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ECN222 Financial Markets and Institutions – 2017
Questions and Answers
Question 1
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Discounted prices compared to all other websites
a)
A derivative is a financial instrument whose value depends on the value of other underlying
variables. These underlying variables are often the prices of traded assets. Four broad categories of
derivative products are forwards, futures, swaps and options. A swap is an agreement to exchange
cash flows at specified future times according to specified rules. They are typically used for interest
rate swaps, and can be used to convert a liability or investment from a fixed rate to a floating rate,
or vice-versa. They can also be used to reduce interest rate risks.
For example, consider a bank that has purchased $100 million 5-year corporate bond which pays a
fixed rate of 5% per year, financed using one-year deposits from customers which costs them a rate
of interest equal to the 1-year LIBOR rate (which varies from year to year). A interest rate swap
would involve the bank swapping these rates of interest with a swap dealer. They would then
receive a rate of 5% to the swap dealer and receives 1-year LIBOR rate. This reduces the interest rate
risk associated with paying their customers the variable LIBOR rate.
b)
The Law of One Price states that the price of an identical good will be the same throughout the
world, regardless of which individual country produces it. Note that this assumes that there are no
costs associated with exchanging currencies, and no transportation costs or other frictions to
impede trade. If the products do not cost the same, then there exists an arbitrage opportunity which
will result in the exchange rate varying such that the prices equalize again. The Law of One Price is
typically applied to the same individual good. In predicts that the Real Exchange Rate equals one in
the long term.
The theory of Purchasing Power Parity is that the exchange rates between two currencies will adjust
to reflect changes in price levels. That is, if one's country price level rises relative to another's, its
currency should depreciate (the other country's currency should appreciate).
c) The quantities that are included on the two sides of a Central Bank’s balance sheet are its assets
and liabilities. Its assets include government securities, such as Treasury bills and bonds which the
bank has purchased on the open market, as well as loans to member banks at the current discount
rate. The second is liabilities, which includes the currency in circulation and any reserves which are
held by the central bank on behalf of banks. The sum of these two items is the monetary base.
Open market operations are one of the four monetary policy tools used by the US Federal Reserve
and is the most important. Open market operations involve purchasing and selling bonds through
the open market. The purpose of holding open market operations is to vary the size of the monetary
base. For example, by buying bonds from private traders, the central bank increases the size of the
monetary base. As a result, this would decrease the federal funds rate which is the rate that banks
charge each other for overnight loans. This is the primary goal of the Federal Reserve’s monetary
policy actions.
d)
i)
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
ECN222 Financial Markets and Institutions – 2017
Questions and Answers
Question 1
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
a)
A derivative is a financial instrument whose value depends on the value of other underlying
variables. These underlying variables are often the prices of traded assets. Four broad categories of
derivative products are forwards, futures, swaps and options. A swap is an agreement to exchange
cash flows at specified future times according to specified rules. They are typically used for interest
rate swaps, and can be used to convert a liability or investment from a fixed rate to a floating rate,
or vice-versa. They can also be used to reduce interest rate risks.
For example, consider a bank that has purchased $100 million 5-year corporate bond which pays a
fixed rate of 5% per year, financed using one-year deposits from customers which costs them a rate
of interest equal to the 1-year LIBOR rate (which varies from year to year). A interest rate swap
would involve the bank swapping these rates of interest with a swap dealer. They would then
receive a rate of 5% to the swap dealer and receives 1-year LIBOR rate. This reduces the interest rate
risk associated with paying their customers the variable LIBOR rate.
b)
The Law of One Price states that the price of an identical good will be the same throughout the
world, regardless of which individual country produces it. Note that this assumes that there are no
costs associated with exchanging currencies, and no transportation costs or other frictions to
impede trade. If the products do not cost the same, then there exists an arbitrage opportunity which
will result in the exchange rate varying such that the prices equalize again. The Law of One Price is
typically applied to the same individual good. In predicts that the Real Exchange Rate equals one in
the long term.
The theory of Purchasing Power Parity is that the exchange rates between two currencies will adjust
to reflect changes in price levels. That is, if one's country price level rises relative to another's, its
currency should depreciate (the other country's currency should appreciate).
c) The quantities that are included on the two sides of a Central Bank’s balance sheet are its assets
and liabilities. Its assets include government securities, such as Treasury bills and bonds which the
bank has purchased on the open market, as well as loans to member banks at the current discount
rate. The second is liabilities, which includes the currency in circulation and any reserves which are
held by the central bank on behalf of banks. The sum of these two items is the monetary base.
Open market operations are one of the four monetary policy tools used by the US Federal Reserve
and is the most important. Open market operations involve purchasing and selling bonds through
the open market. The purpose of holding open market operations is to vary the size of the monetary
base. For example, by buying bonds from private traders, the central bank increases the size of the
monetary base. As a result, this would decrease the federal funds rate which is the rate that banks
charge each other for overnight loans. This is the primary goal of the Federal Reserve’s monetary
policy actions.
d)
i)
