Introduction to Financial Market

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RSM 230 H1S - Financial Markets

Mid Term Exam

March 4th, 2016

Time: 2 hours

SOLUTIONS

INSTRUCTORS:  Will Huggins, Fotini Tolias

INSTRUCTIONS:    

• Part A: Answer all of the multiple choice questions on your Scantron .
• Part B: Answer all the questions on this paper in the space provided.
• This is a closed book exam. No formula sheet is allowed.
• Non-programmable calculators are permitted.

PLEASE check that you have filled in your SCANTRON sheet correctly in PENCIL:

1. Write in and bubble your student ID number (one entry per column) as well as your Last Name and Initials. Hyphenated last names should be bubbled in without spaces or dashes. 

1. Do not make any marks outside the shaded area

Last Name: _______________________________________

First Name: _______________________________________

Student #  :________________________________________  

This exam paper has <> pages including the cover page.

PART A – Multiple choice questions

Please provide your single “best” answer in pencil on the Scantron provided.  All questions are equally weighted (2 points each)

1. An open market operation occurs when:

1. the Bank of Canada buys stocks to support the market
2. the CAD/USD exchange rate gets too high
3. the Bank of Canada buys government bonds from the public
4. the Bank of Canada sells government bonds to the public
5. both c and d are true

1. The money supply increases when the Bank of Canada:

1. sells government bonds to the public
2. offers to pay commercial banks a higher interest rates on their deposits
3. increases the required reserve ratio for chartered banks
4. shifts Government of Canada deposits from its accounts into the banking system
5. all of the above

1. Which of the following represents the primary source of capital in Canada?

1. The foreign (international) sector
2. Households
3. Corporations
4. Government
5. The banking system

1. Primary markets involve _____; while secondary markets involve_____.

1. The sale of securities; the sale of loans
2. Capital formation for the company; shares changing ownership amongst investors
3. The sale of securities of large corporations on a stock exchange; the sale of the securities of smaller companies on a stock exchange
4. Trading of securities on a stock exchange; trading of securities OTC.
5. Creating loans from deposits; selling new shares to investors

2. Which ordering correctly ranks the rates paid on money market securities:

1. Treasury bills < R2High CP < R1High CP < Asset-Backed CP
2. Treasury bills < R1High BA < R1Low BA < R2High securitizations
3. Treasury bills > R1High BA > R1Low CP > R2Low securitizations
4. Treasury bills < R1High CP < R1High BA < R2High Corporate Bonds
5. R1High CP < R2High BA < R2Low CP < Treasury Bills

1. The Bank of Canada's monetary policy is based on:

1. creating full employment
2. managing the CAD/USD exchange rate
3. targeting the money supply
4. the demands of parliament
5. targeting inflation

1. Which of the following statements is not true of non-market intermediaries in Canada:

1. they all maintain cash balances for liquidity purposes
2. they all participate in the CPA
3. they all engage in asset transformation
4. they all manage portfolios of assets
5. the question is a trick, all of the above are true

1. A Purchase and Resale Agreement involves:

1. the Bank of Canada selling securities to chartered banks
2. an interest-free loan from the Bank of Canada to a chartered bank to maintain liquidity
3. decreasing the money supply
4. a bank paying a higher future price for securities it held before the PRA
5. the purchasing of distressed assets from commercial banks

1. Which of the following is NOT affected by central bank monetary policy?

1. Money supply
2. Interest rates
3. The availability of credit
4. The inflation rate
5. None of the above

1. Which of the following statements is TRUE?

1. OSFI oversees Canadian chartered banks, insurers and pension funds.
2. Investment advice received from a broker or financial advisor is not guaranteed
3. OSC is the national regulator of the Canadian securities industry
4. A and C are true
5. A and B are true

1. The major financial assets of the Canadian household sector consists of:

1. Land and pensions & insurance
2. Shares and houses (residential structures)
3. Pensions & insurance and shares
4. Deposits (in banks) and Land
5. None of those combinations        

1. If one-year Treasury bills are currently yielding 3%, what probability of default is implied for commercial paper promising to pay 4% in 1 year?

1. 4%
2. 1%
3. 2%
4. 3%
5. cannot be calculated from this information

1. The Bank Rate is:

1. the Canadian inter-bank lending rate
2. the interest rate charged by banks on loans to their best customers
3. set by the chairman of the US Federal Reserve system
4. interest rate charged by the Bank of Canada to banks that borrow from it
5. the spread between Treasury bills and the prime rate

1. During a flight to quality in money markets, we always observe an increase in:

1. the amount of government borrowing
2. the rate of corporate defaults
3. the volume of inter-bank lending
4. the spread between treasury bills and commercial paper
5. the cost of bond issuance

1. If a bond with a 5.00% coupon, $100 face value, and 3.90% YTM is bought for $101.07 and held until it matures in one year later, the holding period return is:

1. -0.74%
2. 3.90%
3. 5.00%
4. 4.95%
5. Cannot calculate – it depends on how interest rates change between now and then

1. If a 60-day Government of Canada Treasury bills is priced to offer a 4% yield with a maturity value of $1000, the current price will be quoted as:

1. $99.338
2. $99.353
3. $993.38[pic 2]
4. $99.347
5. $993.47

1. Which of the following statements are TRUE about securitization?

1. Securitization transforms credit cards and auto loans into marketable  

securities which are sold to institutional investors

1. Assets are sold to an SIV which issues asset backed commercial paper
2. Credit quality is enhanced by overcollateralization and bank guarantees
3. Most securitizations received strong credit ratings.
4. All of the above are true

1. Fractional reserve banking creates:

1. wealth
2. transparency
3. currency
4. liquidity
5. financial crises

1. When investment dealers market an offering of new bonds, they are acting as ____________ in the _________ market.

1. principals; primary
2. agents; primary
3. agents; third
4. principals; secondary
5. agents; stock

1. Which of the following is true about the Canadian Payments Association?

1. Cheques are settled when banks pay what they owe by writing cheques on their Bank of Canada deposit accounts.
2. The Canadian Payments Association is privately run by the chartered banks to clear and settle cheques and other inter-bank payments.
3. Debits, automatic bank payments and payments for large securities transactions are settled electronically through the Large Value Transfer System
4. It was created by an act of parliament in 1934 to help deal with the Great Depression
5. Chartered banks are paid interest on settlement balances held at the Bank of Canada, based on the target overnight rate less 0.25%

1. If a 30-day Government of Canada Treasury bill sells for a 0.5% discount, its effective yield is:

1. 0.5000%
2. 6.0000%
3. 6.0830%
4. 6.1139%
5. 6.0303%

1. Canadian banking differs from US banking in that:

1. we don't allow branch banking across the country
2. we have no reserve requirements
3. the US market is highly concentrated
4. the central bank regulates all commercial banking activities
5. all of the above

1. Basel 1 requires that banks:

1. disclose all their risks to government regulators
2. retain a percentage of deposits to ensure liquidity
3. have sufficient equity capital to absorb loan losses
4. have Tier 1 capital equal to at least 6% of their total assets
5. bring their off-balance sheet liabilities onto their balance sheet

1. CDIC provides insurance to individuals in the event of:

1. bank failure
2. securities fraud
3. personal bankruptcy
4. insurance default
5. all of the above

13. Assume Canadian Standard Bank had $10 million of cash outflows over the past 30 days.  The bank is required to:

1. Hold $10 million of reserves with the Bank of Canada
2. Hold cash & short term liquid securities equal to $10 million
3. Required to hold 10% of demand and notice deposits
4. Not required to hold anything as Canadian banks are very safe
5. None of the above

Use the the following bond quotation to answer the next two questions (26 & 27):

Loblaw  6%  July 1, 2019:   100.50   101.20    5.94

1. How much would you receive if you sold this bond on March 4th, 2016,   based on the quotation provided above?

1. $1,005 plus accrued interest
2. $1,012 plus accrued interest
3. $1,005 minus accrued interest
4. $1,012 minus accrued interest
5. Cannot tell from the information provided

1. What is the credit spread on the Loblaw's bond assuming the yield on the appropriate government bond is 2%:  

1. 5.94%
2. 2.00%
3. 3.94%
4. 6%
5. 4%

1. Which of the following fixed income securities would you prefer to hold if you believe that probability of default is high since the economy is in a crisis?  

1. Commercial paper, AA rated corporate bonds
2. Commercial paper, Government of Canada bonds
3. Treasury bills, Government of Canada bonds  
4. Bankers' acceptances, Bank bonds
5. Cannot tell from the information provided

1. A government of Canada real return bond has a 2% coupon rate and a principal amount of $1,110 which includes inflation compensation.  What is the semi-annual coupon payment?

1. $22.20
2. $20.00
3. $11.10
4. $10.00
5. $44.40

1. Which of the following risk factors applies to nominal bonds issued by the Government of Canada?

1. Interest rate risk
2. Reinvestment rate risk
3. Inflation risk
4. A and C only
5. A, B and C

PART B – Short Answer Questions.  Each question is worth 10 points.

QUESTION 1 -

Financial intermediaries perform a number of valuable functions which overcome the difficulties associated with direct non-market investment.  Identify and briefly discuss five of the problems. (10 marks)

Answer:  1 pt each for identifying each problem/1 pt for explanation

Any 5 of:

1. Search costs

• How do you find someone to lend money to?

1. Double co-incidence of wants:

• Do they want to borrow exactly what you want to lend?

1. Contracting costs

• How do you write a contract so that you will get your money back?

1. Default

• How do you know the borrower is not a deadbeat or a crook?
• If you don’t receive payment how do you enforce your contract?

1. Liquidity

• If you want your money back early how can you sell the contract?

1. Asymmetric information

• The problem of adverse selection

1. Moral hazard

• The problem that the borrower may change their decision after receiving the money
• They say they will “invest” in a productive asset but then waste the money

QUESTION 2 - If its announcement of the target overnight rate fails to move the rate quickly, what can the Bank of Canada do (by intervening in the market) if the target rate is trading above the target. (6 marks)