APC313 Financial Market

Question 2 2.1 Distinguish between the spot and the forward foreign exchange rates Spot rates are current market price or rate of return - the price available for deals to be done now.

ASSIGNMENT COVER SHEET UNIVERSITY OF SUNDERLAND

BA (HONS) BANKING AND FINANCE

Student ID: 149078874/1

Student Name: Nguyen Thi Kieu Anh

Module Code: APC 313

Module Name / Title: Financial Markets

Centre / College: Banking Academy of Viet Nam

Due Date: 16 Jan 2015

Assignment Title: Individual assignment

Hand in Date: 16 Jan 2015

Students Signature: (you must sign this declaring that it is all your own work and all sources

of information have been referenced)

TABLE OF CONTENTS

INTRODUCTION 4

Question 1 5

1.1 Explain each of following terms: asymmetric information, moral hazard, and quantitative easing (QE) and give example related to financial markets 5

1.1.1 Asymmetric information 5

1.1.2 Moral hazard 5

1.1.3 Quantitative Easing (QE) 6

1.2 Discuss why there is a need to regulate financial markets 7

Question 2 9

2.1 Distinguish between the spot and the forward foreign exchange rates 9

2.2 How are these rates related and determined in the foreign exchange markets 10

2.2.1 Purchasing Power Parity (PPP) 10

2.2.2 Fisher Effect 11

2.2.3 Interest Rate Parity (IRP) 11

Question 3 12

3.1 Explain the operations and activities of London Stock Exchange (LSE) market 12

3.1.1 Operations 12

3.1.2 Activities 12

3.2 With reference to the relevant theoretical and empirical literature and data, critically evaluate the efficiency of this stock exchange market 14

3.2.1 Theory of Efficiency Market Hypothesis (EMH) 14

3.2.2 Literature review of EMH research in LSE 15

3.2.3 Evaluate the efficiency of London stock exchange market 16

3.3 Explain recent upward surges in the FTSE 100 share price index 20

Question 4 21

4.1 Explain the operation and activities and the need for money market 21

4.1.1 Explain the operation and activities of money market 21

4.1.2 Why is there a need for such a market 22

4.2 Explain how a central bank might use the money market to conduct monetary policy in order to target the rate of inflation 22

CONCLUSION 24

REFERENCES 25

APPENDICES 29

INTRODUCTION

This research learns about many aspects of financial markets Firstly, the research gives an overview about terms ‘asymmetric information’, ‘moral hazard’, ‘quantitative easing (QE)’ and identifies the need for regulating financial markets Secondly is distinguishing between spot and forward foreign exchange rates and explain how these rates are determined in foreign exchange markets Next is presenting a brief description of the operations and activities of London Stock Exchange (LSE) Besides, this research reviews studies about efficiency of LSE market, thereby evaluating LSE efficient based on recent data from FTSE

100 Index and three companies listed in FTSE 100, and explaining recent upward surges in FTSE 100 Finally, the research shows the basic understanding of the operations and activities of money market, the need for such a market and explains how a central bank might use the money market to conduct monetary policy in order to target the rate of inflation

of risk and return involved than the buyers The presence of asymmetric information derived from conflict of interest, in which some issuers of financial instruments furnish false or misleading information hurting the public to keep its own interests or gaining higher profit Asymmetric information results in two problems: adverse selection, which occurs before the transaction (ex ante), and moral hazard, which occurs after the transaction (ex post) (Mishkin and Eakins, 2012, p.25) In general, asymmetric information implies information inefficiency of financial markets and source of market failure

The collapse of the Enron Corporation1 in 2001 is considered as a typical example of asymmetric information The existence of inequality information between management and shareholders is pointed out by Butler and Park (2005, p.2) that Enron managers and accountants deceived shareholders into believing the company was in much better financial shape than it actually was, having information about company debt and revenue that the general public did not have This action makes inflation of company stock value beyond its actual worth in order to increase management income and maintain management control As a result shareholders suffered a loss of $11 billion after this scandal was revealed (White, 2011, p.30)

1.1.2 Moral hazard

Moral hazard means the borrower’s ability to apply the funds to different uses than those agreed upon with the lender, who is hindered by his lack of information and control over the borrower (Bebczuk, 2003, p.7) Moral hazard occurs after the transaction and refers to immoral of funds’ users and drawbacks of regulation like government safety nets For instance, there are no high risk-taking incentives for private enterprises because no one will rescue them from bankruptcy In contrast, banks use the money mobilized from their

1 Enron was the seventh-largest U.S public company involved natural gas trading

clients to engage in risky activities without fear of illiquidity risk because they always believe that national government and central bank acting as “lender of last resort” would always bail them out the collapse to keep confidence of public in the banking industry (too-big-to-fail problem)

Moral hazard happens in case of Bernard L Madoff Bernard Madoff was chairman of Bernard L Madoff Investment Securities LLC (BLMIS) - one of the top market makers

on Wall Street and former non-executive Chairman of the NASDAQ stock exchange and many related committees (Boyko, 2009, p.34) Since early 1990s, based on his own reputation in Wall Street and the belief of investors that 10% interest was being added to their account each year; Madoff attracted and defrauded a lot of investors (estimated up to

$64.8 billion) with Ponzi scheme - pay returns to investors from inflow of money of subsequent investors rather than from profit (Amir, 2009) It was not until 2008 that Madoff was arrested and sentenced to 150 years’ imprisonment for money laundering, perjury, false filings with the SEC and fraud (CNN, 2014)

1.1.3 Quantitative Easing (QE)

QE is an extraordinary monetary tool used by central banks to stimulate the economy in the period of recession Normally, in response to economic difficulties, central bank will stimulate more lending and spending by reducing interest rates However, in case of central bank has cut interest rates as far as they can go (zero bound) but the economy still has not recovered, the central bank may pump money into the economy via so called Quantitative Easing (Plumer, 2012)

Central bank creates new money electronically and pumps money into economy indirectly by using money market to buy financial assets from private sector business, including commercial banks, insurance companies, pension funds and non-financial firms Most of the assets purchased are low risk or risk free bonds (Bank of England UK, 2010) As commercial banks mobilize fund at a low interest, it will make low interest loan Central bank also injects money directly for enterprises by buying corporate bonds having low levels of risk It allows business to expand operations cheaply with aim of lowering product prices and creating more jobs, whereby stimulus of spending on goods and services Therefore, in theory, QE is possible to achieve two objectives, namely boost economic growth and reduce unemployment rate On the other hand, it also has following drawbacks: (1) Money creation of central bank lead to risk of inflation; (2) Attempting to

maintain low interest rate devalue the currency whereas aim of monetary policy is to stabilize currency value; (3) Low interest rate of deposit along with high inflation cause depositors to invest into foreign countries Thus, QE only succeed when positive side excels more than negative side

In March 2009, Quantitative easing was first announced in UK at the same time as a last cut in rates sharply to 0.5% Under the agreement of the Treasury, the Bank of England purchased £200 billion of assets, mainly UK government bond (gilts) from financial firms such as banks, insurance companies and pension funds (called as ‘asset purchase scheme’) with aim of boosting nominal spending and thereby helping achieve the 2% inflation target (BBC, 2014a) QE operation had several effects in UK such as: (1) when the bank bought assets, this increased their prices and depressed gilt yields by around 100 basis points (Joyce et al, 2011, p.211); (2) Owing to the return of gilts falls, it encouraged the sellers of assets to invest higher-yielding assets like company shares and bonds Along with the bank of England also bought smaller corporate bonds, it helped businesses reduce the cost of borrowing, in turn led to increase spending in the economy According

to Joyce et al (2011), net equity and corporate issuance by UK private non-financial corporations were particularly strong in 2009, reversing the negative net issuance observed over 2003–08; (3) Kapetanios et al (2012, p.2) estimated that QE is likely to have raised real GDP by as much as 1.5% to 2.0% and boosted annual CPI inflation by between 0.75% to 1.5 percentage points, this would be equivalent to a 150 to 300 basis-point cut in bank rate However, QE affected adversely savers especially pensioner’ income, for instance the annuity rates2 had fallen by 25% (Altmann, 2012)

1.2 Discuss why there is a need to regulate financial markets

According to Mishkin and Eakins (2012, p.30), the government regulates financial markets for two main reasons: to increase the information available to investors (efficiency), to ensure the soundness of the financial system (stability) Indeed, after the failure of financial markets over the years, it is concluded that there are two features of financial system that motivate for the entry of regulation: information asymmetry and systemic risk

As mentioned above, asymmetric information results in adverse selection and moral hazard problem Due to nature of financial markets, all financial products and services are

2 Rates of return on savings made for retirement

very complicated and difficult to compare In unregulated market, the sellers have enough information about the quality of securities while investors are not fully informed; risky firms therefore have incentives to market poor quality securities Since investors cannot evaluate the quality of securities in advance of purchase, good firms cannot sell high quality securities at high prices although investors are always willing to pay high prices for it The presence of the lemons problem or adverse selection causes securities markets

no longer effective channels to raise funds towards good firms as well as keep investors out of financial markets (Mishkin and Eakins, 2012, p.141) Additionally, after mobilizing funds from investors, borrowers may use it in a risky way or commit fraud as case of Madoff in part 1.1.2 above Such thing makes investors suffer losses when the venture fails It lessens confidence of public in financial markets as a result In order to gain public confidence and make financial markets become more efficiency, it is extremely necessary for government to impose some regulations to protect participants of financial markets from fraud and manipulation For example, in US, The SEC was created

by the Securities Exchange Act, 1934, which was passed in the aftermath of the Wall Street Crash in 1929 and the following great depression of 1931-3 The SEC requires companies issuing securities to disclose certain information about sales, assets, and earnings to the public and risk involved in investing Besides, people who sell and trade securities - brokers, dealers and exchanges must treat investors fairly and honestly, putting investors’ interests first (Howells, 2010, p.209)

In intermediation financial markets like banks, the need for keeping customer confidence

is important more than ever Banks operates mainly based on deposits from individuals and institutions to make loan If depositors doubts about the health of bank holding their money, they may rush to withdraw cash from the bank A “bank run” occurs leading to risk of illiquid and collapse of the bank The collapse of one bank causes a loss of confidence in banking in general, creates bad debts for other banks and widespread collapse (financial panics) (Howells and Bain, 2007, p.362) This is called “systemic risk”

or “risk of contagion” Therefore, to defend the economy against financial panics, government also need to provide proper financial regulations like restriction to entry and limits on competition to reduce competitive level in banking system; capital requirement, reserve requirement and deposit insurance and to protect and keep customer confidence

Question 2

2.1 Distinguish between the spot and the forward foreign exchange rates

Spot rates are current market price (or rate of return) - the price available for deals to be

done now The spot exchange rate is quoted as a spread - the difference in price at which market makers are prepared to buy (“bid”) and sell (“ask”) (Howells, 2010, p.127)

A UK Company, for example, must pay 50 million US dollars to a US Company today,

20 November 2014

11/20/2014 at 8:00 AM

1.5642 1.5645 Table 1: Spot rate (ukforex, 2014) The ‘bid’ price is the price at which the currency dealer buys GBP in return of USD The

‘ask’ price is the price at which the currency dealer sells GBP in return of USD

The UK Company has GBP and wants to buy 50 million USD to pay debts, so it must pay the ‘bid’ price Thus, UK Company has to pay

= £31.965 million

Forward rates are prices now for currencies to be delivered at some specified future

time The forward rate may be the same as the spot rate, but usually it is higher (at a

premium to) or lower (at a discount to) than the spot rate (Howells, 2010, p.128)

For example, if the current GBP/USD spot is 1.5642/45 and the three-month forward rate

is 1.5639/41, it means USD is trading at a discount to GBP in European terms, then we could say that the market expect GBP to appreciate against USD It takes fewer GBP to buy USD forward as a result

There are some differences between spot and forward foreign exchange rate listed below:

Spot rate Forward rate Maturity

date

Immediately (+2 days settlement basis)

At a specified date in the future

Objective Just make settlement Make both settlement and hedging

- Do not have explicit value

- No money actually change hands until some agreed upon future date

- Can take advantage of favorable exchange rate at a future date

Risk

prevention

Do not provide protection against unfavorable movements in exchange rates between pricing a contract and the need to buy/sell the foreign currency

Plan more safety since market participants know in advance what their foreign exchange will cost;

Hedging strategies are used to reduce exchange rate risk like locking in a specific exchange rate

Table 2: The differences between spot and forward rate (Carbaugh, 2008, p.358)

To sum up, the biggest difference to distinguish between spot rate and forward rate is hedging By using forward rate, the trader can be protected from currency fluctuations depend upon the terms of the contract

2.2 How are these rates related and determined in the foreign exchange markets

In order to clarify how spot rate and forward rate related and determined in the foreign exchange markets, it is necessary to understand the different theories of exchange rate determination: Law of one price (LOP), Purchasing Power Parity (PPP), Fisher Effect and

Interest Rate Parity (IRP)

2.2.1 Purchasing Power Parity (PPP)

PPP is the idea that the exchange rate adjusts to keep purchasing power constant among currencies or make good changes in inflation rates (Machiraju, 2002, p.76)

There are two versions of PPP: Absolute PPP and Relative PPP

Absolute PPP is based on the “law of one price”, where in the absence of transactions

costs, competitive arbitrage and official trade barriers, identical goods will have the same price in different markets The LOP has formula:

Pi = S × Pi* (1) Where: Pi and Pi* are the domestic and foreign currency prices of commodity i (a good or service) respectively and S is spot rate (Lafrance and Schembri, 2002, p.29)

As for PPP, P represents the total price of the basket of goods and services, where LOP is applied to the aggregate economy:

P = P* × S or S =

(2)

 Spot exchange rates in equilibrium are a reflection of differences in price levels in different countries (Howells, 2010, p.147)

Relative PPP states that changes in exchange rate between two countries are explained

by differences in their inflation rates (Howells, 2010, p.147)

Fisher Effect states that changes in short-term interest rates occur principally because of

changes in the expected rate of inflation (Howells and Bain, 2007, p.204)

rr = rn - Ie (4)4

International Fisher Effect (IFE) is derived from the PPP theory combines with the

Fisher effect5 It says that the difference in the nominal interest rates in two countries determines the movement in the exchange rate between those two currencies (Howells,

2010, p.149)

S = ≈ - (5)6

 The spot rate of one currency with respect to another will change in accordance with differential in interest rates between the two countries (Madura, 2013, p.260)

2.2.3 Interest Rate Parity (IRP)

IRP says that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate (Investopedia, 2014)

3 S0 is the spot exchange rate at the beginning of the time period; S1 is the spot exchange rate at the end of the

time period; IF is the expected annualized inflation rate for foreign country; ID is the expected annualized

inflation rate for domestic country

4 rr: the real rate of interest; rn: nominal rate of interest; Ie: expected rate of inflation

5 PPP = Exchange rates depend on prices; Fisher effect = Interest rates depend on prices

 International Fisher Effect = Exchange rates depend on interest rate

6 S represents the % change in the exchange rate; represents domestic country's interest rate; represents foreign country's interest rate

7 F: Forward rate; S: Spot rate; :Interest rate of foreign country; : Interest rate of domestic country

Question 3

3.1 Explain the operations and activities of London Stock Exchange (LSE) market

London Stock Exchange (LSE), official founded in 1801, is the oldest and fourth-largest stock exchange in the world and the largest in Europe (2011 figures) As one of the most international stock exchange in the world, with around 3,000 companies from over 70 countries listed, it is a prime location for companies and investors to consider investment (World Stock Exchanges, 2012)

3.1.1 Operations

LSE is organized market as it has physical location and listed securities are bought and sold on a trading floor

LSE has three core business areas:

 Capital formation (Capital Markets): to raise capital (Main Market, the Alternative Investment Market - AIM…)

 Risk management (Post Trade Services): to provide a highly active and efficient market for trading in a wide range of securities (Monte Titoli, CC&G)

 Intellectual property:

- Information Services: to supply real-time data and other financial information

to the global financial community (Regulatory News Service - RNS, Proquote, FTSE Indices…)

- Technology Services: to increase the capabilities of trading services (MillenniumIT…) (LSEG, 2014, p.153)

Trading system: the two main types are order-driven system (SETS - Stock Exchange

Electronic Trading System and SETSqx - Stock Exchange Electronic Trading Service - quotes and crosses) and quote driven system (SEAQ - Stock Exchange Automated Quotation)

Trading mechanism: There are 3 main order types including market orders, limit orders,

and stop orders It is carried out through brokers, market makers and specialists

3.1.2 Activities

LSE has two main activities: primary market and secondary market

Primary market enables companies to raise capital efficiently depending on their

individual financing needs (equity or debt) (LSEG, 2014, p.24)

In order to be listed in LSE, companies must meet LSE’s requirements as follows:

LSE - Premium

2

Minimum number of shareholders ×

Minimum market cap of publicly held shares  £175,000

3 Three year track record requirement 

4 Working capital for next 12 months 

Controlling shareholder requirements × subject to current consultation

requirement

Corporate governance disclosure  against UK Corporate

Governance Code Table 3: Summary of LSE premium’s listing requirement (Freshfields, 2014, p.2)

After meeting all listing requirements, firms begin to issue shares for the first time called

an initial public offering (IPO) Through IPOs, shares of companies are listed in the

stock exchange (Banerjee, 2008, p.22) New shares issue of quoted company called

seasoned equity offering (SEO)

Secondary market creates liquidity and determines the price of securities selling in the

primary market Financial instruments in secondary market are traded among investors through markets and trading platforms such as cash equities & ETFs (traded on LSE, Turquoise…), derivatives (LSE Derivative, IDEM), fixed income (MTS, MOT…) and commodities, power and specialist products (IDEM, IDEX, AGREX) (LSEG, 2014, p.7)

In order-driven markets, trading is done through an electronic order book Brokers

acting on behalf of investors carry out placing purchase and sell orders based on formal rules adopted by LSE Orders are automatically ‘matched’ by the system and then proceed to the settlement Remainder of orders, where not fully matched, may be then left

on the system until completed (CFA, 2013, p.23) In quote-driven market, market

makers (financial institutions) input their prices to a central market system (e.g SEAQ)

which market participants have access to view Broker-dealer can then identify the market maker that gives their client the most favorable price, and can call the market maker to strike a deal (CFA, 2013, p.24)

In October 2012, LSE shorten the standard securities settlement cycle from T+3 to T+2 This means that the cash and securities will be exchanged within two days of the trade (LSEG, 2014, p.26) The trading day opened at 8:00 a.m and closed at 4:30 p.m in all days of the week except for Saturday, Sunday and holidays Opening session takes place between 7:50 a.m and 8:00:30 a.m and closing session is 4:30 p.m and 4:37 p.m (Ellul

et al, 2005, p.26)

3.2 With reference to the relevant theoretical and empirical literature and data, critically evaluate the efficiency of this stock exchange market

3.2.1 Theory of Efficiency Market Hypothesis (EMH)

According to Fama (1970, p.388), an efficient market is the one in which prices reflect all available information Efficient Market Hypothesis (EMH) is divided into three forms namely weak form, semi-strong form, and the strong form based on the definition of the available information set

Weak form of the EMH states that all information contained in the past price movements

is fully reflected in current market prices If weak form efficiency exists, then past history

of prices cannot be used for predicting future stock price movements, that is, technical

analysis is useless to earn abnormal return Semi-strong form of EMH suggests that

current market prices reflect not only past prices but all other publicly available information as well like announcement of dividends, annual earnings If a market is semi-strong form efficient, stock price will either response immediately with announced news or no response at all because announced news is not necessary information Therefore, it is impossible for investors to achieve excess return by using fundamental

and technical analysis Thirdly, strong form efficient market assumes that current prices

fully reflect all publicly and privately information It means that in strong form efficient, information spreads so fast that even corporate insiders cannot take advantage of insider information to make abnormal profit (Brigham and Daves, 2013, pp 189-191)

These three forms market efficient are tested in different methods Weak form efficiency

is tested by statistical tests for independence, for example, autocorrelation tests (if security returns are not significant correlated over time, the market is weak form efficient)

and run tests (if series of stock prices change or return change randomly and independent over time, the market is weak form efficient) Semi-strong efficiency is tested by assessing how security returns adjust to particular announcements, so-called event study

If stock prices immediately reflected to information from the announcements, the market

is semi-strong efficient For strong form efficiency, it is recognized by evidence of insider trading profits If corporate insiders earn superior return than other investors, the market

is not strong form efficient However, it cannot be properly tested because the insider information used is not publicly available (Madura, 2013, pp.300-301)

3.2.2 Literature review of EMH research in LSE

There are many studies conducted to test the efficiency of London Stock Exchange, some

of them are showed below:

Kendall (1953) tested for weak form market efficiency by finding serial correlation

coefficients for the first difference of weekly observations of 22 UK stock and commodity price series The result shows that stock prices follow a random walk Kendall concluded that investors could not make money by watching price movements It means market is weak form efficient (Praetz, 1973, pp.203-204) Nevertheless, a different result

is showed by Al-Loughani, N and Chappel, D (1997), they tested the validity of the

weak form on FTSE 30 share index, London Stock Exchange for the period 30 June 1983

to 16 November 1989 by using Dickey-Fuller tests, Lagrange multiplier test, BDS statistic, and GARCH-M model The result of the empirical tests shows that the weak form efficiency is absolutely not valid for the FTSE 30 index because the series were not consistent with any random walk (Sanusi, 2012, p.7)

Marsh (1979) tested for semi-strong form market efficiency by assessing the impact of

right issue announcement on the market price of all companies that had right issues between July 1962 and December 1975 on LSE The researcher concluded that UK market is semi-strong form efficient as the right issues by companies do not have any significant impact on post right issue announcement prices (Sanusi, 2012, p.10)

Gregory, Matatko and Tonks (1997) detected information from director’s trading They

rejected strong form efficient when identifying excess returns in the months after the director’s trades (insider trading) in United Kingdom financial markets (Friederich et al.,

2000, p.2)

3.2.3 Evaluate the efficiency of London stock exchange market

In order to evaluate efficiency of London Stock Exchange, the researcher uses historical data collected from the FTSE 100 Index and three different listed companies in LSE including Tesco PLC, Petrofac Ltd and Royal Bank of Scotland Group PLC

 Tesco PLC (LSE: TSCO) is Britain’s leading grocery and general merchandise

retailer and the third largest in the world It was listed on the London Stock Exchange in 1947 and is a constituent of the FTSE 100 Index The company had a market capitalization of approximately £15.27 billion as of 2 December 2014 (Shareprices, 2014)

 Petrofac Ltd (LSE: PFC) is a leading provider of oilfield services to the

international oil and gas industry In 2005, Group is admitted to the Official List of the London Stock with market capitalization of approximately $1.3 billion and then enters the FTSE 100 after 3 years (Petrofac, 2014)

 Royal Bank of Scotland Group PLC (LSE: RBS) is a UK-centred bank

headquartered in Edinburgh, Scotland It is in the top five of all companies listed on the London Stock Exchange with market capitalization of approximately £24.98 billion In 2009, the company was extremely proud to be voted ‘Best Listed Structured Products’ provider and ‘Best Financial Innovation of the year’ in the highly prestigious 2009 Shares Awards organized by Shares Magazine (RBS, 2014) Based on data of closed prices collected of FTSE 100 and these three companies from 2 June 2014 to 28 November 2014, the researcher does two tests: weak and semi-strong form efficiency

a Test for weak form efficiency

The researcher uses random walk model to assess weak form efficient market