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ECS3701
EXAM PACK
Questions. Answers
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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)
...
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
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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.
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A normal yield curve:
Yield to Maturity
Term to Maturity
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
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