FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
ECN222 Financial Markets and Institutions – 2016
Questions and Answers
Question 1
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
, FOR MORE HIGH-QUALITY PAST PAPER MODEL ANSWERS, ONLINE TUTORING AND
ECONOMICS HELP, visit LondonEconomicsTutors.co.uk.
Discounted prices compared to all other websites
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∗
There is unfavorable empirical evidence for the Efficient Market Hypothesis, which indicates that the
rate of return does not fully reflect all available information. In particular, new information is not
always immediately incorporated into stock prices, and there is a small-firm effect which indicates
that small firms have abnormally high returns. Further, there is a January effect which indicates that
firms earn abnormally high returns in January, and that markets over-react to new information. All of
these facts indicate that the returns which securities earns do not fully reflect all available information.
b) The main financial markets are the debt/bond markets, and the equity market. The four phases of
the business cycle are expansion, peak, contraction, and trough.
Within the debt/bond market, corporations and governments issue debt to financial their activities,
whether that be investment in the case of corporations or government spending in the case of
governments. Within this market, interest rates are determined as a function of supply and demand.
During a business cycle expansion or peak, both the demand and supply of bonds increase.
Depending on whether the demand or supply increase more, this may lead to an increase or
decrease in the price of bonds. The price of bonds is inversely related to the rate of return on bonds.
If the supply increases more than demand, then the equilibrium price decreases and the interest
rate increases. Conversely, if the demand increases more than supply, then the equilibrium price
increases and the interest rate decreases.
An equity market is a market within which company stocks are traded. It allows businesses to be
publicly traded and allows them to raise additional financial capital by selling shares of ownership of
the company. A stock investor can earn a return through capital gain through the stock price
appreciating, and through the dividends paid to the stockholder. The business cycle can impact stock
market prices in a number of ways. In a recession or period of uncertainty, equity prices may
increase as a result of anticipation effects which indicate that the stock market is anticipating a
recovery. Further, they are strongly impacted by interest rates, which typically decline during an
economic downturn.
c) The main functions of a money market are to trade in short-term loans between banks and other
financial institutions. For investors, it provides a way for them to store surplus funds for short
periods of time until it can be put to more profitable uses, and for borrowers it provides a low-cost
source of short-term funds. Within corporations and governments, the inflows and outflows of cash
may not be synchronized, and therefore they need a way to borrow money to plug these gaps.
Within the money market, securities are usually sold in large denominations which have high
liquidity and low default risk and are therefore the securities are practically close to money.
