UMED8V-15-3

Module Title: Economics of International Financial Markets

Examination Duration: 24 Hours online

Assessment opens: 2 May 2023, 14:30

Submission deadline: 3 May 2023, 14:30

ONLINE EXAM

Instructions to Students:

• There are two sections of the exam. Students must answer all four questions from section A and any two questions from section B.

• The questions in Section A carry 10 marks each. Marks are awarded to appropriate methods (formula, model etc.), correct numerical answers and clear and brief explanations. The questions in Section B carry 30 marks each. Marks are awarded to detailed analysis, appropriate use of graphs and clear presentation of examples/evidence.

• As is usual for an exam, for this assessment you are not expected to include full referencing, but are encouraged to cite the sources of key theories, models, case studies, statutes etc.

• This is an individual assessment: do not copy and paste work from any other source or work with any other person during this exam. Text-matching software will be used on all submissions.

• There is no +/- 10% on word count and anything after the maximum word count will not be marked, in line with UWE’s Word Count Policy. The word limit is 2,000 word.

Formatting

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Please include the module name and number and your student number (not your name).

Please indicate clearly which questions you are answering.

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There is no late submission permitted on this timed assessment.

Section A:

1. Consider a bond with a par value of £1,000, a coupon rate of 3.9%, a maturity of 25 years and one coupon instalment per year. The market interest rate of this bond is currently 0.95%. Calculate the fair price of the bond. If the bond price were to change to £1,080 in a year’s time, what would be the interest rate on this bond then?

(10 marks)

2. Consider two assets: Dell stock and Lenovo. You believe Dell stock will either go up in value by 40% or go down in value by 20% next year, with equal probability, and Lenovo will either go up by 30% or go down by 10% next year, with equal probability. Calculate the expected return and standard deviation for each asset. If you were to spread money between the two assets equally, what would be the expected return and standard deviation of the portfolio, assuming their returns are independent of each other? Briefly explain why it is beneficial to hold the portfolio rather than any one of the two assets alone.

(10 marks)

3. Consider the stock of DrReddyslab PLC traded on London Stock Exchange. The beta of the stock is 0.42. The risk-free interest rate is 0.8%. If FTSE all share index is expected to rise by 12% next year, what would be the expected return of DrReddyslab stock next year, according to the Capital Asset Pricing Model (CAPM)? The consensus of analysts is that the Earnings Per Share (EPS) of DrReddyslab is expected to be £5.06 next year. The Return on Equity (ROE) is expected to remain unchanged at 25%. The dividend payout ratio is also expected to remain unchanged at 90%. What would be the fair price of DrReddyslab stock, according to the Constant Growth Dividend Discount Model?

(10 marks)

4. Singapore Exchange (SGX) offers a 3-month $/£ futures contract at $1.10/£. The size of contract is £77,500. Trader C buys one contract and deposits the initial margin of $6,000 in her margin account. The maintenance margin is $5,000. Suppose the futures prices on the following three days are $1.08/£, $1.12/£ and $1.11 respectively. Find out when he would receive a margin call. Suppose she tops up the margin account to $6,000 after receiving the margin call. What is her rate of return on the total investment?

(10 marks)

The fair price of the bond can be calculated using the following formula:

Price = (Coupon Payment / (1 + Market Interest Rate)^1) + (Coupon Payment / (1 + Market Interest Rate)^2) + … + (Coupon Payment + Face Value / (1 + Market Interest Rate)^25)

where Coupon Payment = 0.039 * £1,000 = £39

Plugging in the values, we get:

Price = (£39 / 1.0095) + (£39 / 1.0095^2) + … + (£39 + £1,000 / 1.0095^25) = £1,225.74

Therefore, the fair price of the bond is £1,225.74.

If the bond price were to change to £1,080 in a year’s time, we can calculate the interest rate using the following formula:

Price in one year = (Coupon Payment / (1 + Interest Rate)^1) + (Coupon Payment + Face Value / (1 + Interest Rate)^25)

where Price in one year = £1,080

Plugging in the values and solving for the interest rate, we get:

Interest Rate = 0.0368 or 3.68%

Therefore, the interest rate on the bond in one year would be 3.68%.

The expected return and standard deviation of each asset can be calculated using the following formulas:

Expected return = (Probability of Gain x Expected Gain) + (Probability of Loss x Expected Loss)

Standard deviation = [(Probability of Gain x (Gain – Expected Return)^2) + (Probability of Loss x (Loss – Expected Return)^2)]^(1/2)

For Dell stock, the expected return and standard deviation are:

Expected return = (0.5 x 40%) + (0.5 x -20%) = 10%

Standard deviation = [(0.5 x (40% – 10%)^2) + (0.5 x (-20% – 10%)^2)]^(1/2) = 24.50%

For Lenovo, the expected return and standard deviation are:

Expected return = (0.5 x 30%) + (0.5 x -10%) = 10%

Standard deviation = [(0.5 x (30% – 10%)^2) + (0.5 x (-10% – 10%)^2)]^(1/2) = 18.71%

If the returns are independent of each other, the expected return and standard deviation of the portfolio can be calculated as follows:

Expected return = (Weight of Dell x Expected return of Dell) + (Weight of Lenovo x Expected return of Lenovo) = (0.5 x 10%) + (0.5 x 10%) = 10%

Standard deviation = [(Weight of Dell x Standard deviation of Dell)^2 + (Weight of Lenovo x Standard deviation of Lenovo)^2]^(1/2) = [(0.5 x 24.50%)^2 + (0.5 x 18.71%)^2]^(1/2) = 21.10%

It is beneficial to hold the portfolio rather than any one of the two assets alone because the portfolio offers a lower level of risk (as measured by the standard deviation) than holding either Dell or Lenovo alone. Diversifying across multiple assets can help to reduce risk and volatility in the portfolio.

According to the Capital Asset Pricing Model (CAPM), the expected return of DrReddyslab stock can be calculated using the following formula:

Expected return = Risk-free rate + Beta x (Expected market return – Risk-free rate)

where Risk-free rate = 0.8

Section B:

5. When the Federal Reserve Conducts an expansionary monetary policy, what happens to the money supply? How does this affect the supply of dollars assets? How does this affect the dollar exchange rate in the short run and long run?

(30 marks)

6. Evaluate the statement “if a country wants to prevent its exchange rate from changing, it must give up some control over its money supply”.

(30 marks)

7. At Timekeeper Watch Corp., a director of the company said that the use of dividend discount models by investors is “proof” that the higher the dividend, the higher the stock price.

a. Using a constant-growth dividend discount model as a basis of reference, evaluate the directors’ statement.

b. Explain how an increase in dividend pay-out would affect each of the following (holding all other factors constant):

i. Sustainable growth rate.

ii. Growth in book value.

(30 marks)

8. Evaluate the Efficient Market Hypothesis (EMH) using evidence and explain its implications for investment strategy.

(30 marks)

END OF QUESTION PAPER

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