125364 Mock Examination

SECTION A: Answer Questions  1-20  inclusive  on the yellow  Multiple  Choice Answer Sheet. For each question, select the one best answer.

Q1.     Financial institutions’ functions include:

A.   maturity intermediation.

B.   transmission of monetary policy.

C.  credit allocation.

D.  A and B only.

E.   All of A, B and C are correct.

Q2.    Which of the following statement is false?

A.   The provision for loan loss account on the balance sheet is actual loan losses less loan recoveries in a given time period.

B.   Banks have higher leverage than most manufacturing firms.

C.  Generally banks’ noninterest expense is greater than noninterest income.

D.  Term deposits can be classified as core deposits.

E.   Banks’ net income is direct result of amount, mix, and interest rate of assets and liabilities.

Q3.    A mortgage loan officer is found to have provided false documentation that

resulted in a lower interest rate on a loan approved for one of her friends. The loan was subsequently added to a loan pool, securitised and sold. Which of the following risks applies to the false documentation by the employee?

A.   Market risk

B.   Credit risk

C.  Operational risk

D.  Technological risk

E.   Operational risk and interest rate risk

Q4.     Which of the following situations pose a refinancing risk for a FI (financial institution)?

A.  An FI matches the maturity of its assets and liabilities.

B.  An FI issues $10 million of liabilities of three-year maturity to finance the purchase of $10 million of assets with a two-year maturity.

C.  An FI issues $10 million of liabilities of two-year maturity to finance the purchase of $10 million of assets with a two-year maturity.

D.  An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-year maturity.

E.   None of the above is correct.

Q5.    When cumulative gap (CGAP) is positive and change in spread is also

positive, how will banks’ net income change if interest rates rise?

A.   Interest income will decrease by less than interest expenses, which will result in a higher net income.

B.   Interest income will increase by more than interest expenses, which will result in a higher net income.

C.   Interest income will decrease by more than interest expenses, which will result in a lower net income.

D.   Interest income will increase by less than interest expenses, which will result in a lower net income.

E.   The change in net income will be uncertain.

Q6.     Consider the following repricing buckets and gaps:

What is the annualised change in the bank's future net interest income if the average rate change for assets and liabilities that can be repriced within one year is a decrease of 100 basis points?

A.   $1,700

B.   -$1,700

C.  $1,300

D.  -$1,300

E.   $13,000

Q7.     For a large change in interest rates, convexity indicates:

A.   capital gain effect and capital loss effect is not symmetric.

B.   capital gain effect and capital loss effect is symmetric.

C.   both capital gain and loss is smaller than what the duration model predicts.

D.   both capital gain and loss is larger than what the duration model predicts.

E.   same capital gain/loss effect as what the duration model predicts.

Q8.    What is a swap?

A.   Trading in securities prior to their actual issue.

B.  A contract that gives the holder the right, but not the obligation to buy or sell the underlying asset at a specified price within a specified period of  time.

C.  An agreement between a buyer and a seller at time 0 to exchange a non- standardised asset for cash at some future date.

D.  An agreement between a buyer and a seller at time 0 to exchange a standardised asset for cash at some future date.

E.  An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval.

Q9.     Consider the following scenario: an FI charges a 0.5 per cent loan origination   fee and imposes a 10 per cent compensating balance requirement to be held   as non-interest bearing demand deposits. It further sets aside reserves held at the central bank. The amount of these reserves is 15 per cent of deposits.

What is the gross return on the loan if the base lending rate is 12 per cent and the credit risk premium is 3.055 per cent?

A.   15.555%

B.   17.28%

C.   17%

D.  20.055%

E.   15.055%

Q10.  The linear probability model uses:

A.   forecasted data, such as predicted future prices, as inputs into a model to explain repayment experience on old loans.

B.   current indices, such as consumer price index, as inputs into a model to explain repayment experience on old loans.

C.   past data, such as financial ratios, as inputs into a model to explain repayment experience on old loans.

D.  qualitative data, such as borrowers’ reputation, as inputs into a model to explain repayment experience on old loans.

E.   None of the above is correct.

Q11.  Which of the following statements about RAROC (risk-adjusted return on capital) is true?

A.   RAROC is calculated as the capital at risk divided by the loan's income.

B.   Either duration model or loan default rate can be used to estimate loan risk to calculate RAROC.

C.   RAROC should always be below an FI's RAROC benchmark as otherwise the FI increases its default risk exposure.

D.  Only A and B are correct.

E.   None of the above is correct.

Q12.   Which of the following statements is true?

A.  When setting concentration limits, FIs should use aggregate limits for industries in which performance is highly correlated.

B.   Minimum risk portfolio is the combination of assets that reduces the variance of portfolio return on the lowest feasible level.

C.  Loan loss ratio-based model estimates systematic loan loss risk of a particular sector or industry relative to the total loan portfolio.

D.  Loan volume-based model measures the relative degree of loan

concentration based on deviation from the market portfolio benchmark.

E.  All of the above are correct.

Q13.   n/a

Q14.  A swap by which an FI receives the par value of the loan on default in return for paying a periodic swap fee is called a(an):

A.   net return swap.

B.   total return swap.

C.   pure credit swap.

D.   interest rate swap.

E.   credit spread swap.

Q15.   Loan sales and securitisation are seen as valuable tools in the management

of credit risk. Which of the following does not help FIs managing their risks?

A.   Loan sales and securitisation create moral hazard issues and reduce scrutiny of off-balance sheet activities of FIs.

B.   Loan sales and securitisation allow FIs to better manage their customer relationships.

C.   Loan sales and securitisation reduce FIs industry and/or geographical concentration risk.

D.   Loan sales and securitisation allow FIs to separate their credit risk exposure from the lending process itself.

E.   None of the above is advantages of loan sales and securitisation.

Q16.   Fire-sale price refers to the price received for:

A.  an asset that has to be sold at half price.

B.  a liability that has to be sold at half price.

C. an asset that has to be sold immediately.

D. a liability that has to be sold immediately.

E.  an equity that has to be sold immediately.

Q17.  Which of the following statements is false?

A.   Core funding ratio is defined as core funding amount relative to total loans and advances.

B.   Core funding includes funding with residual maturity longer than one year, including Tier 1 capital and subordinated debt.

C.  Liquidity rules require more emphasis on retail funding.

D.  Currently the core funding ratio in NZ is set at 50%.

E.  The liquidity portfolio generally have lower yield than a portfolio of loans.

Q18.   Financial institutions can be governed by:

A.   Shareholders and the board of directors.

B.   Executive management.

C.   Legal and regulatory authority.

D.  A and C only.

E.   All of A, B and C are correct.

Q19.   n/a

Q20.  Which of the following statements is true?

A.   The Basel Capital Accord imposes minimum earnings ratios on banks in major industrialised countries.

B.   The Basel Capital Accord imposes minimum risk-based capital ratios on banks in major industrialised countries.

C.  The Basel Capital Accord imposes maximum asset values on banks in major industrialised countries.

D.  The Basel Capital Accord imposes minimum liability values on banks in major industrialised countries.

E.   The Basel Capital Accord imposes minimum return on equity on banks in major industrialised countries.

SECTION B: Answer ALL questions. Show all workings for question 21 to 23.

Record final answers to two decimal places.

Question 21

Financial Institution XY has assets of $1 million invested in a 30-year, 10 per cent semi-annual coupon Treasury Bond selling at par. The duration of this bond has been estimated at 9.94 years. The assets are financed with equity and a $900,000, two-year, 7.25 per cent semi-annual coupon capital note selling at par.

A)       What is the leverage adjusted duration gap of Financial Institution XY? [6 marks]

B)       What is the impact on equity value if the relative change in all market interest rates is a decrease of 20 basis points? [2 marks]

C)       What would the duration of the assets need to be to immunise the equity from   changes in market interest rates? [2 marks]

[Total: 10 marks]

Question 22

Consider the case of a simple one-period framework: the one year Treasury strip is yielding 12.5 per cent, and an AAA-rated discount bond with similar maturity is yielding 14.85 per cent. Assume that if the bond defaults, no payment is expected. Record final answer as a percentage to two decimal places.

A)       What is the required risk premium? [1 marks]

B)       What is the probability of default? [2 marks]

C)       Recalculate the probability of default, assuming that the expected recovery from collateral in the event of default is 85% of principal and interest. [2 marks]

[Total: 5 marks]

Question 23

Based on the information below, calculate the expected probability of repayment on   the one-year corporate bond in one year’s time. Record final answer as a percentage to two decimal places. [5 marks]

A)       What is credit rationing? Why do banks usually use credit rationing to control  credit risks for retail loans? [4 marks]

B)       How do banks use both interest rate and credit rationing to control credit risk   for wholesale loans? And why? [4 marks]

[Total: 8 marks]

Question 25

Distinguish between liquidity risk arising from the asset-side and the liability-side of the balance sheet. Give one example for each, respectively. [8 marks]

Question 26

Why do banks need capital? Why are regulators concerned with the levels of capital held by an FI compared to a non-financial institution? [8 marks]

Question 27

List and briefly explain the tools proposed by RBNZ for macro-prudential policy. [8 marks]

Question 28

Briefly explain how asset pricing boom and bust can lead to the decline in economic activities in the initial stage of financial crisis. [8 marks]