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 allowing
it to be used as payment for goods and services. As such it promotes
economic efficiency...
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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 allowing
it 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 an
economy and helps to reduce transaction costs.
Store of Value: serves as a store of purchasing power from the time
the 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 market
in 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
, medium-term deposits held by the private domestic sector at monetary
institutions, 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 the
specific 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 the
interest 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 expressed
as 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 called
a 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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