High-quality past paper questions and answers for the ECN222 Financial Markets and Institutions module for the Queen Mary University of London (QMUL) Economics Course. Each question is reproduced and high-quality full-mark scores are written up clearly for each one. Great for preparing for exams, s...
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ECN222 Financial Markets and Institutions – 2018
Questions and Answers
Question 1
a) Convertible bonds let a bondholder exchange a bond to a number of shares of the issuer's
common stock. These are generally more attractive for investors, because they provide the ability
for the investor to stay with the “safe” return of the bond or exchange it for the riskier common
stock if it becomes profitable to do so. Stocks are riskier than bonds because stockholders have
lower priority than bondholders when a firm goes into liquidation and because stock price increases
are not guaranteed. It is a security that optimally protects the investor’s principal on the downside
but allows them to participate in the upside should the underlying company succeed. A convertible
bond investor can get back some principal upon failure of the company but can benefit from capital
appreciation by converting the bonds into equity if the company is successful.
b) Three factors which can shift the supply of bonds include. Expected profitability of investment
opportunities. In a business cycle expansion with growing wealth, the supply of bonds increases and
the supply curve shifts to the right. Expected inflation, as an increase in expected inflation causes the
supply of bonds to increase and the supply curve to shift to the right. Government budget, as a
higher government deficit increases the supply of bonds and shift the supply curve to the right.
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Question 2
a) In financial markets, expectations regarding returns, risk and liquidity are important in
determining out financial institutions operate, the demand for asses and the price of securities. The
Efficient Market Hypothesis states that the prices of securities in financial markets fully reflect all
available information in an efficient market. Formally, we can first define the realized rate of return
as the sum of capital gains plus cash payments, and the expected rate of return as the cash
payments relative to the expected capital gains:
𝐶 𝑃 − 𝑃
Realised Rate of Return = R = +
𝑃 𝑃
𝐶 𝑃 − 𝑃
Expected Rate of Return = R = +
𝑃 𝑃
The Efficient Market Hypothesis is that, using all available information, the expected rate of return is
equal to the optimal forecast of the rate of return. In equilibrium, the Efficient Market Hypothesis
implies that the optimal forecast of the rate of return (Rof) is equal to the equilibrium return (R*).
Mathematically:
𝑅 = 𝑅∗
Therefore, if the efficient market theory is true, then any available information regarding the latest
news and trends in the stock market contained within Smart Investing magazine has already been
incorporated into current prices within the technology market. Therefore, it would not be beneficial
to sell technology stocks now, as the price has already adjusted to reflect their decreased
profitability.
b) 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). An increase in
productivity of American companies relative to the productivity of other countries would result in an
appreciation of the US dollar relative to other currencies. The mechanism by which this occurs is
because an increase in productivity results in greater demand for U.S. goods, which therefore drives
domestic prices higher, driving an appreciation in the U.S. exchange rate in the long run due to the
purchasing power parity theory.
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