ACFI7012 Financial Markets and Institutions Assignment

Learning outcomes assessed

Both assignments are designed to test your ability to

1. Exhibit a thorough understanding of the main theoretical frameworks which have been used to analyse developments in financial markets and of their key assumptions and methodologies
2. Demonstrate skills of critical appraisal with regard to the evidence put forward to validate theoretical approaches
3. Apply the theoretical and empirical knowledge obtained in the module to the analysis of the impact of financial markets and institutions on businesses using funds and the regulatory issues which arise from this impact.
4. Demonstrate an ability to apply academic knowledge and skills in practical contexts
5. Demonstrate an ability to engage in problem solving in ways appropriate to both participants in and regulators of the financial system
6. Demonstrate an ability to apply formal modelling techniques in the context of financial theory

Question 1.

You are working as an investment adviser for a client who is planning to invest in a country named Rohan. One-year government bonds in Rohan offer a return of 5%. Such bonds are generally agreed to be risk free. The market portfolio in Freedonia offers a return of 15% with a variance of 12%. Your client has especially asked for a report on the following shares which are listed on the Freedonia stock exchange

• Company A offers an expected return of 10%
• Company B offers an expected return of 15%
• Company C offers an expected return of 5%
• Company D offers an expected return of 20%
• Company E offers an expected return of 18%

Task One. Explain why any decision about whether to invest in these companies requires knowledge of the covariance between their returns and returns on the market portfolio. Set out for each company the maximum covariance between these two returns which would make it reasonable to invest in the company concerned. Explain briefly why this covariance is a maximum and why any higher covariance would make investment unwise.

Task Two. Suppose that you are now told that the covariance between the return on company A and the return on the market is 3% and the covariance between the return on company E and the return on the market portfolio is 12%. Company A is a small company and company E has a high book to market ratio. Outline what you would expect to happen to the share price of companies A and E if (i) the Capital Asset Pricing Model is correct and (ii) if the Fama-French Three Factor Model is correct. What would be the implications of each of these models for a decision about whether to invest in these two companies?

Task Three. Your client has also asked you to analyse whether investing in shares in Rohan is sensible at all given the current level of share prices in the Rohan market as a whole or whether it would be better to wait until the market has come down in value. What would your answer to her question be if (i) you are confident that the Efficient Market Hypothesis is correct and if (ii) you believe that the Rohan market may be governed by behavioural or psychological factors? If (ii) does turn out to be correct what techniques exist to help us find out if the market is over-valued?

Question 2.

In the years following the 2007-2008 global financial crisis there has been a significant attempt to introduce a new structure for the regulation of financial institutions. Many analyses of this structure have argued (i) that it has led to substantial changes in micro-prudential regulation but that (ii) it has largely failed to address macro-prudential issues. Critically assess that argument and analyse the extent to which it is a fair judgement of the regulatory structure which has been put in place and what your analysis implies about the future stability of the financial system.

You should choose ONE of the following countries or regions to focus on when preparing your answer

• The USA
• The EU
• The UK

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