ECS2605 May/June 2020: Suggested Solutions
SECTION A:
QUESTION 1
1(a) What is a credit rating? (2)
Credit rating refers to a statistical technique used to assess a borrower’s ability to meet future
payment obligations. It reflects the probability of default of a borrower.
(b) Why does South Africa’s recent sovereign credit rating downgrade imply higher funding
costs for the government? (2)
The downgrade of the credit rating implies that the credit worthiness of SA government bonds
has lowered and as such they have become higher risk for investors. This means that for the
SA government to access funds, they will have to do so at higher interest rates,
(c) Explain the differences in objectives between the lender-of-last-resort function of the
SARB and its accommodation policy. (4)
As a lender of last resort, the objective of the SARB is to provide loans to banks or financial
institutions that are near collapse in order to bring about stability in the financial system. On
its accommodation policy, the SARB attempts to maintain liquidity through the cash reserve
system so that when a bank experiences a shortage of cash reserves, it can either change other
financial assets into cash or borrow funds on the interbank market to eliminate the shortage.
(d) Describe exchange-rate risk and explain how a currency swap can be used to hedge
against exchange-rate risk. (3)
Exchange rate risk refers to the financial risk arising from fluctuations in the value of a base
currency against a foreign currency in which a company or individual has assets or obligations.
This risk can be reduced through hedging for example using currency swaps in which two
parties exchange an equivalent amount of money with each other but in different currencies.
The parties are essentially loaning each other money and will repay the amounts at a specified
date and exchange rate.
Cecil 0785729743
,ECS2605 May/June 2020: Suggested Solutions
(e) Describe the role of the Basel Committee on Banking Supervision (BCBS). (2)
The role of the BCBS is to increase understanding of the supervisory issues and lead to an
improvement in the banking quality through regulating the financial sector,
(f) Explain how the retirement benefit is calculated under both a defined benefit and a
defined contribution retirement fund. (2)
Under the defined benefit employers guarantee a specific retirement benefit amount for all the
member participants based on factors including salary, experience and years of service. On the
define contribution the funding s done by the employees and it is common for the employer
to match these employee contributions to a certain amount.
(g) Name three key objectives of regulators in the financial system. (3)
To create market confidence
Create consumer protection
Enhance financial stability
(h) Explain how the SARB uses its own debentures to manage the liquidity deficit in the
Banking system. (2)
If the SARB sells debentures, it lowers the money supply in the economy as banks and financial
institutions will buy these bonds which lowers the liquidity, while buying back the debentures
leads to an improvement in liquidity
SECTION B
In March and April 2020, the SARB made an extraordinary initial response to the Covid-
19 pandemic and the resulting impact on the South African economy, these measures
included:
1) The unprecedented action of purchasing government bonds in the secondary market
instead of the primary market.
2) In addition to the traditional seven-day weekly repurchase agreements offered to
Cecil 0785729743
,ECS2605 May/June 2020: Suggested Solutions
banks, the SARB announced it would offer twice daily as well as a three-month
repurchase agreements.
3) Reduced the repo rate by 100 basis points, taking it down to 4.25% on 14 April 2020.
Discuss each of these three actions and how they could have a positive impact on the
South African economy.
(a) Purchasing government bonds leads to an injection of money onto the south African
economy and increases liquidity which in turn will lead to higher levels of output
Increasing the amount and reducing the time frame enables the banks and financial institutions
to raise capital in the short term at reduced interest rate levels. Again this improves liquidity
and mitigates interest rate risk
Reduction of the repo-rate through the money transmission mechanism leads to a reduction in
interest rate, which lowers the cost of borrowing, Investment increases, aggregate demand goes
up and the level of output rises.
(b) Discuss the following statement: “All financial activity should be regulated.” (4)
The statement is true because regulation creates stability and through acts like NCR, consumers
are protected, banks are monitored and dissuaded from risky behaviour and as seen in south
Africa, through Hawks, money laundering is reduced. This leads to a sound financial system
and through improved market confidence.
On the other hand, regulation is against the free market system as proposed by Adam Smith
which according to classical theory will instead lead to huge capital outflows and if the
government becomes too involved it might end up chasing away private investment.
(c) Explain the purpose of the SARB’s lender-of-last-resort assistance.
Under which circumstances would this assistance be provided to a bank? (3)
As a lender of last resort, the purpose of the SARB is to provide loans to banks or financial
institutions that are near collapse in order to bring about stability in the financial system. This
assistance would be given to a bank if they are on the verge of collapse as well as situations in
which failure of a bank could lead to a run on banks and this might lead to a failure in the
system.
Cecil 0785729743
, ECS2605 May/June 2020: Suggested Solutions
(d) Explain the difference between life (long-term) and non-life (short-term) insurance and
explain why they have different investment portfolios. (5)
Life insurance refers to insurance that pays out a sum of money either on the death of the
insured person or after a set period. Non-life insurance on the other hand is any type of
insurance other than life insurance. While life insurance is broken down into permanent and
term life policies, non-life insurance includes many types of other insurance policies. Non-life
insurance may cover people, property or legal liabilities.
Non-life insurance is much riskier and as such usually has a higher return with a short term to
maturity to compensate for claims as opposed to the less risky life insurance.
(e) Discuss the core responsibilities of the Prudential Authority and the Financial Sector
Conduct Authority according to the Twin Peaks regulatory framework in South Africa. (2)
Prudential Authority oversees the stability and soundness of the financial system while
Financial Sector Conduct authority oversees the integrity and efficiency of the financial
markets.
(f) Explain how the GDP of the economy may be influenced by a credit downgrade. (4)
Credit downgrade refers to the deliberate decrease in the credit rating of holding debt securities
like bonds and it has the following impact:
Increases the debt servicing costs for government thus reducing spending on social
initiatives
It leads to a depreciation of the rand which raises the cost of imports
Capital outflows caused by lower returns to investments
Lower buying power which causes retrenchments and low demand (recession)
(g) Discuss how a change in any three factors that will affect the interest rate on bonds are
likely to affect the interest rate on bonds. (6)
1) Credit ratings – if credit worthiness of a country is reduced by credit rating agencies
this increases interest rates and therefore lowers bond prices
2) Money demand – if economic agents demand more money, interest rates tend to
increase and bond prices reduce. This is due to the trade-off between holding money
and bonds
Cecil 0785729743
SECTION A:
QUESTION 1
1(a) What is a credit rating? (2)
Credit rating refers to a statistical technique used to assess a borrower’s ability to meet future
payment obligations. It reflects the probability of default of a borrower.
(b) Why does South Africa’s recent sovereign credit rating downgrade imply higher funding
costs for the government? (2)
The downgrade of the credit rating implies that the credit worthiness of SA government bonds
has lowered and as such they have become higher risk for investors. This means that for the
SA government to access funds, they will have to do so at higher interest rates,
(c) Explain the differences in objectives between the lender-of-last-resort function of the
SARB and its accommodation policy. (4)
As a lender of last resort, the objective of the SARB is to provide loans to banks or financial
institutions that are near collapse in order to bring about stability in the financial system. On
its accommodation policy, the SARB attempts to maintain liquidity through the cash reserve
system so that when a bank experiences a shortage of cash reserves, it can either change other
financial assets into cash or borrow funds on the interbank market to eliminate the shortage.
(d) Describe exchange-rate risk and explain how a currency swap can be used to hedge
against exchange-rate risk. (3)
Exchange rate risk refers to the financial risk arising from fluctuations in the value of a base
currency against a foreign currency in which a company or individual has assets or obligations.
This risk can be reduced through hedging for example using currency swaps in which two
parties exchange an equivalent amount of money with each other but in different currencies.
The parties are essentially loaning each other money and will repay the amounts at a specified
date and exchange rate.
Cecil 0785729743
,ECS2605 May/June 2020: Suggested Solutions
(e) Describe the role of the Basel Committee on Banking Supervision (BCBS). (2)
The role of the BCBS is to increase understanding of the supervisory issues and lead to an
improvement in the banking quality through regulating the financial sector,
(f) Explain how the retirement benefit is calculated under both a defined benefit and a
defined contribution retirement fund. (2)
Under the defined benefit employers guarantee a specific retirement benefit amount for all the
member participants based on factors including salary, experience and years of service. On the
define contribution the funding s done by the employees and it is common for the employer
to match these employee contributions to a certain amount.
(g) Name three key objectives of regulators in the financial system. (3)
To create market confidence
Create consumer protection
Enhance financial stability
(h) Explain how the SARB uses its own debentures to manage the liquidity deficit in the
Banking system. (2)
If the SARB sells debentures, it lowers the money supply in the economy as banks and financial
institutions will buy these bonds which lowers the liquidity, while buying back the debentures
leads to an improvement in liquidity
SECTION B
In March and April 2020, the SARB made an extraordinary initial response to the Covid-
19 pandemic and the resulting impact on the South African economy, these measures
included:
1) The unprecedented action of purchasing government bonds in the secondary market
instead of the primary market.
2) In addition to the traditional seven-day weekly repurchase agreements offered to
Cecil 0785729743
,ECS2605 May/June 2020: Suggested Solutions
banks, the SARB announced it would offer twice daily as well as a three-month
repurchase agreements.
3) Reduced the repo rate by 100 basis points, taking it down to 4.25% on 14 April 2020.
Discuss each of these three actions and how they could have a positive impact on the
South African economy.
(a) Purchasing government bonds leads to an injection of money onto the south African
economy and increases liquidity which in turn will lead to higher levels of output
Increasing the amount and reducing the time frame enables the banks and financial institutions
to raise capital in the short term at reduced interest rate levels. Again this improves liquidity
and mitigates interest rate risk
Reduction of the repo-rate through the money transmission mechanism leads to a reduction in
interest rate, which lowers the cost of borrowing, Investment increases, aggregate demand goes
up and the level of output rises.
(b) Discuss the following statement: “All financial activity should be regulated.” (4)
The statement is true because regulation creates stability and through acts like NCR, consumers
are protected, banks are monitored and dissuaded from risky behaviour and as seen in south
Africa, through Hawks, money laundering is reduced. This leads to a sound financial system
and through improved market confidence.
On the other hand, regulation is against the free market system as proposed by Adam Smith
which according to classical theory will instead lead to huge capital outflows and if the
government becomes too involved it might end up chasing away private investment.
(c) Explain the purpose of the SARB’s lender-of-last-resort assistance.
Under which circumstances would this assistance be provided to a bank? (3)
As a lender of last resort, the purpose of the SARB is to provide loans to banks or financial
institutions that are near collapse in order to bring about stability in the financial system. This
assistance would be given to a bank if they are on the verge of collapse as well as situations in
which failure of a bank could lead to a run on banks and this might lead to a failure in the
system.
Cecil 0785729743
, ECS2605 May/June 2020: Suggested Solutions
(d) Explain the difference between life (long-term) and non-life (short-term) insurance and
explain why they have different investment portfolios. (5)
Life insurance refers to insurance that pays out a sum of money either on the death of the
insured person or after a set period. Non-life insurance on the other hand is any type of
insurance other than life insurance. While life insurance is broken down into permanent and
term life policies, non-life insurance includes many types of other insurance policies. Non-life
insurance may cover people, property or legal liabilities.
Non-life insurance is much riskier and as such usually has a higher return with a short term to
maturity to compensate for claims as opposed to the less risky life insurance.
(e) Discuss the core responsibilities of the Prudential Authority and the Financial Sector
Conduct Authority according to the Twin Peaks regulatory framework in South Africa. (2)
Prudential Authority oversees the stability and soundness of the financial system while
Financial Sector Conduct authority oversees the integrity and efficiency of the financial
markets.
(f) Explain how the GDP of the economy may be influenced by a credit downgrade. (4)
Credit downgrade refers to the deliberate decrease in the credit rating of holding debt securities
like bonds and it has the following impact:
Increases the debt servicing costs for government thus reducing spending on social
initiatives
It leads to a depreciation of the rand which raises the cost of imports
Capital outflows caused by lower returns to investments
Lower buying power which causes retrenchments and low demand (recession)
(g) Discuss how a change in any three factors that will affect the interest rate on bonds are
likely to affect the interest rate on bonds. (6)
1) Credit ratings – if credit worthiness of a country is reduced by credit rating agencies
this increases interest rates and therefore lowers bond prices
2) Money demand – if economic agents demand more money, interest rates tend to
increase and bond prices reduce. This is due to the trade-off between holding money
and bonds
Cecil 0785729743
