70044_INDIVIDUAL ASSIGNMENT 2 EBV 3133 MARKET AND FI

FACULTY OF ECONOMICS AND BUSINESS
UNIVERSITI MALAYSIA SARAWAK
94300 Kota Samarahan
Sarawak

Individual Assignment 2

Code / Course : EBV 3133 MARKET AND FINANCIAL SERVICES
Matric No. : 70044
Name : Kalsie Amanda Khang
Semester/Session : 2 / 2021/2022
Due Date : 13 JUNE 2022

Instructions To Students

1. This structure questions consist of FIVE (5) questions.

Answer ALL questions.

2. Please read the questions carefully before answering them.

3. Please provide your answer in Microsoft word format.
• Write full name and matric number in column given
• All answers must be typed written
• Font: Font 12, Times New Roman/ Century Schoolbook, 1.5 spacing.

4. Once completed, save this file and submit by uploading your work through eLEAP
submission link.

5. Submission of plagiarized works or works done by another person or any means of
cheating, partly or fully, will be considered void, and NO marks will be given for
this assignment.

QUESTION 1

Explain why bonds

a. with the same maturity can have different interest rates.

b. with different maturities can have different interest rates.

(3 marks)

Answer:

a.iBondsiwithitheisameimaturityihaveidifferent iinterest irates,iwhichiisireferred itoiasiinterest irate
irisk istructure. iBecause iof idifferences iin idefault irisk, iliquidity, iinformation icosts, iand itaxation,
iinterest irates iand iyields ion icredit imarket iinstruments iof ithe isame imaturity ivary. iThese
ideterminants iare ireferred ito ias ithe irisk istructure iof iinterest irates. iTo ibegin, idefault irisk iis ithe
ilikelihood ithat ia iborrower iwill inot ipayithe ipromised iinterest, iprincipal, ior iboth iin ifull. iThe irisk
ipremium ion ia ifinancial iinstrument iis ithe idifference ibetween iits iyield iand ithe iyield ion ia
icomparable imaturity idefault-risk-free iinstrument. iIn igeneral, ithe ihigher ithe iinterest irate, ithe
ihigher ithe irisk ipremium, iand ithe ihigher ithe idefault irisk. iNext, iliquidity iis iimportant ito
iinvestors ibecause ithey iare iconcerned iabout ithe icost iof iconverting ia ifinancial iinstrument iinto
icash. iAn iincrease iin iliquidity ican imake ian iinstrument imore iappealing ito iinvestors, iwho iwill
ithen iaccept ia ilower irate iof ireturn. iAs ia iresult, ia iless iliquid iasset, iknown ias ian iilliquid iasset,
imust ipay ia ihigher iyield ito icompensate isavers ifor itheir iliquidity isacrifice. iAs ipart iof ithe irisk
ipremium, ithis iliquidity ipremium iis ifrequently icombined iwith idefault irisk. iFurthermore,
iinformation icosts iare iincurred iwhen igathering iinformation inecessitates ithe iuse iof iresources,
ilowering ithe iexpected ireturn ion ia ifinancial iasset. iGovernment ibonds, isuch ias iTreasury ibills,
ihave ithe ilowest iinformation icosts ibecause iall isavers iknow ithe iprincipal iand iinterest iwill ibe
irepaid iwithicertainty (Chen, 2021). iIf ithe iborrowersiare inotiwell iknown,iinformation icostsirise,
iand iresearch imust ibe iconducted ibefore ipotential ilenders iare iwilling ito ibuy ibonds ifrom isuch
iborrowers. iIn iother iwords, ithe ihigher ithe icost iof iinformation, ithe ihigher ithe iinterest irate.
iFinally, iwhether ithe ifinancial iinstrument iis iexempt ifrom itaxation ifor iinterest ipayments ior
icapital igains iinfluences ithe iinstrument's iinterest irate. iIn igeneral, itax-exempt iinstruments ican
iprovide ilower iinterest irates.

b. iThe irelationship ibetween iinterest irates ionibonds ithat iare iotherwise isimilar ibut ihave idifferent
imaturities iis ireferred ito ias iinterest irate istructure. iAs imentioned iby iChen i(2021), ithe iTreasury
iyield icurve idepicts ithe irelationship ibetween ithe iinterest irates ion iTreasury ibonds iof ivarying
imaturities. iWhen ishort-term irates iare ilower ithan ilong-term irates, ithe iyield icurve islopes
iupward. iWhen ishort-term iinterest irates iare ihigher ithan ilong-term iinterest irates, ia idownward-
sloping iyield icurve ioccurs iinfrequently. iThe iterm istructure ishould ibe iable ito iaccount ifor ithree
ifacts: ilong-term ibondiinterest iratesiareiusuallyihigherithanishort-termibondiinterest irates,ishort-
term ibond iinterest irates iare ioccasionally ihigher ithan ilong-term ibond iinterest irates, iand iinterest
irates ion ibonds iof iall imaturities itend ito irise iand ifall itogether. iTo iexplain ifacts, ieconomists ihave
iadvanced ithree itheories iwhich iare iexpectations itheory, isegmented imarkets itheory, iand
iliquidity ipremium itheory ior ipreferred ihabitat itheory. iFirst, iconsider ithe iterm istructure's
iexpectations itheory. iAccording ito iexpectations itheory, ithe iinterest irate ion ia ilong-term ibond iis
ian iaverage iof ithe iinterest irates iinvestors iexpect ion ishort-term ibonds iover ithe ibond's ilifetime.
iThe iterm istructure itheory iof isegmented imarkets ifollows. iAccording ito isegmented imarkets
itheory, itheiinterest irate ion iaibondiofiaispecificimaturityiis idetermined isolelyibyitheidemandiand
isupply iof ibonds iof ithat imaturity. iFurthermore, ithe iliquidity ipremium itheory, ithe imost
icomprehensive itheory iof iterm istructure, iholds ithat ithe iinterest irate ion ia ilong-term ibond iis ian
iaverage iof ithe iinterest irates iinvestors iexpect ion ishort-term ibonds iover ithe ilife iof ithe ilong-term
ibond, iplus ia iterm ipremium ithat iincreases iin ivalue ias ithe ibond imatures.

QUESTION 2

What are the elements in inflation targeting?

(3 marks)

Answer:

Inflation itargeting iis ia irecent imonetary ipolicy istrategy ithat iconsists iof ifive imain icomponents,
ithe ifirst iof iwhich iis ithe ipublic iannouncement iof imedium-term inumerical iinflation itargets.
iFollowing ithat, ian iinstitutional icommitment ito iprice istability ias ithe iprimary igoal iof imonetary
ipolicy, iwith iall iother iobjectives isubordinated. iFurthermore, ian iinformation-inclusive istrategy
iin iwhich imany ivariables, iother ithan imonetary iaggregates ior ithe iexchange irate, iare iused ito
idetermine ipolicy iinstrument isetting. iThen, iincreased itransparency iof ithe imonetary ipolicy
istrategy ithrough icommunication iwith ithe ipublic iand imarkets iabout ithe imonetary iauthorities'
iplans, iobjectives, iand idecisions. iFinally, ithe icentral ibank's iaccountability ifor iachieving iits
iinflation itargets ihas ibeen iincreased. iInflation itargeting istems ifrom ithe irecognition ithat iprice
istability ishould ibe ithe iprimary ilong-run igoal iof imonetary ipolicy, iand ithat ia inominal ianchor iis
ia iuseful itool iin iachieving ithis igoal. iThe ilist ishould iclarify ione iimportant iaspect iof iinflation
itargeting: iit ientails imuch imore ithan ia ipublic iannouncement iof inumerical iinflation itargets ifor
ithe icoming iyear. iThis iis iespecially iimportant iin iemerging imarket icountries ibecause imany iof
ithese icountries iroutinely ireport inumerical iinflation itargets ior iobjectives ias ipart iof ithe
igovernment's ieconomic iplan ifor ithe icoming iyear, idespite ithe ifact ithat itheir imonetary ipolicy
istrategy ishould inot ibe icharacterised ias iinflation itargeting, iwhich irequires ithe iother ifour
ielements ito ibe isustainable iover ithe imedium iterm.

QUESTION 3

Explain how banks manage risk.

(3 marks)

Answer:

Credit irisk iis ithe ibiggest irisk ifor ibanks. iIt ioccurs iwhen iborrowers ior icounterparties ifail ito imeet
icontractual iobligations. iAn iexample iis iwhen iborrowers idefault ion ia iprincipal ior iinterest
ipayment iof ia iloan. iDefaults ican ioccur ion imortgages, icredit icards, iand ifixed iincome isecurities
i(Major Risks for Banks, 2022). iFailure ito imeet iobligational icontracts ican ialso ioccur iin iareas
isuch iasiderivatives iand iguarantees iprovided. iWhile ibanksicannot ibeifullyiprotected ifrom icredit
irisk idue ito ithe inature iof itheir ibusiness imodel, ithey ican ilower itheir iexposure iin iseveral iways.
iSince ideterioration iin ian iindustry ior iissuer iis ioften iunpredictable, ibanks ilower itheir iexposure
ithrough idiversification. iBy idoing iso, iduring ia icredit idownturn, ibanks iare iless ilikely ito ibe
ioverexposed ito ia icategory iwith ilarge ilosses. iTo ilower itheir irisk iexposure, itheyican iloan imoney
itoipeopleiwithigoodicredit ihistories,itransactiwithihigh-qualityicounterparties, ioriownicollateral
ito iback iup ithe iloans.

Besides, imarket irisk imostly ioccurs ifrom ia ibank’s iactivities iin icapital imarkets. iIt iis idue ito ithe
iunpredictability iof iequity imarkets, icommodity iprices, iinterest irates, iand icredit ispreads. iBanks
iare imore iexposed iif ithey iare iheavily iinvolved iin iinvesting iin icapital imarkets ior isales iand
itrading. iCommodity iprices ialso iplay ia irole ibecause ia ibank imay ibe iinvested iin icompanies ithat
iproduce icommodities. iAs ithe ivalue iof ithe icommodity ichanges, iso idoes ithe ivalue iof ithe
icompany iand ithe ivalue iof ithe iinvestment. iChanges iin icommodity iprices iare icaused iby isupply
iand idemand ishifts ithat iare ioften ihard ito ipredict. iSo, ito idecrease imarket irisk, idiversification iof
iinvestments iis iimportant. iOther iways ibanks ireduce itheir iinvestment iinclude ihedging itheir
iinvestments iwith iother, iinverselyirelated iinvestments. i

Moreover, iliquidity irisk irefers ito ithe iability iof ia ibank ito iaccess icash ito imeet ifunding
iobligations. iObligations iinclude iallowing icustomers ito itake iout itheir ideposits. iThe iinability ito
iprovide icash iin ia itimely imanner ito icustomers ican iresult iin ia isnowball ieffect. iIf ia ibank idelays
iproviding icash ifor ia ifew iof itheir icustomer ifor ia iday, iother idepositors imayirush ito itake iout itheir
ideposits ias ithey ilose iconfidence iin ithe ibank. iThis ifurther ilowers ithe ibank’s iability ito iprovide
ifundsiandileads itoiaibank irun.iReasons ithatibanks ifaceiliquidityiproblems iincludeiover-reliance

ion ishort-term isources iof ifunds, ihaving ia ibalance isheet iconcentrated iin iilliquid iassets, iand iloss
iof iconfidence iin ithe ibank ion ithe ipart iof icustomers. iMismanagement iof iasset-liability iduration
icanialsoicauseifundingidifficulties. iThisioccursiwheniaibankihasimanyishort-term iliabilitiesiand
inot ienough ishort-term iassets. iShort-term iliabilities iare icustomer ideposits ior ishort-term
iguaranteed iinvestment icontracts i(GICs) ithat ithe ibank ineeds ito ipay iout ito icustomers i(Major
Risks for Banks, 2022). iIf iall ior imost iof ia ibank’s iassets iare itied iup iin ilong-term iloans ior
iinvestments, ithe ibank imay iface ia imismatch iin iasset-liability iduration. iRegulations iexist ito
ilessen iliquidityiproblems. iTheyiinclude ia irequirement ifor ibanks itoihold ienough iliquid iassets ito
isurvive ifor ia iperiod iof itime ieven iwithout ithe iinflow iof ioutside ifunds.

QUESTION 4

Discuss the most important factors in building an investment portfolio.

(3 marks)

Answer:

The imost iimportant ifactors iin ibuilding ian iinvestment iportfolio iare iby iunderstanding ivarious
ifactors. iBefore istarting itoibuildianieffective ifactor-based iinvestment iportfolio, iyou ineeditoifirst
igain ian iin-depth iunderstanding iof ivarious ifactors. iEquity ifactors iare irelated ito ithe icompany’s
isize ias iwell ias istyle i(growth ior ivalue). iRisk ifactors iinclude ithose, iwhich ican iexplain irisks iand
ireturns. iFixed iincome ifactors iconsist iof icredits, iinterest irates, iand iprepayment irisks. iBesides,
ifactors ialso iinclude ivarious imacroeconomic ivariables, ifor iexample, iinflations iand icommodity
iprices (Benson & Jackson, 2021). iNextiis idiligent irevising. iUnderstand ithe ifactor iexposures iin
iterms iofiaipreviouslyideterminediinvestment iportfolio iandireviseiyourifactoriallocationiprocess
iaccordingly. iThis iis ia isimple imethodologyithat iwill iassist iyou iin igaining ia igreat iunderstanding
iof ithe ifactor iexposures. iThen, iassessing ithe irisks/risk-based iallocation imethod. iBy ichoose ithe
imodel ithat ican ianalyze iyour iportfolio irisk iexposures ias iwell ias ican iproject ifuture irisks. iBy
iusing ithe irisk idecomposition imethod, iyou ican iidentify ihow imuch iand iwhat itypes iof irisks iare
ipresent iin iyour iportfolio. iBesides, iassessing ithe iperformance/result-based iallocation imethod
iwhich ichoose ithe iattributes ithat ican iexplain ithe isources iof iyour ireturns ifrom ithe iportfolio.
iAlways ifollow ia ireturn-oriented iapproach iwhile ibuilding iinvestment iportfolios ibecause ithis
iwill iallow iyou ito ianalyze iits ifuture iperformance. iFurthermore, ifactor itilting imethod. iThis iis
iprobably ithe imost iwidely iused imethod iwhile icreating iportfolios. iIn ithis imethod, iyou ineed ito
iactively itweak iyour iportfolio’s iexposure ito icertain ifactors. iThe iprocess iof itweaking iwill ibe
icarried iout ion ithe ibasis iof iexisting ifactor iallocation. iThen, iequally-weighted iportfolio. iThis iis
ione iof ithe imost ipopular ifactor iallocation istrategies ithat ifollows ia irule idenoted. iThis irule
iassigns iequal itime-invariant iweights ito ieach ione iof ithe ifactors. i iMoreover, iempirical ianalysis
iofifactors.iWithitheihelpiofivariousistatisticsiandiconditionalianalysis iofitheidata,iyouicanicheck
iout iwhether ior inot iyour ifactors iare irobust ito ioutperform iin ithe imarket (How to Build a Factor-
Based Investment Portfolio?, 2020).iIfiyourifactors ifail iinisuchitypesiofirobust ichecks,itheniyou
ican itry ioptimizing ior iadjusting ithem iaccording ito iyour irequirements. iLastly, imixed iallocation
imethods. iIf iyou ifeel ithat ione imethod iis inot iproviding iyou iwith ioptimum iresults, ithen iyou ican
ialso icombine itwo ior imore imethods ito ifollow ia imore idiversified iapproach iwhile icreating iyour

iportfolio. iA imixed-method istrategy iwill icertainly idouble ithe ipositive ioutcomes ias iwell ias ithe
ieffectiveness iof iyour iportfolio.

QUESTION 5

Explain how markets for foreign exchange operate.

(3 marks)

Answer:

The iforeign iexchange imarket iworks ithrough ifinancial iinstitutions, iand iit ioperates ion iseveral
ilevels. iMost ipeople iand ifirms iwho iare iexchanging ia isubstantial iquantity iof icurrency igo ito ia
ibank, iand imost ibanks iprovide iforeign iexchange ias ia iservice ito icustomers (Amadeo, 2022).
iForeign iexchangeitradingiis iaicontract ibetween itwoiparties. iThereiareithreeitypes iofitrades. iThe
ispot imarket iis ifor ithe icurrency iprice iat ithe itime iof ithe itrade. iThe iforward imarket iis ian
iagreement ito iexchange icurrencies iat ian iagreed-upon iprice ion ia ifuture idate. iA iswap itrade
iinvolves iboth. iDealers ibuy ia icurrency iat itoday's iprice ion ithe ispot imarket iand isell ithe isame
iamount iin ithe iforward imarket. iThis iway, ithey ihave ijust ilimited itheir irisk iin ithe ifuture. iNo
imatterihowimuchitheicurrencyifalls, itheyiwillinotiloseimoreithanitheiforwardiprice.iMeanwhile,
itheyican iinvest ithe icurrency itheyibought ion ithe ispot imarket. i

For iexample, iforex itrading iis ione iof ithe iforeign iexchanges iin iMalaysia. iForex iis iderived ifrom
ithe iwords iof iforeign icurrency iand iexchange. iForex iexchange imarket, ialso iknown ias iFX, iis ia
iglobal imarketplace ifor iexchanging ione inational icurrency ifor ianother ito igain ia iprofit; iit iis
iusuallyiexchanged ias ipairs (Hudson, n.d.). iIn ia iworld iwhere iinternational itrade iis inecessaryito
idevelop iand isurvive, icurrencies iare iconsidered ia istandard iin iinternational ibusiness iand iare
iexchanged iin iorder ito iconduct iforeign itrade iand ibusiness. iIn iother iwords, iforex iis ithe ipractice
iofitradingicurrencyiforiprofit. iSomeireal iexamples ioficurrencyiexchange i(butinotiforex)iare,ifor
iexample, iifiyou itravel ito ithe iUnitediKingdom, iyou iwouldn’t ibeiableitoibuyigoods ioriservices iin
ithe iMalaysian iRinggit i(MYR) ibecause iit iis inot ithe ilocally iaccepted icurrency, iand iyou iwill,
iinstead, ineeditoiuseitheiBritish iPound. iTheisameimethod iapplies itoie-commerce itransactions ias
iwell. iIf iyou ibuy ia iset iof imakeup ifrom iSouth iKorea, iyou iwill ineed ito ibuy iit ithrough ithe ilocally
iaccepted icurrency iwhich iis ithe iSouth iKorea iwon. iHowever, iforex itrading iis ialso ia ipopular
iform iof iinvesting ifor iprivate icitizens, ior ialso icalled iretail itraders. iAs imentioned iin iCompare
iHero i(2022), iretail itraders, icompanies, ibanks iand iinstitutions iinteract iin ia imarket ivery isimilar
ito ithe istock imarket. iBut iinstead iof ibuying ia islice iof ia icompany, iyou iexchange icurrencies iacross
idifferent icountries. iAs itraders, iwhat ithey ido iis ithey itake iadvantage iof ithe ismall iprice

imovements ito imake ia iprofit iout iofithat idifference iin imovements iover iailong iperiod iofitime ioria
ishort iperiod iof itime. iFor iexample, ithat ifluctuation ibetween ithe iMalaysian iRinggit iand ithe
iSingapore iDollar iit ichanges ievery iday, iso iinstead iof ijust ichanging iit ito ibuy igoods iand iitems,
ithey ichange iit iover iand iover iagain ito itry ito imake ia iprofit iout iof iit (How the Foreign Exchange
Market Works, n.d.). iHence, iaiuniqueifact iaboutiforex iisithatithereiisinoicentral imarketplace ifor
iforeign iexchange. iBecause iit iis idecentralised, iit iinstead, itrades ielectronically iover-the-counter
i(OTC), imeaning iall itransactions iare iconducted ivia icomputer inetworks ibetween itraders iaround
ithe iworld, irather ithan ion ione icentralised iexchange.

References

Amadeo, K. (2022, January 20). Foreign Exchange Market. Retrieved from The Balance:
https://www.thebalance.com/foreign-exchange-market-3306088

Ask The Expert: A Beginner’s Guide To Forex Trading – How Does Forex Trading Work in
Malaysia? (2022, March 1). Retrieved from Compare Hero:
https://www.comparehero.my/money-tips/articles/forex-trading

Benson, A., & Jackson, A.-L. (2021, December 10). Investment Portfolio: What It Is and How
to Build a Good One. Retrieved from Nerd Wallet:
https://www.nerdwallet.com/article/investing/investment-portfolio

Chen, J. (2021, December 12). Term Structure Of Interest Rates. Retrieved from Investopedia:
https://www.investopedia.com/terms/t/termstructure.asp

How the Foreign Exchange Market Works. (n.d.). Retrieved from Principles of
Macroeconomics 2E: https://opentextbc.ca/macroeconomics2eopenstax/chapter/how-
the-foreign-exchange-market-
works/#:~:text=Firms%20that%20buy%20and%20sell,nation%20where%20their%20
sales%20happened.

How to Build a Factor-Based Investment Portfolio? (2020, December 22). Retrieved from
Wealthface Blog: https://wealthface.com/blog/how-to-build-a-factor-based-
investment-portfolio/

Hudson, D. (n.d.). Foreign Exchange Market. Retrieved from Britannica:
https://www.britannica.com/topic/foreign-exchange-market

Major Risks for Banks. (2022, January 27). Retrieved from Corporate Finance Institute:
https://corporatefinanceinstitute.com/resources/knowledge/finance/major-risks-for-
banks/