This paper must be left in the Examination Hall.

Before you begin, please write your ID number here:

FINANCIAL MARKETS AND INSTITUTIONS

(18BSP422)

January 2019 2 Hours

Answer the ALL questions in Part A and any TWO other questions from Part B.
Questions 1 to 15 should be answered by circling
the correct answer (A, B, C or D) on the exam paper.
Answers to Part B should be in the separate pink answer booklet.
You must write your answers in ink.
Answers written in pencil may receive a zero mark.
Please ensure you write your Student ID Number in the box above.

PART A

This part of the exam is worth 30 of the total available marks.

Place a circle around the correct answer (A, B, C or D) for questions 1 to 15. Each
question is worth 2 out of the available 100 marks.

1. What institution operates on the sell side of the primary market for securities?

A. Asset manager
B. Hedge fund
C. Bookbuilder/ underwriter CORRECT
D. Pension fund

2. What is NOT a feature distinguishing an exchange traded fund (or ETF)?

A. An ETF is passive, tracking an index

B. An ETF is listed on an exchange and traded like an equity
C. An ETF holds only liquid assets that can be easily bought or sold
D. An ETF holds a portfolio diversified across sectors and firm size CORRECT

Page 1 of 7
3. Which of the following is NOT a violation of ‘weak’ market efficiency?

A. Profitable insider trading, based on unpublished company information

B. Dealer trading, standing ready to buy at a quoted bid price and sell at a
higher quoted ask price, profiting from the spread between the two.
CORRECT
C. High frequency trading, profiting from very short-term price movements
D. Long-run fundamental based trading, obtaining better than market returns

4. During a period of strong US economic growth and rising US interest rates, which
bond can be expected to have the largest percentage price fall?

A. 2 year US Treasury note

B. 2 year General Motors Corporate bond
C. 10 year US Treasury bond CORRECT
D. 10 year General Motors Corporate bond

5. A young graduate, setting up a self-manged pension scheme, is deciding in which

investment fund to place their contributions so as to provide for their retirement forty
years from now. On past experience, which choice would give them the highest
pension?

A. An active global equity fund

B. A passive global equity fund CORRECT
C. An active global bond fund
D. A passive global bond fund

6. Which type of firm is most subject to the discipline of the ‘market for corporate
control’ (i.e. hostile takeover).

A. A publicly owned firm with dispersed ownership CORRECT

B. A publicly owned firm with a dominant shareholder owning 40% of equity
C. A family owned firm with professional management
D. A start up with 40% of capital owned by a venture capital fund

7. What is NOT a reason for a private firm to go public through an initial public offering
(IPO) of its shares?

A. Raising cash for investment and expansion

B. Bringing in experienced investors who can contribute expertise to help the
company grow faster CORRECT
C. Rewarding the owners, allowing them to monetise their investment (through
sale or through using as collateral for borrowing)
D. Establishing credibility and reputation with private investors, in order to
reduce the cost of debt and equity financing

Page 2 of 7
8. Which statement is true?

A. A limit order provides liquidity to other market participants; a market order

removes uncertainty about the trading price and time needed for execution
CORRECT
B. A market order provides liquidity to other market participants; a limit order
removes uncertainty about the trading price and time needed for execution
C. A limit order provides liquidity to other market participants and removes
uncertainty about the trading price and time needed for execution
D. A market order provides liquidity to other market participants and removes
uncertainty about the trading price and time needed for execution

9. What is the role of an interdealer broker such as ICAP-TB?

A. They provide a matching service, allowing dealers trade anonymously with

each other to reduce their exposure to changing market prices. CORRECT
B. They reduce the impact on market prices of large financial market trades
C. They provide liquidity to otherwise illiquid markets
D. They are the ‘dealer’s dealer’, providing bid and ask quotes at which they will
buy or sell securities and derivatives from OTC market dealers.

10. A dealer has built up a long position of £10mn in five year government bonds and
wishes to hedge against the resulting market risk. How can they most directly do
this?

A. Reducing both their ‘bid’ and ‘ask’ prices for bonds, so clients buy more and
sell them less.
B. Taking a long position (i.e. an agreement to future purchase) of £10mn in
five-year bond futures in one year’s time
C. Taking a short position (i.e. an agreement to a future sale) of £10mn in five-
year bond futures in one year’s time CORRECT
D. Widening the spread between ‘bid’ and ‘ask’ prices

11. A hedge fund anticipates a strong recovery in a troubled firm over the next 12
months. It buys €50mn of its bonds, currently trading at well below par value, paying
a floating rate of interest with a maturity of five years. How would it hedge this trade
against a rise of interest rates and/ or a rise in average market credit spreads?

A. Buy an interest rate swap (paying fixed, receiving floating LIBOR over five
years); buy CDS index (paying average credit spread over five years).
B. Sell an interest rate swap (receiving fixed, paying floating LIBOR over five
years); buy CDS index (paying average credit spread over five years).
CORRECT
C. Buy an interest rate swap (paying fixed, receiving floating LIBOR over five
years); sell CDS index (receiving average credit spread over five years).
D. Sell an interest rate swap (receiving fixed, paying floating LIBOR over five
years); sell a CDS index (paying average credit spread over five years).
Page 3 of 7
12. Which of the following intermediaries is responsible for guaranteeing derivative and
securities trades?

A. Central counterparty CORRECT

B. Central securities depository
C. Central bank
D. Custodian bank

13. Which two central bank actions both increase market rates of interest?

A. Selling bonds on open market; increasing reserves using repo with

commercial banks
B. Buying bonds on the open market; increasing reserves using repo with
commercial banks
C. Selling bonds on open market; reducing reserves using reverse repo with
commercial banks CORRECT
D. Buying bonds on the open market; reducing reserves using reverse repo with
commercial banks

14. Which contract involves the greatest risk of loss from the failure of the counterparty?

A. Repo (on ‘good collateral’)

B. Bank wholesale deposit CORRECT
C. Treasury bill
D. Foreign exchange swap

15. Taking a short position in an equity requires:

A. Borrowing the equity, then selling it CORRECT

B. Buying the equity, then lending it
C. Borrowing the equity and hedging with an equity index future
D. Buying the equity and hedging with an equity index future

Page 4 of 7
 PART B

(use the separate pink answer booklet to answer questions from this section)

Answer any TWO of the questions in this part of the exam. Each question is worth 35
marks.

16. Irrational Exuberance

(a) Are asset markets (e.g. stock markets, bonds, real estate prices) excessively volatile
relative to ‘fundamentals’ i.e. reasonable estimates of the present discounted value of
future cash flows from these assets? [20 marks]
This can be answered largely from lecture material, especially for stock markets.
Students should be aware and provide examples of large changes in the prices of
financial assets -- both sharp declines at times of economic downturn and stress and
lack of liquidity in markets & strong recoveries when conditions reverse -- and that these
are difficult to explain based just on economic fundamentals. The best arguments will
clearly communicate both theoretical understanding and supporting examples and
evidence.
(b) US stock prices – the S&P 500 index – rose by around 300% between February 2009
and September 2018. Is it possible to determine if this increase was a speculative
bubble that will eventually reverse? [15 marks]
This question is a little more difficult, inviting them to make their own argument. They
could respond by appealing to Fama’s concept of market efficiency, arguing that even
though the rise of prices is difficult to explain, there is no obvious opportunity to predict
movements of the market in future.

17. Bonds and bond risks

(a) Discuss, with reference to the decline in dollar inflation and dollar yields over the
past forty years, how changes in inflation and in bond yields impact the returns to
investment in government bonds [20 marks]

Answering from lecture material, I expect clear discussion of the how inflation market
yields are related to bond prices (increases in inflation/ yields reduces prices). The better
answers must include the discussion of the fall in yields from around 17% in 1979 to 3%
today, associated with falling inflation and greater independence of central banks including
the Federal Reserve.
(b) US inflation and yields are starting to rise with economic recovery and the tightening
of monetary policy. In the light of these recent trends, what portfolio advice would you
give to investors in US government bonds? [15 marks]

Good answers here will be aware of the difficulties of giving portfolio advice and
provide some appropriate risk – return analysis. E.g. the risks of bond investment are
now rather tilted towards the downside, because there is much more room for inflation
and yields to rise than to fall. At the same time, concern about potential tightening of
US monetary policy is making bond markets relatively volatile, especially in emerging
markets. That said, should all depend on investment horizon – over a short 2 – 3 year
there is little alternative to bonds for providing a secure return.

18. Corporate governance

(a) Explain, with examples, why separation of ownership and control can be a problem
for the governance of publicly listed companies. [20 marks]
Page 5 of 7
 Answered from lecture material, should cover the ‘principal agent’ problem involved
with diversified shareholding, that there is little incentive for individual shareholders to
become much involved in the governance of the company. That this may result, for
example, in too much emphasis on short run performance at the expense of long run
growth; or management engaged in vanity projects. Best answers will provide
examples and other supporting evidence.

(b) Contested takeovers are particularly common in ‘anglo-saxon‘ jurisdictions such as

the US, the UK, Australia and Canada. Is this good or bad for shareholders?

[15 marks]

The best answers will recognise the nuance in this question. Depends which
shareholders! Generally the shareholders in acquired companies do well, they get a
price well above the market price before the takeover. The position is much more
mixed for shareholders of the acquiring companies, where too often the desire to make
the deal happen and overoptimism about the benefits leads to much too high a price
being paid. This is in fact an illustration of the problems of separation of ownership and
control discussed under a). Finally strongest answers will recognise the benefits of a
market for corporate control, serving a general discipline on management and
offsetting the problems of separation of ownership and control discussed under (a)

19. Computer based trading and financial market stability.

(a) Describe and explain the rise of computer-based equity trading over the past two
decades, distinguishing algorithmic and high-frequency trading. [20 marks]
The description will need to explain (i) the use of computers to execute client trades and
obtain best execution, taking account of where market liquidity is available and the
preferences of clients over the tradeoff between immediacy and price: (ii) the use of
computers in high frequency trading to exploit very short term predictability in market
prices. The explanation can be helped by brief discussion of order-books (though should
not go into this in too much detail) and how these provide both: (i) the information on
limit orders/ market depth that can be used by computers to determine their trading
decisions; and (ii) the ability to submit or fill limit orders for computerised execution.
(b) Are ‘flash crashes’, such as those of May 2010 or other more recent episodes, an
inevitable consequence of machine v. machine trading? [15 marks]
Here looking for insightful opinion supported by some knowledge of the 2010 flash crash
and subsequent episodes. May argue that this inevitable (supported by the point that
computers do not think if trade is rational, and the continuing occurrence of mini flash
crashes) or that the problems revealed in 2010 are in large part (if not completely) being
resolved, by e.g. introduction of ‘circuit breakers’ or improvements in HFT/ Algo
programming that limits excess response.

20. Benchmark Fixing and Bank Ethics.

(a) Briefly explain how financial market transactions (including in derivatives such as
foreign exchange forwards or interest rate swaps) are used for both reducing risk
exposures and for accepting risk exposures in return for expected profits.
[20 marks]
The answer, drawing on lecture material, should show a good understanding of the
different aspects of trading. They should outline hedging of underlying risk exposures
(from international trade, in asset management) a supporting example or two will be a
good way to demonstrate the understanding. To some extent there is natural hedging with
the position of two participants offsetting each other. But to the extent that remaining risks
must be carried on the market, then they must be accepted by others (‘speculators’) in
return for earning an expected return. Additional credit for any further insight into this quite
Page 6 of 7
tricky question, .e.g noting that dealers holding open unhedged positions are accepting
risk in return for an expected return; or proprietary tradersin e.g. Forex that buy and sell,
each accepting a small part of underlying risk.
(b) Is regulation needed to ensure customers are treated fairly by derivative and foreign
exchange dealers? [15 marks]
Expecting some insight into the problems over recent years of foreign exchange and other
market manipulation of recent year (illustrations and examples helpful, likely to be of forex
manipulation since this is where lecture material focused). Different opinions possible on
the role of regulation with regard to fiduciary duties, of culture and also (possibly) on
technological responses that make markets more transparent and allow the burden of
responsibility for finding a good deal to be placed more on clients.

21. Active versus Passive Fund Management.

(a) Explain, with examples, the operation of passive investment funds and why they are
nowadays so popular with investors. [20 marks]
We have covered quite a bit on this in class. Expecting a discussion of low fee passive
funds, both benchmark tracking open-ended funds and of ETFs. How also active funds
typically, after fees, perform worse than passive funds (and sometimes do no better or
even worse than benchmark. Ideally some illustrative numbers to show aware of the
magnitude of the underperformance. Can usefully refer to the growing share of passive
funds, especially amongst institutionally managed portfolios.
(b) Discuss and assess the benefits and costs to investors of the decline in active
investment management. [15 marks]
At one level this is easy to answer, in most cases the better performance of active funds (if
achieved at all) has not been sufficient to outweigh their higher fees. In most cases
investors obtain better returns from passive investment. I expect supporting examples. The
best answers though will recognise that there are at least potentially costs from the decline
in active management, in particular fewer genuinely active funds that seek to profit from
accepting risk the market function of price revelation may be weakened (resulting e.g. in
greater volatility of pricing and higher costs for using financial markets to hedge risks).

A.K.L. MILNE

Page 7 of 7