If you are looking for MECE-004 IGNOU Solved Assignment solution for the subject Financial Institutions and Markets, you have come to the right place. MECE-004 solution on this page applies to 2022-23 session students studying in MEC courses of IGNOU.
MECE-004 Solved Assignment Solution by Gyaniversity
Assignment Code: MECE-004/AST/2022-23
Course Code: MECE-004
Assignment Name: Financial Institutions and Markets
Year: 2022-2023
Verification Status: Verified by Professor
SECTION A
Answer the following questions in about 700 words each. . The word limits do not apply in case of numerical questions. Each question carries 20 marks.
1. Describe the nature of the financial system in modern economy giving the important types of constituent institutions, markets and instruments. Explain the concept of flow-of-funds in the financial markets.
Ans) Nature of the financial system in modern economy as follows:
Financial Institutions
Financial institutions are commercial entities that mobilise savings, deposit them, and provide credit or financing. They also provide the community a range of financial services. Financial institutions have been categorised in a number of ways. The following are two significant classifications:
Banking institutions and Non-banking institutions: The banking institutions share many characteristics with non-banking institutions, but what sets them apart is that, unlike other institutions, they participate in the economy's payments mechanism, i.e., they provide transaction services, their deposit liabilities make up a significant portion of the national money supply, and they can collectively create deposits or credit, which is money. Sayers distinguished between the two by referring to the former as "creators" of credit and the latter as "purveyors" of credit.
Intermediaries and Non-intermediaries: They lend money and mobilise savings; their responsibilities are to the ultimate savers, while their assets are from investors or borrowers. Intermediaries act as a middleman between savers and investors. Non-intermediary institutions are in the loan business, but they do not get their funding directly from savers. All banking institutions serve as intermediaries, and many non-banking organisations do the same. When they do, these organisations are referred to as non-banking financial intermediaries.
Financial Markets
A mechanism that enables players to transact in financial claims is the financial market.
Additionally, the market offers a mechanism for their needs and demands to interact to determine a price for such claims. Financial institutions, agents, brokers, dealers, borrowers, lenders, savers, and other parties connected by laws, contracts, covenants, and communication networks are among the players on the demand and supply sides of these markets.
Financial markets have been variously classified. Two important classifications are:
Primary market and Secondary market: The primary markets are also referred to as "new issue markets" because they deal in new financial claims or securities. Secondary markets deal with already-issued, already-existing, or already-outstanding securities. Primary markets mobilise savings and give business units new or extra money. Secondary markets make securities issued on primary markets liquid, rather than immediately contributing to the availability of additional capital.
Money market and Capital market: Capital market is a market for long-term securities, that is, securities with a maturity time of one year or more. Money market is a market for short-term securities with a duration of one year or less. Financial markets have also been divided into groups such as formal and informal, official and parallels, domestic and foreign, organised and unorganised, keeping in mind various purposes..
Financial Instruments
A claim against a person or an organisation for the payment of an amount of money and/or a regular payment in the form of interest or dividend at a future date is known as a financial instrument. The phrase "and/or" suggests that one payment will be adequate, while both may be offered.
Primary securities and Secondary securities: Primary or secondary securities are both types of financial instruments. Because they are issued directly from the ultimate fund borrowers to the eventual user, primary securities are also known as direct securities. The marketability, liquidity, reversibility, kind of options, return, risk, and transaction costs of financial institutions vary.
Concept of Flow-of-Funds
The term ‘flow’ means movement and includes both ‘inflow’ and ‘outflow’. The term ‘flow of funds’ means transfer of economic values from one asset of equity to another. Flow of funds is said to have taken place when any transaction makes changes in the amount of funds available before happening of the transaction. If the effect of transaction results in the increase of funds, it is called a source of funds and if it results in the decrease of funds, it is known as an application of funds.
Further, in case the transaction does not change funds, it is said to have not resulted in the flow of funds. According to the working capital concept of funds, the term ‘flow of funds’ refers to the movement of funds in the working capital. If any transaction results in the increase in working capital, it is said to be a source or inflow of funds and if it results in the decrease of working capital, it is said to be an application or out-flow of funds.
2. Discuss the Markowitz theory of efficient portfolio selection. How does the CAPM theory build on it?
Ans) Markowitz theory of efficient portfolio selection (Portfolio Theory) as follows:
The portfolio theory developed by Markowitz takes the actions of an investor into account. According to this idea, when building a portfolio of assets, investors aim to maximise their expected return on investment for a given amount of risk. Portfolios that meet this criterion are referred to as efficient portfolios. How to achieve this is explained by Markowitz's hypothesis.
Regarding the actions of investors, Markowitz made a number of assumptions. These are listed below:
On the basis of their anticipated mean and variance of return, investors select portfolios.
Investors are supposed utility maximisers who avoid risk.
Each investor has a single period of time that they are focused on.
For all hazardous assets, investors have the same expectations regarding expected returns, variances, and covariances.
Markowitz essentially recommended the following process for selecting the best risky asset portfolio: identify the set of efficient portfolios, establish the return-risk indifference curves, and then select the best portfolio. An indifference curve's points offer the same degree of satisfaction. The degree of risk aversion increases with the slope of the indifference curve. The utility rises as one advances left across various indifference curves.
Different portfolios will produce different returns for the same degree of risk. The portfolio with the highest predicted return for a particular level of risk will be chosen by the investor. Typically, the process for attaining the highest projected return for a particular amount of risk is determined by employing quadratic programming, a challenging mathematical technique used in optimisation. Beyond the scope of our conversation, it. We can provide a logical justification.
Given the available assets, an investor has a wide range of portfolio options. A viable portfolio is any one that can be built using the available assets. The feasible set of portfolios is the whole of all viable portfolios. The Markowitz efficient set of portfolios will, however, only comprise a portion of the feasible set of portfolios' frontier. The investor will ultimately select a single portfolio at the return-risk space location where the Markowitz efficient set of portfolios is tangent to an indifference curve. The ideal portfolio is this one.
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) works by Sharpe, Lintner, and Mossin are concerned with economic equilibrium assuming that all investors optimise in the specific way that Harry Markowitz outlined. An equilibrium model of asset pricing is the CAPM. As a result, the CAPM offers knowledge about the link between risk and return and the proper measure of risk for securities, as well as how asset prices behave.
Beyond the ones stated for Markowitz's portfolio theory, certain extra assumptions are made for the CAPM. The first of these is that unrestricted borrowing and lending can occur at the risk-free rate; the second is that investors' expectations of the means, variances, and covariances of security returns are homogeneous; and the third is that there are no flaws in the capital market, such as transaction costs or taxes.
According to these presumptions, a capital asset pricing model that comprises of a capital market line and a security market line is necessary. We must first keep in mind that some assets are risk free in order to fully grasp this. No risk-free asset was taken into account by Markowitz's approach since, according to portfolio theory, efficient portfolios can be built using expected returns and variance. The situation alters once a risk-free asset is included, presuming the investor may borrow and lend at the risk-free rate. It can be demonstrated that the investor is capable of moving beyond the Markowitz efficient frontier to a point with better projected returns.
The investor will choose a portfolio based on a line that slopes upward and is tangent to the Markowitz efficient curve at a certain position on the return-risk plane. The line starts on the y-axis at a point that represents the risk-free return. The capital market line is the name of this line. There will be points on the line vertically above the point on the Markov efficient frontier to the left of the point of tangency of the capital market line to the Markowitz efficient portfolio curve. This demonstrates that when a portfolio contains risk-free assets, the investor will decide for a portfolio that combines borrowing or lending at a risk-free rate with purchases of Markowitz efficient portfolios. The two-fund separation theorem states that every investor who is risk adverse will own both a market portfolio and a combination of risk-free assets.
SECTION B
Answer the following questions in about 400 words each. Each question carries 12 marks.
3. Critically examine the major theories that have been put forward to explain the term structure of interest rates.
Ans) Theories about the explanations for the term structure of interest rates as follows:
The Expectations Hypothesis
According to the expectancies hypothesis, longer-term interest rates are an average of the shorter-term rates that are anticipated to be in effect for the duration of the long-term asset. This claim is based on the theory's supposition that investors view a number of short-term bonds as ideal replacements for long-term bonds. The only element influencing the investor's choice is the expected return that will be received from buying more short-term bonds than a single long-term bond because investors view short and long-term bonds as equivalent (in terms of quality).
The expectations theory also implicitly presupposes that investors are risk-averse and will not pay more to lock in a lower duration interest rate. The cost of purchasing a short-term asset is the same as that of purchasing a long-term asset because it is also assumed that there are no transaction expenses.
The Segmented-Market Hypothesis
In terms of theory, it is at the other end from expectancies theory. According to this, bonds with various maturities can be substituted for one another; the yields of these bonds are calculated independently of one another. It sees the markets for bonds of various maturities as existing separately. The intersection of supply and demand for that particular form of bond determines the yield for each segment.
The market segment theory postulates that investors favour financial instruments with specific terms to maturity. A person will be drawn to and invest in bonds with a 7-year maturity duration if they have idle cash balances that they won't need for another seven years when they do need them due to retirement. Since the transaction costs would be higher in the latter scenario, buying and keeping a bond for seven years is more appealing to him than owning a bond for a shorter period of time before reselling and buying a bond.
Additionally, there would be more interest risk because future interest rates could decrease. A capital loss would result for him when he sold the bond, on the other hand, if he held a short-term bond and the interest rate increased in the following period. According to the segmented-market hypothesis, the yield curve's shape is determined by the relative supply and demand for bonds and other financial instruments with varied maturities.
The Preferred-Habitat Hypothesis
The expectancies hypothesis and the segmented markets hypothesis are combined in the preferred-habitat hypothesis. The segmented markets hypothesis suggests that investors prefer loanable funds with specified terms to maturity, while the preferred habitat theory contends that investors are prepared to substitute away from their preferred terms provided they are compensated for doing so.
Term premium refers to the payment that must be made to investors in order to persuade them to buy securities with a different term to maturity than their chosen terms. The liquidity premium theory is another name for the preferred habitat theory as a result. The expectations hypothesis and the segmented-market hypothesis are combined to form the justification for the preferred habitat hypothesis.
4. Explain the need for, and role of depository systems in secondary markets. Explain the concept of custodial services.
Ans) The following factors were the main causes of the need for a depository system:
Excessively long wait times for the transfer of securities.
Share certificates that were returned because they had fake signatures, mismatched signatures, fake faces, or fake transfer deeds.
Delay in receiving securities following allocation, non-receipt of shares, or refund orders to non-allottees.
Delay in receiving duplicate certificates, shares, and debt instruments
Lack of infrastructure in the banking and postal sectors to manage a high volume of share certificate applications and storage.
The system of depositories has the following role:
The owners of existing securities can choose to use the current share certificate or the depository mode, depending on their preference.
Investors who purchase new securities have two options: they can choose to get their share certificates physically or they can choose to join a depository.
Investors who choose the depository mode continue to gain financially from the shares and voting rights.
Shares kept in depositories are interchangeable, therefore. They lack a recognisable identity or distinct number.
Investors are permitted to own shares through the depository and can get share certificates from the corporation by having the depository's name replaced with their own as the registered shareholder.
When investors choose the depository method, their share certificates are dematerialized and their names are recorded as beneficial owners in the participant's records. The depository is listed as the registered owner of the securities in the register.
Investors who join a depository system must register with one or more participants who act as depositories' agents. Custodial organisations, including banks, financial institutions, etc., are examples of such actors.
Concept of Custodial Services
A key step in the development of a developed stock market system is the provision of effective custodial services. The custodians offer their services as custodians. Depositories are not the same as custodian services. A custodian is a middleman who maintains the client's accounts or holds the client's scarps in custody. An additional set of services offered by a custodian include physical share certificate transfers, the collection of dividends and investment warrants, and compliance with transfer laws. A custodian also serves as a trustee for share certificates and their safekeeping. In addition to these, it informs clients of the status of their investments. A record of dates, bonuses, and rights issues to make claims for benefits on behalf of its clients.
The SEBI Custodian of Securities Regulations 1996 were created to ensure the appropriate operation of their business in recognition of their significance in the securities market. Custodial services in connection to securities are defined by SEBI regulations as the safekeeping of the securities of a client who enters into a contract to obtain those securities and the provision of services incidental thereto.
5. Discuss the Black-Scholes formula on derivative pricing.
Ans) The Black-Scholes model simulates how the price of financial assets, particularly stocks, changes over time. The theoretical value of European put and call stock options is calculated using the Black-Scholes formula using the model's underlying assumptions. Fischer Black and Myron Scholes developed the formula, which was then published in 1973. They expanded on prior studies by Robert C. Merton, Paul Samuelson, and Edward Thorpe. The fundamental finding of Black and Scholes is that if the stock is traded, the option is implicitly priced.
The five main factors that affect an option's price are the stock price, strike price, volatility, time to expiration, and short-term (risk-free) interest rate. These factors are used in the Black-Scholes model to determine a theoretical call price (while disregarding dividends paid during the life of the option). The stock price is multiplied by the cumulative standard normal probability distribution function to arrive at the Black-Scholes call option formula. The outcome of the previous computation is then reduced by the net present value (NPV) of the strike price multiplied by the cumulative standard normal distribution.
In mathematical notation:
Advantages & Disadvantages of the Model
Advantage: The Black-Scholes model's key benefit is speed; it allows you to quickly calculate the pricing of a very large number of options.
Limitation: The Black-Scholes model has one significant drawback: because it only computes the option price at one point in time—at expiration—it cannot be used to appropriately price options using an American-style exercise. It does not take into account the points along the way where an early exercise of an American option would be possible.
The Black-Scholes formula for pricing options looks like this. We used the following assumptions in order to arrive at this equation:
There are no chances for arbitrage (no free lunch).
It is always possible to sell shares short.
No taxes or transaction fees are incurred while creating a portfolio.
The division of all securities is perfect.
Trading can go on indefinitely.
Throughout the duration of the option, the underlying share does not pay dividends.
Over the course of the option's existence, both the share volatility ó and the risk-free rate r are known.
Relation between Binomial Options Pricing Model & Black Scholes Model
Both the binomial and Black-Scholes models are based on the same fundamental presumptions about stock prices: that stock prices follow a stochastic process characterised by geometric brownian motion. As a result, for European options, the Black-Scholes formula is approximated by the binomial model as the number of binomial calculation steps rises. The Black-Scholes model for European options is actually a particular instance of the binomial model in which there are an infinite number of binomial steps. In other words, the continuous process that underlies the Black-Scholes model is approximated discretely by the binomial model.
6. Compare the impact of monetary policy under fixed exchange rates with those under flexible exchange rates.
Ans) The "something else" to which a currency value is set and the "rules of exchange" determine the type of fixed exchange rate system, of which there are many. In a fixed exchange rate system, a country's government announces, or decrees, what its currency will be worth in terms of "something else" and also establishes the "rules of exchange." A gold standard exists, for instance, if the government determines the value of its currency in terms of a specific amount of gold. A reserve currency standard exists when the value of the currency is fixed at a specific percentage of the currency of another nation.
Instead, several nations forbid the market from determining the value of their currency. As an alternative, they "peg" the value of the foreign exchange rate to a set parity, or a specific ratio of rupees to dollars. In this situation, we refer to a nation's fixed exchange rate regime. A government must pledge to protect that parity by being prepared to acquire (or sell) foreign reserves if the market demand for foreign currency is larger (or smaller) than the supply of foreign currency in order to maintain a fixed exchange rate. A country cannot simply declare a fixed parity.
If we take into account capital flows, then under a flexible exchange rate, capital movements have an impact on the domestic economy through having effects on income, output, and employment through the switching of expenditures. They can also alter local prices. The domestic economy is not directly impacted by capital flows with a fixed exchange rate, although it may be by changes to the money supply, interest rates, and other factors. In actuality, when capital mobility is substantial, the central bank loses control over the money supply and consequently over domestic interest rates.
The first benefit of variable rates is monetary policy independence. Governments might utilise monetary policy to achieve internal and external balance if central banks were no longer necessary and obligated to intervene in currency markets to fix exchange rates. Furthermore, no country would be able to export unemployment or inflation to other countries. Second, under a system of flexible exchange rates, the inherent power imbalances present in fixed exchange rate systems, such as those of the US under the Bretton Woods agreement, would disappear, and strong nations like the US would no longer be able to unilaterally determine the global monetary conditions. The exchange rates would function as automatic stabilisers under a flexible exchange rate regime, which is connected to the first point made above. The prompt adjustment of market-determined exchange rates would assist nations in maintaining internal and external balance in the context of shifting aggregate demand even in the absence of an active monetary policy.
The absence of exchange rate risk is a major benefit of fixed exchange rates, and it can significantly improve international trade and investment. The discipline a fixed exchange rate system imposes on a nation's monetary authority, which is likely to produce a far lower inflation rate, is a second important benefit.
Some have argued that it is difficult to have a stable currency, complete capital account convertibility, and interdependence amongst domestic monetary policies all at the same time. Consider a nation that seeks convertibility of its capital account. The last two must therefore be abandoned. Let's briefly discuss a few of the exchange rate arrangements that exist in reality, some of which are partial flexible exchange rates. Systems with intermediate exchange rates include those. There are the "crawling peg," "target zone," "mixed flexible and fixed rates," and "managed or pegged or dirty float" schemes. The wider band system is used when the permitted range of deviations is increased by, say, 2.5 or 3%. Another name for it is a target zone system. In reality, the majority of nations choose managed floats, crawling pegs, or permanent pegs. Right now, it appears that no country favours stable exchange rates. However, it also seems uncommon to have a totally free-floating exchange rate system.
7. Discuss the concept of leverage for a firm. Discuss the important financial and leverage ratios used. Explain the Merton-Miller theorem.
Ans) Leverage is the amount of debt a company has in its mix of debt and equity. A company with more debt than average for its industry is said to be highly leveraged. Leverage is not necessarily bad. When revenues are growing, payments are made with comfortable surpluses and additional debt is acquired to take advantage of market opportunities. However, when revenues are low, a highly leveraged business might fall behind on debt payments and it might not be able to borrow additional money to stay afloat.
Financial and Leverage Ratios
Leverage is occasionally referred to as "gearing," as in Britain. The theory behind leverage ratios is that the more a company's operations are supported by debt, the higher the risk. This is done by analysing the financing mix of the company. The firm's balance sheet can be used to learn more about this. The other method is to calculate coverage ratios, which assess the company's capacity to pay down that debt, using information from the income statement. The debt ratio and the debt-to-equity ratio are two often used ratios that are calculated from the data in balance sheets. In this context, debt includes both short-term and long-term liabilities for the company.
A definition of the debt ratio is:
Debt ratio = Total Liabilities divided by Total Assets
The debt-equity ratio is defined as:
Debt-equity ratio = Total Liabilities divided by Equities
Since total assets equal total liabilities + equity, the following can be demonstrated (you are left with the exercise):
Debt-equity ratio = Debt ratio divided by (1 – Debt Ratio)
We can determine the company's cash flow coverage from the income statements, which is provided as: Financial Coverage
where T refers for a company's taxes and EBIT stands for annual earnings before interest and taxes.
Merton-Miller theorem
Franco Modigliani and Merton Miller challenged this widely held belief in a ground-breaking piece that was published in the American Economic Review in 1958. They demonstrated that, under the supposition that there are no taxes, transaction costs, or other market distortions, the capital structure is unimportant. With the aid of this research, financial discipline will be given a strong theoretical basis and become less dependent on accounting practises and anecdotal evidence and more on mathematical economics and empirical research.
The worth of a corporation is unrelated to its capitalization, according to Modigliani and Miller's initial assertion. Their second assertion is that a risk premium is added to the overall capital cost, which is constant, to establish the equity capital expenses of a leveraged corporation. The debt-to-equity ratio is multiplied by the discrepancy between the total cost of capital and the cost of debt to arrive at this risk premium. In a symbolic sense, it could be symbolised by:
Ke= Ko+( Ko+ Kd)
where
Ke is the equity capital cost.
Kd is the capital debt cost.
Ko stands for the total cost of capital, or weighted average cost of capital.
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