ECS3701 EXAMINATION QUESTIONS AND SUGGESTED SOLUTIONS FOR 2022.

ECS3701 EXAMINATION QUESTIONS AND SUGGESTED SOLUTIONS FOR 2022. 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 Prepared by Douglas Museva from prescribed Unisa material Page 1 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. Prepared by Douglas Museva from prescribed Unisa material Page 2 A normal yield curve: Answer any one of the following two questions : 2.2 Use the theory of asset demand to explain how both (i) and (ii) below will influence the supply of and demand for bonds, the price of bonds and the equilibrium quantity of bonds. (Please answer each question separately.) (i) Higher expected future interest rates. (4) The interaction of supply and demand for bonds is one of the ways in which interest rates are determined. If it is expected that interest rates will rise in the future, then the demand for bonds will decrease and the demand curve for bonds will shift to the left. This is because the increasing interest rate implies a decreasing price and therefore the expectation of lower returns. The equilibrium price and quantity of bonds will decrease, ceteris paribus. (ii) An increase in the expected inflation rate (6) When inflation is expected to rise it lowers the expected return on bonds and so demand will decrease. The returns on other assets tend to increase in times on inflation and therefore bonds become less attractive. An increase in expected inflation also impacts on the supply of bonds. For a given interest rate, when the expected inflation increases, the real cost of borrowing falls and so the quantity of bonds supplied will increase. Prepared by Douglas Museva from prescribed Unisa material Page 3 Yield to Maturity Term to Maturity The overall impact of the above on the price and quantity of bonds is that the equilibrium price of bonds will decrease (and interest rates will rise), but the effect on the quantity of bonds is uncertain. 2.3 Explain the assumptions and predictions of the expectations theory and how well it explains the three empirical observations of the yield curve. (Hint: Write down the formula for the long term interest rate). (10) Expectations theory: the interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond. The key assumption behind this theory is that buyers of bonds do not prefer bonds of one maturity over another, so they will not hold any quantity of a bond if its expected return is less than that of another bond with a different maturity. The expectations theory is able to explain empirical facts (1) and (2) but is unable to explain fact (3).