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ASSIGNMENT SOLUTIONS GUIDE (2014-2015)

M.E.C.-4
Economics of Growth and Development
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SECTION-A
Q. 1. Describe the nature of the financial system in a modern economy giving the important types of constituent
institutions, markets and instruments. Explain the concept of flow-of-funds in the financial markets.
Ans. Financial systems are crucial to the allocation of resources in a modern economy. They channel household
savings to the corporate sector and allocate investment funds among firms; they allow intertemporal smoothing of
consumption by households and expenditures by firms; and they enable households and firms to share risks. These
functions are common to the financial systems of most developed economies. Yet the form of these financial systems
varies widely.
Financial systems depend on the countries viewpoint on freedom of trade. Some countries i.e. The Soviet Union had
socialist financial systems because they value centralized organized state funded trading rather than freedom of trade by
everyone.
Nevertheless, one point needs to be made clearly. When the crisis did hit, the banks did require public sector support.
The Government implemented both retail and wholesale funding guarantees to preserve confidence in the banking system,
while the Reserve Bank expanded its liquidity facilities in order to ensure that banks remained liquid and well-funded.
The financial crisis revealed a major limitation in the banks business model that lay behind the rapid expansion in credit
during the lead-up to the financial crisis - a tendency to fuel much of that lending primarily through short-term wholesale
funding from offshore.
Any modern financial system contributes to economic development and the improvement in living standards by
providing various services to the rest of the economy. These include clearing and settlement systems to facilitate trade,
channelling financial resources between savers and borrowers, and various products to deal with risk and uncertainty.
In principle, these various functions can be provided by banks or other financial institutions or directly through
capital markets. Banks and other financial intermediaries exist because they are an efficient response to the fact that
information is costly. Banks specialize in assessing the credit worthiness of borrowers and providing an ongoing monitoring
function to ensure borrowers meet their obligations. They are rewarded for these services by the spread between the rates
they offer to the accumulated pool of savers, and the rates they offer to potential borrowers. This process is known as
maturity transformation and is at the heart of modern banking. Banks offer a repository for savings, and then transform
them into long-lived (illiquid) assets housing loans and lending to businesses. In addition, banks play a role in providing
payment and settlement services which are necessary for households, business and other financial institutions to settle
day-to-day transactions.
A financial instrument is the written legal obligation of one party to transfer something of value, usually money, to
another party at some future date, under certain conditions.
This is a mouthful, but breaking it down, we see several key features. First, this is a binding, enforceable contract
under the rule of law, protecting potential buyers. Second, there is the transfer of value between two parties, where a party

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can be a bank, insurance company, a government, a firm, or an individual. The future dates may be very specific (like a
monthly mortgage payment) or may be quite uncertain and depend on certain events (like an insurance policy).
Financial instruments, like money, can function as a means of payment or a store of value. As a means of payment,
financial instruments fall well short of money in terms of liquidity, divisibility and acceptance. However, they are considered
better stores of value since they allow for greater increases in wealth over time, but with higher levels of risk. A third
function of these instruments is risk transfer. For certain instruments, buyers are shifting risk to the seller, and are basically
paying the seller to assume certain risks. Insurance policies are a prime example of this.
There is not one financial market, but rather many markets, each dealing with a particular type of financial instrument.
But all financial markets perform crucial functions. By providing a mechanism for quickly and cheap buying and selling
of securities, financial markets offer liquidity. Financial markets allow the interaction of buyers and sellers to determine
the price and the price conveys important information about the prospects of the issuer. Finally, financial markets are the
mechanism for buying and selling the instruments that transfer risks between buyers and sellers.
A set of accounts that is used to follow the flow of money within various sectors of an economy. Specifically, the
account analyzes economic data on borrowing, lending and investment throughout sectors like households, businesses
and farms. The accounts are tracked and analyzed by a countrys central bank. In the United States, this is done by the
Federal Reserve Bank, and the findings are provided approximately 10 weeks after the end of a quarter.
The FOF accounts are used primarily as an economy-wide performance indicator. The data from the FOF accounts
can be compared to prior data to analyze the financial strength of the economy at a certain time and to see where the
economy may go in the future. The accounts can also be used by governments to formulate monetary and fiscal policy.
Q. 2. Discuss the Markowitz theory of efficient portfolio selection. How does the CAPM theory build on it?
Ans. Modern Portfolio Theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for
a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing
the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its
creators won a Nobel memorial prize for the theory, in recent years the basic assumptions of MPT have been widely
challenged by fields such as behavioral economics.
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection
of investment assets that has collectively lower risk than any individual asset. This is possible, intuitively speaking,
because different types of assets often change in value in opposite ways. For example, to the extent prices in the stock
market move differently from prices in the bond market, a collection of both types of assets can in theory face lower
overall risk than either individually. But diversification lowers risk even if assets returns are not negatively correlatedindeed, even if they are positively correlated.
More technically, MPT models an assets return as a normally distributed function (or more generally as an elliptically
distributed random variable), defines risk as the standard deviation of return, and models a portfolio as a weighted
combination of assets, so that the return of a portfolio is the weighted combination of the assets returns. By combining
different assets whose returns are not perfectly positively correlated, MPT seeks to reduce the total variance of the
portfolio return. MPT also assumes that investors are rational and markets are efficient.
The fundamental concept behind MPT is that the assets in an investment portfolio should not be selected individually,
each on its own merits. Rather, it is important to consider how each asset changes in price relative to how every other asset
in the portfolio changes in price.
Investing is a tradeoff between risk and expected return. In general, assets with higher expected returns are riskier.
The stocks in an efficient portfolio is chosen depending on the investors risk tolerance, an efficient portfolio is said to be
having a combination of at least two stocks above the minimum variance portfolio. For a given amount of risk, MPT
describes how to select a portfolio with the highest possible expected return. Or, for a given expected return, MPT
explains how to select a portfolio with the lowest possible risk (the targeted expected return cannot be more than the
highest-returning available security, of course, unless negative holdings of assets are possible.)
Therefore, MPT is a form of diversification. Under certain assumptions and for specific quantitative definitions of
risk and return, MPT explains how to find the best possible diversification strategy.
MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical
modeling of finance. Since then, some theoretical and practical criticisms have been leveled against it. These include
evidence that financial returns do not follow a Gaussian distribution or indeed any symmetric distribution, and that
correlations between asset classes are not fixed but can vary depending on external events (especially in crises). Further,

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there remains evidence that investors are not rational and markets may not be efficient. Finally, the low volatility anomaly
conflicts with CAPMs trade-off assumption of higher risk for higher return. It states that a portfolio consisting of low
volatility equities (like blue chip stocks) reaps higher risk-adjusted returns than a portfolio with high volatility equities
(like illiquid penny stocks). A study conducted by Myron Scholes, Michael Jensen, and Fischer Black in 1972 suggests
that the relationship between return and beta might be flat or even negatively correlated.
The CAPM is a model that derives the theoretical required expected return (i.e., discount rate) for an asset in a
market, given the risk-free rate available to investors and the risk of the market as a whole. The CAPM is usually expressed:
E(Ri) = Rf + i (E(Rm) Rf )
Beta, is the measure of asset sensitivity to a movement in the overall market; Beta is usually found via regression
on historical data. Betas exceeding one signify more than average riskiness in the sense of the assets contribution
to overall portfolio risk; betas below one indicate a lower than average risk contribution.
(E(Rm) Rf ) is the market premium, the expected excess return of the market portfolios expected return over the
risk-free rate.
SECTION-B
Q. 3. Explain the Arbitrage Pricing Theory.
Ans. As its name implies, the Arbitrage Pricing Theory, or APT, describes a mechanism used by investors to identify
an asset, such as a share of common stock, which is incorrectly priced. Investors can subsequently bring the price of the
security back into alignment with its actual value.
The Arbitrage Pricing Theory Model: The APT model was first described by Steven Ross in an article entitled The
Arbitrage Theory of Capital Asset Pricing, which appeared in the Journal of Economic Theory in December 1976. The
Arbitrage Pricing Theory assumes that each stocks (or assets) return to the investor is influenced by several independent
factors.
The APT Formula: Furthermore, Ross stated the return on a stock must follow a very simple relationship that is
described by the following formula:
Expected Return = rf + b1 (factor 1) + b2 (factor 2)... + bn (factor n)
Where:
rf = the risk free interest rate, which is the interest rate the investor would expect to receive from a risk-free
investment. Typically, U.S. Treasury Bills are used for U.S. dollar calculations, while German Government bills
are used for the Euro
b = the sensitivity of the stock or security to each factor
factor = the risk premium associated with each entity
The APT model also states the risk premium of a stock depends on two factors:
The risk premiums associated with each of the factors described above
The stocks own sensitivity to each of the factors; similar to the beta concept
Risk Premium = r rf = b(1) (r factor(1) rf) + b(2) (r factor(2) rf)... + b(n) (r factor(n) rf)
If the expected risk premium on a stock were lower than the calculated risk premium using the formula above, then
investors would sell the stock. If the risk premium were higher than the calculated value, then investors would buy the
stock until both sides of the equation were in balance. Arbitrage is the term used to describe how investors could go about
getting this formula, or equation, back into balance.
Factors Used in the Arbitrage Pricing Theory: Its one thing to describe the APT theory in terms of simple formulas,
but its another matter entirely to identify the factors used in this theory. Thats because the theory itself does not tell the
investor what those factors are for a particular stock or asset, and for a very good reason. In practice, and in theory, one
stock might be more sensitive to one factor than another. For example, the price of a share of Exxon Mobil might be very
sensitive to the price of crude oil, while a share of Colgate Palmolive might be relatively insensitive to the price of oil.
In fact, the Arbitrage Pricing Theory leaves it up to the investor, or analyst, to identify each of the factors for a
particular stock. Therefore, the real challenge for the investor is to identify three items:
Each of the factors affecting a particular stock
The expected returns for each of these factors
The sensitivity of the stock to each of these factors
Identifying and quantifying each of these factors is no trivial matter, and is one of the reasons the Capital Asset
Pricing Model remains the dominant theory to describe the relationship between a stocks risk and return.

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Keeping in mind the number and sensitivities of a stock to each of these factors is likely to change over time, Ross
and others identified the following macro-economic factors they felt played a significant role in explaining the return on
a stock:
Inflation
GNP or Gross National Product
Investor Confidence
Shifts in the Yield Curve
With that as guidance, the rest of the work is left to the stock analyst.
Q. 4. Explain the need for, and role of depository systems in secondary markets. Explain the concept of custodial
services.
Ans. The traditional system of dealing in shares involves dealing in Share Certificates with enormous paper work,
getting the certificate duly endorsed in the buyers name which is complex, time consuming and also involves various
problems not only of bad deliveries of shares but also loss of share certificates in transit.
In the Depository System, the securities of a Shareholder are held in the electronic form by conversion of physical
securities to electronic form through a process called dematerialization (demat) of share certificates and facilitates
transactions electronically without involving any share certificate or transfer deed.
Here, the transfer of securities takes place by means of electronic book entries. The depository system provides
various other direct and indirect benefits as under :
Bad deliveries are almost eliminated.
The risks associated with physical certificates such as loss, theft, mutilation of certificate etc. are eliminated.
It eliminates handling of huge volumes of paper work involved in filling in transfer deeds and lodging the
transfer documents and Share Certificates with the Company.
There will be immediate transfer and registration of your shares (at the end of every settlement cycle, which is 4
working days i.e. T+3) and you need not have to suffer delays on account of processing time.
It leads to faster settlement cycle and faster realisation of sale proceeds.
There will be a faster disbursement of Corporate benefits like Rights, Bonus, etc.
The stamp duty on transfer of securities, which is 0.25% of the consideration on transfer of shares in physical
form is not applicable and you may incur expenditure towards service charges of the Depository Participant.
There could be a reduction in rates of interest on loans granted against pledge of dematerialized securities by
various banks.
There could be reduction in brokerage for trading in dematerialized securities.
There could be reduction in transaction costs in dematerialised securities as compared to physical securities.
Availability of periodical status report to investors on their holding and transactions.
SEBI has initially prescribed that Financial Institutions, FIIs etc. have to deal with BPC shares only in dematerialized
form, from 1-6-1998. SEBI has later prescribed that all settlements of trades done on Stock Exchanges in BPC shares
must be in dematerialized form. However, the option to investors to hold the shares in physical form will continue.
Depository system is playing a significant role in stock markets around the world and hence has become popular and
prevalent in many advanced countries. In India the National Securities Depository Ltd. (NSDL), promoted by Industrial
Development Bank of India, Unit Trust of India, National Stock Exchange is the first depository and Central Depository
Services (India) Ltd, promoted by The Stock Exchange, Mumbai and Bank of India is another depository.
A custodian bank, or simply custodian, is a specialized financial institutionresponsible for safeguarding a firms or
individuals financial assets and is not engaged in traditional commercial or consumer/retail banking such as mortgage
or personal lending, branch banking, personal accounts, Automated Teller Machines (ATMs) and so forth. The role of a
custodian in such a case would be to:
hold in safekeeping assets/securities such as stocks, bonds, commodities such asprecious metals and currency
(cash), domestic and foreign
arrange settlement of any purchases and sales and deliveries in/out of such securities and currency
collect information on and income from such assets (dividends in the case of stocks/equities and coupons (interest
payments) in the case of bonds) and administer related tax withholding documents and foreign tax reclamation
administer voluntary and involuntary corporate actions on securities held such as stock dividends, stock splits,
business combinations (mergers), tender offers, bond calls, etc.
provide information on the securities and their issuers such as annual general meetings and related proxies

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maintain currency/cash bank accounts, effect deposits and withdrawals and manage other cash transactions
perform foreign exchange transactions
often perform additional services for particular clients such as mutual funds; examples include fund accounting,
administration, legal, compliance and tax support services.
Q. 5. Give a theoretical model of central banking, bringing out the relaitonship between the monetary base
and monetary aggregates. What are instruments of monetary policy used by central banks?
Ans. Central Banking takes a comprehensive look at the topic of central banking, and provides readers with an
understanding and insights into the roles and functions of modern central banks in advanced as well as emerging economies,
theories behind their thinking, and actual operations practices. Central banks also usually oversee the commercial banking
system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on increasing
the amount of money in the state, and usually also prints the national currency, which usually serves as the states legal
tender. Examples include the European Central Bank (ECB) and theFederal Reserve of the United States.
The primary function of a central bank is to manage the nations money supply (monetary policy), through active
duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking
sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended
to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or
fraudulent behavior. Central banks in most developed nations are institutionally designed to be independent from political
interference. Still, limited control by the executive and legislative bodies usually exists.
Economists study the relationships between monetary aggregates and the monetary base on the one hand and
macroeconomic variables on the other. These relationships help forecast changes in economic activity, interest rates, and
inflation. Monetary aggregates are measures of a nations money supply; the monetary base is currency held by the public
and in vaults of depository institutions plus reserves of depository institutions.
Following are the instruments of monetary policy used by Central Bank:
M1: Currency held in the vaults of depository institutions, Federal Reserve Banks and the Treasury + travellers
checks + demand and checkable deposits (except those due to the Treasury and depository institutions) cash items in
collection and Federal Reserve Float.
M2: M1 + savings deposits + money market deposits + time deposits under $100K + money market mutual funds +
retirement accounts
M3: M2 + time deposits $100K and over + depository repurchase agreements + Eurodollar deposits + dollardenominated deposits held at foreign offices of US banks + institutional money market funds
MZM: M2 - small time deposits + institutional money market mutual funds.
Q. 6. Compare the impact of monetary policy under fixed exchange rates with those under flexible exchange
rates.
Ans. Unanticipated changes in monetary policy will produce both price (substitution) and income effects. For example,
suppose monetary authorities begin a program of expansionary (easy) monetary policy.
We would then expect the following sequence of events to occur with regard to the price effect:
Real interest rates will be reduced.
As real interest rates are reduced, domestic financial and capital assets become less attractive as a result of their
lower real rates of return. Foreigners will reduce their positions in domestic bonds, real estate, stocks and other
assets. The financial account (or balance on capital account) will deteriorate as a result of foreigners holding
fewer domestic assets. Domestic investors will be more likely to invest overseas in the pursuit of higher rates of
return.
The reduction in domestic investment by foreigners and the countrys citizens will decrease the demand for the
nations currency and increase the demand for the currency of foreign countries. The exchange rate of the nations
currency will tend to decline.
With no government intervention, the financial account and the current account must sum to zero. As the financial
account declines, the current account will be expected to improve by an equal amount. In other words, the
balance of trade should improve. The countrys export will have become relatively cheaper and imports will be
relatively more expensive.
The effect of an expansionary monetary policy is to lower the exchange rate, weaken the financial account and
strengthen the current account. A restrictive monetary policy would be expected to result in the opposite: a higher exchange
rate, a stronger financial account and a weaker current account (a more negative, or a less positive balance of trade).

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With a program of expansionary (easy) monetary policy, the following sequence of events would be expected to
occur with regard to the income effect:
The domestic GDP will rise.
The rise in domestic GDP will tend to increase the demand for imports. The increase in imports will cause the
current account to deteriorate.
The increase in imports purchased will increase the need to convert domestic to foreign currency. As a result, the
exchange rate of the domestic currency will decrease.
With no government intervention, the financial account must now move toward a surplus as the financial and
current account must sum to zero. Due to the increase in imports, foreigners will now have a surplus of the
nations currency. If foreigners do not use that currency to purchase the countrys exports (which would improve
the current account balance), they will ultimately need to invest that currency in the assets of the domestic
country. This explains why countries such as China and Japan invest large sums in assets such as U.S. Treasuries.
The holders of the U.S. currency must put it to work somewhere! Note that foreign investors are often getting
better rates of return than what might be readily apparent because the value of the domestic currency is falling
relative to their own currency.
In summary, the income effect of expansionary monetary policy tends to lower the domestic currency exchange rate,
weaken the current account and work to improve the financial account. A restrictive monetary policy tends to cause the
opposite due to the income effect. The domestic currency exchange rate increases, the current account improves and the
financial account weakens.
As both price and the income effects of monetary policy move in the same direction regarding their impact on the
exchange rate, it is clear that expansionary (restrictive) monetary policy will lower (raise) the countrys exchange rate.
The effect of monetary policy on the current and financial accounts is not so clear because the price and income effects
move in opposite directions. For example, the price effect of easy money on the current account tends to strengthen it,
while the income effect tends to weaken the current account. Since the effects move in opposite directions, it is not
immediately clear what the ultimate impact will be.
We should note that investors can buy and sell financial assets such as stocks and bonds more quickly than producers
and consumers can sell and buy physical goods. So initially, interest rate (substitution) effects would be expected to
dominate. An unanticipated increase in the money supply will cause the exchange rate to go down, the financial account
to weaken and current account to gain strength. Over time, the income effect will come into play. A rising GDP will cause
both the trade balance and financial account to weaken.
Q. 7. Discuss the concept of leverage for a firm. Discuss important financial and leverage ratios used. Explain
the Mertorn-Miller theorem.
Ans. Leverage can be created through options, futures, margin and other financial instruments. For example, say you
have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could
invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.
Most companies use debt to finance operations. By doing so, a company increases its leverage because it can invest
in business operations without increasing its equity. For example, if a company formed with an investment of $5 million
from investors, the equity in the company is $5 million - this is the money the company uses to operate. If the company
uses debt financing by borrowing $20 million, the company now has $25 million to invest in business operations and
more opportunity to increase value for shareholders.
Leverage helps both the investor and the firm to invest or operate. However, it comes with greater risk. If an investor
uses leverage to make an investment and the investment moves against the investor, his or her loss is much greater than it
wouldve been if the investment had not been leveraged leverage magnifies both gains and losses. In the business world,
a company can use leverage to try to generate shareholder wealth, but if it fails to do so, the interest expense and credit
risk of default destroys shareholder value.
Two of the most popular calculations, the debt ratio and debt-to-equity ratio, rely on information readily available on
the companys balance sheet. To determine the debt ratio, simply divide the firms total liabilities by its total assets:
Debt ratio = Total Liabilities/Total Assets
A figure of 0.5 or less is ideal. In other words, no more than half of the companys assets should be financed by debt.
In reality, many investors tolerate significantly higher ratios. Capital-intensive industries like heavy manufacturing depend
more on debt than service-based firms, for example, and debt ratios in excess of 0.7 are common.

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As its name implies, the debt-to-equity ratio instead compares the companys debt to its stockholder equity. Its
calculated as follows:
Debt-to-equity ratio = Total Liabilities / Stockholders Equity
If you consider the basic accounting equation (Assets Liabilities = Equity), you may realize that these two equations
are really looking at the same thing. In other words, a debt ratio of 0.5 will necessarily mean a debt-to-equity ratio of 1. In
both cases, a lower number indicates a company less dependent on borrowing for its operations.
In Financial Innovations and Market Volatility Merton Miller explains the concept using the following analogy:
Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the
cream and sell it at a considerably higher price than the whole milk would bring. (Thats the analog of a firm selling lowyield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low
butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M
proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the
cream plus the skim milk would bring the same price as the whole milk.

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