Banking And Finance Assignment Sample

Introduction Of Banking And Finance

Part A

1. In order to calculate the project's Net Present Value (NPV), we must discount future cash flows back to their present value using the company's 15% cost of capital (hurdle rate).

NPV = Σ [Cash Flow / (1 + Cost of Capital) ^Year]

NPV = (-£30,000,000 / (1 + 0.15) ^0) + (£8,000,000 / (1 + 0.15) ^1) + ... + (£14,000,000 / (1 + 0.15) ^6)

Calculating this, we get: NPV = -£30,000,000 + £6,956,480.87 + £6,054,463.93 + £5,267,752.42 + £4,579,637.35 + £3,975,573.14 + £7,692,570.04 = £3,525,067.75

1. The discount rate at which the NPV equals zero can be used to determine the internal rate of return (IRR). With the aid of financial software or by employing trial and error, we determine the IRR to be around 26.12%.

iii. Recommendation: Offering funding for this project is advised based on the calculated NPV and IRR. The project is anticipated to add value to the company according to the positive NPV (£3,525,067.75), and the IRR (26.12%), which is significantly greater than the company's cost of capital (15%), points to a potentially alluring return on investment. Therefore, it seems like a wise financial move to finance the foreign factory for Livingstone Thompson Ltd. with the potential for big profits.

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Part B

Description of the yield curve's calculation using the YTM and why investors follow changes in the yield curve

Investor Importance, Yield to Maturity (YTM), and the Yield Curve

A key idea in finance, particularly with reference to fixed-income products like bonds, is the Yield to Maturity (YTM). This figure represents the total return an investor would anticipate receiving if they hold a bond until it matures and reinvested all coupon payments at the same rate. YTM, which takes into account both coupon payments and any prospective capital gains or losses due to changes in the bond's market price, is used to calculate the bond's annualised return (Rathnasingha and Dayarathne, 2021).

The yield curve, on the other hand, is a graphical representation of yields (usually YTM) for bonds of the same credit quality across a range of different maturities. In essence, it illustrates the connection between bond yields and maturity dates. Since it offers information about market expectations, the state of the economy, and anticipated changes in interest rates, the yield curve's shape is of great interest to both investors and professionals.

Yield to Maturity (YTM) calculation:

The present value formula is used to determine the current market price of the bond, or YTM, which is equal to the sum of the present values of all future cash flows (coupon payments and principal repayment). The following is its mathematical formula:

Coupon Payment / (1 + YTM)*t = Current Market Price Face Value + [Face Value / (1 + YTM)]t.

Here, n is the total number of periods (or maturities) left before the bond matures, and t stands for the space between each coupon payment. The discount rate that equates the present value of the anticipated future cash flows to the market price of the bond must be found through trial and error in order to answer this equation for YTM.

Construction and interpretation of the yield curve

The yield curve is created by graphing the yields (YTM) of bonds with various maturities against the corresponding maturities of such bonds on the horizontal axis. When markets are functioning normally, the yield curve slopes upward, showing that bonds with longer maturities have higher yields than those with shorter maturities. Most of this can be attributed to the time value of money theory, which states that investors seek greater compensation for the risk associated with keeping their money locked up for a longer period of time (Lartey et al. 2019).

However, there are various scenarios depending on how the yield curve is shaped:

Longer-term yields are higher than shorter-term yields in the typical yield curve, as was already mentioned. Investors anticipate higher interest rates in the future as a result of the economy's stability or growth.

Shorter-term yields are greater than long-term yields when the yield curve is inverted. A recession or downturn in the economy is generally predicted by an inverted yield curve. Investors are looking for higher short-term rates because they are worried about the state of the economy going forward.

The yield curve is flat when yields are essentially constant across different maturities. It may reveal a lack of faith in the rate of economic growth and interest rate changes. Because of the hump in the yield curve, it is likely that medium-term rates are higher than both short-term and long-term rates.

Why Investors Pay Attention to Yield Curve Movement:

The yield curve is one of the most important economic indicators. Changes in its form can shed light on changes in market mood, inflation expectations, and prospective changes to central bank policy. Investors regularly monitor the yield curve in order to assess the status of the economy and project future economic events (Zhang and Shi, 2022).

• Interest Rate Expectations: The yield curve shows what the market expects the interest rates to be in the future. A yield curve with an upward slope indicates expectations of rising interest rates, which may affect the decision to invest in different asset classes. Using this information, investors make any required adjustments to their assets.
• Fixed-Income Investment Strategy: Bond buyers use the yield curve as a guide when purchasing fixed-income assets.
• Risk evaluation: Shifts in the yield curve's structure could be a sign of shifting risk attitudes. An inverted yield curve, for instance, may signal a higher chance of a recession. Based on how they read the yield curve, investors change their exposure to risk and asset allocation.
• Investors analyse the yield difference between various maturities to determine credit risk. Investment choices may be impacted by a widening difference between the yields of bonds with better and worse credit ratings, which may signal deteriorating credit conditions (Di Asih and Abdurakhman, 2021).
• Policy Impact: The yield curve may be impacted by central banks' monetary policy. Investors monitor yield curve fluctuations to spot prospective shifts in the policy rate or the direction of the central bank.

The Yield to Maturity (YTM), a fundamental concept, is used to determine the possible returns from fixed-income assets like bonds (Wang and Han, 2021). To evaluate market expectations, the state of the economy, and interest rate patterns, one can utilise the Yield Curve, which is produced from the YTMs of bonds with various maturities. Investors pay close attention to changes in the yield curve because it offers essential information about the state of the economy, expectations for interest rates, and risk assessment. Using this information, investors may adjust their portfolios as needed and make educated investment decisions.

Part C

Analysis of the statement

Financial intermediaries are essential to the operation of modern financial systems. They act as go-betweens for borrowers and lenders, easing the flow of funds, managing risks, and boosting the overall effectiveness and stability of the financial system. The notion that "Financial intermediaries are essential to a functioning financial system" is critically examined in this article by examining their primary roles, benefits, challenges, and potential drawbacks (Remolina, 2020).

Important Purposes of Financial Intermediaries:

The several crucial duties that financial intermediaries carry out underpin the effective operation of the financial markets.

• Risk reduction and transformation: By combining money from several investors and transferring them to different borrowers, intermediaries are able to lower individual risk exposure. They assess risks, manage portfolios, and diversify investments using their knowledge to improve stability overall.
• Information Asymmetry Mitigation: By bridging the information gap between borrowers and lenders, intermediaries reduce information asymmetry. They lessen the possibility of moral hazard and adverse selection issues that can hinder direct financing by carrying out due diligence, obtaining and analysing financial data, and offering reliable assessments.
• Provision of liquidity: Depositors or investors are offered liquid assets by financial intermediaries, who also guide capital towards less liquid investments like long-term loans or illiquid assets.
• Cost-effectiveness: Scale and scope economies are advantageous to intermediaries. Financial services can be made more widely available and reasonably priced by dispersing the costs of administration, transactions, and monitoring among a wide range of investors and borrowers (Bayar et al., 2021).
• Resource intermediation: Intermediaries, who successfully connect savings with lucrative investments, transfer resources between surplus units (savers) and deficit units (borrowers), fostering capital formation and economic advancement.

Financial intermediaries' advantages:

Efficient financial intermediaries have several advantages for both individuals and the economy as a whole.

• Risk diversification: By pooling and allocating capital, intermediaries help individuals and businesses better manage risk. Individual defaults and market shocks are lessened as a result.
• Market Liquidity and Efficiency: Intermediaries contribute to market liquidity and efficiency by providing market-making services, promoting price discovery, and reducing bid-ask spreads.
• Access to Credit: Financial intermediaries promote financial inclusion and economic growth by extending credit to borrowers who might not immediately have access to capital markets.
• Information and Skill: It is advantageous for both investors and borrowers that intermediaries have specific knowledge and skills in risk management, investment opportunity appraisal, and creditworthiness assessment (Remolina, 2020).
• Stability and Crisis Mitigation: By maintaining stability, preventing a sudden collapse of the credit markets, and fostering economic recovery, well-regulated intermediaries can act as shock absorbers during financial crises.

Potential drawbacks and identified challenges:

Financial intermediaries have many advantages, however there are also difficulties and potential drawbacks:

The existence of intermediaries may result in moral hazard, which could result in systemic instability because borrowers take on excessive risks in the belief that the intermediaries will save them.

• Issues with intermediaries: They could put their own interests ahead of that of their clients. When middlemen act irresponsibly, demand high fees, or are opaque, agency issues may occur.
• Systemic Risk: Because financial intermediaries are interdependent, shocks can spread more quickly and cause systemic crises.
• Regulatory Barriers: Preventing regulatory arbitrage, curbing excessive risk-taking, and sustaining financial stability all depend on effective regulation and supervision of intermediaries.
• Disintermediation: New financial technology (fintech) platforms and technological advancements may eventually lessen the importance of traditional middlemen by enabling direct borrowing and lending between individuals and organisations.

The significance of financial intermediaries in a financial system cannot be overstated, to sum up. They greatly contribute to market stability, economic growth, and financial inclusion by reducing information asymmetry, making liquidity available, and being cost-effective. It is impossible to overestimate the advantages of intermediaries, which include risk diversification, improved market efficiency, and credit accessibility. The necessity for efficient regulation and control is still highlighted by systemic risk, agency problems, and moral hazard. Maintaining a balance between established intermediaries and cutting-edge fintech solutions is essential as the financial landscape changes in response to technology improvements (Aslan, 2021). In order to provide stability, efficiency, and fair access to financial resources, a well-functioning financial system ultimately requires a symbiotic interaction between various intermediaries, regulators, and market participants.

Financial intermediaries play a crucial role in facilitating effective capital allocation, controlling risks, and guaranteeing the general stability of financial markets, as the phrase "Financial intermediaries are vital to a well-functioning financial system" highlight. Financial intermediaries play a crucial role in the smooth operation of the financial system by acting as a link between savers and borrowers, transferring money from surplus to deficit units, and carrying out other essential tasks.

The act of serving as a middleman between individuals with excess money and those who need it for various reasons is known as financial intermediation. Through this process of intermediation, funds are collected from a variety of individuals and organisations and then directed towards profitable lending or investments. A stable financial system requires financial intermediaries. They manage risks, promote the flow of capital, and fill knowledge gaps, all of which help to maintain stable economic conditions and effectively allocate resources. Although the idea of financial intermediation boosts market effectiveness and encourages economic progress, strict regulation and control are required to avoid potential hazards and guarantee that these intermediaries act in the best interests of both investors and borrowers.

Both savers and borrowers can take part in the financial ecosystem thanks to intermediaries' cost-effectiveness, which improves access to financial services. Additional benefits of intermediaries that enable people and companies to pursue growth potential include risk diversification, improved market performance, and democratised loan access.

However, strict control and oversight will always be necessary. The potential for systemic risk highlights the interconnectedness of intermediaries and the requirement for precise control. In order to make sure that intermediaries continue to be aligned with the best interests of their clients and ethical practises, significant oversight is needed due to the potential of agency issues and moral hazard.

Part D

Discussion of the variables that affect how long it takes for the end result to materialise after the use of a monetary policy tool or instrument

The method by which central banks attempt to have an impact on the economy by influencing short-term interest rates and, as a result, impacting the price level is known as the transmission mechanism of monetary policy. Through a multitude of pathways and interactions in this process, modifications to monetary policy instruments or tools are connected to the ultimate goals of price stability, economic growth, and full employment (Boneva et al. 2021). However, a variety of variables that could cause delays between the use of policy tools and the realisation of desired results rely on how effective this transmission mechanism is.

Transmission channels:

The transmission mechanism uses a number of interconnected channels to operate:

• Interest Rate Channel: Similar to the policy rate, central banks have a significant impact on short-term interest rates. The cost of borrowing money for individuals, companies, and financial institutions is impacted by changes in these rates. Because borrowing, spending, and investment are encouraged by lower interest rates, the economy is strengthened and inflation may rise.
• Through the asset price channel, changes in interest rates have an impact on the value of bonds, equities, and real estate. The wealth and financial situation of a household may be impacted by these price fluctuations, which could then affect spending and investment choices (Ihrig et al. 2020).
• Exchange Rate Channel: Changes in interest rates can have an impact on a nation's exchange rate, which can then have an impact on how competitive its exports and imports are.
• Credit Channel: Monetary policy has an impact on credit availability. Interest rate changes have an effect on bank lending rates, which in turn have an impact on borrowing by consumers and businesses. Credit constraints may lead to decreased investment and spending.

The expectations channel, or monetary policy actions, convey the central bank's viewpoint on anticipated economic conditions. Inflation, growth, and interest rate projections are impacted by these signals, and in turn, consumer and business behaviour is impacted.

Time lags-Affecting Factors:

The speed at which monetary policy's ultimate goals are attained depends on a number of variables when its tools are applied.

• Recognition Lag: The time it takes for central banks to evaluate the state of the economy and decide whether to implement policy is known as recognition lag. The act of acquiring and analysing data to detect changes in growth or inflation patterns may cause policy responses to be delayed.
• Operational lag: It is the likely delay that occurs when the central bank decides to use the chosen policy tools. This delay could be attributed to internal administrative procedures, communications, and coordination within the central bank.
• Impact Lag: After policy actions are implemented, it takes time for changes to the economy and to become apparent. For instance, the full effects of interest rate rises on spending, investment, and other economic activity may not be felt for several months.
• Transmission Lag: The efficiency of the transmission mechanism might vary depending on how the financial system is set up and how quickly various channels respond. Some channels may be used to communicate policy changes more quickly than others.
• Expectation Formation: The time it takes for families, businesses, and investors to change their expectations and conduct in response to a change in policy can have a significant impact on the lag between the adoption of a policy and its results.

External variables including trade ties, economic openness, and general economic conditions may cause additional temporal gaps. When and how much a policy will have an effect can all depend on changes in exchange rates, commodity prices, and global demand.

• Policy Reversal Lag: If unanticipated events force the need to reverse a policy move, it may take some time to realise and implement the necessary modifications.

Central banks employ the complex and sophisticated transmission mechanism of monetary policy in order to affect economic circumstances and accomplish their ultimate goals. Timing and effectiveness of policy interventions can be challenging because of the inherent temporal lags in this process, even if changes to policy tools may have broad effects on several channels. These latencies are caused by a variety of elements, such as recognition, operational procedures, transmission dynamics, and outside effects. To successfully negotiate the challenging landscape of monetary policy implementation and its eventual influence on the larger economy, central banks must have a strong grasp of these issues. As a result, they will be able to control expectations and make informed policy decisions (Altavilla et al. 2021).

To affect economic dynamics and accomplish their main goals, central banks purposely use the complex and sophisticated transmission mechanism of monetary policy. However, the complex web of connections inside this mechanism may cause problems for the effectiveness and promptness of governmental interventions. The method has intrinsic time lags that make it harder to achieve the desired results, even while there is the potential for policy changes to resonate across a variety of channels. There are many reasons why there are delays, including the time required to recognise changes in economic conditions, the technical difficulties of putting policies into effect, the complex dynamics of information transmission across numerous channels, and the sizeable influence of outside influences.

The first recognition lag is a significant component because it takes time for central banks to fully understand the state of the economy before choosing whether and how to take policy action. To identify changes in inflation patterns, growth trajectories, and potential risks during this initial period, thorough data collection and analysis are necessary, which causes a delay in the policy response. As a result, the operational lag is the period of time needed for policy decisions to be implemented. The intricate administrative procedures necessary—such as coordination, communication, and the use of certain policy tools—naturally delay the implementation of the intended actions.

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References

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• Aslan, L., 2021. Financial Statement Fraud in the Turkish Financial Services Sector.Istanbul Business Research,50(2), pp.385-409.
• Bayar, Y., Ozkaya, M.H., Herta, L. and Gavriletea, M.D., 2021. Financial development, financial inclusion and primary energy use: Evidence from the European Union transition economies.Energies,14(12), p.3638.
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