ECS3701 EXAM PACK. VERIFIED.

ECS3701 EXAM PACK. VERIFIED. Page 1 MAY/JUNE 2011 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 Page 2 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.