Assignment financial markets (APC 313) january 2015

Bài assignment môn Financial Market APC 313 January 2015. Đánh giá về cung tiền của ngân hàng nhà nước và vai trò của trung gian tài chính trong cung ứng tiền tệ. Xác định lãi suất trong ngắn hạn và cân bằng thị trường tiền tệ.

ASSIGNMENT COVER SHEET UNIVERSITY OF SUNDERLAND

BA (HONS) BANKING AND FINANCE

Student ID: 149080615/1

Student Name: Tran Quyet Thang

Module Code: APC 313

Module Name / Title: Financial Markets

Due Date: 16 Jan 2015

Centre / College: Banking Academy of Viet Nam

Hand in Date: 16 Jan 2015 Assignment Title: Individual assignment

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

Question 1.a: Explain what you understand by each of the following terms In each

case give an example relating to the financial markets to illustrate your answer 1

1 Asymmetric information 1

2 Moral hazard 2

3 Quantitative easing 2

Question 1.b: With close reference to your answer in part (a) above, discuss why there is a need to regulate financial markets 3

Question 2: Distinguish between the spot and the forward foreign exchange rates How these rates are related and determined in the foreign exchange markets? 4

Distinguish between spot rate and forward rate: 4

There are several theories to determine the exchange rate: 5

Interest rate parity (IRP): 5

Law of one price: 6

Purchasing power parity (PPP): 6

Question 3.a: Explain the operations and activities of the London Stock Exchange (LSE) market 8

Question 3.b: With close reference to the relevant theoretical and the empirical literature and your own financial data analysis critically assess the efficiency of this stock exchange market 9

There are some empirical literatures of EMH research in London Stock Exchange (LSE) as follows: 9

1 Access Intelligence plc 10

2 4imprint Group plc 11

3 Al Noor Hospitals Group PLC 13

4 Best of the Best plc 14

Question 3c: How might recent upward surges in the FTSE 100 share price index be explained? 16

Question 4a: Explain the operation and activities of the Money Market 17

Question 4.b: Explain how a central bank might use the Money Market to conduct monetary policy in order to target the rate of inflation 18

1 Reserve Requirement 19

2 Re-discount rate 19

3 Open market operation (OMO) 19

References 21

Appendix 1 – Close price of Access Intelligence plc’s share from 24/09/14 to 22/12/2014 26

Appendix 2 - Close price of 4imprint Group plc’s share from 24/09/14 to 22/12/2014 27

Appendix 3 - Close price of Al Noor Hospital Group plc’s share from 24/09/14 to 22/12/2014 28

Appendix 4 - Close price of Best of the Best plc’s share from 24/09/14 to 22/12/2014 29

Tables Table 1: Sport rate among VND and some foreign currency on 18/11/2014 4

Table 2: Spot rate and Forward rate 4

Table 3: The formula in the interest rate parity 5

Table 4: Example of Law of one price 6

Table 5: The formula of relative PPP 7

Table 6: The formula of International Fisher effect 7

Figures Figure 1: Access Intelligence plc share price change (%) 24/09/14 to 22/12/2014 10

Figure 2: Access Intelligence plc share price from 24/09/14 to 22/12/2014 as an absolute amount 11

Figure 3: 4imprint Group plc share price change (%) from 24/09/14 to 22/12/2014 12

Figure 4: 4imprint Group plc share price from 24/09/14 to 22/12/2014 as an absolute amount 12

Figure 5: Al Noor Hospitals Group PLC share price change (%) from 24/09/14 to 22/12/2014 13 Figure 6: Al Noor Hospitals Group PLC share price from 24/09/14 to 22/12/2014 as an absolute amount 14 Figure 7: Best of the Best plc share price change (%) from 24/09/14 to 22/12/2014 14 Figure 8: Best of the Best plc share price from 24/09/14 to 22/12/2014 as an absolute amount 15 Figure 9: FTSE 100 index from 03/01/1984 to 08/01/2015 16

Question 1.a: Explain what you understand by each of the following terms In each

case give an example relating to the financial markets to illustrate your answer

Risk is the connection between asymmetric information and market failure (Howells, 2010) When asymmetric information happen, lenders lack information about what actually borrowers will do with their money Therefore, lenders will charge high interest for loans for all borrowers to cover credit risk However, borrowers are not the same, some are very risky and some are not It means that for risky borrowers, this interest is still low while borrowers taking loans for legitimate purposes are charging highly This seems to be unfair The asymmetric information causes moral hazard and adverse selection

There are many cases about asymmetric information in stock markets For example, the case of Bach Tuyet Cotton Corporation (BBT) in Vietnam stock exchange, its financial reports showed that the company was profitable, netting VND2.25 billion ($136,360)

in 2006 and VND3 billion ($181,820) in 2007 while in actuality, combined losses exceeded VND17 billion ($1 million) (Nguyen, 2008) This company only announced good reports so investors lost their money Investors did not have right information about performance of BBT, they had to pay high price for low value shares This problem leads investors to lose the truth in investing

2 Moral hazard

Moral hazard arises after the transaction occurs: The lender runs the risk that the borrower will engage in activities that are undesirable from the lender’s point of view because they make it less likely that the loan will be paid back (Mishkin & Eakins, 2012) In addition, the regulation itself may promote moral hazard (Howells, 2010) For example, central banks play an important role as lender of last resort It means that banks would be provided reserves to prevent bank failures from spinning out of control (Mishkin & Eakins, 2012) Therefore, commercial banks could take risky activities without fear of running out of money During the 2008 financial crisis, Fed Chairman Ben S Bernanke’s unprecedented effort to keep the economy from plunging into depression included lending banks and other companies as much as $1.2 trillion of public money confidentially (Keoun & Kuntz, 2011) Some analysts said that banks received emergency cash infusions during the crisis may now believe the Fed will always be there to bail them out of trouble, the thinking goes (Eichler, 2011) Herring, the University of Pennsylvania professor, added some banks may have used the program to maximize profits by borrowing from the cheapest source, because this was supposed to be secret and never revealed’ (Keoun & Kuntz, 2011)

annuities, pensions and inflation For example, annuity rates have fallen from 7.855% for a level income for a 65-year-old man in 2008 to 5.743% in 2012 (Insley, 2012)

Question 1.b: With close reference to your answer in part (a) above, discuss why there

is a need to regulate financial markets

Because of asymmetric information in financial markets, depositors or investors will know less information compare to the one who use funds Therefore, some regulations are carried out to reduce the problems of asymmetric information One issue is the unclear information in financial reports In Vietnam financial markets, investors say that financial reports are not clear enough, especially the reports of state-owned enterprises, while the quality of the information provided by financial institutions is low (VietNamNet Bridge, 2014) Due to lack of information transparency, investors cannot carry out the right management strategy Therefore, they lost the confidence in financial markets These problems happen in many financial markets not only in Vietnam To protect investors, regulators need to design the legislations for listed companies to transparent information For example, EU Transparency Directive (2004/109/EC) requires a regular flow of information issuers of securities traded on regulated markets such as yearly, half-yearly and quarterly financial information, inside information has to be made public as soon as possible to the market, etc (European Commission , 2011) These regulations will help investors have better information for decision making about trading activities

Furthermore, one of the main reasons for regulating financial markets is to stabilize financial market or reduce systemic risk Systemic risk is risk to the entire financial system rather than to individual firms or investors (Hubbard & O’Brien, 2012) For example, in banking systems, depositors have the right to withdraw their money in the banks whenever they want If there is any problems for banks, this will make depositors worry about their savings Therefore, they will withdraw all money in banks at the same time and it leads banks to become insolvent About £2bn has been withdrawn for a short time, when Northern Rock applied to the Bank of England for emergency funds because savers fear for their deposits (Eaglesham, et al., 2007) In addition, banks take deposits and lend not only firms, individuals but also other banks This means that the collapse

of one bank could cause the failure of whole banking system and bring a lot of negative impacts to the whole economy

Question 2: Distinguish between the spot and the forward foreign exchange rates How these rates are related and determined in the foreign exchange markets?

Answer:

Spot rate: the immediate (two-day) exchange of bank deposits (Mishkin, 2013)

Currency code Currency name VND

or within 2 two days as from 18/11/2014

Forward rate: the exchange rate of bank deposits at some specified future date (Mishkin, 2013)

Distinguish between spot rate and forward rate:

Maturity Make payments during 2 days

after the rate is quoted today

Make payments in 1 month, 3 months

or 6 months after rate is quoted today

Purposes

Make payments for import or

export activities, services…

Demand for payments, transfer money

or invest Demand foreign currencies for

studying, working or holiday

Hedging exchange rate fluctuations

Table 2: Spot rate and Forward rate

All the transactions in the spot date or 2 days later could follow the spot foreign exchange rate It means that if your transaction happens today, you can use the spot rate

to make payments today or tomorrow or 2 days later While the forward rate could be

used for future payments or hedge funds to avoid fluctuation of exchange rate For example, you export a machine that cost $1,000 to US on 18/11/2014 and your customer will pay back a month later on 18/12/2014, so you can make a forward contract with a commercial bank to ensure that you can change $1,000 which you receive to VND by the exchange rate quoted on 18/11/2014 This action will help to prevent the exchange

risk

There are several theories to determine the exchange rate:

Interest rate parity (IRP): The currency of the country in which interest rates are

higher will be trading at a forward discount; the currency of the country with the lower interest rates will be at a forward premium (Howells & Bain, 2007)

To prevent riskless arbitrage of investors, one currency will be regulated by increasing

or decreasing the forward rate which depends on spot rate today

The formula in the interest rate parity:

ip is the interest rate on primary currency

Table 3: The formula in the interest rate parity

(Howells, 2010) For example: An investor has $10,000 and the interest rate in US and VN is respectively 3% and 14% per year Suppose that spot rate is USD/VND = 20.000 If this investor deposits $10,000 for a month, on due date he will receive $25 (equal to 500.000VND)

In other case, the investor exchanges this money to 200 million VND and deposits it into a Vietnam commercial bank for a month like in US; on due date, the investor can get about 2.33 million VND If the exchange rate after a month does not change, the investor can have profit (more than 1.5 million VND) by depositing in VND In order

to reduce the exchange risk, the investor could take a contract with a bank with a forward rate after 1 month However, this riskless arbitrage will be prevented by adjusting the forward rate after a month following the formula above

Forward rate = Forward rate = 1+3%

1+14% × 20.000 = 19.789

Law of one price: If two countries produce an identical good, and transportation costs

and trade barrier are very low, the price of the good should be the same throughout the world no matter which countries produces it (Mishkin & Eakins, 2012) This theory means that if there is the same goods in the different countries, its price will be the same

For example:

A shirt in Vietnam 400.000 VND

A shirt in US $20

Table 4: Example of Law of one price

Based on this theory, 400.000VND should equal to $20 It means that the exchange rate USD/VND = 20.000

Purchasing power parity (PPP): The exchange rate between two currencies depends

on the purchasing power of each currency in its home country and the exchange rate changes to keep the home purchasing power of the two currencies equal (Howells & Bain, 2007)

For example: the spot rate is USD/VND = 20.000 The price of a shirt in Vietnam is 400.000 VND but in US it costs $30 (equal to 600.000 VND) It can lead US citizens

go to Vietnam to purchase shirts so the demand for shirts in Vietnam will increase and the price also increases while in US, it is opposite These things will cause USD/VND

to decrease This is called absolute form of PPP

However, the basket of goods and their quality in each country is different so the absolute PPP cannot illustrate the accurate spot rate Therefore, the changes in exchange

rate between two countries are depended on the inflation rate - this is the idea of relative PPP (RPPP) (Howells, 2010)

The formula is as follows:

𝜋𝐷 𝑒 − 𝜋𝐹𝑒

1 + 𝜋𝐹𝑒 =

𝐸𝑡+1𝑒 − 𝐸𝑠

𝐸𝑠Where: 𝜋 is the rate of inflation

D and F indicate domestic and foreign

e indicates an expected value

𝐸𝑠 is the spot exchange rate expressed in direct quotation

Table 5: The formula of relative PPP

(Howells, 2010) For example: Spot rate: VND/USD = 20.000

Expected inflation in Vietnam for next year: 8%

Expected inflation in US for next year : 3%

According to RPPP formula, the forward rate for the next year can be calculated as follows:

𝐸𝑡+1𝑒 = [𝜋𝐷 𝑒− 𝜋𝐹𝑒

1+ 𝜋𝐹𝑒 ] × 𝐸𝑠+ 𝐸𝑠 = [0.08−0.03

1+0.03 ] × 20.000 + 20.000 = 0.049 × 20.000 + 20.000 = 20.980

 Forward rate for next year: VND/USD = 20.890

The exchange rate also determined based on the interest rate International Fisher effect (IFE): Nominal interest consist of two elements: the real rate of interest, and the

expected rate of inflation It follows that differences in expected inflation rate provide one cause of differences in international interest rates (Howells & Bain, 2007)

The formula based on this theory: Where:

𝑖𝐷− 𝑖𝐹

1 + 𝑖𝐹 =

𝐸𝑡+1𝑒 − 𝐸𝑠

𝐸𝑠

i is the nominal rate of interest

Table 6: The formula of International Fisher effect

(Howells, 2010)

It means that the countries which have high nominal interest rate, the value of these currency might reduce in the future

In conclusion, all three including IRP, PPP and IEF assume that the market is perfect,

no transaction costs, no government intervention…However, IRP shows the relation between spot rate and forward through interest rate while RPPP and IEP illustrate determination of spot rate through inflation and nominal interest rate

Question 3.a: Explain the operations and activities of the London Stock Exchange

(LSE) market

London Stock Exchange is one of the world’s oldest stock exchanges and can trace its history back more than 300 years Starting life in the coffee houses of 17th century London, London Stock Exchange quickly grew to become the City’s most important financial institution Over the centuries following, London Stock Exchange has consistently led the way in developing a strong, well-regulated stock market and today lies at the heart of the global financial community (LSE, 2015)

The London Stock Exchange has four core business areas:

 Equity markets – the main market for listed companies and the Alternative Investment Market (AIM) for unlisted securities

 Trading services – trading platforms that are used by broking firms around the world to buy and sell securities

 Market information – the provision of prices and news

 Derivatives - a recent diversification beyond the core equity markets In collaboration with the Nordic exchange group OMX, the London Stock Exchange created EDX London in 2003

(Oxford, 2008)

To join Main Market, the company will need the approval of prospectuses and admission of companies to the Official List from the UK Listing Authority (UKLA) and the admission to trading from the Exchange Moreover, to achieve a successful listing and admission to trading, companies must deliberate over many considerations

so they need to have different types of adviser including sponsor, bookrunner, lawyers, reporting accountant, financial PR, other advisers like registrars, financial printers and remuneration consultants (LSE, 2015)

SETS is the London Stock Exchange’s flagship electronic order book, trading FTSE100, FTSE250, FTSE Small Cap Index constituents, Exchange Traded Funds,

Exchange Trading Products as well as other liquid AIM, Irish and London Standard listed securities For SETS order book, auction starts the day at 8:00; continuous trading / order entered 8:00 to 16:00; auction closes the day at 16:30 SETS developments also support a wide array of order types such as passive only, stop orders, stop limit orders, hidden limit orders… (LSEG, 2015)

Question 3.b: With close reference to the relevant theoretical and the empirical

literature and your own financial data analysis critically assess the efficiency of this stock exchange market

The efficiency market hypothesis (EMH) state that financial markets make a best use

of all available information in determining a share’s price (Howells & Bain, 2007) To become an efficient market, there are many participants who have full information and work independently in analyzing and price the securities so that they can adjust the share’s price quickly based on the information

According to (Fama, 1970), EMH is divided into three levels:

 Weak form: the information set is just historical prices

 Semi-strong form: the concern is whether prices efficiently adjust to other information that is obviously publicly available (e.g., announcement of annual earnings)

 Strong form: the concern is whether given investors or groups have monopolistic access to any information relevant for price formation

There are some empirical literatures of EMH research in London Stock Exchange (LSE) as follows:

According to findings of (HUDSON, et al., 1996) by testing the daily returns from FTSE 30 of LSE for a long time, they shown that the technical trading rules have predictive ability if sufficiently long series of the stock indices are considered The results of their studies are seen as supporting the weak form efficiency of financial markets

In the works of (AL-LOUGHANI & CHAPPELL, 1997), they shown that the weak form of the efficient markets hypothesis is certainly not valid for the FTSE 30 share index; the series does not follow a random walk

However, the studies of (MILIONIS & MOSCHOS, 2000) evaluated the weak form of the efficient markets hypothesis and a random walk based on the works of (AL-LOUGHANI & CHAPPELL, 1997) And then, they carried out a contrast conclusion that the hypothesis of weak form market efficiency of LSE cannot be rejected

The data about daily share price from some quoted companies on LSE will be collected

to access the EMH of this stock exchange market

1 Access Intelligence plc

Access Intelligence plc is a United Kingdom-based company which provides software and computer services to critical compliance and legislative driven businesses in both

the public and private sectors (FT, 2015)

Figure 1: Access Intelligence plc share price change (%) 24/09/14 to 22/12/2014

Source: Modified from Yahoo Finance, 2014 Based on data about daily share price in 90 days, the correlation between change in share price and time is calculated as r = -0.086 – very low value nearly to 0 This means that the movement of share price and time are independent Furthermore, it can be seen clearly that the levels of share price change fluctuates randomly and do not follow any rules For example, at the highest point, share price increases by 29.87% on 02/12/14 and at the lowest point, it goes down by 12.08% on 19/11/14 the future share price cannot be indicated by past share price This means that LSE have weak form EMH

Figure 2: Access Intelligence plc share price from 24/09/14 to 22/12/2014 as an absolute amount

Source: Yahoo Finance, 2014

On 08/12/14, Access Intelligence plc announce about issuing new Convertible Loan Notes to increase the working capital of company Furthermore, the trading update shows that sales and profit will be at similar levels to those achieved in the corresponding period last year and the year-end cash position in line with market expectations and will be significantly enhanced by the completion of the issue of the new CLNs Additionally, research analysts at Sanlam Securities suggest a potential upside of 180.00% from the company’s current price (Bidgoli, 2014) These information show the good future of share price of ACC In fact, share price increases from 2.75 on 05/12/14 to 2.88 on 08/12/2014 and peak at 3.42 on 09/12/14 As above, change in share price of Access Intelligence plc already show the weak form EMH Furthermore, the share price moves based on the current information This illustrates the semi-strong EMH of LSE

2 4imprint Group plc

4imprint Group is a UK listed leading international direct marketer of promotional products supplying promotional products under the brand name 4imprint The Group's strategy is to deliver profitable organic growth, gaining market share in the large and highly fragmented markets in which it operates (4imprint Group, 2015)

Figure 3: 4imprint Group plc share price change (%) from 24/09/14 to 22/12/2014

Source: Modified from Yahoo Finance, 2014 The correlation (r) between change in 4imprint Group plc share price and time equal to 0.014 – no correlation between two items This means that change in share price does not depend on time The figure also shows that the increase and decrease of share price are not the same in the different time It means that there is no trading rule for investors

to make more profits It means that MHE of LSE is weak form

Figure 4: 4imprint Group plc share price from 24/09/14 to 22/12/2014 as an absolute amount

Source: Yahoo Finance, 2014