Consider two bonds, a 10-year premium bond with a coupon rate higher than its required rate of return and a zero coupon bond that pays only a lump sum payment after 10 years with no interest over its life. Which do you think would have more interest rate risk—that is, which bond’s price would change by a larger amount for given changes in interest rates? Explain your answer.
> What are two ways a DI can offset the liquidity effects of a net deposit drain of funds? How do the two methods differ? What are the operational benefits and costs of each method?
> How is a DI’s distribution pattern of net deposit drains affected by the following? a. The holiday season. b. Summer vacations. c. A severe economic recession. d. Double-digit inflation.
> What are core deposits? What role do core deposits play in predicting the probability distribution of net deposit drains?
> The probability distribution of the net deposit drain of a DI has been estimated to have a mean of 2 percent. a. Is this DI increasing or decreasing in size? Explain. b. If a DI has a net deposit drain, what are the two ways it can offset this drain of
> What are the two reasons liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance sheet? What is meant by fire-sale prices?
> How is the liquidity problem faced by investment funds different from the liquidity problem faced by DIs and insurance companies?
> What is the greatest cause of liquidity exposure that property–casualty insurers face?
> Why does deposit insurance deter bank runs?
> A mutual fund plans to purchase $10 million of 20-year T-bonds in two months. The bonds are yielding 7.68 percent. These bonds have a duration of 11 years. The mutual fund is concerned about interest rates changing over the next two months and is conside
> Describe the unprecedented steps the Federal Reserve took with respect to the discount window operations during the financial crisis.
> What is a bank run? What are some possible withdrawal shocks that could initiate a bank run? What feature of the demand deposit contract provides deposit withdrawal momentum that can result in a bank run?
> What are the several components of a DI’s liquidity plan? How can such a plan help a DI reduce liquidity shortages?
> Define each of the following four measures of liquidity risk. Explain how each measure would be implemented and utilized by a DI. a. Financing gap and financing requirement. b. Sources and uses of liquidity. c. Peer group ratio comparisons. d. Liquidity
> Why should a credit officer be concerned if a mid-market business borrower’s liquidity ratios differ from the industry norm?
> How does ratio analysis help answer questions about the production, management, and marketing capabilities of a prospective borrower?
> Why must an account officer be well versed in the FI’s credit policy before talking to potential mid-market business borrowers?
> What are some of the special risks and considerations when lending to small businesses rather than large businesses?
> In what ways does the credit analysis of a mid-market borrower differ from that of a small-business borrower?
> How does an FI evaluate its credit risks with respect to consumer and small-business loans?
> An FI has a $200 million asset portfolio that has an average duration of 6.5 years. The average duration of its $160 million in liabilities is 4.5 years. Assets and liabilities are yielding 10 percent. The FI uses put options on T-bonds to hedge against
> What are the purposes of credit-scoring models? How do these models assist an FI manager to better administer credit?
> What are the primary considerations used by FIs to evaluate mortgage loans?
> Explain how modern portfolio theory can be applied to lower the credit risk of an FI’s portfolio.
> Consider the coefficients of Altman’s Z score. Can you tell by the size of the coefficients which ratio appears most important in assessing the creditworthiness of a loan applicant? Explain.
> Why is an FI’s bargaining strength weaker when dealing with large corporate borrowers than mid-market business borrowers?
> What are conditions precedent?
> Why is credit risk analysis an important component of FI risk management?
> The sales literature of a mutual fund claims that the fund has no risk exposure since it invests exclusively in default risk free federal government securities. Is this claim true? Why or why not?
> What is reinvestment risk? How is reinvestment risk part of interest rate risk? If an FI funds short-term assets with long-term liabilities, what will be the impact on earnings of a decrease in the rate of interest? An increase in the rate of interest?
> What is refinancing risk? How is refinancing risk part of interest rate risk? If an FI funds long-term fixed-rate assets with short-term liabilities, what will be the impact on earnings of an increase in the rate of interest? A decrease in the rate of in
> Corporate Bank has $840 million of assets with a duration of 12 years and liabilities worth $720 million with a duration of seven years. Assets and liabilities are yielding 7.56 percent. The bank is concerned about preserving the value of its equity in t
> What is the process of asset transformation performed by a financial institution? Why does this process often lead to the creation of interest rate risk? What is interest rate risk?
> Which type of cash withdrawal presents very little liquidity risk? Which type of cash withdrawal is a source of significant liquidity risk for DIs?
> What is liquidity risk? What routine operating factors allow FIs to deal with this risk in times of normal economic activity? What market reality can create severe financial difficulty for an FI in times of extreme liquidity crises?
> In the 1980s, many thrifts that failed had made loans to oil companies located in Louisiana, Texas, and Oklahoma. When oil prices fell, these companies, the regional economy, and the thrifts all experienced financial problems. What types of risk were inh
> Discuss the interrelationships among the different sources of FI risk exposure. Why would the construction of an FI risk management model to measure and manage only one type of risk be incomplete?
> Characterize the risk exposure(s) of the following FI transactions by choosing one or more of the following: a. Credit risk b. Interest rate risk c. Off-balance-sheet risk d. Foreign exchange rate risk e. Country/sovereign risk f. Technology risk (1) A b
> What is the difference between technology risk and operational risk? How does internationalizing the payments system among banks increase operational risk?
> What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency?
> If you expect the Swiss franc to depreciate in the near future, would a U.S.-based FI in Basel, Switzerland, prefer to be net long or net short in its asset positions? Discuss.
> A U.S. insurance company invests $1,000,000 in a private placement of British bonds. Each bond pays £300 in interest per year for 20 years. If the current exchange rate is £1.5612 for US$1, what is the nature of the insurance company’s exchange rate risk
> An FI has a $100 million portfolio of six-year Eurodollar bonds that have an 8 percent coupon. The bonds are trading at par and have a duration of five years. The FI wishes to hedge the portfolio with T-bond options that have a delta of –0.625. The under
> If an FI has the same amount of foreign assets and foreign liabilities in the same currency, has that FI necessarily reduced the risk involved in these international transactions to zero? Explain.
> What is the difference between firm-specific credit risk and systemic credit risk? How can an FI alleviate firm-specific credit risk?
> If the Swiss franc is expected to depreciate in the near future, would a U.S.-based FI in Bern City, Switzerland, prefer to be net long or net short in its asset positions? Discuss.
> What two factors provide potential benefits to FIs that expand their asset holdings and liability funding sources beyond their domestic borders?
> What is foreign exchange risk? What does it mean for an FI to be net long in foreign assets? What does it mean for an FI to be net short in foreign assets? In each case, what must happen to the foreign exchange rate to cause the FI to suffer losses?
> What is the nature of an off-balance-sheet activity? How does an FI benefit from such activities? Identify the various risks that these activities generate for an FI and explain how these risks can create varying degrees of financial stress for the FI at
> Consider again the two bonds in Question 13. If the investment goal is to leave the assets untouched until maturity, such as for a child’s education or for one’s retirement, which of the two bonds has more interest rate risk? What is the source of this r
> How does a policy of matching the maturities of assets and liabilities work (a) to minimize interest rate risk and (b) against the asset-transformation function for FIs?
> How can interest rate risk adversely affect the economic or market value of an FI?
> Village Bank has $240 million worth of assets with a duration of 14 years and liabilities worth $210 million with a duration of four years. In the interest of hedging interest rate risk, Village Bank is contemplating a macrohedge with interest rate T-bon
> What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?
> Describe the different pension funds sponsored by the federal government.
> Describe the “pay as you go” funding method that is used by many federal and state or local government pension funds. What is the problem with this method that may damage the long-term viability of such funds?
> What is the difference between an IRA and a Keogh account?
> What have the trends been for assets invested in defined benefit versus defined contribution pension funds in the last three decades?
> What are the three types of formulas used to determine pension benefits for defined benefit pension funds? Describe each.
> Describe the difference between a defined benefit pension fund and a defined contribution pension fund.
> Describe the difference between an insured pension fund and a noninsured pension fund. What type of financial institutions would administer each of these?
> What types of pension reforms have countries tried as their populations age and contributions to pension funds decrease?
> Describe the major features of ERISA.
> Refer to Problem 12. How does consideration of basis risk change your answers? a. Compute the number of T-bond futures contracts required to construct a macrohedge if T-bond futures are priced at 96 and the duration of the T-bond underlying the futures c
> What was the motivation for the passage of ERISA?
> Describe the issues associated with the long-term viability of the Social Security fund.
> What are some of the arguments for and against the use of market value versus book value of capital?
> What are the differences between the economist’s definition of capital and the accountant’s definition of capital? a. How does economic value accounting recognize the adverse effects of credit risk? b. How does book value accounting recognize the advers
> What is the difference between book value accounting and market value accounting? How do interest rate changes affect the value of bank assets and liabilities under the two methods?
> What is convexity?
> What are the criticisms of using the duration model to immunize an FI’s portfolio?
> If a bank manager was quite certain that interest rates were going to rise within the next six months, how should the bank manager adjust the bank’s duration gap to take advantage of this anticipated rise? What if the manager believed rates would fall?
> If you use duration only to immunize your portfolio, what three factors affect changes in an FI’s net worth when interest rates change?
> How is duration related to the interest elasticity of a fixed income security? What is the relationship between duration and the price of the fixed-income security?
> Consider the following balance sheet (in millions) for an FI: a. What is the FI’s duration gap? b. What is the FI’s interest rate risk exposure? c. How can the FI use futures and forward contracts to create a macrohe
> Consider the re pricing gap model. a. What are some of its weaknesses? b. How have large banks solved the problem of choosing the optimal time period for re pricing?
> What is the spread effect?
> What is the gap-to-total-assets ratio? What is the value of this ratio to interest rate risk managers and regulators?
> If a bank manager was quite certain that interest rates were going to rise within the next six months, how should the bank manager adjust the bank’s re pricing gap to take advantage of this anticipated rise? What if the manager believed rates would fall?
> Which of the following is an appropriate change to make on a bank’s balance sheet when GAP is negative, spread is expected to remain unchanged, and interest rates are expected to rise? a. Replace fixed-rate loans with rate-sensitive loans. b. Replace mar
> What is the CGAP effect? According to the CGAP effect, what is the relation between changes in interest rates and changes in net interest income when CGAP is positive? When CGAP is negative?
> What is a maturity bucket in the re pricing gap model? Why is the length of time selected for re pricing assets and liabilities important when using the re pricing gap model?
> What is the re pricing gap? In using this model to evaluate interest rate risk, what is meant by rate sensitivity? On what financial performance variable does the re pricing gap model focus? Explain.
> How do monetary policy actions by the Federal Reserve impact interest rates?
> The average daily net transaction accounts of a local bank during the most recent reserve computation period is $325 million. The amount of average daily reserves at the Fed during the reserve maintenance period is $24.60 million, and the average daily v
> A mutual fund plans to purchase $500,000 of 30-year Treasury bonds in four months. These bonds have a duration of 12 years and are priced at 96-08 (32nds). The mutual fund is concerned about interest rates changing over the next four months and is consid
> City Bank has estimated that its average daily net transaction accounts balance over the recent 14-day computation period was $225 million. The average daily balance with the Fed over the 14-day maintenance period was $8 million, and the average daily ba
> Disregarding the capital conservation buffer, what is the bank’s capital adequacy level (under Basel III) if the par value of its equity is $225,000, surplus value of equity is $200,000, retained earnings is $565,545, qualifying perpetu
> What is the contribution to the asset base of the following items under the Basel III requirements? a. $10 million cash reserves. b. $50 million 91-day U.S. Treasury bills. c. $25 million cash items in the process of collection. d. $5 million UK governme
> Financial Fitness Bank reported a debt-to-equity ratio of 1.75× at the end of 2018. If the firm’s total assets at yearend were $25 million, how much of its assets are financed with debt? How much with equity?
> Third Fifth Bank has the following balance sheet (in millions), with the risk weights in parentheses. In addition, the bank has $20 million in commercial direct-credit substitute standby letters of credit to a public corporation and $40 million in 10-y
> Two depository institutions have composite CAMELS ratings of 1 or 2 and are “well capitalized.” Thus, each institution falls into the FDIC Risk Category I deposit insurance assessment scheme. Further, the institutions
> What is the bank’s risk-adjusted asset base? Data for Problem 12: A bank’s balance sheet information is shown below (in $000). On-Balance-Sheet Items Face Value $ 121,600 5,400 414,400 9,800 159,000 Cash Shor
> Dudley Bank has the following balance sheet and income statement. For Dudley Bank, calculate: a. Return on equity b. Return on assets c. Asset utilization d. Equity multiplier e. Profit margin f. Interest expense ratio g. Provision for loan loss rati
> Third Bank has the following balance sheet (in millions), with the risk weights in parentheses. The cumulative preferred stock is qualifying and perpetual. In addition, the bank has $30 million in performance-related standby letters of credit (SLCs) to
> Onshore Bank has $20 million in assets, with risk-adjusted assets of $10 million. CET1 capital is $500,000, additional Tier I capital is $50,000, and Tier II capital is $400,000. How will each of the following transactions affect the value of the CET1, T
> Megalopolis Bank has the following balance sheet and income statement. For Megalopolis, calculate: a. Return on equity b. Return on assets c. Asset utilization d. Equity multiplier e. Profit margin f. Interest expense ratio g. Provision for loan loss
> A bank purchases a six-month $1 million Eurodollar deposit at an interest rate of 6.5 percent per year. It invests the funds in a six-month Swedish krona bond paying 7.5 percent per year. The current spot rate of U.S. dollars for Swedish krona is $0.18/S
> Jeff Krause purchased 1,000 shares of a speculative stock on January 2 for $2.00 per share. Six months later on July 1, he sold them for $9.50 per share. He uses an online broker that charges him $10 per trade. What was Jeff’s annualized HPR on this inve
> John Reardon purchased 100 shares of Tomco Corporation in December 2016 at a total cost of $1,762. He held the shares for 15 months and then sold them, netting $2,500. During the period he held the stock, the company paid him $3 per share in cash dividen
> Referring to Problem 13.18, assume you are using a constant-ratio plan with a rebalance trigger of speculative-to-conservative of 1.25. What action, if any, should you take in time period 2? Be specific. Problem 13.18: Using the data in the following t
