Assignment Code: BECE-141/AST/TMA/2022-23

Course Code: BECE-144

Assignment Name: Financial Economics

Year: 2022-2023

Verification Status: Verified by Professor

Maximum Marks: 100

Answer all the questions

A. Long Answer Questions (word limit-500 words) 2 × 20 = 40 marks

Q1) Explain the significance of the financial system. What are important functions of financial institutions?

Ans) The significance of the financial system includes:

1. By the mobilisation of public and corporate savings, assist in the formation of significant financial resources.

2. By providing the required funding for the cultivation of land, the production of goods, and the supply of services, you can encourage investment in the manufacturing, service, and agriculture sectors.

3. Satiate both immediate and future financial requirements.

4. By creating credit, banking organisations multiply the available financial resources.

5. Transferring excess money from one sector of the economy to another while keeping in mind the priorities of the country.

6. Promote the conversion of physical assets into financial assets so that trade, commerce, agriculture, manufacturing, and service industries can flourish in a balanced way.

7. Offer a range of financial assets to meet the various demands of both public and business investors.

8. Provides a mechanism for risk and uncertainty control. They lower the danger of capital loss by investing money in a variety of businesses.

9. Encourage entrepreneurship and support new initiatives.

10. Aid in quickening the nation's economic expansion.

11. Facilitate wiser decision-making.

12. Finance should be made available to the government.

The important functions of financial institutions are as follows:

Directing the Payment System: The management of the payment system is one of the main duties of financial organisations. Payment systems are used to describe regular economic dealings between people and companies. By using wire transfers, debit and credit cards, checking and savings accounts, and other financial instruments, financial institutions keep the payment system in motion.

Assisting with Resources and Capital: Financial institutions provide credit to people who can repay it, assisting both individuals and businesses with resource and capital management. Banks and other institutions might pool their resources to make loans available to others. Families and businesses can borrow money through loans and credit cards and repay it on time. Financial institutions assist people and businesses in gaining access to the resources they require to be successful because it can be challenging to raise money for a new or current business or personal endeavour.

Moving Financial Resources: This function is so important because financial institutions can more readily and flexibly transfer resources from one party to another than can individuals or businesses.

Risk Management: For businesses and households, financial institutions handle risk and uncertainty. Accidents and other problems that arise in business or personal life can be handled more easily because to the ability of insurance firms and other financial sector businesses to pool and share the risk with large numbers of people.

Informing Financial Decisions: Financial institutions' information enables both consumers and businesses to make secure judgments in the present. They offer their clients top-notch consulting for their profitable investments.

Maintaining the Market: Financial institutions also enable stock market investment by individuals and other organisations. Investors can invest for the long term or the short term with the hope of earning a higher return. Companies can issue stock to increase cash flow depending on investors buying stock thanks to institutions like stock exchanges and brokers.

Q2) What are the important features of fixed income securities?

Ans) The important features of fixed income securities are as follows:

From the corporate world, there are two types of fixed income/cost securities:

a) Debt instruments.

b) Preference shares.

1. Debentures and bonds The holders of the securities, referred known as debt holders, are creditors of the form. Because they lack voting privileges within the company, holders of these securities are not involved in decision-making.

2. Interest is paid to debt holders at a coupon rate. This rate is established by an agreement in accordance with the debt instrument and is based on the security's face value. Zero coupon bonds, on which the holder does not receive periodic interest, are an exception.

3. Bonds and debentures clearly state their face value and redemption value on the front of the instrument. The two could be the same or distinct. If the bond is a convertible debenture, it may be redeemed by being converted into equity shares.

4. Prior to equity owners, other unsecured creditors, and preference shareholders, debt holders receive paid upon the firm's collapse.

Corporate Securities

Bonds and Debentures represent the most important types of fixed income securities as investment vehicles.

Their various types and classification are as follows:

1. Secured and Unsecured Debentures: Secured debt obligations place a charge on the company's assets. Unsecured debentures are issued on the basis of the issuer's overall creditworthiness and have no charge over the assets.

2. Convertible and Non-convertible Debentures: A convertible debenture is one that, in accordance with the terms of the issue, converts into equity shares of the issuing business at or before maturity.

Redeemable and Irredeemable Debentures: Almost all debentures have a predetermined maturity period and are redeemable. On the instrument's face, this time period is mentioned.

Zero Coupon fully Convertible Bonds: These bonds have no set interest rate and will fully and compulsorily convert at a specific time after the bond's issuance.

Deep Discount Bonds: It is a type of bond with no coupons that specifies the issue price, the maturity date, and the maturity amount.

Callable Bonds: When a bond is callable, the corporation reserves the ability to retire it at any point after a predetermined amount of time.

Putable Bonds: In the case of puttable bonds, after an initial lock-in period, the holder has the option to redeem the bonds with the corporation at any time.

Floating Rate Bonds: Contrary to popular belief, floating rate bonds have a coupon rate that is related to another interest rate known as a benchmark rather than a set rate, as is the case with fixed rate securities.

Preference Shares: Preference shares are subject to a set rate dividend payment that serves as an appropriation of earnings. However, if the corporation lacks sufficient liquidity or distributable income, it may be unable to pay preference dividends. On the other hand, investors anticipate dividend payments, and there are negative consequences if the pay-out is not made. The company's reputation will suffer, and it might not be able to obtain money in the future.

B. Medium Answer Questions (word limit-250 words) 3 × 10 = 30 marks

Q3) Briefly discuss expected utility theory of decision-making

Ans) In commercial settings, such as those involving insurance, capital investments, marketing, and operations, the idea of expected utility and the maximisation of expected utility have broad applications. In these situations, it is typically possible to define the usefulness of the potential outcomes in terms of prospective financial gains and losses. Businesses can calculate the expected utility of each option in terms of its expected financial profits by using their estimation of the likelihoods of the outcomes of the options available to them along with their associated monetary losses and gains. According to the maximisation of expected utility principle, the option with the highest expected utility is simply the one with the highest predicted profit. This option is the best one to choose.

Although anticipated utility has been a key notion in the study of economic behaviour, its application to situations of choice in business and economics has drawn criticism. For instance, some theorists in the social and behavioural sciences contend that due to human cognitive limitations, the idea of expected utility as a guide to decision-making is too idealistic to be used in the majority of important decision scenarios. As a result, these critics support constrained rationality theories that are more cognizant of these constraints and employ evaluative concepts that are independent of the specific types of evaluations necessary to calculate expected utility. Others have claimed that using expected utility to guide economic and policy decisions has led to inaccurate assessments, particularly when non-monetary outcomes like possible deaths or environmental harm are scaled using monetary terms.

Q4) Explain the internal and external determinants that affect the formulation of corporate policy.

Ans) The internal determinants that affect the formulation of corporate policy are as follows:

1. Corporate Mission: The company's corporate mission serves as both the rationale for the organization's existence and the driving force behind its operations.

2. Corporate Objectives: The company's mission is broken down into manageable, measurable, and time-bound goals. These are referred to as business goals.

3. Resources: The nature, scope, and timeliness of each organization's operations are determined by its resources.

4. Management Values: The values of the senior management guide every organization's corporate vision, mission, policy, objectives, and tactics. Management values are nothing more than the opportunities and strengths that top management uses to act in a particular way.

The external determinants that affect the formulation of corporate policy are as follows:

1. Industry Structure: The number of competitors in the market, the market share that the company and its competitors have achieved, entrance and exit barriers, and the numerous strategies and policies that the company and its rivals have adopted are all part of the industry structure.

2. Social Environment: The social milieu in which an entity operates has an impact on how the organization's business policy is developed.

3. Legal Environment: Any organisation must operate in accordance with the many rules and regulations set forth by the local government where it is based.

4. Political Environment: Any organisation will succeed in setting up shop in a nation with a stable political climate.

5. Economic Environment: The demand for the goods or services provided by the entity in which the organisation operates; the availability of inputs such as raw materials, cash, labour, and equipment; etc. make up an organization's economic environment.

6. Technology: Any firm nowadays needs to stay on top of the most recent technical advancements taking place in its industry in order to function and develop.

Q5) What is Debt Securitisation? Explain risks attached to debt securitization.

Ans) Debt securitization is grouping several securities of the same type, transforming them into different kinds of securities, and then marketing the resulting products as brand-new securities. The majority of the time, it is bank-issued house loans that are sold to asset management firms, who then restructure them into brand-new securities and float them further on the market. Because it gives banks access to cash and gives investors who are making monthly interest payments security, debt securitization benefits both the issuer and the investor.

The risk of debt securitization is also present. These securities are extremely dangerous and complicated. It becomes exceedingly challenging to track which debt has not been returned if the loans on which these securities are based are not repaid on time or the individual defaults because it is very challenging to determine which security is based on which debt in this system.

When debtors are in default on their loans, bad debts develop. Bad debts have the potential to disrupt the cash flows of securitized assets like mortgage-backed securities (MBS), which is one of the main dangers involved. However, the risk of bad debt can be distributed among investors. The risk may be totally borne by one investor group or distributed over the entire investing pool, depending on how the securitized instruments are constructed.

C. Short Answer Questions (word limit 100 words) 2 × 3 × 5 = 30 marks

Q6) Differentiate between:

(a) Allais paradox and Ellsberg paradox.

Ans) The differences between Allais paradox and Ellsberg paradox are as follows:

Allais Paradox: The Allais paradox illustrates the "certainty effect," which states that when a certain conclusion is possible, risk aversion is increased.

Ellsberg Paradox: The Ellsberg Paradox is a contradiction between people's choices and the theory of subjective expected value. It is typically considered to be proof of ambiguity aversion, a tendency for people to choose decisions with quantifiable risks over those with unknowable, unquantifiable dangers. According to Ellsberg's results, decisions with an inherent amount of risk are preferred above those with an unknown level of risk when the possibility of risk is obvious.

(b) Forwards and Futures

Ans) The differences between Forwards and Futures are as follows:

(c) Systematic risk and non-systematic risk

Ans) The differences between Systematic risk and non-systematic risk are as follows:

Q7) Write short notes on the following.

(a) Hedge Funds

Ans) The term "hedge fund" refers to a class of private investment entities that manage portfolios made up of a mix of derivative and securities positions using a range of methodologies. The performance might occasionally be stand-alone from the state of the market as a whole. In order to manage the portfolio and give investors returns, hedge fund managers may take both long and short positions. These funds might use a lot of leverage. An aggressively managed portfolio of assets in several asset types and geographical areas is what is known as a hedge fund. These funds utilise leverage, take both long and short positions, and/or mix derivatives. High returns are desired by hedge fund managers, whether in absolute or relative terms. The limited investment restrictions on these funds make investing challenging.

(b) Internal Rate of Return

Ans) Internal rate of return equalises present value of inflows and outflows, and as a result, NPV is equal to zero. It is purely determined by a proposal's cash inflows and outflows, without taking the current interest rate into account. IRR is calculated, and its value is compared to the interest rate to see whether the plan is acceptable. The application will be approved specifically if the IRR is higher than the interest rate. The trial-and-error method, which involves applying discount rates successively until the present value of inflows and outflows equals one another, is used to determine IRR.

(c) Hypothesis testing

Ans) In statistics, the process of hypothesis testing involves putting an analyst's presumption about a population parameter to the test. The type of data used and the purpose of the study will determine the methodology the analyst uses. An assumption or a statement about one or two parameters involving one or more populations is referred to as a statistical hypothesis. A statistical hypothesis could be valid or could not. We must determine whether the proposed hypothesis is true or false using the data from a sample, or samples. We could determine whether the hypothesis is correct with confidence if we knew the identities of every person in the population.e.