Week 1

1b) Participants and functions of fi

There are 3 participants in the financial system which are end-users such as households and firms, financial
intermediaries and market makers.

Households want to maximise their utility from their current and future consumption. One way to do this is by
investing in financial assets bringing them gains in the future. This acts to smooth consumption. This means
households want to lend their surplus funds with a short horizon.

Firms on the other hand want to maximize the (discounted) sum of their current and future profits. They can
do this through investments such as replacement investment (replace obsolete equipment) or net investment
(expand the level of activity). Firms finance these investments with retained earnings, bank loans, new equity
or bond issuing. The firm plans to finance the investments with a long horizon meaning they don’t want to give
money back to lenders that are on a short horizon.

This creates a problem where households want to lend on a short horizon while firms want to borrow on a
long horizon.

This could be solved by the price mechanism where there are lower interest rates for short-term lending and
higher interest rates long term borrowing. However, this has a problem where it disincentives households to
save and firms to invest.

The real solution is financial intermediaries.

Financial intermediaries have 3 functions.

There is a process called asset transformation. Households have savings which are their assets. This is
deposited to a financial intermediary and now the financial intermediatory has liabilities which are the
deposits as they need to pay it back. The Financial intermediary's assets is the loans that are given to firms and
these loans are the firm's liabilities as the firm needs to pay back the loan to the financial intermediatory.

One is maturity transformation, a practice in which the financial institution borrows money for the short term
to lend for the long term. The financial institution relies on the idea that all depositors won’t come at the same
time asking for their money and so only needs to keep enough liquidity in the bank to satisfy the forecast for
possible demand from depositors.

The other function is risk transformation where they construct diversified portfolios where assets have a
negative correlation. For example, lending to firms in industries that oppose each other. So, if one industry
experiences a decline then this is offset by the growth in the other industry.
The final function is transaction cost reduction. This is done by lower search costs and economies of scale.

List and briefly describe the various types of Financial Intermediaries

There are bank financial intermediaries such as retail banks and investment banks.

Retail banks cater to households and businesses. They accept deposits from individuals and businesses and
then use these deposits as funds for loans to individuals or businesses. This practice relies on the idea that not
all depositors want their money back at the same time so they only need to keep enough liquidity to meet
forecasted demand for deposits. Investment banks deal with institutional investors, large corporations and
governments and they offer services such as Corporate finance, asset management, proprietary trading or
agency brokerage and market-making.

There are also non-bank financial intermediaries such as finance houses, building societies and pension funds.
Finance houses specialize in funding short-term durable expenditures for households, often through
arrangements like hire purchase agreements. These agreements allow buyers to pay a monthly rate to use a
good and eventually become its owner. Building societies function as financial institutions providing banking
services, with a focus on financing long-term durable expenditures, such as mortgages, for their members.
Pension funds play a role in managing and investing funds contributed by employees and employers, primarily
earmarked for retirement benefits.

There are also specialist financial intermediaries such as arbitrageurs, hedgers and speculators. Arbitrageurs
perform fundamental analysis and exploit price differences of the same asset in different markets meaning
that they buy low in one market and sell high in the other. Hedgers using futures contracts or options seek
minimise the risk of circumstances such as share prices falling or interest rates going up. Speculators anticipate
future prices and so they take positions such as long or short to profit.

Securities are the second component of the financial system and can be classified based on various criteria.
Describe the various types of existing securities by using different classification criteria.

A security is a claim to some underlying asset (financial or physical).

One classification criterion is the type of issuer whether it be domestic, government or corporation. Examples
of government securities are treasury bonds and an example of corporate securities is stocks.
Another classification criterion is the currency of denomination. For example, domestic bonds which are
traded in £ in the UK or Eurobonds which are traded in the in UK in other currencies.
Ownership and participation rights is another classification criterion. For example, there is common stock
where you gain an ownership stake in the company and voting rights and potential dividends. Preference stock
gives what is mentioned for the common stock except the voting right.
Another classification criterion is collateral. Collateral distinguishes securities as either secured or unsecured.
Secured securities are backed by collateral such as a house so in the case of a default the bank gains equity
equal to the default amount or more in the house which they can sell to recoup the loan. Unsecured securities
have no collateral so are deemed riskier however they offer potentially higher returns.
Another classification criterion is maturity. A maturity with less than 1 year is a short-term security and an
example is a treasury bill. There are callable securities where the issuer can redeem the security before its
maturity date. There are also perpetuities which have no maturity date.
Another classification criterion is income payments. Fixed income securities such as bonds deliver pre-
determined interest rates to the holder while variable income securities such as common stock does not
guarantee fixed payments however, the owner can benefit from dividends depending on the company’s
profitability.

Describe the Financial market?

A market is a system where securities are created and transferred.

Markets in which securities have maturities in less than a year are called money markets. Examples of these
are Treasury bills, commercial bills, and negotiable certificates of deposit.
On the other hand capital markets are where you have long-term bonds or shares.
The markets are either primary or secondary. The primary market is a market where the security is first issued
(IPO) while the secondary market is where existing securities are being traded.
Also, there are the exchange and over-the-counter markets. In the exchange market, trading occurs through
centralised platforms such as Trading 212 where buyers and sellers interact in a regulated environment. On the
other hand, OTC market is decentralised with transactions taking place directly between two parties. OTC
markets are used when you have specific needs that cannot be satisfied with the securities in the exchange
market. For example, customisable futures contracts where you hedge your position against some of the
things your business generates. In OTC market an example of the other party is an investment bank.

1a) List and briefly describe the various types of orders that an investor can give to his/her broker. [40%]

Market order: best possible price

Buy Stop order: buy X (e.g., 20) shares as soon as the price rises above P (£23)

Sell Stop order: sell X (e.g. 50) shares as soon as the price drops below P (£10)

Limit order: buy/sell at a specified price or better (sell 20 shares when the price equal or higher than £25)

Stop limit order is a type of to buy or sell a specified quantity of a financial instrument at a specified price or
better after a given stop price has been reached. E.g. Sell £101 stop, £90 limit= executed if share price falls
below £101, but not lower than £90

Day order: the order is cancelled if it is not executed on a particular day.

Open order: remains in effect until it is either executed or cancelled.

Fill-or-kill order: cancelled if it cannot be executed immediately.

Round lot order: buy/ sell in the standard trading unit for a stock exchange (ex: 100 shares London Stock
Exchange)

Week 2
a) How do interest rates work
Nominal Interest rates are the interest rate before inflation is taken into account, whilst Real interest rates are
the interest rates once inflation has been taken into account. Nominal Interest rates show you the percentage
increase in the value of your investment, but they don't account for changes in spending in future periods.
Real Interest rates show an accurate measure of the cost of borrowing and the reward from saving whilst
taking inflation into account.

Zero lower bound problem is when interest rates are difficult to change which makes it more difficult for
Central banks to absorb any macroeconomic shocks within the economy. Such as a fall in economic activity
due to a fall in consumption and a higher rate of unemployment. With interest rates approaching close to 0%,
Central banks cannot change this further as it could already lead to a liquidity trap. This is where the interest
rates are so low that consumers and firms decide to save more as they continue to expect interest rates to fall.
This leads to lower consumption and investment, ultimately leading to a fall in economic growth. If the
monetary policy becomes ineffectual, then Fiscal policy will have to be implemented to solve any macro
shocks within the economy, eg: Public spending on houses (incentivize consumers to take out
loans/mortgages). Zero lower bound can also lead to possible deflation as the price of goods falls due to lack
of spending, this can further delay spending as consumers expect prices to fall and hence start saving.

To solve the zero bound problem the central bank can employ quantitative easing which is an instrument of
monetary policy used by the central bank where the central bank purchases assets such as bonds on the open
market. This injects liquidity into the economy as those who had their assets brought from the central bank
will spend the money from the sale and this drives demand in the economy. Prices will start to increase
meaning people won’t expect deflation anymore and so will start to spend instead save which further
increases the demand.

In general, the zero-lower bound problem can cause issues with traditional monetary instruments, but using
QE can improve the money supply in the economy and incentivize consumers and firms to start spending.

Causes of low interest rates

Low interest rates occur when the supply of funds available for lending exceeds the demand for borrowing.
This situation arises when individuals lack confidence in the economy, leading them to prioritise saving due to
concerns about potential future uncertainties that may necessitate significant expenditures.

inflation is a general increase of the prices of goods and services in an economy.

Week 4
a) Explain what money market securities are. Describe the two ways in which this type of security are
quoted. [40%]

Money market securities are short-term (maturity less than one year) debt instruments issued by
governments, financial institutions, and corporations to meet their short-term funding needs. They cannot be
liquidated before maturity, and have a Fixed-rate and Interest & capital repaid at maturity (no intermediate
payments).

The advantages of money market securities are the high liquidity and low risk brought about due to their
short-term nature and their typical issuer being highly creditworthy.

Examples of money market securities include certificates of deposit, Treasury Bills (Issued by the government),
bills of exchange (issued by companies against the sale of goods), bankers acceptance (Written promise by a
borrower to a bank to repay borrowed funds – tradable on a secondary market) and commercial paper
(promissory notes issued by large firms that are unsecured (no collateral).

One way a money market security is quoted is a yield basis: % of interest. For example, if a CD with a face
value of £100 is quoted with a yield of 2%, the investor can expect an annual return of £2.
Another way a money market security is quoted is on a discount basis: sold at a discount from the face value.
For example, a treasury bill with a face value of £100 quoted on a discount basis is £98, the £2 difference is the
discount and represents the buyer's return.

b) Explain reinvestment risk and breakeven rates

In notes
 Week 5

b) List the various types of bonds and briefly describe their

characteristics. [60%]

a bond is a type of security under which the issuer owes the holder a debt. a bond pays interest periodically
and repays the principal at a stated time, known as maturity. The maturity of a bond is greater than 1 year

There are variable rate bonds: linked to current interest rates, index-linked bonds: linked to an index such as
inflation, income bonds where coupons are only paid if company income is sufficient,
double-dated bonds: range of possible redemption dates, callable bonds: redemption date chosen by issuer/
holder, convertible bonds: can be converted into other types of bonds/equity, perpetual bonds: no redemption
date,
corporate bonds: bonds issued by corporation to finance operations or expansion,
domestic bonds: issued in £ in the UK, foreign bonds: issued in £ by foreign issuers, Eurobonds = issued and/or
traded in the UK in a foreign currency.

(a) Describe how a bond’s “dirty price” moves around the clean price and explain why this occurs. (40%)

Accrued interest is the interest that has been earned but not yet paid to the bondholder. The accrued interest
increases each day until the payment of the coupon as shown by the diagram where AI>O. When there is
positive accrued interest, the bond has a dirty price which is the clean price + the accrued price meaning when
accrued interest is greater than 0, the clean price is lower than the dirty price.

On the day of the coupon payment the price drops as there are fewer payments left. The price starts rising
again with the increased accrued interest until the next coupon payment where the price drops again. This is
repeated until the bond matures.

In the diagram, there is a time period x to c. In this period if a bondholder sells their bond, then the new
bondholder won’t get the next coupon payment and the next coupon payment will go to the old bondholder.
The price drops at x as if you buy the bond at that time,
you won’t receive the next coupon payment and so you
shouldn’t pay any accrued interest. The accrued interest is
in fact negative at that time meaning the dirty price is
lower than the clean price. This is to compensate the new
bondholder for holding the bond even thou the next
coupon payment will go to the old bondholder.

(b) Discuss the Expectations Hypothesis, the Liquidity Preference Theory, the Preferred Habitat Theory and
the Market Segmentation Theory. How do these four theories help us explain the yield curve?
Liquidity Preference Theory: As borrowers prefer to borrow for longer periods, while investors prefer to stay
liquid, a liquidity premium is required by lenders to forgo liquidity • Liquidity premium increases with maturity

• Preferred Habitat Theory says that supply and demand

conditions determine the slope of the yield curve. Banks
demand short maturities, pension funds demand long
maturities, no particular group demands medium –
hump-shaped

Let 𝑠1 and 𝑠2 denote the spot rates for a one-year and two-year zero-coupon bonds, respectively. Derive the
argument behind the formula for the implicit forward rate 1 2 rf on a one-year bond maturing 2 years from
today. Explain the meaning of implicit forward rates in relation to the spot-yield curve. [40%

Week 7
Porter’s Five Forces Model and explain why we should care
An environmental threat is any individual, group, or organization outside of the firm that seeks to reduce the
firm’s performance. It consists of threats from buyers, substitutes, suppliers, entrants and rivalry. We care
about the environment as determines the size of a firm's competitive advantage which affects the firm’s ability
to generate above-average returns. Wide moat: a company with strong CA – Narrow moat: a company with
some CA – No moat: a company with no CA.
Types of stock
Common stock represents ownership in a company and typically comes with voting rights at shareholder
meetings. Shareholders may have the right to vote on certain company decisions, such as the election of the
board of directors. Common stockholders are also entitled to a share of the company's profits, usually in the
form of dividends, although not all companies pay dividends. However, in the event of liquidation, common
stockholders are the last in line to receive assets after all debts and preferred stock claims are satisfied.

Preferred stock is another form of equity ownership, but it has characteristics of both equity and debt. They
typically receive a fixed dividend before any dividends are paid to common stockholders. However, preferred
stockholders usually do not have voting rights. In the event of liquidation, preferred stockholders are paid
before common stockholders but after bondholders and other debtholders.

Dual-class stock refers to a structure in which a company issues different classes of shares, typically Class A and
Class B, with each class having different voting rights. This structure allows certain shareholders, often
company founders or key insiders, to retain control over the company even if they own a minority of the total
equity.
 Dividend policy and stock buybacks
Retained earnings are the cheapest source of funding. There are 2 reasons why we use these earnings as
dividends instead of reinvesting them. 1 reason is the principle agent problem. The principal (shareholders)
want a return on their investment which conflicts with the agent's (management) objective which is to grow
the company. The shareholders have power over management as they can vote them out.
The second reason is Higher dividends can be used to signal that managers are optimistic about a firm’s future
earning capabilities which can get more people to buy the stock and increase stock price.

Another way to return money to investors is Stock buybacks reduce the number of shares outstanding which
tends to increase the price of each remaining share.

– Debt to Capital Ratio = Debt / (Debt + Equity)

Compare the characteristics of equity with those of debt and discuss how the capital structure of the firm
changes at different stages of the firm’s development.
Equity and debt are two primary forms of financing with distinct characteristics that impact the financial
structure and risk profile of companies. Equity represents ownership in a company, and investors who hold
equity, such as common shareholders, become partial owners with voting rights. On the other hand, debt
represents borrowed capital, and lenders, such as bondholders or banks, receive fixed interest payments and
have a claim on the company's assets. Debt comes with a contractual obligation to repay the principal amount
at maturity. In the event of liquidation debt holders will get their money back before equity holders. Equity has
infinite maturity while debt has a fixed maturity. The interest payments from debt is tax deductible while
dividend payments from equity is not.
Hybrid securities. They possess some characteristics of debt and some of equity. Examples: • Convertible debt
• Preferred stock
1. Start-up: – Owners’ equity. Perhaps bank debt
2. Expansion: – Owners’ equity and venture capital. Some firms will become public (IPO)
3. High growth: – Additional equity issues. Perhaps issuance of convertible debt
4. Mature growth: – Internal financing and corporate debt
5. Decline: – Internal financing. Debt retiring and stock buy-back

Derive the Gordon’s growth model for pricing a share and explain the economic logic behind this model.
[60%]

Week 9
Describe the main characteristics of foreign exchange markets and explain the difference between direct
and indirect quotations. [40%]
The FX market is the market in which the national currency is traded for other currencies. In this market, an
exchange rate is the price of one currency in terms of another currency. Currencies can be: – Freely
convertible: holders can exchange without any restrictions – Partially convertible: central bank imposes certain
conditions – the maximum amount that can be exchanged (ex. Argentina), maximum fluctuation range and
finally Not convertible (closed economies.
The main characteristics of these markets include high liquidity, continuous operation 24 hours a day (except
weekends), and a vast network of participants, including central banks, financial institutions, corporations, and
individual traders.
One crucial concept in foreign exchange is the quotation of currency pairs. Currencies are quoted in pairs,
where one currency is expressed in terms of another. Direct quotation refers to the price of foreign currency in
terms of domestic currency (ex: how many £s for 1$?), while indirect quotation refers to the price of domestic
currency in units of foreign currency (ex: how many $s for 1£?)

Describe at least three types of risk faced by a commercial firm with operations in foreign countries. [40%]
Exchange risk is the risk that adverse movements in the exchange rate will reduce the return from an
investment. If you convert currencies and the currency you converted from appreciates you are making a
negative return if you convert it back.

• Transaction costs: Investing in foreign markets can entail higher costs

Double taxation: Taxes due both in domestic and foreign country, or higher taxes in foreign countries
• Political risk: Risk of expropriation (the action by the state or authority of taking property from its owner for
public use or benefit), revolution (ex. Libya), or simply default (again, Argentina), etc.
• Transaction risk: Risk arising from invoicing in a foreign currency
• Translation risk: Risk to the balance sheet from having assets and/ or liabilities denominated in a foreign
currency (value of asset decreases from fluctuation in exchange rate meaning you can’t borrow as much)

Solution: Hedging using forward currency transactions

c) Derive the rate of appreciation/depreciation of the exchange rate between two currencies using the
purchasing power parity (PPP) and explain the effect of changes in the inflation rate in either
country. [60%

Derive the covered interest rate parity and explain the economic meaning of this relationship. [60%]
 Week 10

Carefully explain the process of marking to market. [40%]

Marking to market is an accounting process employed in futures and other derivative markets to adjust the
value of a financial contract to reflect its current market price. At the end of each trading day, the
clearinghouse recalculates the value of each participant's futures position based on the prevailing market
prices. The difference between the contract's original price and its current market value is known as the daily
variation margin, which represents either a gain or loss for the participant. If the market value of the futures
contract has increased, the participant receives the gain, and if it has decreased, the participant incurs a loss
and this loss is deducted from their margin account. If the level of the margin account falls below a specific
threshold (maintenance margin) then the variation margin is the additional (top-up) payment that has to be
made to stay above the threshold. The process of marking to market ensures that participants have sufficient
funds in their margin accounts to cover potential losses and allows for the immediate recognition and
settlement of gains or losses which reduces default risk.

Describe the characteristics of a futures contract and the role played by a clearing house and explain how a
company could use a futures contract to hedge against risk.
. [40%]

a futures contract is a standardized legal contract (details not negotiable) traded on organized exchanges to
buy or sell an asset at a certain future time (delivery time) for a certain price. Forward contracts are
customised to needs while futures contracts are standard. They are more liquid than forward contracts and
minimise default risk. This is because the clearing house guarantees the fulfilment of the contract.

A clearinghouse is an intermediary for futures contracts that manages and mitigates default risk. Acting as a
central counterparty, the clearinghouse becomes the guarantor for both the buyer and the seller in a futures
transaction. It ensures the fulfilment of contractual obligations by requiring participants to post the initial
margin (down payment made by the counterparties to cover any losses at the end of trading whereby the
initial margin is usually calculated by taking the worst probable loss that the position could sustain and can be
paid in either cash or collateral)
The clearinghouse also actively manages the margin accounts through the process of marking to market.
A company can utilize futures contracts to hedge against various risks, such as commodity price fluctuations or
currency exchange rate movements. For instance, if a company anticipates a future increase in the cost of raw
materials, it can enter into a futures contract to lock in the current price, safeguarding itself against potential
financial losses due to rising prices.

Describe the characteristics of a forward contract. [40%]

A forward contract is an agreement to buy or sell an asset at a certain future time (delivery time) for a certain
price. They are tailor-made to meet the requirements of the two counterparties and no money is usually
exchanged until delivery. Characteristics are that they cannot be cancelled without mutual agreement (not
very liquid), obligations of one counterparty cannot be transferred to a third party (not marketable – cannot
be traded without mutual agreement) and the Counterparty may default (credit risk). This risk arises from the
possibility that one of the parties involved in the contract may fail to fulfill their financial obligations. For
example, if an investor holds a long futures position (agrees to buy the asset in the future) and the
counterparty holding the short position (agrees to sell the asset in the future) defaults, the investor may face
challenges in receiving the agreed-upon delivery or payment.
Let 𝑃𝑆 𝑇 be the spot price at time of delivery, and 𝑃𝐹 be the forward price – If 𝑃𝑆 𝑇 > 𝑃𝐹 → buyer gains – If 𝑃𝑆
𝑇 < 𝑃𝐹 → seller gains • The greater the difference between 𝑃𝑆 𝑇 and 𝑃𝐹 the greater the incentive for the
losing counterparty to default. Long position → Agreement to buy the underlying asset. Short position →
Agreement to sell the underlying asset
Forward contracts are traded ‘over the counter’ (i.e. outside exchanges) between financial institutions and
their clients.
Forward contracts Can be used to hedge foreign currency risks.

Derive the fair pricing of a generic futures contract with no uncertainty and explain the economic logic
behind the formula.

Answer: Like most pricing formulas in finance, the fair pricing of a

generic futures contract with no uncertainty is based on an arbitrage
argument. That is, we are looking for an alternative strategy which
generates the same cash flows produced by the asset we are interested
in. To avoid the possibility for riskless speculation, the cost of this
alternative strategy must be the same as the price of our asset.
In this case, the argument is based on the following two strategies:
i. Strategy 1: Sell a futures contract with delivery in T years at current
price pf. At the end of T years, buy the asset in the cash market at
some price Pr (spot price at time 1);
"l.
Strategy 2: Borrow to buy the same asset in the cash market at
price PS (current spot market). Hold on to the asset for T years. At T,
sell the asset at price Pf and repay the loan.
The profit from Strategy 1 is Pf - Pf. The profit from strategy 2 is
-PS(1+rT) +Pf+d*PS *T
where r = annual carry costs (insurance, interests, etc.), and d = gross
annual return from holding the asset. Given lack of uncertainty, the two
strategies must satisfy Pó - P$ = 0.
Also, both strategies are riskless and require no initial wealth, so they
should generate identical profits, that is,
-pS(1+rT)+Pf+d*ps *T = 0
If this was not the case, an arbitrageur could make money by exploiting
the mispricing of the futures contract.
But then, it must also be the case that
P/ = PS[1 + (r - d)T]
where r-d is the cost-of-carry.

The formula provides an economic explanation for differences

between the current spot price and the (current) price of the futures
contract. For example, the futures price is higher than the spot price
when rd, that is, when the costs associated with holding the
underlying asset exceed the benefits. This leads to the futures price
being higher than the spot price because opening a futures position
avoids the associated costs which make the futures contract more
valuable then holding the underlying asset. As a result, the issuer will
price this benefit into the futures price. A similar but reversed logic
applies when d>r, in which case there will be less demand for futures
contracts and as such a lower price.

b) Derive the formula for the pricing of a currency futures contract and explain the economic logic behind
the formula. [60%]
 Week 11
What are options?
Options are standardised contracts that: provide the holder with the right to buy (call option) or sell (put
option) a particular underlying asset for a predetermined price (known as Exercise price) at or before a
specified date (maturity date) in the future. Options have no obligation to buy and for this right, there is a
option premium which is paid to the writer of the option. This premium consists of intrinsic value (the
difference between the current market price of the underlying asset and the strike price) and the time value
(The more time available for the option to potentially move in the buyer's favour, the higher the time value).
European option: can be exercised only at maturity date American option: can be exercised at any date, but no
later than the maturity date. Writer → supplies the option • Holder → demands the option

Call options
the right to buy a given number of shares in the underlying stock on or before a specific date (maturity date) at
a fixed price (exercise price)
Put Options: the right to sell a given number of shares of an underlying stock at a fixed price (exercise price) on
or before a specified date (maturity date)
How to price an option

Difference between options and futures

Options are standardised contracts that: provide the holder with the right to buy or sell a particular underlying
asset for a fixed price at or before a specified date in the future while futures are standardised contracts that
obligate