QUESTION ONE

A). You are going to use the following hypothetical financial information to measure
the money supply in the Zambia in 2017.

Traveller’s checks held by the public: K38 billion

Bills and coins in circulation: K615 billion

Bills and coins in vaults of commercial banks: K37 billion

Demand deposits: K905 billion

Savings deposits: K4 trillion

Government bonds held by the public: K218 billion

Government bonds held by the Bank of Zambia: K251 billion

Amounts owed on credit cards: K279 billion

Credit limits on credit cards: K514 billion

Small time deposits: K2, 321 billion

Money market mutual funds: K2, 956 billion

Using this information calculate M1 and M2. Some of the above information is not
used to calculate the money supply. Explain for each, why they are not included in
your calculation.

M1 = Currency (bills and coins in circulation) + Demand deposits + traveller’s

checks

= K615 + K905 + K38= K1, 558 billion

M2 = M1 + Saving deposits + Small time deposits + Money market mutual funds

= K1,558 + K4,000 + K2,321 + K2,956

= K10,835 billion

Bills and coins in the vaults of commercial banks are part of their reserves, but
they are not in the hands of the public and are not part of the money supply.

Credit card balances are not included in any money stock definition, because they
are not considered to be a method of payment. Such transactions are just deferrals
of payment to a future date. The amounts that are still available to be charged on

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 credit cards (credit limits minus amounts owed) may well be regarded as a means
of payment by many of us, but they are not included in any definition of the money
supply.

Government bonds are not included in the money supply either. Bonds held by the
public represent the amounts that the government owes us, and are part of our
wealth, but they cannot be used as a means of payment and cannot be converted
to cash easily enough to be included in the definitions of M1 and M2. The money
supply does not include the bonds held by Central Bank, even though the Central
Bank uses bonds to change the money supply by open market operations. Thus
the bonds that the Central Bank holds now were presumably acquired through
open market operations in the past, and the current money supply is in part a result
of that, but that is already measured from the items included in the definitions of
M1 and M2. [6 Marks]

B). Critically explain the constituent elements of the definition of money.

Money is (1) anything of value, (2) generally accepted as (3) medium of exchange
being (4) legal tender in a (5) particular jurisdiction. [5 Marks]

C). Explain the primary functions of money in an economy.

1. Medium of Exchange
2. Store of value
3. Means of deferred payments
4. Unit of account or standard of monetary measurements [8 Marks]

D). Derive the equation of the IS and LM curve and show the nature of their slopes.
IS curve is given as follows Y=C+I+G for a closed economy, therefore we also know
that the components of Y are related to key variables such as interest rates (i) and
taxes (T).

Therefore, Y=C(Y-T) + I (i) + G is the equation of the Investment Savings (IS) curve.

[3 Marks]

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LM curve is given as follows M=l (Y,r), therefore we also know that the transaction
demand for money is related to key variables such as interest rates (i) and Income (Y).

Therefore, m=l(Y, r) is the equation of the liquidity money (LM) curve.

[3 Marks]
[Total=25 Marks]

QUESTION TWO

A). The James Corporation issued a new series of bonds on January 1, 1985. The
bonds were sold at par (K1, 000); had a 1% coupon; and mature in 30 years, on
December 31, 2014. Coupon payments are made semi-annually (on June 30 and
December 31).

i. What was the yield for holding the bond until maturity on January 1, 1985?
James Corporation stocks were sold at par, the original YTM equalled the
coupon rate of 1%. [2 Marks]
ii. What was the price of the bonds on January 1, 1990, 5 years later, assuming
that interest rates had fallen to 0.78%?
50 10
2 1000
𝑉𝐵 = ∑ 50 +
𝑡=1 (1 +
0.0078 0.0078 50
) (1 +
2 2 )
K1, 049.88 [2 Marks]
iii. Find the current yield, capital gains yield, and total return on January 1, 1990,
given the price as determined in Part b.

The current yield=0.95248%

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 The capital gains yield=-0.1725%
The total return=0.78% [3 Marks]
iv. On July 1, 2008, 6½ years before maturity, James’s bonds sold for K916.42.
What were the YTM, the current yield, the capital gains yield, and the total return
at that time?

YTM=1.1981%

Current yield=1.09%

The capital gains yield=0.1069%

Total return at that time=1.1981% [4 Marks]

B). Using the supply-and-demand for bonds framework show why interest rates are
pro-cyclical (rising when the economy is expanding and falling during recessions).

i. Reason being is very simple when economy booms that means that people are
having more money, people’ money and wealth both increases. On the same
time firms also enjoys the profit mode and have more lucrative opportunities of
investment and thus supply of bonds also increases. Hence both the demand
and supply for bonds increases, but demand for the bonds does not increase
at the pace at which supply of bonds increases and the resultant equilibrium
interest rates rises,
ii. also on the other hand when market register recession, people and business
do not have much money, and thus the demand and supply of bonds
decreases, demand and supply curves both shift towards the left but as
contrastingly demand curve shift lessor as compare to supply curve thus
resulting this interest rates falls on the same time prices of bonds increases.
That means the bottom line is that when market is on boom the interest rates
tend to be on higher side and bond prices fall, when market enter into recession
then interest rates shows a fall tendency. Thus this proves interest rates are
procyclical.

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Page 5 of 13
 [5 Marks]

C). Twaambo wants to purchase 157 days Treasury Bills with the face value of K 150
000 he requires an interest rate of 9%.

(i) Determine the price he is going to pay for the Treasury bills.

𝟎. 𝟎𝟗 × 𝟏𝟓𝟕
= 𝟏𝟓𝟎, 𝟎𝟎𝟎 × 𝟏 − = 𝐊𝟏𝟒𝟒, 𝟏𝟗𝟑. 𝟏𝟓
𝟑𝟔𝟓
Or

𝟎. 𝟎𝟗 × 𝟏𝟓𝟕
= 𝟏𝟓𝟎, 𝟎𝟎𝟎 × 𝟏 − = 𝐊𝟏𝟒𝟒, 𝟏𝟏𝟐. 𝟓𝟎
𝟑𝟔𝟎
[2 Marks]

(ii) Determine the interest income if he buy the Treasury bill.

= 𝟏𝟓𝟎, 𝟎𝟎𝟎 − 𝟏𝟒𝟒, 𝟏𝟗𝟑. 𝟏𝟓 = 𝐊𝟓, 𝟖𝟎𝟔. 𝟖𝟓

Or
= 𝟏𝟓𝟎, 𝟎𝟎𝟎 − 𝟏𝟒𝟒, 𝟏𝟏𝟐. 𝟓𝟎 = 𝐊𝟓, 𝟖𝟖𝟕. 𝟓

[2 Marks]

D). Explain the functions of financial intermediaries found in the Zambian financial
markets.

i. Risk transfer
ii. Reduce transaction costs
iii. Maturity transformation
iv. Solve the problem of information asymmetry
v. Savings and investments

[5 Marks]

[Total=25 Marks]

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QUESTION THREE

A). Mishkin and Eakins argue that many of the structural aspects of the financial
system can be explained in terms of transactions costs and asymmetric information
problems. What are their arguments? Are they convincing?

Transaction costs, the time and money spent in carrying out financial transactions, are
a major problem for people who have excess funds to lend. Financial intermediaries
can substantially reduce transaction costs because they have developed expertise in
lowering them; and because their large size allows them to take advantage of
economies of scale, the reduction in transaction costs per dollar of transactions as the
size (scale) of transactions increases. For example, a bank knows how to find a good
lawyer to produce an airtight loan contract, and this contract can be used over and
over again in its loan transactions, thus lowering the legal cost per transaction.

Asymmetric information in financial markets means that investors may be subject to

adverse selection and moral hazard problems that may hinder the efficient operation
of financial markets. Risky firms or outright crooks may be the most eager to sell
securities to unwary investors, and the resulting adverse selection problem may keep
investors out of financial markets.

Furthermore, once an investor has bought a security, thereby lending money to a firm,
the borrower may have incentives to engage in risky activities or to commit outright
fraud. The presence of this moral hazard problem may also keep investors away from
financial markets. Government regulation can reduce adverse selection and moral
hazard problems in financial markets and increase their efficiency by increasing the
amount of information available to investors.

[6 Marks]

B). Kafue Fisheries paid a dividend of K0.58 per share this year. Dividends at the end
of each of the next five years are expected to be as follows:
Year 1 K0.70
Year 2 K0.83
Year 3 K0.96
Year 4 K1.09
Year 5 K1.22

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After year 5, dividends are expected to grow indefinitely at 10 percent a year. If your
required rate of return for Kafue Fisheries’ common stock is 12 percent, what is the
most that you would pay per share for Kafue Fisheries today?
T
DT DT+1
P0 = ∑ +( ) (1 + r)−T
(1 + r) t r − gc
t=1
D1 D2 D3 D4 D5 DT+1
P0 = + + + + + ( ) (1 + r)−5
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)4 (1 + r)5 r − gc

0.70 0.83 0.96 1.09 1.22 1.342

P0 = + + + + +( ) (1.12)−5
(1.12)1 (1.12) 2 (1.12) 3 (1.12) 4 (1.12) 5 0.12 − 0.10

𝐏𝟎 = 𝟒𝟏. 𝟎𝟔
[5 Marks]
C). Discuss the differences between weak form, semi-strong form and strong form
capital market efficiency, and discuss the significance of the efficient market
hypothesis (EMH) for the investor.

The efficient-market hypothesis (EMH) is a theory in financial economics that states

that asset prices fully reflect all available information. A direct implication is that it is
impossible to "beat the market" consistently on a risk-adjusted basis since market
prices should only react to new information.

The Three Basic Forms of the EMH

The efficient market hypothesis assumes that markets are efficient. However, the
efficient market hypothesis (EMH) can be categorized into three basic levels:
1. Weak-Form EMH
The weak-form EMH implies that the market is efficient, reflecting all market
information. This hypothesis assumes that the rates of return on the market should be
independent; past rates of return have no effect on future rates. Given this assumption,
rules such as the ones traders use to buy or sell a stock, are invalid.
2. Semi-Strong EMH
The semi-strong form EMH implies that the market is efficient, reflecting all publicly
available information. This hypothesis assumes that stocks adjust quickly to absorb
new information. The semi-strong form EMH also incorporates the weak-form

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hypothesis. Given the assumption that stock prices reflect all new available information
and investors purchase stocks after this information is released, an investor cannot
benefit over and above the market by trading on new information.

3. Strong-Form EMH
The strong-form EMH implies that the market is efficient: it reflects all information both
public and private, building and incorporating the weak-form EMH and the semi-strong
form EMH. Given the assumption that stock prices reflect all information (public as well
as private) no investor would be able to profit above the average investor even if he
was given new information.

Weak Form Tests

The tests of the weak form of the EMH can be categorized as:

1. Statistical Tests for Independence - In our discussion on the weak-form

EMH, we stated that the weak-form EMH assumes that the rates of return on
the market are independent. Given that assumption, the tests used to examine
the weak form of the EMH test for the independence assumption. Examples of
these tests are the autocorrelation tests (returns are not significantly correlated
over time) and runs tests (stock price changes are independent over time).
2. Trading Tests - Another point we discussed regarding the weak-form EMH is
that past returns are not indicative of future results, therefore, the rules that
traders follow are invalid. An example of a trading test would be the filter rule,
which shows that after transaction costs, an investor cannot earn an abnormal
return.

Semi-strong Form Tests

Given that the semi-strong form implies that the market is reflective of all publicly
available information, the tests of the semi-strong form of the EMH are as follows:

1. Event Tests - The semi-strong form assumes that the market is reflective of all
publicly available information. An event test analyzes the security both before

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 and after an event, such as earnings. The idea behind the event test is that an
investor will not be able to reap an above average return by trading on an event.
2. Regression/Time Series Tests - Remember that a time series forecasts
returns based historical data. As a result, an investor should not be able to
achieve an abnormal return using this method.

Strong-Form Tests
Given that the strong-form implies that the market is reflective of all information, both
public and private, the tests for the strong-form center around groups of investors with
excess information. These investors are as follows:

1. Insiders - Insiders to a company, such as senior managers, have access to

inside information. SEC regulations forbid insiders for using this information to
achieve abnormal returns.
2. Exchange Specialists - An exchange specialist recalls runs on the orders for
a specific equity. It has been found however, that exchange specialists can
achieve above average returns with this specific order information.
3. Analysts - The equity analyst has been an interesting test. It analyzes whether
an analyst's opinion can help an investor achieve above average returns.
Analysts do typically cause movements in the equities they focus on.
4. Institutional money managers - Institutional money managers, working for
mutual funds, pensions and other types of institutional accounts, have been
found to have typically not perform above the overall market benchmark on a
consistent basis.
[8
Marks]
D). Briefly explain the following concepts used in financial markets. [2 Marks
each]
i. Random walk theory
 A random walk is a mathematical object, known as a stochastic or random
process that describes a path that consists of a succession of random steps
on some mathematical space such as the integers.
 The movements of an object or changes in a variable that follow no
discernible pattern or trend.

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 ii. Stock market equilibrium
The stock market determines prices by constantly-shifting movements in the
supply and demand for stocks. The price and quantity where supply are equal
is called “Market Equilibrium”, and one major role of stock exchanges is to help
facilitate this balance.
Required rate of return equal to Expected rate of return
iii. Money multiplier
The money multiplier is the amount of money that banks generate with each
kwacha of reserves. Reserves is the amount of deposits that the Central Bank
requires banks to hold and not lend. Banking reserves is the ratio of reserves
to the total amount of deposits.
[Total=25 Marks]

QUESTION FOUR

A). Distinguish between financial assets and real assets.

 Financial assets: These are intangible assets whose value is obtained from a
contractual claim. In manufacturing industry, assets that represent claim on the
firm's assets are considered as the financial assets. Examples: Stocks, bonds, and
bank deposits are considered as financial assets.
 Real assets include precious metals, commodities, real estate, agricultural land,
machinery and oil. They are appropriate for inclusion in most diversified portfolios
because of their relatively low correlation with financial assets such as stocks and
bonds. [4 Marks]

B). Financial assets have unique features that make them recognisable and useful in
the financial markets. Briefly explain five (5) properties of financial assets.
i. Moneyness
ii. Divisibility and Denomination
iii. Reversibility
iv. Cash Flow
v. Term to Maturity
vi. Convertibility
vii. Currency

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viii. Liquidity
ix. Return Predictability
x. Complexity
xi. Tax Status [5 Marks]

C). Demonstrate your understanding of the following concepts and terms;

i. Call money-
 Call money is money loaned by a bank that must be repaid on demand.
Brokerages use call money as a short-term source of funding to maintain
margin accounts for the benefit of their customers who wish to leverage their
investments.
 It is often used by brokerage firms to finance margin accounts.
 Short-term bank loan that does not contain regular principal and interest
payments.
ii. Mutual fund- A mutual fund is an investment vehicle made up of a pool of
moneys collected from many investors for the purpose of investing in
securities such as stocks, bonds, money market instruments and other
assets.
iii. Venture Capitalist-
A venture capitalist is an investor who either provides capital to startup
ventures or supports small companies that wish to expand but do not have
access to equities markets.
iv. Investment Bank-
 A bank that purchases large holdings of newly issued shares and
resells them to investors.
 Is a special segment of banking operation that helps individuals or
organisations raise capital and provide financial consultancy services
to them.
v. Shadow banking
 A shadow banking system is the group of financial intermediaries
facilitating the creation of credit across the global financial system but
whose members are not subject to regulatory oversight.

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  The shadow banking system also refers to unregulated activities by
regulated institutions.
 The shadow banking system is a term for the collection of non-bank
financial intermediaries that provide services similar to traditional
commercial banks but outside normal banking regulations.
[10 Marks]

D). Describe how the structure of the Zambian financial system can be explained by
the problem of asymmetric information.

 Regulation
 Registered Commercial banks
 Insurance companies

[6 Marks]

[Total=25 Marks]

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