitigated through scheduling regular and comprehensive risk assessments, taking a risk-based approach and investing time and resources in high-risk sectors and coming up with programs to manage and mitigate risk.

The technique used to mitigate credit risk is making credit risk models and rechecking the credibility of loan borrowers.