ACCA Applied Skills · Financial Management

The nature and role of financial markets and institutions: formula sheet

Full chapter guide

Key formulas

Discount instrument: price: Price = Face value × (1 − d × n ÷ 365); d is the quoted discount rate and n the days to maturity. Use this only if the question quotes a discount rate. Use the day-count given in the question if it differs from 365.
Discount instrument: return over the period: Return = (Face value − Price) ÷ Price; Divide by the price paid, not by face value. This is the actual yield for the period held.
Annualised simple yield: Annual yield = Return over period × (365 ÷ n); Simple annualisation. For compound annual equivalent use (1 + return)^(365 ÷ n) − 1.
Money market versus capital market: Money market: up to 1 year. Capital market: over 1 year.; This is the usual dividing line. Treat it as the standard rule of thumb for exam answers.
Weak form efficiency: Price reflects all past price and trading information; Technical analysis (chartism) cannot give consistent excess returns. Price changes follow a random walk.
Semi-strong form efficiency: Price reflects all publicly available information (includes weak form); Fundamental analysis cannot give consistent excess returns. Prices adjust quickly to new announcements.
Strong form efficiency: Price reflects all information, public and private (includes semi-strong); Even insiders cannot gain consistently. Evidence does not generally support this form.
Primary vs secondary market: Primary = new securities, cash goes to the issuer. Secondary = existing securities, cash goes to the selling investor; Use this test to classify any transaction in a question.
Implication of efficiency for managers: Share price = fair value given available information; Managers cannot fool the market with creative accounting. Timing of issues matters less. Wealth maximisation means making good investment decisions.
Bank quote rule (two-way quote): Bank buys the base currency (the '1 unit' currency) at the lower rate and sells it at the higher rate. The customer always gets the less favourable rate.; Example: a quote of €0.92 – €0.93 per $1 has the dollar as the base. The bank buys dollars at €0.92 and sells dollars at €0.93. So a customer selling $1 receives €0.92, and a customer buying $1 pays €0.93. Always check which currency is the base before you pick the rate.
Spot conversion: Foreign amount ÷ rate = home amount (rate in foreign per 1 home); Foreign amount × rate = home amount (rate in home per 1 foreign); Check which currency is the 'one' in the quote before converting.
Spread: Spread = higher rate − lower rate of the two-way quote; The spread is the bank's dealing cost.
Forward rate (interest rate parity): F = S × (1 + i foreign) ÷ (1 + i home), with S in foreign per 1 home; Interest rate parity implies that the currency with the higher interest rate trades at a forward discount, so it is weaker in the forward rate. Use interest rates for the period to the forward date.
Option outcome: Step 1: compare the strike rate with the market rate and use the better one. Step 2: include the premium (with interest if relevant) in the final result.; An option is exercised only if the strike rate beats the market rate. The premium is paid whether or not you exercise, so it is a separate cost. Deduct it from a receipt or add it to a payment after you have chosen the rate, and do not leave it out of either outcome.
Policy rate transmission: Policy rate ↑ → bank lending rates ↑ → borrowing and spending ↓ → inflation pressure ↓; Reverse for a cut. This is the usual direction, not a guaranteed result, as effects work with time lags.
Open market operations: Central bank buys securities → money supply ↑ and interest rates ↓; sells securities → money supply ↓ and interest rates ↑; The central bank pays for purchases with new reserves credited to banks.
Bond price and yield: Market interest rates ↑ → bond prices ↓ (and yields ↑); Useful for linking monetary policy to the value of fixed-rate debt.
Real interest rate (approximate): Real rate ≈ nominal rate − inflation rate; Central banks target the real cost of borrowing. Fisher's exact form is (1 + nominal) = (1 + real) × (1 + inflation).
Components of an interest rate: Rate = risk-free rate + risk premium (credit spread) + term (maturity) premium + liquidity premium; A way of remembering the factors. It is not a formula for exam calculations.
Credit spread: Credit spread = yield on risky bond − yield on risk-free bond of similar maturity; Compare bonds with the same term. Government bonds are the usual risk-free benchmark.
Expectations theory (two-year example): (1 + 2-year spot rate)² = (1 + 1-year spot rate) × (1 + forward rate for year 2); Gives the implied forward rate. In FM it is usually tested in words, but you can use this relation to check the shape of the curve.
Shape rules: Upward slope: long yields > short yields. Inverted: long yields < short yields. Flat: roughly equal.; Under pure expectations, upward means rates are expected to rise, and inverted means they are expected to fall.

Quick revision

Financial intermediaries link savers and borrowers and add value by pooling funds, transforming maturity and spreading risk.
Money markets deal in short-term finance, usually up to one year; capital markets deal in long-term finance.
The primary market raises new funds; the secondary market trades existing securities and gives liquidity.
Weak form efficiency: prices reflect past price information, so charts cannot beat the market.
Semi-strong form: prices also reflect all public information, so analysing published reports gives no consistent gain.
Strong form: prices reflect all information, including private information.
Spot market deals now; forward contracts fix a future exchange rate; futures are standardised and exchange traded.
Derivatives such as options, futures and swaps are mainly used to manage risk, though they can also be used to speculate.
Central banks set monetary policy, act as lender of last resort and influence short-term interest rates.
A normal yield curve slopes upward; an inverted curve slopes downward and is often read as an expectation of lower future rates.
Interest rates reflect a real return plus compensation for inflation, risk and lack of liquidity.
Objective questions score all or nothing, so read every option fully before choosing.

Common mistakes

Treating intermediaries and financial markets as the same thing. Fix: Remember that with an intermediary the funds pass through its balance sheet and the saver holds a claim on it. In a market, securities are traded directly between investors and issuers.
Describing maturity transformation as lending long and borrowing long. Fix: It means borrowing short (deposits) and lending long (loans). The terms differ.
Saying the issuing company receives money when its shares are traded on the stock exchange. Fix: Only a new issue brings cash to the company. A trade between investors in the secondary market changes the owner of the share, not the company's funds.
Calculating the yield on a discount instrument as discount ÷ face value. Fix: Actual return is (Face − Price) ÷ Price. The investor's outlay is the price, so divide by the price.
Saying a share sale between two investors raises money for the company. Fix: Use the cash test. Only new issues put cash into the company. Secondary trades just change the owner.
Mixing up weak and semi-strong form. Fix: Weak is past prices only. Semi-strong is all public information. Strong is all information including private.
Using the wrong side of the bank's two-way quote. Fix: Take the bank's viewpoint. The bank always trades at the rate that favours the bank, so you get the less favourable rate.
Dividing when you should multiply (or the reverse). Fix: Write the quote with units, such as '1.50 euros per $1', and cancel units in your calculation.
Saying a central bank sets the interest rates that every bank charges customers. Fix: The central bank sets or influences the policy rate. Commercial banks add margins for risk and cost, so market rates follow but differ.
Getting the direction of open market operations wrong. Fix: Remember it from the central bank's side. When it buys securities it pays out money, so the supply rises. When it sells, it takes money in, so the supply falls.

Exam tips

In objective tests, match the exact mismatch in the question (size, term, risk or cost) to the function. Read the wording closely.
For written parts, apply each function to the scenario facts. A bare list earns few marks.
Mention the liquidity risk of maturity transformation when asked to evaluate.
If asked to distinguish intermediaries from markets, state both clearly: funds through a balance sheet versus direct trading in securities.
Keep answers short and structured: one function, one sentence of explanation, one link to the case.
In Section A, decide the time horizon first. Most money market versus capital market questions can be answered from this alone.
Learn one line for each instrument: who issues it, whether it is secured, and whether it is sold at a discount. Options often differ on exactly one of these.
For discount calculations, write the denominator on the page before dividing. Since objective questions give no partial marks, one wrong denominator costs the whole answer.