FINANCIAL ECONOMICS GENERAL COMMENTS. The following table shows the distribution of candidate by scores: Overall Performance of Candidates

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1 GENERAL COMMENTS FINANCIAL ECONOMICS The following table shows the distribution of candidate by scores: Overall Performance of Candidates Grade Marks No of Candidates % of Candidates Distinction P F F F Total The above table indicates that the overall pass rate is 62%, which is a marked improvement over previous diets pass rate. The candidates should try to sustain this tempo by adequately preparing for the examination rather than just relying on their residual knowledge. They should get exposed to materials on the course, especially materials on some financial institutions which they hitherto were not conversant with. Attempt and Performance of Candidates by s Absolute (and Percentages) Attempt 100 (100) 79 (90) 61 (69) 21 (24) 58 (66) 19 (27) 27 (31) Clear 44 (50) 53 (67) 33 (54) 05 (24) 35 (60) 04 (21) 13 (48) Pass Fail 44 (50) 26 (33) 28 (46) 16 (76) 23 (40) 15 (79) 14 (52)s 1 Indicate which of the following statements are TRUE or FALSE and comment briefly to substantiate the choices made: 16 (i) National (Nominal) rate of interest is real rate of interest minus the rate of inflation. (ii) An expansionary operation by the Central Bank of Nigeria occurs when it sells bonds to the commercial banks and the public in the open market. (iii) In an IS/LM framework, an increase in money supply will make LM curve shift to the right. (iv) In the current account of the Balance of Payments of a country, export of goods and services and the receipt of transfer payments are entered as credit. (v) A bear market, as relates to the Capital Market, is when the prices of stocks are going up and the market is showing confidence (vi) Depreciation of a country s currency reduces the domestic prices of imports and raises the foreign prices of exports of a country trying to correct a disequilibrium in its balance of payments position. (vii) Bankers Acceptance is a money market instrument used to finance international and domestic trade. (viii) A tax is regressive when the percentage of one s income paid as tax goes up as one s income increases. (ix) Under a regime of fixed exchange rate, adjustments to equilibrium occur in the domestic economy via a change in international liquidity. (x) In a closed economy, the larger the level of savings, the larger the level of income. This is the true/false question which tests candidates understanding of concepts, principles and policy issues in several aspects of the syllabus of Financial Economics, domestic financial institutions, international Finance, International Financial Institutions and Economic Theory. It contains ten statements. Candidates are expected to indicate which of them are true or false and then comment to substantiate their choices. Being a compulsory question, it was attempted by all the candidates. However, only 50% of them had a clear pass in it. Majority of them made correct choices but had problem providing satisfactory explanations for their choices. Their knowledge of basic concepts and principles in the course has room for improvement. Candidates should consult relevant and standard textbooks on Financial Economics to improve their performance. It is however important to note that the very first question was faulty. Nominal rate of 17

2 interest was inadvertently written as National rate of interest. It is heartwarming that a few of the candidates pointed it out. Some did not attempt the question at all. It was given to all of them as a bonus so as not to unduly penalise them. i. False. The reverse is the case. Real interest rate is nominal interest rate less the rate of inflation. ii. False. An expansionary open market operation of the CBN is when it buys bonds from commercial banks and makes payments by crediting the accounts of the commercial banks at the CBN. This increases the lending ability of the commercial banks and their capacity to grant credit to customers. iii. True. The LM curve shifts to the right with the increase in the money supply given the demand for money, or due to the decrease in the demand for money. With the increase in money supply, the LM curve shifts to the right to LM 2 which moves the economy to a new equilibrium point E 2. The increase in money supply brings down the interest rate to R 2 from R 1 in the money market. iv. True. The export of goods and services and the receipt of transfer payments are entered as credit in the balance of payments because they represent receipts from foreigners. v. False. A bear market, as relates to the capital market, is when the prices of securities are falling or are expected to fall. vi. False. Depreciation raises the domestic prices of imports and reduces the foreign prices of exports of a country trying to correct disequilibrium in its balance of payments. This makes its imports more expensive and its exports cheaper. vii. True. Bankers Acceptance is a cheque drawn on a bank by an importer or exporter of goods and represents the bankers conditional promise to pay the face value of the note at maturity. viii. False. A tax is regressive when people with smaller incomes pay a greater percentage of their incomes as tax compared to people relatively better off, i.e. people with higher incomes. ix. True. It is a characteristic of the fixed exchange rate mechanism that government must possess enough international reserves for adjustment purposes. x. False. In a closed economy, savings constitute a leakage out of the income flow. The larger it is, the larger the leakage and therefore the smaller the income will be. Note: Award 2.5 marks for each correct response. 2 (a) Define monetary policy and explain the main instruments used to regulate money supply in the economy. What are the macroeconomic goals of monetary policy in Nigeria? The question requires a definition of monetary policy and an identification of the instruments used to regulate money supply. The second part of the question requires a discussion of the macroeconomic goals that the instruments of monetary policy are meant to achieve. It was the most popular question outside the compulsory question. The pass rate was 67%. Most candidates were at home with the identification and discussion of the instruments of monetary policy. However, most of them lost marks in the second part. They demonstrated poor understanding of macroeconomic objectives. (a) Monetary policies are those measures taken by the monetary authorities to control the cost, quantity and directions of credit in the economy to achieve macroeconomic objectives. (2 Marks) 18 19

3 The main instruments used to regulate money supply in the economy are as follows: (i) Open Market Operations: This involves the buying and selling of government bonds, treasury bills and other securities in the open market (to and from commercial banks, individuals and other interested institutions). If for any reason, the Central Bank decides to reduce the amount of money in circulation, it would sell treasury bills in the open market. The intended effect will be to reduce banks reserves and therefore reduce their ability to create credit. (v) specified institutions to mop up excess liquidity from such institutions. The effect is that the special deposit or stabilisation securities would reduce the cash reserves and reduce credit creation. Selective Credit Control: Apart from the controls that aim at regulating credit creation and controlling money stock, the CBN can also monitor the economy by giving directives to banks on priorities to follow in virtually all areas of their operations. Examples include sectoral allocation of credit, imposition of credit ceiling, etc. (ii) (iii) (iv) The Manipulation of the Rediscount Rate (Bank Rate): The rediscount rate is the interest rate charged by the Central Bank whenever it discounts bills for commercial banks. If the CBN aims at reducing money supply, it raises the rediscount rate. This increases the cost of borrowing by the Commercial Banks. Since the latter are profit maximisers, they will not only curtail the number of bills rediscounted at the CBN, but will also raise their own rate of interest. The effect is to reduce lending and credit expansion. Legal Reserve Ratio: This is a measure through which the CBN exercises considerable control over the cash and other reserves of banking institutions. It is the proportion of liquid assets to deposit liabilities that must be maintained by banks. When the Central Bank wants to reduce the money supply using the reserve ratio, it will only need to adjust the ratio upwards. The increase in reserve ratio will curtail lending activities. The reverse will be the case if the CBN intends to expand money supply. Special Deposits and Stabilization securities: This is one of the modern methods of controlling money supply designed to supplement the traditional techniques. If the CBN wants to reduce money supply, it may impose a special deposit of say 2% on banks and this would oblige banks to keep 2% of their total deposit liabilities with the CBN in a special account. Alternatively, the CBN issues stabilisation securities to 20 (vi) Moral Suasion. This is simply exhortation or an expectation by the CBN that banks would reason along with it, appreciate the needs of the economy and regulate their activities accordingly. (3 x 5 = 15 marks) Macroeconomic goals of Monetary Policy in Nigeria. i. Full Employment: To achieve a high level of human and physical resources utilization, i. e. employment of about 94% of those seeking employment. ii. Price Stability: Prevention of upward movement of prices (inflation) or downward movement of prices (deflation). iii. Economic Growth: Expansion of the productive capacity of the economy to generate increased flow of goods and services. iv. Achieving Balance of Payments Equilibrium: Promotion of a debt-free and self-reliant economy. v. Equitable Distribution of Income and Wealth: This is to ensure that every citizen has access to the basic necessities of life and reduce the gap between the income of the rich and the poor. vi. Increased Industrialisation. To achieve an increase in the rate of industrialisation and employment in the economy. (2 x 4 = 8 marks. ) 21

4 3 (a) What is deposit insurance? Discuss the roles of the Nigeria Deposit Insurance Corporation (NDIC) in the Nigerian economy. The question requires a definition of what deposit insurance is and the role of the NDIC in the Nigerian economy. The question was popular, having been attempted by 69% of the candidates. However, the pass rate was only 54%. Many of the candidates could not define the concept of deposit insurance correctly. Interestingly, many of them knew only the deposit insurance role of the NDIC, oblivious of the regulatory and supervisory roles of the institution. (a) Deposit insurance is a process aimed primarily at protecting depositors from bank failures by guaranteeing a minimum deposit repayment thereby promoting public confidence in the banking industry. The roles of the Nigeria Deposit Insurance Corporation (NDIC) in the Nigerian economy are: i. Provision of deposit insurance services to financial institutions. The Corporation is required to insure all deposit liabilities of licensed banks and non-bank deposit taking financial institutions in Nigeria. Thus, the licensed banks or financial institution are mandated to pay 15/16 of 1% per annum of their total deposit liabilities as premium to the Corporation. ii. Giving a guarantee to pay depositors in case of imminent or actual suspension of payments by an insured bank or financial institutions. A depositor s claim is limited to a maximum of N100,000 in the event of a bank failure. iii. Assisting the CBN and the Federal Ministry of Finance and Economic Development in the formulation and implementation of banking policy so as to promote sound banking practices. iv. Giving assistance to insured banks and financial institutions in time of difficulty, especially where suspension of payments is threatened, thereby avoiding damage to public confidence in the banking system. 22 v. Inspection and supervision of commercial banks. The NDIC assists in the inspection and supervision of commercial banks to ensure that they act in accordance with laid-down rules and regulations guiding their establishment. vi. Provision of loans to commercial banks that are in financial difficulty. This is to safeguard depositors funds and also maintain public confidence in the banking system. vii. Liquidation of a distressed bank and active involvement in the processes such as sale of assets and the distribution of the proceeds to shareholders net of liabilities. i. Note 1. Award 5 marks for the definition in (a) ii. Note 2. Award 4 marks for each of any 5 points mentioned and explained in (i) to (vii). 20 marks 4 Explain the following terms: a) Open Market Operation. b) Certificate of Deposit. c) Banker s Unit Fund. d) Call Money Scheme. The question requires an explanation of some monetary policy and money market instruments. Inexplicably, the question was the least popular, having been attempted by only 24% of the candidates with an equal percentage pass rate. It was only Open Market Operation that was fairly attempted. Certificate of Deposit, Banker s Unit Fund and Call Money Scheme were all poorly discussed. The performance was inexplicable because one expected students of Financial Economics to be conversant with the concepts. (a) Open Market Operations: This is one of the monetary policy instruments used by the CBN to regulate the supply of money in the economy. It involves the CBN buying and selling treasury bills/securities and bonds. If the objective is a reduction in money supply, the CBN simply sells bills and bonds to the commercial banks. Since the latter pay by drawing cheques on their deposits at 23

5 (c) (d) the CBN, their cash reserves fall accordingly. This reduces the capacity to make loans and expand credit. Conversely, an expansionary monetary policy entails the purchase of bills and bonds from the commercial banks and the payment for these by increasing the commercial banks deposits at the CBN. This raises the cash reserves of commercial banks and enlarges their base for lending and credit expansion. Certificate of Deposit: This is an inter-bank instrument usually in two forms the negotiable and the non-negotiable certificates of deposit. The negotiable certificate is usually issued in units of not less than N50,000 for maturity period of three to thirty-six months; while the non-negotiable certificate is held till maturity but issued in smaller denominations of between N1,000 and N50,000. These instruments are issued by banks, but with the approval of the CBN to tap funds in the economy, especially from investors who prefer anonymity. The approval of the CBN also carries a guarantee by the CBN and therefore it is safe. Bankers Unit Fund (BUF): The CBN operates BUF through which it provides an avenue for merchant and commercial banks and other financial institutions, to invest part of their liquid funds in money market assets linked to the Federal Government Development Stocks. Participants invest in multiples of N10,000 while the CBN in turn invests the pooled funds in available government stocks of various dates of maturity and receive interest payment on the investment. Call Money Scheme: This is a practice whereby a bank places its surplus funds in call money in another bank which is temporarily in need of liquid funds. It is call money in the sense that the creditor bank can ask for repayment at any time the need arises. Thus, call money are funds invested on a day-to-day basis and, as a result, the interest payable on such funds is relatively low. Note 1: Award 6 marks for each concept = 24 marks. Note 2: Award 1 mark for creditable presentation (a) Distinguish between Deficit Budget and Balanced Budget. Explain various methods of financing Budget Deficit in an economy. The question requires a distinction between deficit and balanced budget and an explanation of the various methods of financing a deficit budget. The question was popular. It was attempted by 66% of the candidates. The pass rate was good. 60% of the candidates had a clear pass in it. Most candidates were at home in distinguishing between deficit and balanced budget. However, many of them lost marks in discussing the methods of financing a budget deficit. Many could not discuss beyond taxation and borrowing. Most of them were not aware of printing of additional notes seigniorage - as a method of financing a budget deficit. (a) Deficit Budget: This arises when government s proposed expenditure for a new fiscal year is greater than the expected revenue. It may be adopted to stimulate economic growth during a recession; while Balanced Budget occurs when government s proposed expenditure and expected revenue for a new fiscal year are equal. This may be adopted when the government desires to keep the level of economic activities relatively stable as in the preceding year. Methods of Financing Budget Deficit i. Raising Loans from the Public: Budget deficit may be financed through additional borrowing from members of the public. By issuing bonds to members of the public the government raises funds which it can use to finance a deficit budget. The method may not be inflationary since disposable income will reduce. ii. Raising the Level of Taxation. Government may impose additional taxes on members of the public and the proceeds used to finance a budget deficit. This method is also not inflationary since the additional taxes reduce the disposable income of individuals and corporate bodies. 25

6 iii. iv. Borrowing from the Banking System: When the Central Bank wants to borrow directly from the banking system, it will issue debt instruments directly to banking institutions. Instruments like treasury bills, treasury certificates, and loan stock or stabilisation securities may be used. The effect of borrowing directly from the banking system will depend on whether or not the banks are fully loaned up. External Borrowing: External borrowing or offshore financing refers to credits that are obtained in foreign exchange and are also to be serviced and repaid in foreign currency. Such loans may be bilateral, i.e. negotiated between two friendly countries on a mutual basis. v. Printing of More Money: The most inflationary method is resorting to printing more money to finance excess government expenditure where the additional notes are not backed by real resources or gold. This leads to a rise in aggregate demand in excess of aggregate supply and therefore inflation. Note 1: Award 8 marks for the definition in (a) Note 2: Award 4 marks for each of any 4 points in (i) to (v). 16 marks. Note 3: Award 1 mark for good presentation. (a) The main functions of the Securities and Exchange Commission (SEC) as stipulated in Section 6 of the SEC Decree Number 29 of 1988, are: i. Determining the amount, price and time at which the securities of a company are to be sold to the public either through offer for sale or subscription (the pricing function was transferred to the Issuing Houses following the deregulation of the capital market in 1991). ii. Registering securities proposed to be offered for sale or subscription to the public or to be offered privately with the intention that the securities shall be held ultimately other than to those the offer was made. iii. Maintaining surveillance over the securities market to ensure orderly, fair and equitable dealings in securities. iv. Registering Stock Exchanges or their branches, registrars, investment advisers, securities dealers and their agents and controlling and supervising their activities with a view to maintaining proper standards of conduct and professionalism in the securities business. v. Acting as a regulatory apex organisation of the Nigerian capital market, including the Nigerian Stock Exchange and its branches to which it would be at liberty to delegate power. vi. Reviewing, approving and regulating mergers, acquisitions and all forms of business combinations. 6 (a) Discuss the main functions of the Securities and Exchange Commission (SEC) Outline the principal functions/services of Discount Houses. The question demands a discussion of the main functions of the Securities and Exchange Commission (SEC) and an outline of the functions of Discount Houses. It was one of the least popular questions as only 27% of the candidates attempted it. The pass rate was even lower 21%. It is disappointing that candidates of Financial Economics are not conversant with the SEC and Discount Houses. 26 The principal functions of Discount Houses as specified in the guidelines for Discount Houses, are: i. To ensure efficiency in the operation of the money market in Nigeria; ii. To act as an intermediary between the CBN and the licensed banks; iii. To facilitate the issue and sale of short term government iv. securities by tender; To provide discount/rediscount facilities for treasury bills government securities and other eligible financial instruments acquired by the banks; v. To accept short-term deposits from the banks vi. To provide short-term accommodation to banks. 27

7 Note 1: Award 3 marks for each of any 5 points in (a) (i) to (vi) 15 marks Note 2: Award 2 marks for each of any 5 points in (i) to (vi) 10 marks. 7 (a) What is IS LM? Using the IS LM model, show the effects of the following on interest rate and income: i. Monetary expansion. ii. Increase in Government Expenditure. This is a question on macroeconomics a definition of the IS LM method of interest rate determination and the application of the framework to fiscal and monetary policy issues. Only 31% of the candidates attempted the question. One is pleasantly surprised, however, that as high as 48% of those who attempted it had a clear pass in it. Most of them did well in the definition of IS LM. Some, however, lost vital marks in distinguishing between the diagrams of a change in money supply and that of a change in government expenditure. (a) IS LM IS: This shows the combination of interest rate and levels of income where there is equality between savings and investment such that there is equilibrium in the product market of the economy. The IS curve slopes downwards to the right, indicating an inverse relationship between the rate of interest and levels of income. LM: This shows all combinations of interest rate and levels of income where there is equality between the demand for and the supply of money such that there is equilibrium in the Money Market. The LM curve slopes downwards to the left, showing a positive relationship between rate of interest and levels of income. (i) Monetary Expansion: The LM function shifts to the right with monetary expansion or increase in money supply given the demand for money. If the CBN follows an expansionary monetary policy, it will buy securities in the open market. The payment for the purchase will increase the volume of money in circulation. This shifts the LM curve to the right. Monetary Expansion With the monetary expansion, the LM curve shifts from LM 1 to LM 2. While income increases from Y 1 to Y 2, the rate of interest falls from R 1 to R 2 as illustrated in the diagram above

8 Increase in Government Expenditure As illustrated above, with an increase in government expenditure, there is a shift in the IS curve from IS 1 to IS 2. There will be an increase in income from Y i to Y 2 and an increase in the rate of interest from R 1 to R 2. The new equilibrium is established at point E 2. Note 1: Award 4 marks for the definitions in (a) and 1 mark for the diagrams = 5 marks. Note 2: Award 10 marks for each of (i) and (ii) = 20 marks. 30