TERM 1 AY2007-08

Mid-Term Test
20th Oct 2007

FNCE102

FINANCIAL INSTRUMENTS, INSTITUTIONS AND MARKETS

INSTRUCTIONS TO CANDIDATES

1 The time allowed for this test paper is 2.5 hours.

2 This test paper contains 2 sections.

Section 1: 15 MCQ questions (1 mark each)

Section 2: 10 Short answer questions (3 marks each)

There are a total of Ten (10) pages including this instruction sheet.

3 You are required to answer ALL questions.

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SECTION 1: MCQ

Please choose the correct answer from choices (A) to (E). (1 mark each)

Question 1

Due to an internal crisis, an FI is going to liquidate some of its assets. The chosen assets are
listed below, with their face values, current sale values and 1 year sale values. What is the 1 year
liquidity index for these assets?

Asset Face Value ($) Current sale value ($) 1 year sale value ($)
Stock A 15,000 9,000 10,500
Bond B 1,000 3,000 3,500
T-bills 4,000 10,000 11,500

A) 0.06
B) 0.16
C) 0.26
D) 0.56
E) 0.86

Solution: E

1 year Liquidity Index

= (15,000/20,000)(9,000/10,500) + (1,000/20,000)(3,000/3,500) +
(4,000/20,000)(10,000/11,500)
= 0.86

Question 2

Bank A pays 8% pa interest, compounded quarterly, on its money market account. The managers
of Bank B want its money market account to equal Bank A’s effective annual rate, but interest is to
be compounded on a monthly basis. What nominal, or quoted, rate must Bank B set?

A) 1.24% pa
B) 2.34% pa
C) 5.84% pa
D) 7.94% pa
E) 10.54% pa

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Solution: D

Compute the Effective Annual Return for Bank A.

EAR = (1 + iNom/m)m - 1
= (1 + 8%/4)4 – 1
= 8.24%

Bank B must have the same effective annual rate.

EAR = (1 + iNom/m)m - 1
= (1 + iNom /12)12 – 1
= 8.24%

iNom = 7.94% pa

Question 3

Assume that it is now January 1, 2004 and you will need $1,000 on January 1, 2008. To help you
reach your $1,000 goal, your father offers to give you $400 on January 1, 2005. You will get a
part-time job which makes 6 additional payments of equal amounts each 6 months thereafter. If
all of this money is deposited in a bank which pays 8% pa, compounded semiannually, how large
must each of the 6 payments be? (Assume payments in arrears.)

A) $34.56
B) $39.56
C) $74.46
D) $90.90
E) $150.90

Solution: C

FV of $400 deposit your father gave you on January 1, 2005.

FV = $400 (FVIF 8/2%, 6) = $506.13

Additional amount needed = $1,000 - $506.13 = $493.87

Since the payments are at the end of each period, use 6 periods,

FV = $X (FVIFA 8/2%,6)
= $493.87
$X = $74.46

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Question 4

A 20 year convertible bond has the following terms:

Yearly Coupon $70

Coupon rate 7% pa
Maturity Date 20 years
Quality Rating Baa
Current stock price $35
Conversion Price $50
10-year Baa bond rate 13% pa
10-year Riskfree rate 9% pa
20-year Baa bond rate 12% pa
20-year Riskfree rate 8% pa

Calculate the straight bond value and conversion value at time 0.

A) $626.53, $700
B) $626.53, $750
C) $326.53, $800
D) $626.53, $850
E) $326.53, $700

Solution: A

Coupon payment = $70 = 7% x Par value

Par value = $1,000
Straight bond value = $70 (PVIFA 12%, 20) + $1,000 (PVIF 12%, 20)
= $626.53

Conversion value = CR x prevailing stock price

= $1,000/$50 x $35
= $700

Question 5

Which of the following is false?

A) Initial public offerings (IPOs) are usually underwritten by a bank, which also advises
on the IPO.
B) Every shareholder is entitled to a claim on the firm’s liquidated assets, after
employees of the firm are paid.
C) Share investment carries a risk of capital loss.
D) Raising funds through a private placement is faster than a public offering.
E) Shareholders must vote in person so as to ensure the firm is managed by capable
personnel.

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Solution: E

E is false because:
Voting can be done through proxy too.

The rest are true because:

B) Employees are also paid before shareholders, who have the residual claim.
D) Private placement is a group of investors instead of public offering, which is to the
public, so it is faster to raise funds through a group of designated investors.

Question 6

Figure (a) Figure (b)

Which of the following is false?

A) Figure (a) is not a reversal pattern.

B) Figure (b) shows a wedge at a market bottom.
C) Figure (a) shows a bear flag.
D) Figure (b) is a head & shoulders reversal pattern.
E) A downtrend breakout is shown in Figure (b).

Solution: D
D is false because:
Figure (b) is a wedge pattern, not a head & shoulders reversal pattern.
The rest are true because:
A) Figure (a) is a continuation pattern.
C) A bear flag is a flag in a downtrend.
E) A downtrend breakout is when the share price penetrates the resistance line, showing
the end of a downtrend. (resistance line = the price level that is difficult for prices to
penetrate upwards; downtrend resistance line = connects successively lower tops)

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Question 7

Which of the following is false?

A) Singapore corporate bonds are thinly traded in the secondary market.

B) Offshore corporate bonds, on the other hand, are actively traded in the Asian Dollar
Bond secondary market.
C) Singapore companies would rather rely on the stock market and private placement of
bonds for capital expenditure programs, than public offering of bonds.
D) If you are submitting a non-competitive bid for Singapore Government bonds,
although you may specify the amount you want, you are subjected to a maximum bid size.
E) In a Singapore dollar repurchase agreement for Singapore Government securities, the
seller is effectively borrowing from the buyer of the securities.

Solution: B

B is false because:
Offshore corporate bonds are also inactively traded, as most are held till maturity.

The rest are true because:

C) More well-informed of the stock market and private placement of bonds is faster for
raising funds.
D) Competitive bids: you may specify amount & desired yield level.
Non-competitive bids: you may specify amount, but subjected to a maximum bid size
(T-bill = S$1mil, T-bonds = S$2mil). Yield = weighted average yield based on the yields of
successful applicants.
E) The seller agrees to buy back the securities at a higher price in the future, effectively
taking a loan from the buyer of the securities, using SGS as the collateral.

Question 8

Today, you would like to invest in a zero-coupon T-bill, which has a face value of S$20,000. If it is
maturing on Jan 20, 2006 and offers a 6.7% yield, how much would you be paying for it? Assume
today is Nov 6, 2005.

A) S$5,720.83
B) S$9,727.76
C) S$11,810.76
D) S$29,921.88
E) None of the above.

Solution: E

Use Discount Yield formula.

Id = [(P1 – P0) / P1] x 365/h

Where:

Id = 6.7%
P1 = S$20,000
P0 = ask price = S$19,724.66
h = 75 days to maturity = 24 + 31 + 20

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365 calendar days is used because S$ denominated T-bills

Question 9

According to the Expectations theory of the term structure of interest rates:

A) Buyers require an additional incentive to hold long-term bonds.

B) When the yield curve is downward sloping, short-term interest rates are expected to
remain relatively stable in the future.
C) Interest rates on bonds with different maturities do not move together over time.
D) Yield curves should be equally likely to slope downward as slope upward.
E) Investors have strong preferences for short-term relative to long-term bonds,
explaining why yield curves always slope upward.

Solution: D

Others are wrong because:

A) This is true for Liquidity Premium Theory.
B) ST i/r are expected to be lower in the future.
C) Interest rates on bonds with different maturities move together over time.
E) Investors have no preferences for bonds with different maturities.

D) is right because yield curves will slope downwards & upwards when expected ST
i/r are lower & higher respectively in the future.

Question 10

Table (a): T-bill rates

Maturity Rate A Rate B
Mar 10, 2001 2.18 2.20
Mar 17, 2001 2.20 2.22
Apr 15, 2001 2.21 2.23
Apr 21, 2001 2.22 2.25
May 10, 2001 2.25 2.26
May 15, 2001 2.27 2.28

Assume today is Mar 2, 2001. Calculate the ask price of a zero-coupon T-bill with face value of
S$20,000 with maturity on Apr 21, 2001, by referring to the Table (a) above.

A) S$13,939.18
B) S$14,959.30
C) S$19,939.18
D) S$25,332.20
E) S$28,332.20

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Solution: C

Use Discount Yield formula.

Id = [(P1 – P0) / P1] x 365/h

Where:

Id = 2.22% (choose lower rate for ask rate)

P1 = S$20,000
P0 = ask price = S$19,939.18
h = 50 days to maturity = 29 + 21
365 calendar days is used because S$ denominated T-bills

Question 11

Your ownership interest in Company A, which has 4 million shares outstanding, is 0.1%. The
company announces a rights offering, through which it plans to sell another 2 million shares.
Each shareholder will receive 0.5 right for each share owned. 1 share of the company is selling
for $10 before the rights offering, and selling at a 30% discount after that. Assume you do not
wish to exercise your rights, how much could you sell them for? (Assume 1 right can be
exchanged for 1 share in the new issue).

A) $2
B) $20
C) $2,000
D) $3,000
E) $4,000

Solution: E

You own = 0.1% x 4mil = 4,000 shares

After rights offering: you receive = 0.5 x 4,000 = 2,000 rights to buy 2,000 new shares
Total Market Value of Company before rights = $10 x 4 mil shares = $40 mil
Total Market Value of Company after rights
= ($10 x 4 mil old shares) + ($7 x 2 mil new shares) = $40 mil + $14 mil = $54 mil
Share price after rights issue = $54mil/6mil shares = $9/share
Your Right allows you to buy new share (worth $9) at $7.
Hence, value of 1 Right = $2

Your ownership interest is unchanged:

Before (4,000/4mil) = 0.1%
After (6,000/6mil) =0.1%

You sell all your rights for 2,000 rights x $2 = $4,000

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Question 12

Which of the following is false?

A) Technical analysts develop trading rules from observations of past price movements
of the stock market and individual stocks.
B) Fundamental analysis involves making investment decisions based on examination of
fundamental economic and company variables.
C) Technical analysts believe that “The market is not its own best predictor”.
D) Under technical analysis, trends of stock prices change in reaction to fear and greed.
E) Technicians are also chartists.

Solution: C

C) Technical analysts believe that “The market IS its own best predictor”.

Question 13

Which of the following is false regarding the upcoming revamp of SGX’s listing rules.

(A) SESDAQ will be transformed into a “New Board”, which will be a sponsor-supervised board.
(B) There is no admission criteria for a sponsor.
(C) Sponsors will determine the suitability of companies for listing on “New Board” and review
IPO admission.
(D) The focus of the Main Board will be “Size” and “Quality”.
(E) The “New Board” will aim to attract both local and foreign small and growing companies to list.

Solution: B

SGX will impose strict admission rules for sponsors.

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Question 14

Which of the following is false?

(A) In Singapore, when you sell shares, there must be shares available in your CDP
(Central Depository Pte Ltd) securities account for debiting on or before the due
date.
(B) Assume Saturday is a public holiday, if you contract to buy shares on Friday, you
must pay for them by Tuesday.
(C) XYZ share is quoted at $2.20/$2.30. A broker who received a buy market order from
his client will book the market seller at $2.30.
(D) Placing a limit order is risky for the investor because negative information on the
share may result in a loss to the investor.
(E) A stop order allows market trends to trigger a trade.

Solution: B

B is false because:
You must pay for the shares by Wednesday, not Tuesday.

Question 15

Which of the following is true?

(A) Shares on the Main Board of SGX have high price volatility because they are all of
large companies in the electronics sector.
(B) Trading in any quantity less than 1 board lot is called odd lot trading.
(C) SESDAQ was set up to help companies with paid-up capital of at least S$15mil list
shares.
(D) In Singapore, all share transactions must be conducted through a broker.
(E) Share price indices such as The Straits Times Index is a good market indicator
because it comprises a fixed composition of companies which cannot be changed.

Solution: B

The rest are false because:

(A) Shares on SESDAQ of SGX have high price volatility because they are of small
companies in the electronics sector.
(C) Companies on Main Board have a paid-up capital of at least S$15mil.
(D) In Singapore, investors in shares can also walk in to any authorized trading centre
located in selected branches of local banks, and special counters operated by SGX
stock brokerage firms to buy and sell shares without going through a broker.
(E) Share price indices such as The Straits Times Index is a good market indicator
because it represents different performing industries in the economy.
The composition of companies can change and are not fixed.

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SECTION 2: Short Answer Qns

Please write your answers in the blank answer sheets provided and Number the pages.
(3 marks each)

Question 1

What is a “sinking fund” condition for a bond indenture and how does it work?

Solution:

What is it?
This provides for a systematic retirement of a bond issue. This requires the issuing company to
call and retire a portion of its bonds each year. This is designed to protect the bondholders by
assuring that the issue is retired in an orderly manner. This type of bond is considered to be safer
& typically carry a lower interest rate.

How it works?
 Firm deposits money with bond trustee periodically, who invests and uses the accumulated
sum to retire the entire bond issue at maturity.
 Firm handles sinking fund payments itself:
- Funds used to retire bonds periodically by the firm itself are pegged to the firm’s
earnings or sales, or
- A mandatory fixed amount is used periodically by the firm itself to retire bonds.

Question 2

Assume the following information:

Riskfree rate: 10%

Return on market portfolio (kM): 14%
Beta of stock A: 1.4
Required rate of return on stock A: kA

Suppose riskfree rate decreases to 9% and the slope of the Security Market Line remains
constant, how will this affect kM and kA?

Solution:

Before change in kRF

SML: ki = kRF + (kM – kRF) bi
kA = 10% + (14% - 10%) 1.4 = 15.6%

After change in kRF

SML: ki = kRF + (kM – kRF) bi
kA = 9% + (13% - 9%) 1.4 = 14.6%

kM will decrease by 1% to maintain the slope at 4%.

kA will decrease by 1% to 14.6%.

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Question 3

ABC Company needs to raise $25mil to construct new production facilities. The firm’s straight
nonconvertible debentures currently yield 14% pa. Today, its stock sells for $30 per share; the last
dividend was $2; and the expected growth rate is a constant 9%. Investment bankers have
tentatively proposed that the firm raise the $25mil by issuing convertible debentures. These
convertibles would have a $1,000 par value, carry a coupon rate of 10%, have a 20-year maturity,
and be convertible into 20 shares of stock. The bonds would be non-callable for 5 years, after
which they would be callable at a price of $1,075; this call price would decline by $5 per year in
Year 6 and each year thereafter.

Calculate the expected floor value of a convertible bond at end of Year 5.

(Assume today is time 0).

Solution:

Step 1:
Calculate straight bond value.

Coupon payment = 10% x Par value = 10% x $1,000 = $100

Straight bond value = $100 (PVIFA 14%, 15) + $1,000 (PVIF 14%, 15)
= $754.31

Step 2:
Calculate conversion value at end of year 5.

Conversion value = CR x prevailing stock price

= 20 x $30 (1.09)5 = $923.17

Step 3
Floor price of bond = higher of (straight bond value, conversion value)
= $923.17

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Question 4

Happy Food company is experiencing a rapid growth period. For the next 2 years, dividends are
expected to grow at a rate of 15% pa. In the 3rd year, the growth is 13% pa. Thereafter, a
constant growth rate of 6% pa is expected. Recently, Happy Food paid dividends of $1.15. What
is the stock price today if we assume a required rate of return of 12% pa?

Solution:

Step 1: Calculate the sum of the PVs of the dividends in the supernormal growth period.

D0 = $1.15
D1 = $1.15 (1.15) = $1.3225
D2 = $1.3225 (1.15) = $1.5209
D3 = $1.5209 (1.13) = $1.7186

Sum of all PVs = PV (D1, D2, D3)

= $3.62 (A)

Step 2: Find the PV of the stock price at the end of Year 3.

P3 = D4 / (r – g) = [D3 (1 + g)] / (r – g)
= [$1.7186 (1 + 6%)] / (12% - 6%)
= $30.36

PV of P3 = $21.61 (B)

Step 3: Sum (A) and (B)

Stock price today = $3.62 + $21.61 = $25.23

Question 5

State the 3 functions of Indirect Finance played by Financial Institutions.

(Just list the functions, elaboration is not necessary.)

Solution:

3 functions of Indirect Finance played by FIs. (Refer Lecture 1 notes)

1. Reduce Transaction costs
2. Risk Sharing
3. Reduce Information Asymmetry problems

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Question 6

A 3 year Treasury Note has face value of $1,000. It pays semiannual 10% pa coupons and sells
at par. How would the use of the Duration model differ from the Time value of money bond
valuation model if interest rate increases by 5% pa?

Solution:

Cashflow No. Time Cashflow Amt PVCF PVCF x t

1 0.5 50 47.62 23.81
2 1.0 50 45.35 45.35
3 1.5 50 43.19 64.79
4 2.0 50 41.14 82.28
5 2.5 50 39.18 97.95
6 3.0 1,050 783.53 2,350.59
Total = 1,000 Total = 2,664.77

For bonds selling at par, YTM = Coupon rate = 5% semiannually

Duration = 2,664.77 / 1,000 = 2.66 years

When interest rate increases by 5% pa: new YTM = 15% pa

(1) Using Duration model

Change in Price/Initial Price = -2.66 [(Change in R) / (1+R)]

= -2.66 (0.05/1.05) = -12.67%
New Price = $1,000 x (100% - 12.67%)
= $873.30

(2) Using Bond Valuation model

Old price = $50 (PVIFA5%,6) + $1,000 (PVIF5%,6) = $1,000

New price = $50 (PVIFA7.5%,6) + $1,000 (PVIF7.5%,6) = $882.65

Difference in using 2 models = $873.30 - $882.65 = - $9.35

Duration overpredicts the fall in price by $9.35.

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Question 7

A zero coupon bond has 10 years to maturity. Calculate the new price using the Duration model if
yields rise by 0.8% pa to 10% pa. Current price of the bond is $800. Face value is $2,075.

Solution:

Old yield = 10% - 0.8% = 9.2% pa

New yield = 10% pa

For zero coupon bonds, Duration = Maturity = 10 years

Duration = 10 yrs = -(Change in Price/Initial Price)/ [(Change in R) / (1+R)]

= -(Change in Price/$800)/ (0.008 / 1.092)

Change in Price = -$58.61

New Price = $800 - $58.61 = $741.39

Question 8

Table: Exchange Rates on Feb 16, 2007

Bid Ask
EURUSD 1.0980 1.0990
USDJPY 122.10 122.25
GBPUSD 1.6723 1.6733
USDSGD 1.3960 1.3970

On Jan 16, 2007, you invested in a British pound denominated CD of equivalent US$8mil at
USDGBP: 0.6350/52, yielding 12% p.a..
What is your US$ gain from the investment today, Feb 16, 2007?

Solution:

Step 1

Convert US$8mil to pounds = US$8mil x GBP0.6350/US$1 = GBP5,080,000

Step 2

Earn interest of 12% pa, 1 month earn = 1%.

P+I = GBP5,080,000 x (1.01) = GBP5,130,800

Step 3

On Feb 16, 2007, Convert pounds back to US$

(sell GBP, buy US$ at GBPUSD bid rate 1.6723)
= GBP5,130,800 x US$1.6723/GBP = US$8,580,236.84

Gain = US$8,580,236.84 – US$8mil = US$580,236.84

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Question 9

Jimmy, a new bondholder matches the periodic cashflows from the bond for his installments on a
bank loan. His bank loan’s interest period is on a 6 months’ basis. The bond has 5 years to
maturity with 8% pa coupons and face value of S$10mil. If the bond sells in the market for
S$9.5mil, which of the following is true? Explain.

(A) Yield on the bond is 4.64% pa.

(B) The cost of borrowings for Charlie is 5% pa.
(C) The yield on the bond is greater than its coupon rate.
(D) The bond is a premium bond.
(E) None of the above.

Solution: C

Current market price = S$9.5mil = S$400,09999900 (PVIFA i%, 10) + S$10mil (PVIF i%, 10)
Semiannual Coupon payment = (8%/2) x S$10mil = S$400,000
I% = 4.64% (for half a year)
YTM = 4.64% x 2 = 9.28% pa

(A) Wrong. Should be 9.28% pa.

(B) Wrong. Not enough information to calculate cost of funds on loan.
(C) True. YTM = 9.28% pa > 8% pa coupon rate
(D) Wrong. The bond is a discount bond. (PV < Face value; Coupon rate < YTM)
(E) Wrong.

Question 10

Assuming real interest rates are the same and purchasing power parity holds. In 1 year’s time,
nominal interest rate spread between US and Japan is 6% pa, with US having a higher nominal
interest rate. What is the exchange rate in 1 year’s time? (Assume spot exchange rate:
JPY130/US$1).

Solution:

Spot exchange rate: JPY130/US$1 = US$0.0077/JPY1

Int (US) – Int (Japan) = 6% = Inflation (US) – Inflation (Japan)

= Change in Exchange rate/Spot Exchange rate
Change in Exchange rate = 6% x US$0.0077 = US$0.000462
New Exchange rate = US$0.0077 + US$0.000462 = US$0.00816/JPY1
= JPY122.55/US$1

Japanese Yen appreciates, US$ depreciates.

- End -

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