ECS3701 EXAM PACK Questions. Answers

Page 1 ECS3701 EXAM PACK Questions. Answers Page 2 ECS301 [New ECS3701] SELECTED EXAMINATION QUESTIONS AND SUGGESTEDSOLUTIONS MAY/JUNE 2011 Part 1: Definition and functions of money (15 Marks) Answer all questions in part 1. 1.1 List and explain the three primary functions of money. (2) Medium of Exchange: money serves as a medium of exchange allowingit to be used as payment for goods and services. As such it promotes economic efficiency by reducing the time taken for transactions to take place. Unit of Account: used to measure value of goods and services in aneconomy and helps to reduce transaction costs. Store of Value: serves as a store of purchasing power from the timethe income is earned to the time it is spent. 1.2 What is the difference between primary and secondary financial markets: (2) Primary and Secondary markets: Primary market is the market in which financial instruments are issued, while the secondary market is the marketin which financial instruments are traded. 1.3 What is fiat money? (3) Fiat Money: paper currency decreed by government as legal tender. It is largely dependent upon trust of the value of the currency. 1.4 How is the M2 money stock measured in South Africa? List ALL the components. (4) M2 consists of M1 plus deposits which are almost money. Apart from coins, banknotes and demand deposits it also includes short-term and Page 3 medium-term deposits held by the private domestic sector at monetaryinstitutions, commercial banks and savings institutions. Part 2: Financial markets (20 Marks) Answer question 2.1. 2.1 (i) Explain the difference between the yield to maturity of a bond and the return on a bond. Please provide the relevant formulas to substantiate your answer. (5) Yield to Maturity: of the several common ways to calculate interest rates, the most important is the yield to maturity. The key to calculating the yield to maturity for any credit market instrument, is to equate today’s value of the credit instrument with the present value (PV) of all of its future cash flow payments. The bond price and the yield to maturity are negatively related. The formula used to calculate the yield to maturity depends upon thespecific credit instrument being considered. In this case the yield to maturity on a bond, refer to the formula in the textbook. [P = C/(1 + i) + C/(1 + i)2 .......... C/(1 + i)n + F/(1 + i)n] The return on a security shows how well you have done by holding this security over a stated period of time and it can differ substantially from theinterest rate measured by the yield to maturity. The rate of return is defined as the payments to the owner plus the change in its value expressedas a fraction of its purchase price. Because of fluctuating interest rates, the capital gains and losses on long-term bonds can be large. (ii) Provide a definition for the yield curve and draw a normal yield curve. Please clearly label your graph and axes. (5) When the yields on bonds with differing terms to maturity but the same risk, liquidity and tax considerations are plotted on a graph, this is calleda yield curve. Normal yield curves are upward-sloping and this means that the long-term interest rates are above the short-term interest rates. Page 4 Yield to Maturity Term to Maturity A normal yield curve: Answer any one of the following two questions : 2.2 Use the theory of asset demand to explain how both (i) and (ii) below will influence the supply of and demand for bonds, the price of bonds and the equilibrium quantity of bonds. (Please answer each question separately.) (i) Higher expected future interest rates. (4) The interaction of supply and demand for bonds is one of the ways in which interest rates are determined. If it is expected that interest rates will rise in the future, then the demand for bonds will decrease and the demand curve for bonds will shift to the left. Thisis because the increasing interest rate implies a decreasing price and therefore the expectation of lower returns. The equilibrium price and quantity of bonds will decrease, ceteris paribus. (ii) An increase in the expected inflation rate (6) When inflation is expected to rise it lowers the expected return onbonds and so demand will decrease. The returns on other assets tend to increase in times on inflation and therefore bonds becomeless attractive. An increase in expected inflation also impacts on the supply of bonds. For a given interest rate, when the expected inflation increases, the real cost of borrowing falls and so the quantity Page 5 ofbonds supplied will increase. Page 6 The overall impact of the above on the price and quantity of bondsis that the equilibrium price of bonds will decrease (and interest rates will rise), but the effect on the quantity of bonds is uncertain. 2.3 Explain the assumptions and predictions of the expectations theory and how well it explains the three empirical observations of the yield curve. (Hint: Write down the formula for the long term interest rate). (10) Expectations theory: the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over thelife of the long-term bond. The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. The expectations theory is able to explain empirical facts (1) and (2) but is unable to explain fact (3). The three empirical facts are: • Interest rates on bonds of differing maturities move together over time. [A rise in short-term rates (STR) will raise people’s expectations of future short-term rates. Because long-term rates (LTR) are the average of expected future short-term rates, the rise inSTRs will lead to rise in LTRs causing LTRs and STRs to move together.] • When short-term interest rates are low, yield curves are more likely tohave an upward slope; when short-term rate are high, yield curves are more likely to slope downwards and be inverted. [When STRs are high people will generally expect them to fall in the future and so LTRs will be lower than STRs because the average of expected future STRs would be lower than current STRs and the yield curve slopes downwards.] • Yield curves almost always slope upward. [Expectations theory suggests that the typical yield curve should be flat rather than upwardsloping]