FIN 444 MIDTERM TOTAL POINTS 45 MzF

(Please rename the file with your name & ID. Read the questions carefully and answer in the spaces provided (you
may change the size of the text boxes to fit your answers). Good luck!)

1. What is the BOT for a country? How is it measured? What do foreign investors consider when evaluating
the BOT? (3 points)

Balance of Trade (BOT) refers to a country’s volume of trade, i.e. merchandise exports and merchandise
imports. Additionally, it includes ‘unilateral current transfers’ which means funds that are coming in or
going out of an economy without the need for repayment, e.g. foreign aid.

BOT is calculated as; Exports – Imports +/- Unilateral Current Transfers. A positive BOT is denoted as
trade surplus and a negative BOT as trade deficit.

Foreign investors are not concerned about trade surplus or deficit but rather emphasize on the
movement of exports and imports. A country where both exports and imports are rising (assuming
exports are rising at faster rate than imports) is considered as a better economy to invest, e.g. an
emerging economy.

2. What are the Capital & Financial accounts for a country? What do we use them to measure? What would
a negative balance on these accounts indicate for a country? (3 points)

Capital account and Financial account are components used to measure the Balance of Payment (BOP).
BOP is a summary of a country’s net ownership of assets, where capital account comprises of net non-
financial assets and financial account comprises of net financial assets (portfolio investments). A negative
balance depicts that the domestic country owns more foreign assets.

3. What are the 3 fundamental economic factors that foreign investors consider? Describe briefly how these
factors are related to each other? (3 points)

Foreign investors consider the following economic factors, i.e. inflation, interest rates and national
income.

Inflation refers to the rise in the general price level which reduces the purchasing power of individuals.
The central bank uses the interest rates as tool to control money supply in the economy. Therefore,
Interest rates are manipulated to control inflation, i.e. if inflation increases then savings interest rates are
increased to encourage people to save more thus reducing money supply in the economy and in turn
inflation. Similarly, due to the rise in interest rates, people can earn more returns from their savings thus
increasing the national income which will eventually increase the money supply and cause inflation to rise
again. But there is a time lag in between manipulating interest rates and its effects on inflation and
national income.
4. What is the international money market? How does it operate? Discuss its key characteristics briefly. (3
points)

The international money market, also known as the euro currency market, refers to a marketplace for
forex trading. Eurobanks are used to facilitate the exchange of accepting deposits and providing loans in
various currencies. The market uses the London Inter Bank Offered Rate (LIBOR) as a benchmark for the
call money rate. It is a coordinated market but not necessarily efficient.

5. What are the two types of capital markets? How are they different from each other? (2 points)

Capital markets are classified as organized exchange (e.g. NYSE) and over the counter (OTC) exchange
(e.g. NASDAQ.com). Organized exchange are centralized and have a specific location but OTC exchange
are decentralized and does not operate from a specific location.

6. What is an “indenture”? Describe briefly the fundamental components of an indenture and briefly discuss
the three different kinds of international bonds. (4 points)

An indenture is a debt contract. For example, bonds. It consist of the following components:

 Face Value, i.e. loan amount denoted on a bond.

 Interest Rate, i.e. the coupon rate charged on the lending amount.
 Maturity, i.e. time span over which the contract will exist.
 Underwriting, i.e. guarantor of the debt.

International Bonds are:

 Foreign Bonds – denominated in the holder’s home currency.

 Euro Bonds – denominated in the issuer’s home currency.
 Global Bonds – denominated in any currency and underwriting becomes a procedure.
7. What is a forward contract? Describe its characteristics and briefly discuss the difference between the two
types of forward contracts that exist. (3 points)

A forward contract is an agreement that allows the holders to buy or sell any amount of currencies at a
particular rate, and at a particular point in time. The contract consists a fixed forward rate, an exercise
date, amount (minimum $1 million). It can be exercised only on the exercise date. A fixed price must be
paid on the contract, regardless of whether it is exercised or not. Forward contracts cannot be bought by
individuals but only by institutions and government, and it cannot be bought or sold. It is usually issued
by financial institutions. It is called a premium contract if the spot rate is lower than the forward rate. If
the spot rate is greater than the forward rate then it is called a discount contract.

Forward contracts are of two types, i.e. American forward contract and non-deliverable forward contract
(NDF). On the exercise day, for a forward contract, the holder must possess the total transaction amount
but for a NDF the holder only has to possess the premium or discount amount.

8. What is a futures contract? Describe its characteristics briefly. Finally, discuss the strategy of OFFSET with
futures contracts. (4 points)

A futures contract is an agreement that allows the holders to buy or sell a particular amount of a particular
commodity, at a particular rate, and at a particular point in time. Futures contract includes a strike rate, an
exercise date, amount (standardized). It can be only exercised four times annually, on the third day of the
third week of every three months. The futures market operate in both organized exchanges and OTC. No
restrictions on who can hold futures contract but must have a brokerage account (through a broker) with a
margin. It can also be bought or sold before the exercised date.

Offsetting refers to holding both a buy and a sell futures contract in order to minimize losses (or even earn
profits).

9. What are the 3 different classifications of options contracts – what do they mean? What are the three
different types of options contracts? Describe each type briefly. (4 points)

Options contracts are classified into,

 In the money, i.e. if exercised, options contract will generate profits.

 At the money, i.e. if exercised, options contract will be at the break-even point.
 Out of the money, i.e. if exercised, options contract will incur losses.

Types of options contracts are:

 American style options contract – It has a strike rate, expiration date, amount, premium (%)
 Conditional options contract – it has a strike rate, expiration date, amount, trigger rate, higher
premium (%)
 European style option contract – it has a strike rate, exercise date, amount, lower premium (%)
10. What is a straddle in options trading? What is a spread? How are they different? (3 points)

The primary purpose of an options contract is to make speculative profits. However, if there is uncertainty
in speculations than a straddle can be used to minimize the risk and earn returns, i.e. holding a call options
contract as well as a put options contract and exercising either one of them based upon the change in the
commodity price. In contrast, spread is used when the speculator is certain about the direction of the
movement in the commodity’s price, i.e. holding multiple options contract (call or put) to maximize
returns. A vertical spread refers to options contract with different strike rate and a horizontal spread refers
to options contract with different expiration date. Usually, speculators use a bull spread which refer to
using both vertical and horizontal spread.

11. Economies today can be classified as developed, emerging or frontier markets? Describe each type briefly.
(3 points)

Developed Economies – These are countries which are usually AAA or AA rated. Organizations in these
economies seek investment opportunities in developing nations to grow in the global economy. In these
countries, the living standards are high and growth potential is comparatively lower. However, these
economies are beneficial in terms of risk diversification.

Emerging Economies – These are countries which give organizations in developed nations great prospect
for investment as they have rising demand, unutilized workforce potential and natural resources as well.
These markets are having high sales potential and rated as BBB, BB or B.

Frontier Economies – These economies are considered as a great source for natural resources however
have very poor economies and with low sale potential or risk diversification.

12. Consider the relationship between two hypothetical currencies (currency A & currency B). Describe briefly
what will happen if i. Interest rates in Country A go up ii. Inflation in country A goes up iii. Income levels in
country A rise? (4 points)

i. Given that interest rates are rising in country A, thus foreign investors will be willing to deposit their
money in country A. This will increase the demand for A’s currency and thus it will appreciate against
currency B.
ii. As inflation increases in country A, it will make domestic goods in A, expensive thus imports from
country B may rise which in turn increases the demand for currency B and reduce the supply of
currency A. Therefore, currency A will depreciate against currency B.
iii. Given that national income levels are rising hence people in country A will start to consumer more
thus increasing demand. The shift in demand will contribute to inflation as general price levels will rise
(assuming supply is not shifting). Additionally, demand for imports will increase thus making the
currency A depreciate against currency B.

13. What is an SDR? (1 point)

SDR means special drawing right. It is a unit of currency used by the IMF. Formally known as the SDR
basket which is calculated by assigning weights to certain currencies.
14. What is arbitrage? Describe the concept of arbitrage and its relationship to equilibrium briefly. (3 points)

Arbitrage refers to disequilibrium, i.e. commodity prices may vary in different markets which provides an
opportunity to people to benefit from, e.g. Prices of fish will be higher in Bashundhara than Kawran Bazar.
To utilize the opportunity of buying fishes from Kawran bazar and selling in Bashundhara to earn profits is
known as an arbitrary activity. However, in accordance with the efficient markets hypothesis, markets are
more or less efficient thus arbitrage will push the market towards the equilibrium.

15. Why does a conditional options contract have a higher premium than an American options contract? (2
points)

A conditional options contract offers more flexibility to the holder as the payment for premium is only
applicable if the price of the commodity is equal to/greater than the trigger rate. Therefore, it charges a
higher a premium than American options contract.