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COURSE TITLE: FINANCIAL MARKETS Students: ID : 12-100 Lecturer: UBIS INTAKE 5: 2020 COURSE CODE: COURSE Final Assignment A Critical review (25 points) Summary of the article: The article analyzes the impact of the financial crisis onto developing countries Consists of main content The reasons of the crisis: st, the cost of credit is higher; nd, export earning is decline; rd the confidence of investors is decrease; 4th, The stock market and growth of economic is slowdown; and 5th, the rich countries is recession Impact of financial failures to the economy of developing countries 1st, banking system is failure; 2nd, domestic lending is reduction; rd, export earnings is reduction; th, financial flows is reduction; 5th, investments of private sector and household consumption is reduction; and, 6th, unemployment and poverty is higher The financial crisis in year 2009 is US and EU After, impact to developing countries why: 1st, almost developing countries depend on trade with US and EU; nd, balance of payments of developing countries is difficult; rd, fiscal deficits is very large; th, the macroeconomic management policies is poorly; and, th, financial institutions system is weak The policy responses and the efforts to resolve the crisis financial: 1st, IMF loan short term liquidity with countries facing balance of payment; 2nd, WB and IFC meet countries with difficulties investment and social spending; 3rd, in the long term, the financial institutions in the country self-improvement organization, to improve competitiveness in a modern, professional and provide more financial products; 4th, the governments consider expansionary monetary policies carefully; and, 5th, reform of the international financial system more urgently Review: in my opinion, the article was basically full assessment of the impact of the 2009 financial crisis onto developing countries and measures to resolve the crisis This is an article with good reference value However, one thing that we must note that the nature of the developing countries have weak available, to meet the financial crisis storm, makes the development of more severe disease Visualize that the health of the economy of developing countries such as small boats, because world economic integration should be the sea, so having a lot of risks and challenges B Assignment (25 points) Go to the website http://www.federalreserve.gov/releases and find up-to-date interest rates TABLE 11.1 Sample Money Market Rates, April 8, 2010 Instrument Interest Rate (%) Prime rate 3.25 Federal funds 0.19 Commercial paper 0.23 month CDs (secondary market) 0.23 London interbank offer rate 0.45 Eurodollar 0.30 Treasury bills (4 week) 0.16 Source: Federal Reserve Statistical Bulletin, Table H15, April 9, 2010 TABLE 11.2Sample Money Market Rates, November 8, 2013 Instrument Interest Rate (%) Prime rate 3.25 Federal funds 0.08 Commercial paper 0.13 month CDs (secondary market) n.a London interbank offer rate n.a Eurodollar 0.22 Treasury bills (4 week) 0.02 Source: Federal Reserve Statistical Bulletin, Table H15, November 8, 2013 Compare the rates for items: to the day 08/11/2013 - Item a – prime rate: stable since 08/04/2010 - Item c – commercial paper: decrease 0.1%, equivalent to 43.48% compared with 08/04/2010 What are the different theories explaining the term structure of interest rates? Statistics on actual financial markets, the term structure of interest rates almost to follow rules: a) “Interest rates on bonds of different maturities move together over time b) When short-term interest rates are low, yield curves are more likely to have an upward slope; when short-term interest rates are high, yield curves are more likely to slope downward and be inverted c) Yield curves almost always slope upward”1 To explain this, there are three theories about the term structure of interest rate launched: The expectations theory, This theory describes that: “The interest rate on a long-term bond will equal an average of the shortterm interest rates that people expect to occur over the life of the long-term bond”2 Example 1: Short-term interest rates by year year 1, respectively6%, 7% 1[CITATION Fin \p 97 \l 1033 ] 2[CITATION Fin1 \p 98 \l 1033 ] Thus, the interest rate of bonds is expected to years (6% +7%) / = 6.5% / year That is the short-term interest rates will change with the long-term interest rates This theory is only perfect when accompanied by the following assumptions: the buyer will buy the most profitable securities, no stories like this stock more thanother securities of feeling In other words, it is“to be perfect substitutes” This theory explains: Rule a: “short-term interest rates have had the characteristic that if they increase today, they will tend to be higher in the future Hence a rise in short-term rates will raise people’s expectations of future short-term rates Because long-term rates are the average of expected future short-term rates, a rise in short-term rates will also raise long-term rates, causing short- and long-term rates to move together” Rule b: “When short-term rates are low, people generallyexpect them to rise to some normal level in the future, and the average of futureexpected short-term rates is high relative to the current short-term rate Therefore,long-term interest rates will be substantially higher than current short-term rates,and the yield curve would then have an upward slope and conversely But don’t explains the rule c The market segmentation theory, This theory describes that: “markets for differentmaturity bonds as completely separate and segmented The interest rate for each bond with a different maturity is then determined by the supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities.”3 This theory is only perfect when accompanied by the following assumptions:” bonds of differentmaturities are not substitutes at all, so the expected return from holding a bond of one maturity has no effect on the demand for a bond of another maturity” The theory explains the rule c: in the typical situation the demand for long-term bonds is relatively lower than that for short-term bonds, long-term bonds will have lower prices and higher interest rates, and hence the yield curve will typically slope upward But don’t explains the rule a and b 3[CITATION Mis \p 102 \l 1033 ] Hence, there is an other theories launched, neutralize theory and explain the rules above Liquidity premium theory, this theory describes that: “the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the longterm bond plus a liquidity premium (also referred to as a term premium) that responds to supply-and-demand conditions for that bond.”4 Example 2: back to the example above, 2-year liquidity costs assumed at 0.3% / year Thus, long-term interest rates is: (6% +7%) / + 0.3% = 6.8% / year How can forward rates of interest be derived from the term structure of interest rates? - Forward rate is the rate determined at the time of signing the contract, but done in the future with pre-determined time limit - To see how How can forward rates of interest be derived from the term structure of interest rates, let’s start the analysis using the approach we took in developing the pure expectations theory Recall that because bonds of different maturities are perfect substitutes, we assumed that the expected return over two periods from investing $1 in a two-period bond, which is (1 + i2t)(1 + i2t) –1, must equal the expected return from investing $1 in one-period bonds, which is (1 + it)(1+it+1)-1 This is shown graphically as follows: In other words: (1 + i2t)(1 + i2t) – = (1 + it)(1+it+1)-1 it+1 4[CITATION Mis1 \p 103 \l 1033 ] where i2t= two-year bond rate it= bond rate year it+1= bond rate year This measure of it+1is called the forward rate because it is the one-period interestrate that the pure expectations theory of the term structure indicates is expectedto prevail one period in the future To differentiate forward rates derived from theterm structure from actual interest rates that are observed at time t, we call theseobserved interest rates spot rates we obtain the general solution for the forward rate n periods into the future: Go back example 1, it+1 = (1+0.065) /(1+0.06) -1=0.07=7% C Case study (50 points) In your view, how does a change in the value of the Italian lira affect Conti's earnings and balance sheet? Answer: If The Italian lira decreased needmoreliratochange1 USD: reduced the amount of profit from Paretti Textiles transferred back to Conti, i.e reduce Conti's earnings reduced the amoun of balance sheet of Paretti Textiles => reduced consolidated of balance sheet of Conti Example 3: assuming - USD/ITL:1,438.54 - Total assets of Paretti in 1992: 100,000,000.00 ITL # 69,514.92 USD - Profit of Paretti in 1992: 10,000,000.00 ITL # 6,951.49 USD - USD/ITL:1,438.54 If ITL decreased 10%, so USD/ITL = 1,582.39, and then, - Total assets of Paretti in 1992 by USD # 63,195.55 USD - Profit of Paretti in 1992 by USD # 6,319.55 So, Conti lost 631.94 USD by profit and 6,319.37 USD by total assets And, opposition If The Italian lira increased: need less lira to change USD: rise the amount of profit from Paretti Textiles transferred back to Conti, i.e rise Conti's earnings rise the amoun of balance sheet of Paretti Textiles =>rise consolidated of balance sheet of Conti What hedging strategy you recommend for Conti's Italian subsidiary? There are cases: If depreciation of Italian lire against USD, the hedging strategy should they to prevent the loss, that is buying USD forward contract with term due today to the end of the fiscal year 1992, with value = profit of Paretti in 1992 Example 4: go back example 3, assuming: forward rate at the end of the fiscal year 1992, USD/ITL: 1,500.00, so: - Total assets of Paretti in 1992 by USD # 66,666.67 USD - Profit of Paretti in 1992 by USD # 6,666.67 USD So that, Conti has benefit 347.12 USD with profit and 3,471.12 USD with total assets compare with not thing It has another hedging, that is buy call option USD with term due today to the end of the fiscal year 1992 and with value = profit of Paretti in 1992 When due, if USD appreciation against Italian lire, so make call option, if USD depreciation against Italian lire, so buy USD at the market to earn more profit However, when making these decisions must also consider the cost of the call option