- 1 A. Long Answer Questions (word limit-500 words) 2 × 20 = 40 marks
- 2 1) Explain the significance of the financial system. What are important functions of financial institutions?
- 3 2) What are the important features of fixed income securities?
- 4 B. Medium Answer Questions (word limit-250 words) 3 × 10 = 30 marks
- 5 3) Briefly discuss expected utility theory of decision-making.
- 6 4) Explain the internal and external determinants that affect the formulation of corporate policy.
- 7 5) What is Debt Securitisation? Explain risks attached to debt securitization.
- 8 C. Short Answer Questions (word limit 100 words) 2 × 3 × 5 = 30 marks
- 9 6) Differentiate between:
- 10 (a) Allais paradox and Ellsberg paradox.
- 11 (b) Forwards and Futures
- 12 (c) Systematic risk and non-systematic risk
- 13 7) Write short notes on the following.
- 14 (a) Hedge Funds
- 15 (b) Internal Rate of Return
- 16 (c) Hypothesis testing.
|Title||BECE-144: IGNOU BAG Solved Assignment 2022-2023|
|Degree||Bachelor Degree Programme|
|Course Name||FINANCIAL ECONOMICS|
|Programme Name||Bachelor of Arts (General)|
|Last Date for Submission of Assignment:||For June Examination: 31st April|
For December Examination: 30th September
A. Long Answer Questions (word limit-500 words) 2 × 20 = 40 marks
1) Explain the significance of the financial system. What are important functions of financial institutions?
Ans: The financial system is an integral part of modern economies and plays a vital role in facilitating the flow of funds from savers to borrowers. It is comprised of a variety of intermediaries, such as banks, insurance companies, pension funds, investment banks, and stock exchanges, which are involved in the process of channeling funds from savers to borrowers.
There are several key functions that financial institutions perform which are important for the functioning of the financial system:
- Mobilization of Savings: Financial institutions play a crucial role in pooling savings from individuals and making it available to those who need funds for investment or consumption. This helps to mobilize savings, increase investment and promote economic growth.
- Intermediation: Financial institutions act as intermediaries between savers and borrowers, matching the two groups to facilitate the flow of funds. By pooling funds from many savers and lending them to borrowers, financial institutions can reduce the risk of loss for both parties and increase the availability of credit.
- Risk Management: Financial institutions offer a range of financial products, such as insurance and derivatives, that help to manage the risks associated with investments and borrowing. By spreading the risk across a large number of participants, financial institutions can reduce the impact of any one event on the financial system as a whole.
- Information Provision: Financial institutions play a crucial role in gathering and analyzing information about potential borrowers, which helps to reduce the risk of lending and improve the efficiency of the financial system.
- Liquidity Provision: Financial institutions provide short-term funding to help meet the liquidity needs of borrowers. This helps to ensure that the financial system remains stable and that credit is available when it is needed.
2) What are the important features of fixed income securities?
Ans: Fixed income securities are financial instruments that provide a fixed stream of income to investors in the form of interest payments. The following are some of the important features of fixed income securities:
- Fixed Coupon: Fixed income securities typically offer a fixed coupon or interest rate, which means that the income received by the investor is predictable and does not fluctuate with changes in market conditions.
- Principal Guarantee: Fixed income securities are generally considered to be less risky than other types of investments, as they offer a guarantee of the return of the principal amount at maturity.
- Maturity: Fixed income securities have a specified maturity date, at which point the principal amount is returned to the investor. This provides a clear exit strategy for investors, who can plan their investment accordingly.
- Credit Risk: Fixed income securities are subject to credit risk, which is the risk that the issuer will default on its obligation to make interest payments or repay the principal. The creditworthiness of the issuer is a key determinant of the risk associated with fixed income securities.
- Market Risk: The market value of fixed income securities can fluctuate in response to changes in interest rates and economic conditions. This means that the value of the investment may decline if interest rates rise or if the issuer’s financial condition worsens.
- Taxation: Fixed income securities are subject to taxation, which can reduce the overall return received by the investor. The taxation of fixed income securities varies depending on the jurisdiction and the type of security.
B. Medium Answer Questions (word limit-250 words) 3 × 10 = 30 marks
3) Briefly discuss expected utility theory of decision-making.
Ans: Expected utility theory is a normative decision-making model that assumes individuals are rational and make choices based on their preferences, probabilities, and utilities. According to this theory, people calculate the expected utility of each available option, which is the product of the probability of an outcome and its corresponding utility, and then choose the option with the highest expected utility.
The theory is based on the assumption that people are risk-averse and prefer known outcomes to uncertain ones. People also have a consistent way of evaluating outcomes, with a higher preference for those with higher utilities. The expected utility theory helps to explain why people are often willing to pay a premium for insurance, which reduces the uncertainty of potential outcomes.
In addition, the theory can be used to understand individual behavior in a variety of contexts, including investments, consumer behavior, and public policy. For example, it can help to explain why people are willing to pay more for a product that has a higher perceived quality, as the expected utility of owning a high-quality item is greater than that of a lower-quality item.
However, the expected utility theory has some limitations, as it assumes that individuals are fully rational and make decisions based purely on their preferences and probabilities. In reality, people may be influenced by a variety of factors, such as emotions, cognitive biases, and limited information, which can affect the accuracy of expected utility calculations.
4) Explain the internal and external determinants that affect the formulation of corporate policy.
Ans: Corporate policy refers to the guidelines, rules, and principles that an organization follows in its operations and decision-making. The formulation of corporate policy is influenced by a range of internal and external determinants.
Internal determinants refer to the factors within the organization that impact the formulation of corporate policy. Some of the key internal determinants include the company’s goals and objectives, its culture, its organizational structure, and the experience and expertise of its employees. The company’s goals and objectives provide a framework for policy formulation and help to determine which policies are most important. The organizational culture and structure can also play a significant role in shaping policy, as they can influence the way decisions are made and the values that are emphasized.
External determinants refer to the factors outside of the organization that impact policy formulation. These factors can include economic conditions, government regulations, competition, and social and environmental factors. Economic conditions, such as a recession or a period of growth, can impact the company’s financial situation and shape its policy decisions. Government regulations can also play a significant role in policy formulation, as companies must comply with laws and regulations related to employment, safety, and the environment. Competition can also influence policy, as companies must stay competitive and respond to changes in the market. Social and environmental factors, such as public concerns about sustainability and social responsibility, can also impact the formulation of corporate policy.
5) What is Debt Securitisation? Explain risks attached to debt securitization.
Ans: Debt securitization is a financial process in which a company pools its debt obligations, such as loans or bonds, and sells them as securities to investors. The goal of debt securitization is to transfer risk from the originator of the debt (the company) to the investors who purchase the securities.
The process of debt securitization begins with the creation of a special purpose vehicle (SPV) that purchases the debt obligations from the company. The SPV then issues securities, backed by the debt obligations, to investors. The securities are usually divided into different tranches, each with a different level of risk and return. The tranches are then sold to investors with varying risk tolerance levels.
While debt securitization can offer many benefits to companies, such as improved liquidity, reduced funding costs, and access to new sources of financing, it also comes with several risks. Some of the key risks attached to debt securitization include:
- Credit risk: The risk of default by the underlying borrowers in the pool of debt obligations.
- Interest rate risk: The risk that changes in interest rates will negatively impact the value of the securities.
- Prepayment risk: The risk that the underlying borrowers may prepay their debts, leading to a decrease in the expected cash flows for the securities.
- Market risk: The risk that changes in market conditions, such as changes in investor demand or economic conditions, will negatively impact the value of the securities.
- Operational risk: The risk of operational errors or failures in the securitization process, such as inaccuracies in the documentation or servicing of the underlying debts.
C. Short Answer Questions (word limit 100 words) 2 × 3 × 5 = 30 marks
6) Differentiate between:
(a) Allais paradox and Ellsberg paradox.
Ans: The Allais paradox and Ellsberg paradox are both decision-making anomalies in which individuals make choices that deviate from standard economic theories. The Allais paradox refers to a preference reversal in which individuals change their choices between two options based on the presentation of a third, irrelevant option. The Ellsberg paradox refers to individuals’ tendency to behave irrationally in ambiguous situations, often showing preference for known risks over unknown risks. These paradoxes demonstrate the limits of traditional economic models and highlight the importance of considering psychological factors in decision-making.
(b) Forwards and Futures
Ans: Forwards and futures are financial contracts used to hedge against or speculate on price changes in underlying assets. A forward contract is a customized, privately negotiated agreement between two parties to buy or sell an asset at a specified future date and price. Futures are standardized contracts traded on an exchange, with a pre-determined expiration date and price, and the obligation to buy or sell the underlying asset at that price. Both are used for price discovery, risk management, and speculation. However, futures have the added advantage of being traded on a regulated exchange, providing greater standardization, transparency and liquidity compared to forwards.
(c) Systematic risk and non-systematic risk
Ans: Systematic risk and non-systematic risk are two types of financial risk that affect investments. Systematic risk, also known as market risk, is the risk inherent in the entire market and affects all investments. This type of risk is related to macroeconomic factors, such as changes in interest rates, inflation, or political events. It cannot be diversified away through portfolio management. Non-systematic risk, also known as specific risk or diversifiable risk, is unique to a particular investment or company and arises from factors such as management decisions, competition, or industry-specific events. This type of risk can be reduced through diversification, as it affects only a portion of a portfolio.
7) Write short notes on the following.
(a) Hedge Funds
Ans: Hedge Funds: Hedge funds are alternative investment vehicles that use a variety of strategies to generate returns that are uncorrelated with the broader market. These strategies often involve taking on higher levels of risk, leveraging their investments, and using complex financial instruments such as derivatives. Hedge funds are typically open to a limited number of accredited investors, such as high net worth individuals, and are less regulated than traditional investment vehicles like mutual funds. The goal of hedge funds is to deliver absolute returns, meaning they aim to generate positive returns regardless of market conditions. However, this approach also means that hedge funds can be subject to large losses during market downturns.
(b) Internal Rate of Return
Ans: Internal Rate of Return (IRR) is a commonly used metric to evaluate the profitability of an investment. It is defined as the discount rate that makes the present value of future cash flows equal to the initial investment. IRR provides a single metric for comparing investments with different durations, cash flows and investment costs. IRR is a valuable tool for financial decision-making as it helps investors compare the expected returns from different investments and make informed decisions about where to allocate capital. However, IRR has its limitations, such as difficulty in comparing investments with non-uniform cash flows, and sensitivity to changes in the underlying assumptions. It is important to consider IRR in conjunction with other financial metrics, such as net present value (NPV) and payback period.
(c) Hypothesis testing.
Ans: Hypothesis testing is a statistical method used to determine the validity of a claim or hypothesis about a population parameter based on sample data. The process involves formulating a null hypothesis (the default assumption that the claim is not true) and an alternative hypothesis (the claim being tested), selecting a sample from the population, calculating a test statistic, and making a decision about whether to accept or reject the null hypothesis based on a pre-determined level of significance. The outcome of the hypothesis test is used to make inferences about the population parameter. Hypothesis testing is used in various fields, including scientific research, medical studies, and business analysis, to test claims and make informed decisions based on data.
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For June Examination: 31st April, For December Examination: 30th October