Section A – 40 marks

1. When a company finances its short-term assets with short-term debt, this is known as the:

A: identical principle
B: equalisation theory
C: corresponding principle
D: matching principle

2. If a government’s income from tax receipts exceeds its expenditure, the government is
running:

A: a deficit, and is a net borrower of funds

B: a surplus, and is a net borrower of funds
C: a deficit, and is a net saver of funds
D: a surplus, and is a net saver of funds

3. All of the following statements about the issuing of a commercial bill are true EXCEPT:

A: it is sold at discount to face value

B: a bank may accept it
C: the drawer is the party that issues the bill
D: the discounter is the party that borrows the funds

4. An increase in the prices of goods and services causes the demand for funds to _____ and
market interest rates should _______.

A: fall; increase
B: fall; decrease
C: rise; increase
D: rise; decrease

5. When issuing commercial paper, it is important for a company to have:

A: a party to act as an acceptor and guarantee payment

B: collateral to attach to the issue
C: a well-established reputation in the markets
D: investors organised by the investment bankers to sell the issue

6. A negotiable certificate of deposit:

A: is a term deposit because it has a specified maturity date

B: can be issued by banks to meet their operational liquidity
C: is a short-term discount security
D: All of the above.
7. A company borrows $75 000 from a bank, to be amortised over 5 years at 8.5% per annum.
The annual instalment is:

A: $12 657.43
B: $16 275.00
C: $19 032.43
D: None of the above.

8. When a company has a deal with a bank lender that allows access to short-term funds, this
is called:

A: a debt facility
B: a credit facility
C: a debt provision
D: a liability provision

9. _______ is the security backed by real estate.

A: A debenture
B: An income bond
C: A mortgage bond
D: A fixed-charge debenture

10. Which type of financial claim is not satisfied until those of the creditors holding certain
senior debts have been fully satisfied?

A: mortgage bonds
B: unsecured notes
C: subordinated debentures
D: deferred interest debentures

11. Using the expectations theory of term structure, a negatively sloped yield curve indicates
that investors expect:

A: falling long-term interest rates

B: rising long-term interest rates
C: falling short-term interest rates
D: rising short-term interest rates

12. A $1000 face value bond with coupon rate of 8% paid annually has five years to maturity. If
bonds of similar risk are currently earning 6%, what is the current price of the bond?

A: $920.15
B: $1000
C: $1084.25
D: None of the above.
13. The type of lease where the costs of ownership and operation are borne by the lessee, who
agrees to make a residual payment at the end of the lease period, are:

A: a direct lease
B: a financial lease
C: an operating lease
D: a leveraged lease

14. The higher the credit rating given to a bond issue:

A: the higher the credit risk

B: the higher the yield
C: the lower the yield
D: the higher the country risk

15. The crowding-out effect refers to:

A: corporate borrowing exceeding government borrowing

B: government borrowing reducing the available funds for borrowing
C: heavy long-term borrowing by government
D: corporations issuing securities of long maturity

16. If market interest rates move upwards after an investor buys a government bond, the
investor may:

A: sell the bond back to Treasury

B: sell the bond in the secondary markets for a capital loss
C: sell the bond in the secondary markets for a capital gain
D: hold the bond until the market rates return to their original level and then have a
capital gain

17. Financial institutions hold government securities because of:

A: liquidity requirements
B: interest rate expectations
C: funding requirements
D: All of the above.

18. Monetary policy in Australia is implemented by the Reserve Bank, and currently is
principally directed towards:

A: affecting the level of short-term interest rates

B: effecting a reduction in the current account deficit
C: affecting the level of growth in the money supply
D: affecting the value of the AUD, and the exchange rate
19. If one company has better access to fixed-term financing than another company, it may be
said that this company has a:

A: lower credit rating

B: comparative advantage
C: higher credit rating
D: lower credit risk

20. Price stability is desirable because:

A: everyone is better off when prices are stable

B: inflation creates uncertainty about future planning
C: it guarantees full unemployment
D: it increases the efficiency of the Australian Reserve Bank

21. When the Australian Reserve Bank sells Commonwealth government securities, it:

A: injects extra cash into the financial markets

B: loosens monetary policy
C: puts a downward pressure on interest rates
D: tightens monetary policy

22. If Japan imports more Australian goods, all else being equal, there will be an increased:

A: Australian demand for yen

B: Australian demand for dollars
C: Japanese demand for yen
D: Japanese demand for dollars

23. What type of option will an option buyer purchase if they believe a share price will rise?

A: call
B: put
C: warrant
D: swaption

24. The term structure of interest rates:

A: reflects the differing tax treatment received by different securities

B: represents the variation in yields for similar instruments differing in maturity
C: always results in an upward-sloping yield curve
D: generally results in a downward-sloping yield curve
25. The segmented markets theory:

A: has difficulty explaining why yield curves are usually upward-sloping

B: has difficulty explaining why yield curves are usually downward-sloping
C: ignores the existence of market participants who seek to take advantage of price
differences
D: provides a good explanation of why yields on bonds of varying maturities tend to move
together

26. If the Australian central bank wished to cause the AUD to appreciate, it would _______
AUD and _______ foreign currency.

A: buy; sell
B: sell; sell
C: sell; buy
D: buy; buy

27. Calculate the current exchange rate EUR/JPY, given these two quotes:
USD/EUR 0.9780-90
USD/JPY 119.20-30

A: EUR/JPY 116.57-79
B: EUR/JPY 116.67-70
C: EUR/JPY 121.86-88
D: EUR/JPY 121.76-98

28. In a fixed-for-floating interest rate swap:

A: the amounts payable depend on a specified principal that is exchanged at the outset
B: one party pays another party an amount calculated according to a floating interest rate
on a notional principal, in exchange for an amount calculated on the basis of a fixed
interest rate
C: only interest flows are exchanged until maturity, when the principal is exchanged
according to the difference in the interest rates over the lifetime of the swap
D: Both A and B.

29. The Reserve Bank increases interest rates to reduce the level of spending in the economy.
As the rate of growth in economic activity slows, the demand for funds also slows. This
impact of a change in interest rates is described as the:

A: inflation effect
B: liquidity effect
C: income effect
D: monetary effect
30. A tariff is a:

A: tax on goods exported to other countries

B: tax on goods purchased from other countries
C: limit on the number of goods that may be imported
D: subsidy by governments granted to exporting companies

31. An options contract:

A: is another name for a forward contract

B: gives the right to buy or sell an underlying asset at a predetermined price by a specified
time
C: may be written for debt securities but not equities
D: may be written for equities but not debt securities

32. For the buyer of an option, the premium paid for the contract represents the:

A: transactions cost
B: maximum return
C: largest potential loss
D: yield

33. An investor holds long call options that may be exercised at any time over the next month.
The spot price of the underlying asset is $12.75; the strike price of the option is $15.10; and
the premium paid was $2.35. What is the value of the option to the holder?

A: -$2.35
B: zero
C: $10.40
D: $15.10

34. A covered call position is comparable to:

A: a long put
B: a short put
C: a long straddle
D: a vertical spread

35. When interest rates increase:

A: the price of call options generally falls

B: the price of the underlying share usually increases
C: the price of put options generally falls
D: the volatility of the underlying asset falls
36. A company issues a 90-day bill with a face value of $100 000, yielding 7.65% per annum.
What amount would the company raise on the issue?

A: $84 130.46
B: $92 350.21
C: $98 123.39
D: $98 148.62

37. An Australian export company wishes to sell its euro receipts, EUR 500 000, through an FX
dealer and receives the following quote: ‘Aussie mark spot is one-twenty-two fifty-five to
sixty five’. What is the value of the export receipt?

A: $407 664.09
B: $407 996.74
C: $612 750.00
D: $613 250.00

38. All of the following statements are advantages of a swap transaction, EXCEPT:

A: it usually allows the company to achieve a lower cost of funds

B: it is used to hedge both interest rate risk and foreign exchange risk
C: it facilitates the restructure of cash flows associated with existing borrowings
D: it transfers the credit risk to the counterparty.

39. When a bond investor buys a credit default swap (CDS), they:

A: will pay a premium to the seller

B: will receive compensation from the protection seller if a default occurs
C: will retain their original bonds
D: All of the above.

40. When a loan agreement contains actions for a borrowing company to comply with, these
are called:

A: accounting ratios
B: negative covenants
C: positive covenants
D: loan options

Each question in this section is worth 1 mark

------------END OF SECTION A------------

Answers:
1. D
2. D
3. D
4. C
5. C
6. D
7. C
8. B
9. C
10. C
11. C
12. C
13. B
14. C
15. B
16. B
17. D
18. A
19. B
20. B
21. D
22. D
23. A
24. B
25. C
26. A
27. D
28. B
29. C
30. B
31. B
32. C
33. A
34. B
35. C
36. D
37. A
38. D
39. D
40. C
 Section B – 60 marks

Question 1
A) A number of exchange rate regimes have evolved over time. Each country is responsible
for determining the exchange rate regime that will apply to its currency.
i. Briefly describe three of the main types of exchange rate regimes adopted by
major trading countries. For each regime provide an example of a country that has
adopted that regime. (6 marks)
Four regimes were covered in class, students only need to describe 3 of them.
1) Floating exchange rate – exists when the exchange rate for the currency of a country is
allowed to move as factors of supply and demand dictate. Major currencies such as the USD,
GBP, JPY, EUR, and AUD adopt floating exchange rate.
2) Managed float exchange rate – allow the currency to move within a defined range, or band,
relative to another major currency. The exchange rate is allowed to adjust providing such
movements do not adversely impact upon the economic objectives of the country. This
regime is used by China*, Singapore, Malaysia, and Indonesia.
3) Crawling peg exchange rate – allows the currency to appreciate gradually over time, but
within a limited range established by the government. Similar to a managed float, but
generally accepted in the markets that the currency is undervalued. Many commentators
would suggest that China operates this regime.
4) Linked exchange rate – a currency is directly linked to another currency; for example the
Hong Kong Dollar (HKD) is linked to the USD
ii. In 1992, George Soros reportedly made a $1bn profit by “shorting the pound”.
Outline the factors that determine whether a central bank is able to protect its
domestic currency from depreciation in the case that speculators are selling large
amounts of the currency. (4 marks)
The central bank is able to counteract the actions of speculators by a) buying its own currency,
b) increasing the level of interest rates in the domestic market, c) imposing restrictions on
capital flows.
The ability for this to work is limited by the size of foreign currency reserves, the ability to
increase interest rates (and maintain them at higher levels) given other economic factors, the
importance of international capital flows in funding the domestic economy, and the ability to
persuade the market that the measures can be preserved long enough to deter speculators.
Soros made money by selling pounds (lots of them) in order to profit by future devaluation.
The UK government tried buying the pound, and increasing interest rates but this ultimately
failed and the GBP left the ERM.

B) With the aid of a relevant diagram, explain how the equilibrium AUD/USD exchange rate
would change if there is a forecast increase in Australia’s inflation rate while the US
inflation rate remains stable. (10 marks)
Purchasing power parity contends that exchange rates will adjust to ensure prices on the same
goods are equal between countries.
A sustained surge in Australian inflation will increase the costs of local goods, US demand for
Australian goods will fall. Therefore, there would be a reduction in the demand for the
Australian Dollar (AUD). The demand curve would move from D0 to D1.
At the same time, Australians would be able to seek relatively cheaper goods for overseas. The
supply of the AUD would increase as importers purchased the USD. The supply curve would
move from S0 to S1.
The net result would be a fall in the equilibrium exchange rate – i.e. the AUD will depreciate.
The appropriate diagram would look like the following: (6 marks for explanation, 3 marks for
diagram, 1 mark for stating that net result is AUD depreciation / fall in equilibrium rate)

AUD/USD

S0

P0 S1

P1

D1 D0

C) An Australian exporter has entered into a contract under which it will receive payment in
Swiss Francs (CHF) in 6 months. The company is concerned at its exposure to foreign
exchange risk and decides to enter into a forward exchange contract with its bank.
i. Explain the particular risk that the exporter is concerned about. (2 marks)
The exporter is concerned about the value of its receipts falling; i.e. the exporter is concerned
that the CHF may depreciate relative to the AUD. (2 marks)
ii. Given the following data, calculate the forward rate the exporter will receive –
express this rate with the Australian Dollar (AUD) as the base currency. Assume
365 days a year in all cases.
USD/CHF: 0.8835-39
AUD/USD: 0.9241-43
1-month Australian interest rate: 2.64% p.a.
6-month Australian interest rate: 2.74% p.a.
1-month US interest rate: 0.15% p.a.
6-month US interest rate: 0.33% p.a.
1-month Swiss interest rate: 0.00% p.a.
6-month Swiss interest rate: 0.07% p.a. (8 marks)
The students first need to calculate the AUD/CHF spot rate.
0.9241 x 0.8835 = 0.8164; 0.9243 x 0.8839 = 0.8170; AUD/CHF = 0.8164-70 (3 marks)
In 6-months, the exporter will receive CHF and convert them into AUD (i.e. Sell CHF and Buy
AUD). Therefore the appropriate forward rate to place into the forward rate formula is 0.8170.
AUD is base currency so the formula should be as follows:
1+(0.0007×0.5) 1.00035
Forward Rate = 0.8170 [1+(0.0274×0.5)] = 0.8170 [ 1.0137 ] = 0.8088 (5 marks)
Question 2
A) The interest rate swaps market has grown exponentially since its inception in the early
1980s. Outline the main rationale for the existence of the interest rate swaps market as it
applies to the fixed interest rate and variable interest rate between different borrowers.
Propose why and under what circumstances it might be expected that borrowers could
have different comparative advantages in the debt markets? (8 marks)
The main concept / rationale for the existence of the market is ‘comparative advantage’. (1
mark)
That is, by borrowing in the market in which a firm had a comparative advantage and by
swapping their interest payment obligations, both parties achieve a cost of funds lower than
could be achieved without the swap. (3 marks)
Variations in the comparative advantage of a firm between the fixed and variable rate markets
may derive from the perceptions of different lenders in each of the markets; for example, in
the variable rate market the differential may come from the credit departments of bank
lenders, while in the fixed rate market the primary influence may be the respective credit
ratings issued by credit rating agencies. (4 marks)

B) In your role as an analyst, you are provided with the data given below. Distinguish in
which of the two scenarios it would be possible to arrange a profitable swap. Construct a
fully labelled diagram for the cash-flows of a direct swap in the profitable scenario.
Assume that the comparative advantage net differential is to be shared equally between
the two companies. (12 marks)
Borrower Fixed Rate Variable Rate
Scenario 1 A 5.80% BBSW – 0.50%
B 7.60% BBSW + 1.30%
Scenario 2 X 6.40% BBSW + 1.10%
Y 4.20% BBSW + 0.10%

Scenario 1:
Fixed Rate A = 5.80%, B = 7.60%, Differential = 1.80%
Variable Rate A = BBSW-0.50%, B = BBSW+1.30%, Differential = 1.80%
Net Diff. = Nil

Scenario 2:
Fixed Rate X = 6.40%, Y = 4.20%, Differential = 2.20%
Variable Rate X = BBSW + 1.10%, Y = BBSW + 0.10%, Differential = 1.00%
Net. Diff = 1.20%

A profitable swap is only possible under Scenario 2. (5 marks)

The net differential of 1.20% is to be split evenly between X and Y (i.e. each will benefit
by 0.60%)
Y should borrow in the market where it has greatest comparative advantage (Fixed-rate)
and X should borrow in the market where it has the least comparative disadvantage
(Variable-rate) and then engage in a swap.
 5.80% fixed payments
Firm X Firm Y
Variable BBSW + 1.10%
Variable 4.20%
BBSW + fixed
1.10% payments

Borrows Borrows
variable rate fixed rate
debt debt

Cash-flows:
Firm X Firm Y
Pay -BBSW + 1.10% Pay - 4.20%
Receive BBSW + 1.10% Receive +5.80%
Net Zero Net +1.60%
Pay -5.80% Pay -BBSW+1.10%
Net 5.80% Net BBSW+0.50%
Both parties have benefited by 0.60% (i.e. X pays 5.80% rather than 6.40%, Y pays
BBSW+0.50% rather than BBSW+1.10%) (7 marks)

C) As an analyst working within a major corporation you are responsible for managing a
portfolio of credit instruments. You are preparing a presentation to the Treasurer on the
structure of a credit default swap that you are considering purchasing for your portfolio.
Explain the purpose and structure of a credit default swap. In your explanation you should
include the different types of settlement that are possible. Evaluate whether the credit
default swap can eliminate credit risk from your portfolio. (10 marks)
 A credit default swap allows one party to transfer credit risk to another party.
 The buyer of a CDS pays a premium to the seller (writer) of the CDS. The premium is
usually a number of basis points relative to the credit protection amount. (1 mark)
 The credit protection relates to debt issued by, or loans given to, a reference entity (the
borrower). (1 mark)
 If default occurs by a reference entity, the CDS will specify how settlement will occur.
 Physical settlement requires the protection buyer to deliver the notional value of the debt
of the reference entity in return for payment by the protection seller. (2 marks)
 Cash settlement requires the protection seller to pay a net cash amount to the protection
buyer, being the difference between the face value and the current market value of the
underlying reference debt instruments. (2 marks)
 The CDS will specify what represents a credit default event. These include bankruptcy,
obligation acceleration, obligation default, cash payment failure, repudiation and
moratorium of debt by a nation state. (1 mark)
 CDS are generally available only on particular debt issues, or loans, on specific reference
entities. It may not be possible to purchase a CDS on all investments in the portfolio. Even
if this is possible, or you purchase a ‘basket’ CDS which insures against all credit risk in
your portfolio it will not eliminate your credit risk. Instead, the credit risk is transferred
from the reference entity to the seller of the CDS. (3 marks)