BECE-144: FINANCIAL ECONOMICS solved assignment

 BECE-144: FINANCIAL ECONOMICS solved assignment

1) Explain the significance of the financial system. What are important functions of financial institutions? 

Ans.

Significance of the Financial System & Functions of Financial Institutions

1. Significance of the Financial System

A financial system refers to the institutions, markets, instruments, and regulations that facilitate the flow of funds between savers and borrowers. It plays a crucial role in economic growth and stability.

Key Importance:

✅ Mobilization of Savings – Channels funds from savers to productive investments.
✅ Efficient Allocation of Resources – Directs capital to the most profitable ventures.
✅ Economic Growth – Facilitates investment in industries and infrastructure.
✅ Liquidity & Risk Management – Provides mechanisms like insurance, hedging, and diversification.
✅ Monetary Stability – Supports the implementation of monetary policies by central banks.

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2. Important Functions of Financial Institutions

Financial institutions (e.g., banks, insurance companies, stock markets) perform essential functions in the economy.

1. Intermediation Function

• Connect savers and borrowers, ensuring efficient capital allocation.
• Example: Banks accept deposits and provide loans to businesses.

2. Liquidity Provision

• Ensure that individuals and firms can convert assets into cash easily.
• Example: ATMs, money markets, and stock exchanges.

3. Risk Management

• Provide financial instruments to hedge risks (e.g., insurance, derivatives).
• Example: Life insurance policies, futures contracts.

4. Credit Creation

• Banks create credit by lending more than their deposits, fueling economic activity.
• Example: Home loans, business financing.

5. Facilitating Payments & Settlements

• Ensure smooth transactions through banking networks, digital payments, and clearing systems.

Example: Credit cards, UPI, SWIFT for international transactions.

 2) What are the important features of fixed income securities? 

Ans.

Important Features of Fixed Income Securities

1. Fixed Interest Payments

• Pays a fixed or pre-determined interest (coupon) at regular intervals.
• Example: A corporate bond with a 5% annual coupon pays $50 annually on a $1,000 bond.

2. Maturity Date

• Fixed income securities have a specific maturity date when the principal is repaid.
• Short-term (<1 year), Medium-term (1-10 years), Long-term (>10 years).

3. Face Value (Par Value)

• The amount the issuer agrees to repay at maturity.
• Example: A bond with a par value of $1,000 means investors receive $1,000 at maturity.

4. Credit Risk

• The risk that the issuer may default on interest or principal payments.
• Government bonds (e.g., U.S. Treasury bonds) are low risk, while corporate bonds have higher risk.

5. Market Price Fluctuations

• Prices of fixed income securities change with interest rates and market conditions.
• Inverse relationship: When interest rates rise, bond prices fall, and vice versa.

6. Liquidity

• Some securities (e.g., Treasury bills) are highly liquid, while others (e.g., corporate bonds) may have lower liquidity.

7. Callability (Callable Bonds)

• Some bonds are callable, meaning the issuer can redeem them before maturity.
• Example: A company may call a bond if interest rates drop to refinance at a lower rate.

8. Inflation Risk

• Fixed payments may lose purchasing power over time if inflation rises.
• Inflation-protected securities (e.g., TIPS) adjust for inflation.

3) Briefly discuss expected utility theory of decision-making  

Ans.

Expected Utility Theory of Decision-Making

1. Definition:

Expected Utility Theory (EUT) is a framework used in economics and decision theory to model how individuals make choices under uncertainty. It suggests that people choose the option that maximizes their expected utility, rather than simply maximizing expected monetary value.

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2. Key Assumptions:

1. Rationality – Individuals act rationally to maximize their utility.
2. Probability-Weighted Outcomes – Decisions are based on the probability of different outcomes.
3. Diminishing Marginal Utility – Additional wealth provides less additional satisfaction (risk aversion).
4. Independence of Irrelevant Alternatives – Preferences remain consistent regardless of other options.

3. Importance & Applications:

✅ Used in investment decisions (e.g., stock vs. bonds).
✅ Helps in insurance (people buy insurance due to risk aversion).
✅ Applied in public policy and behavioral economics.

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6. Limitations:

❌ Real-world deviations – People often don't behave rationally (e.g., loss aversion).
❌ Overlooks emotions – Doesn't fully explain psychological biases.

4) Explain the internal and external determinants that affect the formulation of corporate policy. 

Ans.

Determinants Affecting the Formulation of Corporate Policy

Corporate policy formulation is influenced by a variety of internal and external factors that shape strategic decisions, objectives, and operational guidelines. These factors ensure that corporate policies align with the business environment and long-term goals.

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1. Internal Determinants (Within the Organization)

Organizational Vision and Mission

• The mission statement defines the company's purpose and core values.
• The vision statement sets long-term aspirations, guiding policy decisions.

Leadership and Management Style

• Policies are influenced by the attitudes, expertise, and risk appetite of top executives.
• Autocratic vs. participative leadership styles affect policy-making.

Organizational Structure

• Centralized vs. decentralized structures influence decision-making speed and flexibility.
• Bureaucratic organizations may have rigid policies, while startups adopt flexible policies.

Financial Strength and Resources

• The availability of capital determines investment and expansion policies.

Corporate Culture and Ethics

• Ethical values impact policies on corporate social responsibility (CSR), employee relations, and sustainability.

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2. External Determinants (Outside the Organization)

 Economic Environment

• Interest rates, inflation, GDP growth, and market stability affect financial and pricing policies.

Political and Legal Environment

• Government regulations, labor laws, and trade policies influence corporate decisions.

Technological Advancements

• Rapid technological change forces companies to adapt policies for innovation and competition.

Competition and Industry Trends

• Competitor strategies and market trends push companies to adjust pricing, marketing, and operational policies.

Social and Cultural Factors

• Changing consumer preferences, demographics, and ethical concerns shape corporate policies.

Globalization and Market Expansion

• International trade policies, tariffs, and foreign exchange rates impact expansion policies.

5) What is Debt Securitization? Explain risks attached to debt securitization. 

Ans.

Debt Securitization

Debt securitization is a financial process in which illiquid assets (like loans, mortgages, or receivables) are converted into marketable securities and sold to investors. It helps financial institutions free up capital and transfer credit risk.

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Risks Attached to Debt Securitization

1. Credit Risk (Default Risk)

• Borrowers may default on loan payments, reducing investor returns.
• Example: The 2008 financial crisis was triggered by high mortgage defaults in securitized assets.

2. Liquidity Risk

• In economic downturns, these securities may become illiquid, making them difficult to sell.
• Example: Mortgage-backed securities became unsellable during financial crises.

3. Market Risk

• Changes in interest rates and economic conditions affect the value of securitized assets.
• Rising interest rates may reduce demand for mortgage-backed securities.

4. Moral Hazard

• Banks may issue risky loans since they transfer the risk through securitization.
• Example: Lenders offering subprime mortgages without verifying borrower credibility.

5. Complexity & Transparency Risk

• Some securitized products (e.g., CDOs) are highly complex and lack transparency.
• Investors may misjudge risks, leading to financial instability.

6) Differentiate between: 

(a) Allais paradox and Ellsberg paradox. 

Ans.

Feature	Allais Paradox	Ellsberg Paradox
Concept	Demonstrates that people violate expected utility theory when choosing between certain and probabilistic outcomes.	Demonstrates that people prefer known probabilities over ambiguous probabilities, contradicting expected utility theory.
Key Idea	People tend to overweight certainty (certainty effect) even when the expected utility is lower.	People show ambiguity aversion and prefer known risks over unknown risks.
Example	Choosing between: Option A: $1 million (certain). Option B: 10% chance of $5M, 89% chance of $1M, 1% chance of nothing. People irrationally prefer Option A, even when Option B offers higher expected value.	Choosing between two urns: Urn 1: 50 red & 50 black balls (known probability). Urn 2: 100 balls, but the mix of red and black is unknown. People prefer betting on Urn 1, showing ambiguity aversion.
Bias Explained	Certainty Effect – People overvalue certain outcomes over probabilistic gains.	Ambiguity Aversion – People avoid uncertain outcomes, even when probabilities may be favorable.
Violation of EUT	Shows that people do not evaluate probabilities linearly.	Shows that people avoid unknown probabilities, contradicting rational choice theory.
Real-World Implications	Insurance markets (people overpay for certainty).	Stock markets (investors avoid stocks with uncertain outcomes).

(b) Forwards and Futures 

Ans.

Feature	Forwards	Futures
Definition	A private agreement between two parties to buy/sell an asset at a future date for a pre-agreed price.	A standardized contract traded on exchanges to buy/sell an asset at a future date at a predetermined price.
Trading Venue	Over-the-Counter (OTC) – Privately negotiated.	Exchange-Traded – Standardized contracts.
Customization	Fully customizable (price, quantity, and settlement terms).	Standardized in terms of size, expiration date, and settlement terms.
Regulation	Unregulated (counterparty risk is high).	Highly regulated (reduces counterparty risk).
Settlement	Settled at contract maturity (physical or cash).	Marked-to-market daily (gains/losses settled daily).
Counterparty Risk	High risk due to default possibility (as it's a private contract).	Lower risk since the exchange acts as an intermediary.
Liquidity	Low liquidity (difficult to exit before maturity).	High liquidity (easy to trade on exchanges).
Common Users	Large corporations, institutions, and banks for hedging.	Traders, investors, and institutions for speculation and hedging.
Example	A wheat farmer enters a forward contract with a miller to sell 1,000 kg of wheat at $500 per ton after 3 months.	A trader buys an oil futures contract at $80 per barrel on the Chicago Mercantile Exchange (CME).

(c) Systematic risk and non-systematic risk 

Ans.

Feature	Systematic Risk	Non-Systematic Risk
Definition	Risk that affects the entire market or economy and cannot be eliminated through diversification.	Risk that is specific to a company, industry, or sector and can be reduced through diversification.
Other Names	Market Risk, Undiversifiable Risk.	Specific Risk, Idiosyncratic Risk, Diversifiable Risk.
Causes	Macroeconomic factors like inflation, interest rates, recessions, political instability, and natural disasters.	Firm-specific factors like management decisions, company performance, labor strikes, fraud, or bankruptcy.
Impact	Affects all assets and industries in the economy.	Affects only a particular company or industry.
Can it be Diversified?	No, cannot be eliminated through portfolio diversification.	Yes, can be reduced by holding a well-diversified portfolio.
Example	A global recession impacts all stock markets and industries.	A scandal at a specific company (e.g., Volkswagen’s emissions scandal) affects only that firm’s stock.

7) Write short notes on the following. 

(a) Hedge Funds 

Ans.

Hedge funds are private investment funds that use aggressive strategies like leverage, derivatives, short selling, and arbitrage to generate high returns for their investors. Unlike mutual funds, hedge funds have less regulation and are exclusive to wealthy individuals and institutional investors.

Key Features

• High Risk-High Return – Uses complex strategies for high gains.
• Limited Regulation – Operates with fewer restrictions than mutual funds.
• Exclusive Access – Open only to accredited investors.
• Diverse Strategies – Includes long/short equity, global macro, event-driven, and quantitative strategies.
• High Fees – Charges a 2% management fee and 20% performance fee (commonly known as the "2 and 20" model).

(b) Internal Rate of Return 

Ans.

(c) Hypothesis testing.

Ans.

Definition

Hypothesis testing is a statistical method used to make decisions or inferences about a population based on sample data. It helps determine whether a claim (hypothesis) about a population parameter is likely to be true.

Types of Errors

• Type I Error (False Positive) → Rejecting H0H_0 when it is true.
• Type II Error (False Negative) → Failing to reject H0H_0 when it is false.

Example

A company tests whether a new drug is more effective than the existing one:

• H0: The new drug has no effect.
• H1: The new drug is more effective.
• If p-value < 0.05, reject H0 and conclude the drug is effective.