TEST BANK for Financial Markets and Institutions 8th Edition by Saunders Anthony, Marcia Cornett

Chapter 1: Introduction TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Primary markets are markets in which users of funds raise cash by selling securities to funds suppliers. ⊚ ⊚

true false

2) Secondary markets are markets used by corporations to raise cash by issuing securities for a short time period. ⊚ ⊚

true false

3) Corporate security issuers are always directly involved in funds transfers in the secondary market. ⊚ ⊚

4)

true false

The NYSE is an example of a secondary market. ⊚ ⊚

true false

5) Central governments sometimes indirectly intervene in foreign exchange markets by affecting foreign exchange rates through raising or lowering interest rates. ⊚ ⊚

6) less.

true false

Money markets are the markets for securities with an original maturity of one year or

⊚ ⊚

true false

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7) Financial intermediaries rather than financial systems are the most common agents to channel funds from the suppliers to the users of funds. ⊚ ⊚

true false

8) There are three types of major financial markets today: primary, secondary, and derivatives markets. The NYSE and NASDAQ are both examples of derivatives markets. ⊚ ⊚

true false

9) Asset transformation by financial intermediaries involves increasing the risk attributes of securities such as mortgages, bonds, and stocks. ⊚ ⊚

true false

10) One of the factors responsible for globalization of financial markets and institutions is deregulation. ⊚ ⊚

true false

11) The average cost incurred by financial institutions to collect information is larger than that of individuals. ⊚ ⊚

true false

12) The Vol-cker Rule prohibits U.S. depository institutions from engaging in proprietary trading. ⊚ ⊚

true false

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13)

Financial intermediation provides direct transfer of funds to the users. ⊚ ⊚

true false

14) In the United States, the SEC provides deposit insurance for $250,000 per person per bank. ⊚ ⊚

true false

15) An Enterprise Risk Management (ERM) system is responsible for managing the totality of a firm’s risk exposures. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) What factors are encouraging financial institutions to offer overlapping financial services such as banking, investment banking, brokerage, etc.? 1.I. Regulatory changes allowing institutions to offer more services 2.II. Technological improvements reducing the cost of providing financial services 3.III. Increasing competition from full-service global financial institutions 4.IV. Reduction in the need to manage risk at financial institutions

A) I only B) II and III only C) I, II, and III only D) I, II, and IV only E) I, II, III, and IV

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17) IBM creates and sells additional stock to the investment banker Morgan Stanley. Morgan Stanley then resells the issue to the U.S. public through its mutual funds.

This transaction is an example of a(n): A) primary market transaction.

B) asset transformation by Morgan Stanley.

C) money market transaction.

D) foreign exchange transaction.

E) forward transaction.

18) IBM creates and sells additional stock to the investment banker Morgan Stanley. Morgan Stanley then resells the issue to the U.S. public through its mutual funds.

Morgan Stanley is acting as a(n)

A) asset transformer.

B) asset broker.

C) government regulator.

D) foreign service representative.

E) derivatives trader.

19) A corporation seeking to sell new equity securities to the public for the first time in order to raise cash for capital investment would most likely:

A) conduct an IPO with the assistance of an investment banker.

B) engage in a secondary market sale of equity.

C) conduct a private placement to a large number of potential buyers.

D) place an ad in the Wall Street Journal soliciting retail suppliers of funds.

E) issue bonds with the assistance of a dealer.

20)

The largest capital market security outstanding in 2019 measured by market value was:

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A) securitized mortgages.

B) corporate bonds.

C) municipal bonds.

D) Treasury bonds.

E) corporate stocks.

21)

The diagram below is a diagram of the:

A) secondary markets.

B) primary markets.

C) money markets.

D) derivatives markets.

E) commodities markets.

22) and allow a financial intermediary to offer safe liquid liabilities such as deposits while investing the depositors' money in riskier illiquid assets.

A) Diversification; high equity returns B) Price risk; collateral C) Free riders; regulations D) Monitoring; diversification E) Primary markets; foreign exchange markets

23)

Depository institutions include:

A) banks only.

B) thrifts only.

C) finance companies only.

D) banks and thrifts.

E) All of these choices are correct.

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24) Match the intermediary with the characteristic that best describes its function. 1.I. Provide protection from adverse events 2.II. Pool funds of small savers and invest in either money or capital markets 3.III. Provide consumer loans and real estate loans funded by deposits 4.IV. Accumulate and transfer wealth from work period to retirement period 5.V. Underwrite and trade securities and provide brokerage services 1.Thrifts 2.Insurers 3.Pension funds 4.Securities firms and investment banks 5.Mutual funds

A) 1, 3, 2, 5, 4 B) 4, 2, 3, 5, 1 C) 2, 5, 1, 3, 4 D) 2, 4, 5, 3, 1 E) 5, 1, 3, 2, 4

25) Secondary markets help support primary markets because secondary markets: 1.I. offer primary market purchasers liquidity for their holdings.

2.II. update the price or value of the primary market claims.

3.III. reduce the cost of trading the primary market claims.

A) I only B) II only C) I and II only D) II and III only E) I, II, and III

26) Financial intermediaries (FIs) can offer savers a safer, more liquid investment than a capital market security, even though the intermediary invests in risky illiquid instruments because:

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A) FIs can diversify away some of their risk.

B) FIs closely monitor the riskiness of their assets.

C) the federal government requires them to do so.

D) FIs can diversify away some of their risk and closely monitor the riskiness of their assets.

E) FIs can diversify away some of their risk and the federal government requires them to do so.

27) Households are increasingly likely to both directly purchase securities (perhaps via a broker) and also place some money with a bank or thrift to meet different needs. Match the given investor's desire with the appropriate intermediary or direct security.

1.I. Money likely to be needed within six months 2.II. Money to be set aside for college in 10 years 3.III. Money to provide supplemental retirement income 4.IV. Money to be used to provide for children in the event of death 1.Depository institutions 2. Insurer 3.Pension fund 4.Stocks or bonds

A) 2, 3, 4, 1 B) 1, 4, 2, 3 C) 3, 2, 1, 4 D) 1, 4, 3, 2 E) 4, 2, 1, 3

28) As of 2019, which one of the following derivatives instruments had the greatest amount of notional principal outstanding?

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A) Futures B) Swaps C) Options D) Bonds E) Forwards

29)

Which of the following is/are money market instrument(s)?

A) Negotiable CDs B) Common stock C) T-bonds D) 4-year maturity corporate bond E) Negotiable CDs, common stock, and T-bonds

30)

The Securities Exchange Commission (SEC) does not:

A) decide whether a public issue is fairly priced.

B) decide whether a firm making a public issue has provided enough information for investors to decide whether the issue is fairly priced.

C) require exchanges to monitor trading to prevent insider trading.

D) attempt to reduce excessive price fluctuations.

E) monitor the major securities exchanges.

31)

The most diversified type of depository institutions is:

A) credit unions.

B) savings associations.

C) commercial banks.

D) finance companies.

E) mutual funds.

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32)

Insolvency risk at a financial intermediary (FI) is the risk:

A) that promised cash flows from loans and securities held by FIs may not be paid in full.

B) incurred by an FI when the maturities of its assets and liabilities do not match.

C) that a sudden surge in liability withdrawals may require an FI to liquidate assets quickly at fire sale prices.

D) incurred by an FI when its investments in technology do not result in cost savings or revenue growth.

E) that an FI may not have enough capital to offset a sudden decline in the value of its assets.

33) Depository institutions (DIs) play an important role in the transmission of monetary policy from the Federal Reserve to the rest of the economy because:

A) loans to corporations are part of the money supply.

B) bank and thrift loans are tightly regulated.

C) U.S. DIs compete with foreign financial institutions.

D) DI deposits are a major portion of the money supply.

E) thrifts provide a large amount of credit to finance residential real estate.

34)

Liquidity risk at a financial intermediary (FI) is the risk:

A) that promised cash flows from loans and securities held by FIs may not be paid in full.

B) incurred by an FI when the maturities of its assets and liabilities do not match.

C) that a sudden surge in liability withdrawals may require an FI to liquidate assets quickly at fire sale prices.

D) incurred by an FI when its investments in technology do not result in cost savings or revenue growth.

E) that an FI may not have enough capital to offset a sudden decline in the value of its assets.

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35) Money markets trade securities that: 1.I. mature in one year or less.

2.II. have little chance of loss of principal.

3.III. must be guaranteed by the federal government.

A) I only B) II only C) I and II only D) I and III only E) I, II, and III

36)

Which of the following are capital market instruments?

A) 10-year corporate bonds B) 30-year mortgages C) 20-year Treasury bonds D) 15-year U.S. government agency bonds E) All of these choices are correct.

37)

Commercial paper is a:

A) time draft payable to a seller of goods, with payment guaranteed by a bank.

B) loan to an individual or business to purchase a home, land, or other real property.

C) short-term fund transferred between financial institutions usually for no more than one day.

D) marketable bank-issued time deposit that specifies the interest rate earned and a fixed maturity date.

E) short-term unsecured promissory note issued by a company to raise funds for a short time period.

38)

A negotiable CD is a:

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A) time draft payable to a seller of goods, with payment guaranteed by a bank.

B) loan to an individual or business to purchase a home, land, or other real property.

C) short-term fund transferred between financial institutions usually for no more than one day.

D) marketable bank-issued time deposit that specifies the interest rate earned and a fixed maturity date.

E) short-term unsecured promissory note issued by a company to raise funds for a short time period.

39) Financial intermediaries’ ability to reduce the average cost of collecting information because of their efficient operations allows them to take advantage of:

A) asset transformation.

B) economies of scale.

C) economies of scope.

D) transformational trading.

E) standardization.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

40) Discuss how secondary markets benefit issuers and investors.

41)

How can brokers and dealers make money? Which activity is riskier? Why?

42)

What does an asset transformer do? Why is asset transformation a risky activity?

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43) How can using indirect finance rather than direct finance reduce agency costsfor users of funds that is associated with monitoring funds?

44)

What have been the major factors contributing to growth in the foreign financial markets?

45) You are a corporate treasurer seeking to raise funds for your firm. What are some advantages of raising funds via a financial intermediary (FI) rather than by selling securities to the public?

46) How can a depository intermediary (DI) afford to purchase long-term risky direct claims from users of funds and finance these purchases with safe, liquid, short-term, low-denomination deposits? What can go wrong in this process?

47) Discuss the benefits to funds suppliers of using a financial intermediary asset transformer in place of directly purchasing claims such as stocks or bonds. What is the major disadvantage?

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48) Discuss the major macro benefits of financial intermediaries. What role does the government have in the credit allocation process?

49) What determines the price of financial instruments? Which are riskier, capital market instruments or money market instruments? Why?

50) Explain how the credit crunch originating in the mortgage markets hurt financial intermediaries' attempts to use diversification and monitoring to limit the riskiness of their loans and investments while offering more liquid claims to savers.

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Answer Key Test name: Chap 01_8e 1) TRUE 2) FALSE 3) FALSE 4) TRUE 5) TRUE 6) TRUE 7) TRUE 8) FALSE 9) FALSE 10) TRUE 11) FALSE 12) TRUE 13) FALSE 14) FALSE 15) TRUE 16) C 17) A 18) A 19) A 20) E 21) B 22) D 23) D 24) C 25) E 26) D 14

27) D 28) B 29) A 30) A 31) C 32) E 33) D 34) C 35) C 36) E 37) E 38) D 39) B 40) The secondary markets provide liquidity to investors after their initial purchase of the security. This liquidity encourages them to purchase the security at the initial offer. The current market price also reflects current prospects for the firm and the competitiveness of the issue relative to similar securities. Corporate treasurers follow their stock's price closely because the stock price reflects how well their firm and the market are performing. The current security price also provides information about the cost of obtaining any additional funds.

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41) An asset broker assists buyers and sellers of securities by providing a mechanism for buyers or sellers to process their orders. If the broker assists one party in finding another party, the broker charges a small fee called a commission. An asset dealer buys the security for his or her own account at the bid price and then sells the security at a higher ask price.

The dealer profits by earning the bid-ask spread or the difference between the buy and sell prices. The dealer's function is riskier because the dealer must maintain an inventory of the asset and honor quotes to buy and sell. If the security is risky, the value of the inventory can fluctuate with market prices. The broker takes less risk because he or she does not own the security.

42) An asset transformer buys one security from a customer and makes or creates a separate claim in order to raise funds. For example, a bank accepts deposits and uses them to make loans. This is normally a risky activity because the asset acquired will be riskier than the security (or deposit) used to raise funds because the intermediary hopes to profit on the spread between the rate earned on the asset claim and the rate paid on the liability claim. In order for this spread to be positive, generally speaking, the asset must be riskier than the liability.

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43) A large FI has a greater incentive to monitor the behavior of users of funds in indirect financing. The FI supposedly hires and trains experts who know how to collect information about a fund's user and evaluate whether the fund's user is acting appropriately. In direct finance, a fund user sells claims to the public at large. In this case, there is little incentive for an individual claim holder to monitor and attempt to enforce good behavior on the part of the fund's user. The benefit of monitoring and enforcement is shared among all claim holders, but the cost would be borne by the sole individual. This is termed the "freerider" problem. If there is improved monitoring of borrower behavior, the problem of agency costs is likely to be reduced.

44) 1.The amount of savings available for investment in foreign countries has increased.

2. International investors have looked to the United States and other markets for better investment opportunities.

3. The Internet has helped provide additional information on foreign markets and overseas investment opportunities.

4. Specialized intermediaries such as country-specific mutual funds have been developed to facilitate overseas investments.

5. The euro has had a notable impact on the global financial system by being an important currency for international transactions.

6. Deregulation of foreign markets has allowed many new investors to participate in international investing.

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45) Advantages include: ● Speed: Funds can normally be raised more quickly through FIs. ● Registration process/cost: The registration process can be quite costly and time-consuming in terms of workers' hours, audit fees, and fees to investment bankers. Raising funds via an FI can be less expensive, particularly for smaller capital needs or when funds are needed for only a short time period. (Maturities of 270 days or less do not require registration, nor do private placements.) ● Flexible terms: Nonstandard terms can be negotiated with FIs but are difficult to sell to the public. For example, if a borrower can only begin paying interest after two years, he or she would have a difficult time selling bonds to the public. ● Ability to change terms: There is a greater ability to renegotiate terms if necessary. Terms of public issue generally cannot be changed outside of court. ● Privacy: Less information is made public.

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46) DIs can afford to do so because the rate they must pay to attract funds is lower than the rate they can charge on their riskier assets. A lot can go wrong, however, including: ● If the money lent is not repaid, the DI may not be able to repay its depositors on demand (credit and liquidity risk). Diversification of the credit risk is a key way DIs limit credit risk. ● The difference between the rate earned on assets and the rate paid on liabilities is called the Net Interest Margin (NIM). The NIM can turn negative if interest rates rise or if the rates on long-term securities fall below the interest rate risk on short-term securities (after adjusting for risk). ● Because the assets and liabilities are different claims, it is possible for the value of the assets to drop resulting in an insolvent institution (insolvency risk). Because the assets are primarily financial, their value can be quite volatile. As a result, risk management is crucial at today's financial institution. ● DIs attract many savers with a small amount of funds. DIs then invest the bulk of these savings in investments that cannot be immediately liquidated. If the savers lose confidence in the DI, they will seek to withdraw their money, which can precipitate a liquidity crisis and cause insolvency.

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47) Potential benefits to funds suppliers are as follows: ● Professional risk managers to assess risk of borrower's claim and help decide the correct price to pay. ● Risk reduction via: ● insurance. ● additional diversification. ● more frequent monitoring. ● additional cushion of FI equity. ● improved liquidity of funds supplier’s claim on FI. ● Denomination intermediation. ● Maturity intermediation. ● The major disadvantage is that you may forego potentially higher returns if you do not purchase the riskier direct claims.

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48) ● Money supply transmission: Depository institutions affect the level of money supply growth in the economy. The money supply is increased when the Fed increases money available to banks, but the extent of money supply growth is affected by banks' decisions to lend the increased supply of funds. If the banks do not lend the increased money, the given increase in funds by the Fed will result in only a small change in the total money supply in the economy. ● Credit Allocation: FIs price risk and allocate capital to users who they believe can generate a high enough rate of return to compensate the lender for the risk the lender bears in loaning the money. FIs also monitor the borrower's condition after the loan is made. A wellfunctioning economy must have sound mechanisms for allocating capital. In capitalist countries, FIs and markets allocate capital to its highest valued uses, thereby maximizing economic growth. The role of government is to ensure disclosure of risks and fair practices of all involved. In communist and some socialist countries, governments allocate capital according to a current political agenda and strong, lasting economic growth is rarely, if ever, seen in these countries. As the text indicates, the government can also channel credit to socially deserving areas such as housing, farms, and small business development. ● Intergenerational wealth transfers and risk shifting: Pension funds and insurance firms allow investors to transfer wealth through time, while avoiding taxation, and/or allow investors the ability to choose which risks in their life they will bear and which they will insure. ● Payment services: The ability to store and quickly move large sums of money (or many small sums) at low cost with little risk encourages greater investment by market participants and, thus, lowers the overall cost of funds in our economy.

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49) The price of any financial instrument is the present value of future cash flows discounted at an appropriate rate. A small change in interest rates causes a large change in present value of distant cash flows. Hence, the prices of long-term capital market instruments are more sensitive to changes in interest rates than prices of short-term instruments. In addition, distant cash flows for stocks are not known with certainty.

Changing economic prospects can cause very large changes in current stock values. Money market instruments have predictable cash flows and mature in one year or less, so they are much less risky.

50) Financial intermediaries' (FIs) attempts to diversify away from specific risk failed when large portions of the debt markets "seized up" and stopped functioning. At that point, many security prices declined all at once, regardless of historical correlations among security prices. This is a failure of diversification to reduce risk. FIs exploit diversification principles and economies of scale to allow the FI to invest large amounts of money. They also must closely monitor the riskiness of their loans and securities, and many FIs are also regulated by the government to ensure they manage the riskiness of their assets. Some would argue that FIs failed to monitor the riskiness of many of their mortgage investments as well, leading to large numbers of poor investments.

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Chapter 2: Determinants of Interest Rates TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) The real risk-free rate is the increment to purchasing power that the lender earns in order to induce him or her to forego current consumption. ⊚ ⊚

true false

2) If you earn 0.5 percent a month in your bank account, this would be the same as earning a 6 percent annual interest rate with annual compounding. ⊚ ⊚

3)

true false

Simple interest calculations assume that interest earned is never reinvested. ⊚ ⊚

true false

4) An investor earned a 5 percent nominal risk-free rate over the year. However, over the year, prices increased by 2 percent. The investor's real risk-free rate was less than his nominal rate of return. ⊚ ⊚

true false

5) Earning a 5 percent interest rate with annual compounding is better than earning a 4.95 percent interest rate with semiannual compounding. ⊚ ⊚

true false

6) For any positive interest rate, the present value of a given annuity will be less than the sum of the cash flows, and the future value of the same annuity will be greater than the sum of the cash flows.

1

⊚ ⊚

true false

7) With a zero interest rate, both the present value and the future value of an N payment annuity would equal N × payment. ⊚ ⊚

true false

8) Given all other factors are unchanged, households generally supply more funds to the markets as their income and wealth increase. ⊚ ⊚

true false

9) An increase in the perceived riskiness of investments would cause a movement up along the supply curve. ⊚ ⊚

true false

10) An increase in the marginal tax rates for all U.S. taxpayers would probably result in reduced supply of funds by households. ⊚ ⊚

true false

11) When the quantity of a financial security supplied or demanded changes at every given interest rate in response to a change in a factor, this causes a shift in the supply or demand curve. ⊚ ⊚

true false

12) An improvement in economic conditions would likely shift the supply curve down and to the right and shift the demand curve for funds up and to the right.

2

⊚ ⊚

true false

13) The risk that a security cannot be sold at a predictable price with low transaction costs at short notice is called liquidity risk. ⊚ ⊚

true false

14) Convertible bonds will normally have lower promised yields than straight bonds of similar terms and quality. ⊚ ⊚

15)

true false

We expect liquidity premiums to move inversely with interest rate volatility. ⊚ ⊚

true false

16) Everything else equal, the interest rate required on a callable bond will be less than the interest rate on a convertible bond. ⊚ ⊚

true false

17) The term structure of interest rates is the relationship between interest rates on bonds that are similar in all terms except for maturity. ⊚ ⊚

true false

18) The unbiased expectations hypothesis of the term structure posits that long-term interest rates are unrelated to expected future short-term rates.

3

⊚ ⊚

true false

19) The traditional liquidity premium theory states that long-term interest rates are greater than the average of current and expected future short-term interest rates. ⊚ ⊚

true false

20) According to the market segmentation theory, short-term investors will not normally switch to intermediate- or long-term investments. ⊚ ⊚

true false

21) According to the liquidity premium theory, investors preferring long-term bonds over short-term bonds would require lower liquidity premium. ⊚ ⊚

true false

22) As the liquidity of corporate bonds decreases, the risk premium required on those bonds decreases as well. ⊚ ⊚

23)

true false

An increase in interest rates increases the demand for loanable funds. ⊚ ⊚

true false

24) A higher level of wealth causes the demand for loanable funds to increase and interest rates to fall.

4

⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

25) An investment pays $400 in one year, X amount of dollars in two years, and $500 in three years. The total present value of all the cash flows (including X) is equal to $1,500. If the nominal interest rate is 6 percent, what is X?

A) $702.83 B) $822.41 C) $789.70 D) $749.67 E) $600.00

26) An insurance company is trying to sell you a retirement annuity. The annuity will give you 20 payments with the first payment in 12 years when you retire. The insurance firm is asking you to pay $50,000 today. If this is a fair deal, what must the payment amount be (to the nearest dollar) if the interest rate is 8 percent?

A) $5,093 B) $12,824 C) $9,472 D) $11,874 E) $10,422

27) Suppose you can save $2,000 per year for the next ten years in an account earning 7 percent per year. How much will you have at the end of the tenth year if you make the first deposit today?

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A) $34,187.75 B) $29,567.20 C) $31,217.36 D) $27,364.15 E) $18,364.25

28) An annuity and an annuity due with the same number of payments have the same future value if the interest rate is 10 percent. Which one has the higher payment?

A) They both must have the same payment since the future values are the same.

B) There is no way to tell which has the higher payment.

C) An annuity and an annuity due cannot have the same future value.

D) The annuity has the higher payment.

E) The annuity due has the higher payment.

29) You go to the Wall Street Journal and notice that yields on almost all corporate and Treasury bonds have decreased. The yield decreases may be explained by which one of the following?

A) A decrease in U.S. inflationary expectations.

B) Newly expected decline in the value of the dollar.

C) An increase in current and expected future returns of real corporate investments.

D) Decreased Japanese purchases of U.S. Treasury bills/bonds.

E) Increases in the U.S. government budget deficit.

30)

YIELD CURVE FOR ZERO-COUPON BONDS RATED AA Maturity 1 year 2 year 3 year 4 year 5 year 6 year

YTM 8.00% 8.11% 8.20% 8.50% 8.75% 8.85%

Maturity 7 year 8 year 9 year 10 year 11 year 12 year

YTM 9.15% 9.25% 9.35% 9.47% 9.52% 9.77%

Maturity 13 year 14 year 15 year 16 year 17 year 18 year

YTM 10.45% 10.65% 10.75% 10.95% 11.00% 11.25%

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Assume that there are no liquidity premiums.

To the nearest basis point, what is the expected interest rate on a four-year maturity, AA zerocoupon bond purchased six years from today?

A) 10.41% B) 10.05% C) 9.16% D) 10.56% E) 9.96%

31)

YIELD CURVE FOR ZERO-COUPON BONDS RATED AA Maturity 1 year 2 year 3 year 4 year 5 year 6 year

YTM 8.00% 8.11% 8.20% 8.50% 8.75% 8.85%

Maturity 7 year 8 year 9 year 10 year 11 year 12 year

YTM 9.15% 9.25% 9.35% 9.47% 9.52% 9.77%

Maturity 13 year 14 year 15 year 16 year 17 year 18 year

YTM 10.45% 10.65% 10.75% 10.95% 11.00% 11.25%

Assume that there are no liquidity premiums.

You just bought a 15-year maturity Xerox corporate bond rated AA with a zero percent coupon.

You expect to sell the bond in eight years. Find the expected interest rate at the time of sale.

A) 13.92% B) 11.00% C) 8.85% D) 12.49% E) 12.80%

32)

According to the liquidity premium theory of interest rates:

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A) long-term spot rates are higher than the average of current and expected future shortterm rates.

B) investors prefer certain maturities and will not normally switch out of those maturities.

C) investors are indifferent between different maturities if the long-term spot rates are equal to the average of current and expected future short-term rates.

D) the term structure must always be upward sloping.

E) long-term spot rates are totally unrelated to expectations of future short-term rates.

33)

Of the following, which is the most likely effect of an increase in income tax rates?

A) Decrease in the savings rate.

B) Decrease in the supply of loanable funds.

C) Increase in the interest rates.

D) All of these choices are correct.

34) Upon graduating from college this year, you expect to earn $25,000 per year. If you get your MBA, in one year you can expect to start at $35,000 per year. Over the year, inflation is expected to be 5 percent. In today's dollars, how much additional (less) money will you make from getting your MBA (to the nearest dollar) in your first year?

A) −$2,462 B) $8,333 C) $8,750 D) $9,524 E) $10,000

35) Investment A pays 8 percent simple interest for 10 years. Investment B pays 7.75 percent compound interest for 10 years. Both require an initial $10,000 investment. The future value of A minus the future value of B is equal to (to the nearest penny).

8

A) $2,500.00 B) −$2,500.00 C) $1,643.32 D) $3,094.67 E) −$3,094.67

36) You buy a car for $38,000. You agree to a 60-month loan with a monthly interest rate of 0.55 percent. What is your required monthly payment?

A) $634.24 B) $745.29 C) $605.54 D) $764.07 E) None of these choices are correct.

37) You want to have $5 million when you retire in 40 years. You believe you can earn 9 percent per year on your investment. How much must you invest each year to achieve your goal when you retire? (Ignore all taxes.)

A) $10,412 B) $11,619 C) $14,798 D) $15,295 E) None of these choices are correct.

38) An investor wants to be able to buy 4 percent more goods and services in the future in order to induce her to invest today. During the investment period, prices are expected to rise by 2 percent. Which statement(s) below is/are true?

1.I. 4 percent is the desired real risk-free interest rate.

2.II. 6 percent is the approximate nominal rate of interest required.

3.III. 2 percent is the expected inflation rate over the period.

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A) I only B) II only C) III only D) I and II only E) I, II, and III

39) Classify each of the following in terms of its effect on interest rates (increase or decrease): 1.I. Perceived risk of financial securities increases.

2.II. Near term spending needs decrease.

3.III. Future profitability of real investments increases.

A) I increases: II increases: III increases B) I increases: II decreases: III decreases C) I decreases: II increases: III increases D) I decreases; II decreases; III decreases E) None of these choices are correct.

40) Classify each of the following in terms of its effect on interest rates (increase or decrease): 1.I. Covenants on borrowing become more restrictive.

2.II. The Federal Reserve increases the money supply.

3.III. Total household wealth increases.

A) I increases; II increases; III increases B) I increases; II decreases; III decreases C) I decreases; II increases; III increases D) I decreases; II decreases; III decreases E) None of these choices are correct.

10

41) Inflation causes the demand curve for loanable funds to shift to the supply curve to shift to the .

and causes the

A) right; right B) right; left C) left; left D) left; right

42) An individual actually earned a 4 percent nominal return last year. Prices went up by 3 percent over the year. Given that the investment income was subject to a federal tax rate of 28 percent and a state and local tax rate of 6 percent, what was the investor's actual real after-tax rate of return?

A) −0.36% B) 0.66% C) 0.72% D) 1.45% E) 2.64%

43) A 15-payment annual annuity has its first payment in nine years. If the payment amount is $1,400 and the interest rate is 7 percent, what is the most you should be willing to pay today for this investment?

A) $5,825.11 B) $12,751.08 C) $6,416.67 D) $7,421.24 E) $6,935.74

11

44) Which of the following would normally be expected to result in an increase in the supply of funds, all else equal?

1.I. The perceived riskiness of all investments decreases.

2.II. Expected inflation increases.

3.III. Current income and wealth levels increase.

4.IV. Near term spending needs of households increase as energy costs rise.

A) I and III only B) II and III only C) II, III, and IV only D) I and IV only E) I, II, III, and IV

45) An investor requires a 3 percent increase in purchasing power in order to induce her to lend. She expects inflation to be 2 percent next year. The nominal rate she must charge is about:

A) 3 percent.

B) 2 percent.

C) 1 percent.

D) 5 percent.

E) 7 percent.

46) The term structure of interest rates is upward sloping for all bond types. A certain AAArated, noncallable 10-year corporate bond has been issued at a 6.15 percent promised yield.

Which one of the following bonds probably has a higher promised yield?

A) A similar quality municipal bond.

B) A noncallable, AAA-rated corporate bond with a five-year maturity.

C) A callable, AAA-rated corporate bond with a 15-year maturity.

D) A noncallable, AAA-rated convertible corporate bond with a 10-year maturity.

E) All of these choices are correct.

47)

Which of the following bond types pays interest that is exempt from federal taxation?

12

A) Municipal bonds B) Corporate bonds C) Treasury bonds D) Convertible bonds E) Municipal bonds and Treasury bonds

48)

The relationship between maturity and yield to maturity is called the .

A) loan covenant B) term structure C) bond indenture D) Fisher effect E) DRP structure

49)

According to the unbiased expectations theory:

A) markets are segmented and buyers stay in their own segment.

B) liquidity premiums are negative and time varying.

C) the term structure will most often be upward sloping.

D) the long-term spot rate is an average of the current and expected future short-term interest rates.

E) forward rates are less than the expected future spot rates.

50) Suppose that the current one-year Treasury-bill rate is 3.15 percent and the expected oneyear rate 12 months from now is 4.25 per-cent. According to the unbiased expectations theory, what should be the current rate for a two-year Treasury security?

13

A) 3.70% B) 4.15% C) 2.36% D) 4.74% E) 5.50%

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) Suppose you borrow $15,000 and then repay the loan by making 12 monthly payments of $1,297.92 each. What rate will you be quoted on the loan?

52)

What is the loanable funds theory of interest rates?

53) What is the difference between the expected real interest rate and the real risk-free interest rate actually earned?

54) Can the actual real rate of interest be negative? When? Can the expected real rate be negative?

14

55) In October 1987 stock prices fell 22 percent in one day and bond rates fell also. Use the loanable funds theory to explain what happened.

56) A foreign investor placing money in dollar-denominated assets desires a 4 percent real rate of return. Global inflation is running about 3 percent, and the dollar is expected to decline against her home currency by 1.5 percent over the investment period. What is her minimum required rate of return? Explain.

57) Would you expect the demand curve for businesses to be steeper than the demand curve for funds by the federal government? Explain.

58) Who are the major suppliers and demanders of funds in the United States and what is the typical position of each?

59) According to current projections, Social Security and other entitlement programs will soon be severely underfunded. If the government decides to cut social security benefits to future retirees and raise Social Security taxes on all workers, what will probably happen to the supply of funds available to the capital markets? What will be the effect on interest rates?

15

60) The one-year spot rate is currently 4 percent; the one-year spot rate one year from now will be 3 percent; and the one-year spot rate two years from now will be 6 percent. Under the unbiased expectations theory, what must today's three-year spot rate be? Suppose the three-year spot rate is actually 3.75 percent, how could you take advantage of this? Explain.

61)

Explain the logic of the liquidity premium theory of the term structure.

62)

Explain the market segmentation theory of the term structure.

16

Answer Key Test name: Chap 02_8e 1) TRUE 2) FALSE 3) TRUE 4) TRUE 5) FALSE 6) TRUE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) TRUE 12) TRUE 13) TRUE 14) TRUE 15) FALSE 16) FALSE 17) TRUE 18) FALSE 19) TRUE 20) TRUE 21) FALSE 22) FALSE 23) FALSE 24) FALSE 25) C X = [$1,500 − ($400/1.06) − ($500/1.063)] × 1.062 17

26) D $50,000 × 1.0811 = Pmt × PVIFA (8%, 20 yrs.)

27) B FV = $2,000{[(1 + 0.07)10 − 1]/0.07}(1 + 0.07) = $29,567.20. With a financial calculator, set the payments at Begin mode, BGN, since the savings are happening at the beginning of the interest earning periods, then N = 10, I = 7, PV = 0, PMT = −2,000, then compute FV = $29,567.20.

28) D 29) A 30) A [(1.094710/1.08856)](1/4) − 1 31) D (1.107515/1.09258)(1/7) − 1 32) A 33) D 34) B (35,000/1.05) − 25,000 35) E [10,000 + (800 × 10)] − [10,000 × 1.077510] 36) B Pmt = 38,000/PVIFA (i = 0.55%, n = 60) 37) C $5 million/[(1.0940 − 1)/0.09] 38) E 39) E

18

40) D 41) B 42) A {0.04 × [1 − (0.28 + 0.06)]} − 0.03 43) D PV0 = $1,400 × {[1 − 1.07-15]/0.07}/1.078 44) A 45) D 46) C 47) A 48) B 49) D 50) A 0.5 − 1 = .03699, or 3.699% which is 1R2 = [(1 + .0315)(1 + .0425)] 3.70% rounded.

51) The interest rate is the solution to the following: PV = PMT × [(1 − (1 + r)−N))/r], or $15,000 = $1,297.92 × [(1 − (1 + r)−12))/r] r = 0.5836% per month You will be quoted the monthly rate times 12, or 0.5836% × 12 = 7.00%. The effective annual rate is then found as 1.005836 12 − 1 = .0723, or 7.23%.

52) The level of interest rates in the economy is set by economic agents' willingness to make funds available to capital markets and borrowers' demand for funds in the capital markets at various interest rates. The interest rate where the supply of funds matches demand for funds is the equilibrium interest rate.

19

53) The expected real rate of interest is the nominal rate minus the expected inflation rate. The actual (or realized) real rate is the nominal rate of interest (absent default) minus the actual rate of inflation.

54) The actual real rate can be negative when actual inflation is greater than the nominal rate of interest. The expected real rate normally must be positive because investors build into the nominal rate a premium for expected inflation. However, in Japan, expected real rates have historically been negative for certain periods on bank accounts and have still attracted funds. Investors in this case are willing to pay a (small) storage premium to banks for the convenience and safe keeping that bank accounts provide.

55) The worsening of perceived future economic conditions and a likely increase in risk premiums on equities caused a so-called "flight to quality." Reduced supply of funds in stock markets caused falling prices and, as the money moved into bonds, the increased supply of funds available for borrowing pushed bond rates down.

56) Approximately 4% + 3% + 1.5% = 8.5% She would have to earn an additional 3 percent to cover the rising cost of goods and services and an additional 1.5 percent to cover the loss in value of her dollars, since the dollars she will get back will buy fewer units of her home currency. All this is needed in order to preserve a 4 percent increase in real purchasing power in her home country.

57) Because businesses have a profit motive and the federal government does not, we would expect business demand for funds to be more sensitive to the interest rate than the federal government demand. Hence, the demand for funds by businesses would exhibit a flatter curve (more elastic) than the demand by the government (less elastic).

20

58) Households; net suppliers Businesses; net demanders Governments; net demanders Foreign investors; net suppliers 59) Cutting future benefits should encourage additional savings by the working public to fund workers’ retirements. This should lead to an increase in the supply of funds available. Raising taxes, on the other hand, may curtail savings because of the reduction of income. This would reduce the supply of funds available. The net effect on interest rates is indeterminate.

60) Under the unbiased expectations theory, the three-year spot rate should equal the geometric average of the three one-year rates to prevent arbitrage [(1.04 × 1.03 × 1.06)1/3 − 1] = .043259, or 4.3259%. If the three-year spot is actually 3.75 percent, one should borrow any given amount, say $1,000, for the full three years at the three-year rate of 3.75 percent and simultaneously invest the money for one year at 4 percent, and then roll the investment over in one year and earn 3 percent in the second year and then finally roll the investment over one final time and earn 6 percent in year three. Your average annual investment return is 4.3259 percent and the annual borrowing rate is 3.75 percent. You net the difference without using any of your own money.

61) Securities with different maturities are not perfect substitutes so the unbiased expectations theory does not strictly hold. In particular, there is a preference for shorter-term holdings. Thus, to induce investors to invest long term, a premium interest rate over what could be earned by investing short term and rolling the investment over must be offered.

21

62) This argument is actually a more extreme version of the liquidity premium argument. Not only are different maturity securities not perfect substitutes, broadly speaking, they are not substitutes at all, and one cannot imply that supply and demand conditions in one maturity segment affect supply and demand conditions in another segment. Banks are usually hypothesized as short-term investors and pension funds and life insurers are cast in the role of long-term investors. Both are myopic in that they ignore yields outside of their normal sector. No explanation of why other less myopic investors do not enter the market to exploit unarbitraged advantages among rate differentials is put forth. Presumably, in innovative capital markets, participants would not leave profit opportunities unexploited.

22

Chapter 3: Interest Rates and Security Valuation TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) If interest rates increase, the value of a fixed-income contract decreases and vice versa. ⊚ ⊚

true false

2) At equilibrium, a security's required rate of return will be less than its expected rate of return. ⊚ ⊚

true false

3) If a security's realized return is negative, it must have been true that the expected return was greater than the required return. ⊚ ⊚

true false

4) Suppose two bonds of equivalent risk and maturity have different prices such that one is a premium bond and one is a discount bond. The premium bond must have a greater expected return than the discount bond. ⊚ ⊚

true false

5) A bond with an 11 percent coupon and a 9 percent required return will sell at a premium to par. ⊚ ⊚

true false

6) A fairly-priced bond with a coupon less than the expected return must sell at a discount from par. ⊚ ⊚

true false 1

7) All else equal, the holder of a fairly-priced premium bond must expect a capital loss over the holding period. ⊚ ⊚

8)

true false

The duration of a four-year maturity, 10 percent coupon bond is less than four years. ⊚ ⊚

true false

9) All else held constant, the longer the time to maturity, the lower the security's price sensitivity to an interest rate change. ⊚ ⊚

true false

10) All else held constant, the greater a security's coupon, the lower the security's price sensitivity to an interest rate change. ⊚ ⊚

true false

11) For a given interest rate change, a 20-year bond's price change will be twice that of a 10year bond's price change. ⊚ ⊚

12)

true false

Any security that returns a greater percentage of the price sooner is less price volatile. ⊚ ⊚

true false

2

13)

A zero-coupon bond has a duration equal to its maturity and a convexity equal to zero. ⊚ ⊚

true false

14) The lower the level of interest rates, the greater a bond's price sensitivity to interest rate changes. ⊚ ⊚

15)

The higher a bond's coupon, the lower the bond's price volatility. ⊚ ⊚

16)

true false

true false

All else held constant, higher interest rates lead to lower bond convexity. ⊚ ⊚

true false

17) A 10-year maturity, zero-coupon bond will have lower price volatility than a 10-year bond with a 10 percent coupon. ⊚ ⊚

true false

18) Ignoring default risk, if a bond's expected return is greater than its required return, then the bond's market price must be greater than the present value of the bond's cash flows. ⊚ ⊚

true false

19) The coupon rate represents the most accurate measure of the bondholder’s required return.

3

⊚ ⊚

20)

true false

All else held constant, the higher the interest rate is the higher the duration. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) The required rate of return on a bond is:

A) the interest rate that equates the current market price of the bond with the present value of all future cash flows received.

B) equivalent to the current yield for nonpar bonds.

C) less than the expected return for discount bonds and greater than the expected return for premium bonds.

D) inversely related to a bond's risk and coupon.

E) None of these choices are correct.

22)

Duration is:

A) the elasticity of a security's value to small coupon changes.

B) the weighted average time to maturity of the bond's cash flows.

C) the time until the investor recovers the price of the bond in today's dollars.

D) greater than maturity for deep discount bonds and less than maturity for premium bonds.

E) the second derivative of the bond price formula with respect to the yield to maturity.

4

23) Which of the following bond terms are generally positively related to bond price volatility? 1.I. Coupon rate 2.II. Maturity 3.III. YTM 4.IV. Payment frequency

A) II and IV only B) I and III only C) II and III only D) II only E) II, III, and IV only

24)

The interest rate used to find the present value of a financial security is the:

A) expected rate of return.

B) required rate of return.

C) realized rate of return.

D) realized yield to maturity.

E) current yield.

25)

A security has an expected return less than its required return. This security is:

A) selling at a premium to par.

B) selling at a discount to par.

C) selling for more than its present value.

D) selling for less than its present value.

E) a zero-coupon bond.

26) A bond that you held to maturity had a realized return of 8 percent, but when you bought it, it had an expected return of 6 percent. If no default occurred, which one of the following must be true?

5

A) The bond was purchased at a premium to par.

B) The coupon rate was 8 percent.

C) The required return was greater than 6 percent.

D) The coupons were reinvested at a higher rate than expected.

E) The bond must have been a zero-coupon bond.

27) You would want to purchase a security if the price is expected return is the required rate of return.

the present value or if the

A) greater than or equal to; less than or equal to B) greater than or equal to; greater than or equal to C) less than or equal to; greater than or equal to D) less than or equal to; less than or equal to

28) A 10-year annual payment corporate bond has a market price of $1,050. It pays annual interest of $100 and its required rate of return is 9 percent. Is the bond correctly priced, overpriced, or underpriced? If it is overpriced or underpriced, then list by how much.

A) Correctly priced B) Overpriced by $14.18 C) Underpriced by $14.18 D) Overpriced by $9.32 E) Underpriced by $9.32

29) A 12-year annual payment corporate bond has a market price of $925. It pays annual interest of $60 and its required rate of return is 7 percent. Is the bond correctly priced, overpriced, or underpriced? If it is overpriced or underpriced, then list by how much.

6

A) Correctly priced B) Overpriced by $7.29 C) Underpriced by $7.29 D) Overpriced by $4.43 E) Underpriced by $4.43

30) An eight-year corporate bond has a 7 percent coupon rate. What should be the bond's price if the required return is 6 percent and the bond pays interest semiannually?

A) $1,062.81 B) $1,062.10 C) $1,053.45 D) $1,052.99 E) $1,049.49

31) A 15-year corporate bond pays $40 interest every six months. What is the bond's price if the bond's promised YTM is 5.5 percent?

A) $1,261.32 B) $1,253.12 C) $1,250.94 D) $1,263.45 E) $1,264.79

32) A corporate bond has a coupon rate of 10 percent and a required return of 10 percent.

This bond's price is:

A) $924.18.

B) $1,000.00.

C) $879.68.

D) $1,124.83.

E) not possible to determine from the information given.

7

33) A 10-year, annual payment corporate coupon bond has an expected return of 11 percent and a required return of 10 percent. The bond's market price is:

A) greater than its present value.

B) less than par.

C) less than its expected rate or return.

D) less than its present value.

E) $1,000.00.

34) An eight-year, annual payment, 7 percent coupon Treasury bond has a price of $1,075.

The bond's annual expected rate of return must be:

A) 13.49 percent.

B) 5.80 percent.

C) 7.00 percent.

D) 1.69 percent.

E) 4.25 percent.

35) A six-year, annual payment corporate bond has a required return of 9.5 percent and an 8 percent coupon. Its market value is $20 over its present value. What is the bond's expected rate of return?

A) 8.00% B) 10.21% C) 9.98% D) 9.03% E) 3.53%

8

36) Corporate Bond A returns 5 percent of its cost in PV terms in each of the first five years and 75 percent of its value in the sixth year. Corporate Bond B returns 8 percent of its cost in PV terms in each of the first five years and 60 percent of its cost in the sixth year. If A and B have the same required return, which of the following is/are true? 1.I. Bond A has a bigger coupon than Bond B. 2.II. Bond A has a longer duration than Bond B. 3.III. Bond A is less price-volatile than Bond B. 4.IV. Bond B has a higher PV than Bond A.

A) III only B) I, III, and IV only C) I, II, and IV only D) II and IV only E) I, II, III, and IV

37) A corporate bond returns 12 percent of its cost (in present value terms) in the first year, 11 percent in the second year, 10 percent in the third year, and the remainder in the fourth year.

What is the bond's duration in years?

A) 3.68 years B) 2.50 years C) 4.00 years D) 3.75 years E) 3.32 years

38) A semiannual payment bond with a $1,000 par has a 7 percent quoted coupon rate, a 7 percent promised yield to maturity, and 10 years to maturity. What is the bond's duration?

A) 10.00 years B) 8.39 years C) 6.45 years D) 5.20 years E) 7.35 years

9

39) An annual payment bond with a $1,000 par has a 5 percent quoted coupon rate, a 6 percent promised yield to maturity, and six years to maturity. What is the bond's duration?

A) 5.31 years B) 5.25 years C) 4.76 years D) 4.16 years E) 3.19 years

40) If an N-year security recovered the same percentage of its cost in present value terms each year, the duration would be:

A) N. B) 0.

C) sum of the years/ N. D) N!/N2.

E) None of these choices are correct.

41)

All is held constant, the the duration of a bond.

the coupon and the

the maturity; the

A) larger; longer; longer B) larger; longer; shorter C) smaller; shorter; longer D) smaller; shorter; shorter E) None of these choices are correct.

42) A four-year maturity, zero-coupon corporate bond with a required rate of return of 12 percent has an annual duration of years.

10

A) 3.05 B) 2.97 C) 3.22 D) 3.71 E) 4.00

43)

A decrease in interest rates will:

A) decrease the bond's present value.

B) increase the bond's duration.

C) lower the bond's coupon rate.

D) change the bond's payment frequency.

E) not affect the bond's duration.

44) A 10-year maturity coupon bond has a six-year duration. An equivalent 20-year bond with the same coupon has a duration:

A) equal to 12 years.

B) less than six years.

C) less than 12 years.

D) equal to six years.

E) greater than 20 years.

45) A six-year maturity bond has a five-year duration. Over the next year, maturity will decline by one year and duration will decline by:

A) less than one year.

B) more than one year.

C) one year.

D) N years.

E) N/( N − 1) years.

11

46) An annual payment bond has a 9 percent required return. Interest rates are projected to fall 25 basis points. The bond's duration is 12 years. What is the predicted price change?

A) −2.75% B) 33.33% C) 1.95% D) −1.95% E) 2.75%

47) A bond that pays interest annually has a 6 percent promised yield and a price of $1,025.

Annual interest rates are now projected to fall 50 basis points. The bond's duration is six years.

What is the predicted new bond price after the interest rate change? (Do not round on intermediate calculations.)

A) $1,042.33 B) $995.99 C) $1,054.01 D) $987.44 E) None of these choices are correct.

48) A bond that pays interest semiannually has a 6 percent promised yield and a price of $1,045. Annual interest rates are now projected to increase 50 basis points. The bond's duration is five years. What is the predicted new bond price after the interest rate change? (Do not round intermediate calculations.)

A) $1,020.35 B) $1,069.65 C) $1,070.36 D) $1,019.64 E) None of these choices are correct.

49)

Convexity arises because:

12

A) bonds pay interest semiannually.

B) coupon changes are the opposite sign of interest rate changes.

C) duration is an increasing function of maturity.

D) present values are a nonlinear function of interest rates.

E) duration increases at higher interest rates.

50)

The duration of a 180-day T-Bill is (in years):

A) 0.493.

B) 0.246.

C) 1.

D) 0.

E) indeterminate.

51)

The duration of a 91-day T-Bill is (in years):

A) 0.325.

B) 0.249.

C) 0.715.

D) 0.

E) Indeterminate.

52) For large interest rate increases, duration the fall in security prices, and for large interest rate decreases, duration the rise in security prices.

A) overpredicts; overpredicts B) overpredicts; underpredicts C) underpredicts; overpredicts D) underpredicts; underpredicts E) None of these choices are correct.

13

53) Suppose you owned stock in a company for the last three years. You originally bought the stock three years ago for $30 and just sold it for $56. The stock paid an annual dividend of $1.35 on the last day of each of the past three years. What is your realized return on this investment?

A) 15.36% B) 36.14% C) 26.85% D) 37.58% E) None of these choices are correct.

54) You are considering the purchase of a certain stock. You expect to own the stock for the next four years. The current market price of the stock is $24.50 and you expect to sell it for $55 in four years. You also expect the stock to pay an annual dividend of $1.25 at the end of Year 1, $1.35 at the end of Year 2, $1.45 at the end of Year 3, and $1.55 at the end of Year 4. What is your expected return from this investment?

A) 21.78% B) 18.36% C) 26.68% D) 32.85% E) None of these choices are correct.

55) A preferred stock is expected to pay a constant quarterly dividend of $1.25 per quarter into the future. The required rate of return, Rs, on the preferred stock is 13.5 percent. What is the fair value (or price) of this stock?

A) $37.04 B) $24.36 C) $52.36 D) $18.65 E) None of these choices are correct.

14

56) You are evaluating a company's stock. The stock just paid a dividend of $1.75. Dividends are expected to grow at a constant rate of 5 percent for a long time into the future. The required rate of return (Rs) on the stock is 12 percent. What is the fair present value?

A) $26.25 B) $22.50 C) $35.26 D) $50.25 E) None of these choices are correct.

57) A common stock paid a dividend at the end of last year of $3.50. Dividends have grown at a constant rate of 6 percent per year over the last 20 years, and this constant growth rate is expected to continue into the future. The stock is currently selling at a price of $35 per share.

What is the expected rate of return on this stock?

A) 18.7% B) 22.5% C) 16.6% D) 8.4% E) None of these choices are correct.

58) A stock you are evaluating is expected to experience supernormal growth in dividends of 12 percent over the next three years. Following this period, dividends are expected to grow at a constant rate of 4 percent. The stock paid a dividend of $1.50 last year and the required rate of return on the stock is 11 percent. Calculate the stock's fair present value. (Do not round intermediate calculations.)

A) $16.24 B) $21.56 C) $24.25 D) $27.48 E) None of these choices are correct.

59)

The basic principle of valuation states that the value of any asset is: 15

A) the present value of all future cash flows generated by the asset.

B) the sum of all future cash flows generated by the asset.

C) the present value of next year’s cash flow only.

D) the degree of cash flow riskiness is not a relevant factor in valuation.

E) None of these choices are correct.

60) You bought a stock three years ago and paid $45 per share. You collected a $2 dividend per share each year you held the stock and then you sold the stock for $47 per share. What was your annual compound rate of return?

A) 8.89% B) 8.51% C) 5.84% D) 4.44% E) 2.96%

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

61) Is the realized rate of return related to the expected return? The required return? Explain.

62) Conceptually, why does a bond's price fall when required returns rise on an existing fixed income security?

63) A 15-year, 7 percent coupon annual payment corporate bond has a present value of $1,055.62. However, you pay $1,024.32 for the bond. By how many basis points is your expected return different from your required return?

16

64) What is convexity? How does convexity affect duration-based predicted price changes for interest rates changes?

65) An investor owned a 9 percent annual payment coupon bond for six years that was originally purchased at a 9 percent required return. She did not reinvest any coupons (she kept the money under her mattress). She redeemed the bond at par. What was her annual realized rate of return? What if she did reinvest the coupons but only earned 5 percent on each coupon? Why are your answers not equal to 9 percent?

66)

Explain the effects of coupon and maturity on volatility.

67) All else held constant, which would have a longer duration: (a) a five-year fully amortized installment loan with semiannual payments or (b) a five-year semiannual payment bond? Why?

68)

How does an increase in interest rates affect a security's duration?

17

69) An investor is considering purchasing a Treasury bond with a 16-year maturity, a 6 percent coupon, and a 7 percent required rate of return. The bond pays interest semiannually. a.What is the bond's modified duration? b.If annual promised yields decrease 30 basis points immediately after the purchase, what is the predicted price change in dollars based on the bond's duration?

70) You have five years until you need to take your money out of your investments to make a planned expenditure. Right now, bonds are promising an 8 percent return. You buy a five-year duration bond. After you buy the bond, interest rates fall to 6 percent and stay there for the full five years. You reinvest the coupons and earn 6 percent. Will your realized return be more or less than the originally promised 8 percent? Explain.

71) A nine-year maturity, AAA-rated corporate bond has a 6 percent coupon rate. The bond's promised yield is currently 5.75 percent and the bond sells for its fair present value. The bond pays interest semiannually and has an annual duration of 7.1023 years. a.What is the bond's convexity? b.If promised yields decrease to 5.45 percent, what is the bond's predicted new price, including convexity? c.Based on your result in b, would you prefer to have a bond with more or less convexity?

Explain.

18

72) The preferred stock of ACE pays a constant $1.00 per share dividend. The common stock of ACME just paid a $1.00 dividend per share, but its dividend is expected to grow at 4 percent per year forever. ABLE common stock also just paid a dividend of $1.00 per share, but its dividend is expected to grow at 10 percent per year for five years and then grow at 4 percent per year forever. All three stocks have a 12 percent required return. How much should you be willing to pay for a share of each stock? Which stock will give you the best return? Explain.

19

Answer Key Test name: Chap 03_8e 1) TRUE 2) FALSE 3) FALSE 4) FALSE 5) TRUE 6) TRUE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) FALSE 12) TRUE 13) TRUE 14) TRUE 15) TRUE 16) TRUE 17) FALSE 18) FALSE 19) FALSE 20) FALSE 21) E 22) B 23) D 24) B 25) C 26) D 20

27) C 28) C Price = $100 × PVIFA [9%, 10 years] + $1,000 × PVIF (9%, 10 years) = $1,064.18; Market value is underpriced by $1,064.18 − $1,050 = $14.18.

Calculator Method: N = 10 PMT = −100 I/Y = 9 FV = −1,000 Solve for PV which is $1,064.18; Market value is underpriced by $1,064.18 − $1,050 = $14.18.

29) D Price = $60 × PVIFA [7%, 12 years] + $1,000 × PVIF (7%, 12 years) = $920.57; Market value is overpriced by $925 − $920.57 = $4.43.

Calculator Method: N = 12 PMT = −60 I/Y = 7 FV = −1,000 Solve for PV which is $920.57; Market value is overpriced by $925 − $920.57 = $4.43.

30) A

21

Price = $35.00 × PVIFA (6%/2, 8 years × 2) + $1,000 × PVIF (6%/2, 8 years × 2) Calculator Method: N = 16 PMT = −35 I/Y = 3 FV = −1,000 Solve for PV which is $1,062.81.

31) B Price = $40.00 × PVIFA (5.5%/2, 15 years × 2) + $1,000 × PVIF (5.5%/2, 15 years × 2) Calculator Method: N = 30 PMT = −40 I/Y = 2.75 FV = −1,000 Solve for PV which is $1,253.12.

32) B When coupon rate = required return, price = par.

33) D 34) B

22

$1,075 = $70 × PVIFA (E(r)%, 8 years) + $1,000 × PVIF (E(r)%, 8 years); Solve using trial and error or a calculator.

Calculator Method: N=8 PMT = 70 PV = −1,075 FV = 1,000 Solve for I/Y which is 5.80%.

35) D PV = $933.70 = $80 × PVIFA (9.5%, 6 years) + $1,000 × PVIF (9.5%, 6 years); ($933.70 + $20) = $80 × PVIFA (E(r)%, 6 years) + $1,000 × PVIF (E(r)%, 6 years); Solve using trial and error or a calculator.

Calculator Method: First find the Present Value of this bond.

N=6 PMT = −80 I/Y = 9.5 FV = −1,000 Solve for PV which is $933.70.

The market value is $933.70 + $20 =$953.70, using this value solve for I/Y to find E(r).

PV = −953.70 PMT = 80 N=6 FV = 1,000 Solve for I/Y to get 9.03%.

36) D 37) E 23

3.32 = (12% × 1) + (11% × 2) + (10% × 3) + (67% × 4) 38) E Σ[(t × CFt/(1.035)t)]/($1,000) 39) A Σ[(t × CFt/(1.06)t)]/$950.83 40) C 41) E 42) E Duration of zero-coupon bond definition.

43) B 44) C 45) A 46) E −12 × (−0.0025/1.09) = 0.0275, or 2.75% 47) C $1,025 + [−6 × (−0.0050/1.06) × $1,025] = $1,054.01 48) D [(−5/1.03) × 0.0050 × $1,045] + $1,045 = 1,019.64 49) D 50) A 180/365 = 0.493 51) B 91/365 = 0.249 52) B 53) C

24

Use a financial calculator to solve for IRR as follows: CF0 = −$30, CF1 = $1.35, CF2 = $1.35, CF3 = $57.35 Compute IRR = 26.85%.

54) C Use a financial calculator to solve for IRR as follows: CF0 = −$24.50, CF1 = $1.25, CF2 = $1.35, CF3 = $1.45, CF4 = $56.55 Compute IRR = 26.68%.

55) A Rs = (4 × $1.25) / 0.135 = $37.04 56) A P0 = ($1.75 × 1.05)/(0.12 − 0.05) = $26.25 57) C E( Rs) = ($3.50 × 1.06/$35) + 0.06 = 0.166, or 16.6% 58) D D1 = $1.50 × 1.12 = $1.68 D2 = $1.68 × 1.12 = $1.88 D3 = $1.88 × 1.12 = $2.11 D4 = $2.11 × 1.04 = $2.19 P3 = $2.19/(0.11 − 0.04) = $31.31 CF3 = $2.11 + $31.31 = $33.42.

Use the Calculator to solve for the NPV: CF0 = 0, CF1 = $1.68, CF2 = $1.88, CF3 = $33.42, I/Y = 11 to get NPV = $27.48 59) A 60) C 25

Use a financial calculator to solve for IRR as follows: CF0 = −$45, CF1 = $2, CF2 = $2, CF3 = $49, Compute for IRR = 5.84%.

61) Yes and no. The required return determines the initial size of the coupon and the offer price and, as the r changes, it forces the market price to change. As the buy and sell prices and reinvestment rates on coupons change, the realized return will be affected. However, the required return is an ex-ante rate designed to compensate investors for risk. The realized return may be less than or more than the expected or the required returns. That is the nature of risk. If you repeat the same investment with the same terms over and over, you should, on average, earn a realized return equal to the required return.

62) Since the cash flows are set by contract, the only way a new investor can expect to earn the new higher required return is to pay less for the bond, so the price has to fall. Traders sell the existing bond in favor of newer, higher-rate bonds, dropping the price and raising the expected return.

26

63) The difference between expected return and required return is 0.33%, or 33 basis points, calculated as follows: r = 6.41% $ 1,055.62 = $ 70 × [PVIFAr,15 years] + $1,000 × [PVIFAr,15 years] E( r) = 6.74% $ 1,024.32 = $ 70 × [PVIFAE(r),15 years] + $1,000 × [PVIFAE(r),15 years] E( r) is 6.74% − 6.41% = 0.33%, or 33 basis points more than your r.

Calculator Solution: First solve for the required return: PV = −1,055.62 FV = 1,000 PMT = 70 N = 15 Solve for I/Y = 6.41%.

Now solve for the E( r): PV = −1,024.32 FV = 1,000 PMT = 70 N = 15 Solve for I/Y = 6.74%.

The difference between expected return and required return is 6.74% − 6.41% = 0.33%, or 33 basis points.

27

64) Convexity is a measure of the nonlinearity (curvature) of a change in a bond's price caused by a change in interest rates. The level of convexity increases for greater interest rate changes. Duration is a linear estimate of a bond's price change as the interest rate changes from its current level. Due to convexity, the greater the interest rate change, the greater the error in using duration to estimate the bond's price change.

For a multimillion-dollar bond portfolio, the dollar errors can be quite significant. In abnormal markets, bond investors may face more or less risk than the bond's duration would imply.

Using calculus, we can also answer as follows: Duration is the first derivative of the bond price formula with respect to a change in interest rates. As such, it is accurate only for extremely small changes in interest rates. Duration gives only an approximation of the actual value change for interest rate movements that are normally observed in the market.

28

65) You can't use the bond price formula in this case because of the lack of reinvestment.

First alternative: Do not reinvest the coupons at all.

PV = $1,000 purchase price (coupon = YTM when purchased) FV = $90 × 6 = $540 + $1,000 par = $1,540 With a financial calculator, input: PV = −1,000, FV = 1,540, N = 6, PMT = 0 and solve for I to get 7.46%.

Second alternative: Reinvest coupons at 5 percent.

PV = $1,000 purchase price (coupon = YTM when purchased) The future value will be $1,000 plus the sum of the future values of each of the $90 reinvested at 5 percent. With a financial calculator, first find the sum of the future values of each of the $90. PMT = −90, I = 5, N = 6, PV = 0, and solve for FV 1 to get $612.17 and then add $1,000 to this amount to get the FV = $612.17 + $1,000 = $1,612.17. Finally, to solve for r, using the financial calculator, input FV = 1,612.17, PV = −1,000, N = 6, PMT = 0, and solve for I to get 8.29%.

The realized returns are less than 9 percent because the investor did not reinvest the coupons at the required rate of return. In order to earn a compound rate of return equal to the promised yield, an investor must reinvest the coupons and earn the promised yield for the remaining time to maturity.

66) The longer the maturity, the greater the price sensitivity of an asset with respect to interest rate changes. The larger the coupon payments, or any interim cash flows, the lower the price sensitivity of an asset with respect to asset changes. In general, any security that returns a greater proportion of an investment more quickly will be less price volatile because this allows the investor to respond to the interest rate change, minimizing the opportunity cost.

29

67) The bond will have a longer duration because you receive interest payments only until maturity, whereas the amortizing loan pays principal and interest throughout the life of the loan. Hence, the loan pays more (%) money back sooner. That makes the loan less volatile than the bond.

68) At higher interest rates, the present value of more distant cash flows is reduced by a greater amount than near-term cash flows due to compounding. For example, the present value of the tenth cash flow falls more than the present value of the first cash flow if rates rise. This shifts a greater portion of the present value weights to the near-term cash flows, which, in turn, results in a shorter duration. The converse is true for falling interest rates.

69) a. The bond's price is $904.66 and the bond's modified duration is found as follows: Σ[(t × CFt/(1.035))t]/($904.66) = 10.19 years is the duration; Modified duration = 10.19/1.035 = 9.85 years b. With a decrease of 30 basis points in annual promised yields: Predicted Δ Bond Price = −9.85 × −.0030 = .0295, or 2.95%; So, the $ price change is 0.0295 × $904.66 = $26.72 70) You will earn the promised 8 percent return. Because you chose a bond with a duration equal to the five-year time period, the loss in reinvestment income from reinvesting the coupons at 6 percent instead of 8 percent will just be offset by having a higher-than-expected sale price of the bond in five years.

71) a. Bond's convexity: rate change CX = 108 × [(ΔP−/P) + (ΔP+/P)] New r P(Old) = $ 1,017.37

0.00005 2.8800% P−

2.8700% P+

30

108 =

100,000,000

ΔP−/P ΔP+/P

(0.000690093) 0.000690678

[(ΔP−/P) + (ΔP+/P)] CX =

5.84901E−07

ΔP

$ 1,016.67

$ 1,018.08

($0.70208)

$ 0.70268

58.49006 = Convexity

b. With a new promised YTM = 5.45 percent, the YTM change is 30 basis points and the bond's new predicted price is found as: ΔP/P = -DurMod × ΔYTM + 1/2 × CX × ΔYTM2 = (−6.90385 × −0.0030) + (½ × 58.49006 × 0.0032) = .0209748, or 2.09748%.

The bond's new price should be $1,017.37 + (2.09748% × $1,017.37) = $1,038.714. c. An investor would prefer more convexity, with greater convexity or curvature; as yields drop, the bond's price will increase more.

72) ACE: P = 1/0.12 = $8.33 ACME: P = 1(1.04)/(0.12 − 0.04) = $13.00 ABLE: D0 = $1; D1 through D5 grow at 10% per year, D6 = D5 × (1 + g2); P5 = D6/(r − g2); g2 = 4% g1

D1

D2

D3

D4

D5

ABLE 10% D0

1.1

1.21

1.331

1.4641 P5 =

1.61051 20.93663

1.1

1.21

1.331

1.4641

22.54714

1

D6

g2

r

1.6749304 4.00% 12%

P0 = $ 16.62

If the stocks are priced at their fair values as calculated above, all three will give the investor the same pretax rate of return of 12 percent. A good stock buy is one where the price is less than the present value of the expected future cash flows, regardless of the expected growth rate in the cash flows.

31

32

Chapter 4: The Federal Reserve System, Monetary Policy, and Interest Rates TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Federal Reserve interest rate decisions can be vetoed by the U.S. president or the Congress. ⊚ ⊚

true false

2) Four seats on the FOMC are allocated to Federal Reserve Bank presidents on an annual rotating basis. ⊚ ⊚

3)

true false

The monetary base is the amount of coin and currency in circulation plus reserves. ⊚ ⊚

true false

4) Nationally chartered banks are required to become members of the Federal Reserve System. ⊚ ⊚

5)

true false

About 38 percent of all U.S. banks are members of the Federal Reserve System. ⊚ ⊚

true false

6) The major asset of the Federal Reserve is currency outside banks and the major liability is U.S. Treasury securities. ⊚ ⊚

true false

1

7) The seven members of the Board of Governors of the Federal Reserve System serve 14year nonrenewable terms. Each Board member is appointed by the president and confirmed by the Senate. ⊚ ⊚

true false

8) Federal Reserve Board members are appointed by the U.S. president and confirmed by the Senate for a nonrenewable 10-year term. ⊚ ⊚

true false

9) If the FOMC wished to generate faster economic growth, they could issue a policy directive to the Federal Reserve Board Trading Desk to purchase U.S. government securities. ⊚ ⊚

true false

10) An increase in Treasury securities held by the Fed leads to a decrease in the money supply. ⊚ ⊚

true false

11) One of the objectives of the FOMC is to formulate policies to promote 100 percent employment. ⊚ true ⊚ false

12) During the 2010–2014 period, the Federal Reserve purchased long-term treasury securities as part of the Quantitative Easing program. ⊚ ⊚

true false

2

13) The Quantitative Easing program initiated by the Federal Reserve during the 2010–2014 period, involved the purchase of long-term corporate bonds. ⊚ ⊚

true false

14) According to the FOMC regarding actions taken in 2012, inflation targeting promotes maximum employment. ⊚ ⊚

true false

15) Countries with independent central banks are subject to political pressure to conduct monetary policies with short-term expectations. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) The primary policy tool used by the Fed to meet its monetary policy goals is:

A) changing the discount rate.

B) changing reserve requirements.

C) devaluing the currency.

D) changing bank regulations.

E) open market operations.

17)

The Federal Reserve System is charged with:

3

A) regulating securities exchanges.

B) conducting monetary policy.

C) providing payment and other services to a variety of institutions.

D) setting bank prime rates.

E) conducting monetary policy and providing payment and other services to a variety of institutions.

18) The is a nationwide network jointly operated by the Fed and private institutions that electronically process credit and debit transfers of funds.

A) Fedwire B) ACH C) CHIPS D) NASDAQ E) SWIFT

19) The is a network linking over 5,300 banks with the Federal Reserve that is used to transfer deposits and make loan payments between participants.

A) Fedwire B) ACH C) CHIPS D) NASDAQ E) SWIFT

20) All else held constant, if the Fed was targeting the quantity of money supplied and money demand dropped, the Fed would likely . If the Fed was instead targeting interest rates and money demand dropped, the Fed would likely .

4

A) increase the money supply; do nothing B) do nothing; decrease the money supply C) decrease the money supply; do nothing D) do nothing; increase the money supply E) increase the money supply; decrease the money supply

21) Which of the following is the major monetary policy-making body of the U.S. Federal Reserve System?

A) FOMC B) OCC C) FRB bank presidents D) U.S. Congress E) Group of Eight

22)

The major liability of the Federal Reserve is:

A) U.S. Treasury securities.

B) depository institution reserves.

C) currency outside banks.

D) vault cash of commercial banks.

E) gold and foreign exchange.

23)

The major asset of the Federal Reserve is:

A) U.S. Treasury securities.

B) depository institution reserves.

C) currency outside banks.

D) vault cash of commercial banks.

E) gold and foreign exchange.

5

24)

The Fed funds rate is the rate that:

A) banks charge for loans to corporate customers.

B) banks charge to lend foreign exchange to customers.

C) the Federal Reserve charges on emergency loans to commercial banks.

D) banks charge each other on loans of excess reserves.

E) banks charge securities dealers to finance their inventory.

25)

The discount rate is the rate that:

A) banks charge for loans to corporate customers.

B) banks charge to lend foreign exchange to customers.

C) banks charge each other on loans of excess reserves.

D) banks charge securities dealers to finance their inventory.

E) the Federal Reserve charges on loans to commercial banks.

26) The Fed offers three types of discount window loans. credit is offered to small institutions with demonstrable patterns of financing needs, credit is offered for short-term temporary funds outflows, and credit may be offered at a higher rate to troubled institutions with more severe liquidity problems.

A) Seasonal; extended; adjustment B) Extended; adjustment; seasonal C) Adjustment; extended; seasonal D) Seasonal; primary; secondary E) Adjustment; seasonal; extended

27)

Before 2003 the discount window loan rate was set:

6

A) below the target Fed funds rate.

B) above the target Fed funds rate.

C) equal to the target Fed funds rate.

D) equal to the repurchase rate.

28)

A decrease in reserve requirements could lead to an:

A) increase in bank lending.

B) increase in the money supply.

C) increase in the discount rate.

D) increase in bank lending and an increase in the money supply.

E) increase in bank lending and an increase in the discount rate.

29) Bank A has an increase in deposits of $20 million dollars and all bank reserve requirements are 10 percent. Bank A loans out the full amount of the deposit increase that is allowed. This amount winds up deposited in Bank B. Bank B lends out the full amount possible as well and this amount winds up deposited in Bank C. What is the total increase in deposits resulting from these three banks?

A) $48.00 million B) $54.20 million C) $56.33 million D) $57.10 million E) $60.00 million

30) The Fed changes reserve requirements from 10 percent to 7 percent, thereby creating $900 million in excess reserves. The total change in deposits (with no drains) would be:

7

A) $3,000 million.

B) $15,625 million.

C) $12,857 million.

D) $3,795 million.

E) None of these choices are correct.

31) If the Fed wishes to stimulate the economy, it could: 1.I. buy U.S. government securities.

2.II. raise the discount rate.

3.III. lower reserve requirements.

A) I and III only B) II and III only C) I and II only D) II only E) I, II, and III

32)

Currently the Fed sets monetary policy by targeting:

A) the Fed funds rate.

B) the prime rate.

C) the level of nonborrowed reserves.

D) the level of borrowed reserves.

E) the stock market.

33)

From October 1982 to July 1993, the Federal Reserve targeted:

8

A) the Fed funds rate.

B) borrowed reserves.

C) nonborrowed reserves.

D) M1.

E) M3.

34) Assume oil prices rise in the United States, generating concerns that inflation may increase. If the Fed wishes to ensure that inflation does not get out of hand, the Fed could:

A) intervene in the currency markets to push the value of the dollar down.

B) decrease the discount rate.

C) lower the target Fed funds rate.

D) lower the target money supply growth rate.

E) reduce reserve requirements at banks.

35) The Fed changes reserve requirements from 10 percent to 14 percent, thereby eliminating $750 million in excess reserves. The total change in deposits (with no drains) would be (rounded):

A) $7.917 billion.

B) $6.630 billion.

C) $5.357 billion.

D) $4.934 billion.

E) None of these choices are correct.

36) The Fed increases bank reserves in the system by $75 million. If there are no drains, the expected change in bank deposits is:

9

A) $82.5 million.

B) $945 million.

C) $750 million.

D) $1,500 million.

E) $655 million.

37) If the Fed is targeting interest rates and money demand increases, an appropriate policy response would be to:

A) increase reserve requirements.

B) increase the discount rate.

C) buy U.S. Treasury securities from government bond dealers.

D) increase government spending.

E) None of these choices are correct.

38)

The major monetary policy-making arm of the Federal Reserve is the:

A) Board of Governors.

B) Council of Federal Reserve Bank presidents.

C) Office of the Comptroller of the Currency.

D) Federal Reserve Bank of New York.

E) None of these choices are correct.

39) In the area of bank supervision, which of the following are functions of the Federal Reserve Banks? 1.I. Examinations of state member banks 2.II. Approval of member bank and bank holding company acquisitions 3.III. Deposit insurance

10

A) I only B) I and II only C) II and III only D) I and III only E) I, II, and III

40)

The Check 21 Act, effective in October 2004, does which of the following?

A) Allows bank customers to better take advantage of bank float B) Requires banks to immediately clear all customer deposits C) Prohibits the Fed from being involved in check clearing to prevent unfair competition with private check clearing agencies D) Authorizes the use of an electronic image to facilitate paperless check clearing E) Eliminates all fees on checking

41) A bank has $770 million in checkable deposits. The bank has $85 million in reserves.

The bank's required reserves are and its excess reserves are .

A) $85 million; $0 B) $770 million; $85 million C) $89 million; $21 million D) $685 million; $8.5 million E) $77 million; $8 million

42)

The Federal Reserve does all but which one of the following?

A) Conducts monetary policy B) Supervises and regulates bank activities C) Serves as the commercial bank for the U.S. Treasury D) Operates check clearing and wire transfer facilities E) Insures deposits

11

43)

Which of the following is not a goal of monetary policy?

A) Moderate long-term interest rates B) Stable interest rates C) High employment D) Stable prices E) All of these choices are correct.

44) Which of the following is not a program initiated by the world’s major central banks during the financial crisis of 2007 to avoid a deep worldwide recession?

A) Expansion of retail deposit insurance B) Capital injections C) Purchase of U.S. dollars D) Debt guarantees E) Asset purchases/guarantees

45) What are the intended consequences from charging an interest on excess reserves by Central banks?

A) Banks lend less money.

B) Interest rates increase.

C) Banks deposits increase.

D) Banks lend more money.

E) All of these choices are correct.

46) In the aftermath of the 2007 financial crisis, the Fed used several programs to increase liquidity, including .

12

A) expansion of the discount window B) setting up the Term Auction Facility C) lending to investment banks D) purchase of long-term treasury bonds E) All of these choices are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

47) What are the four major functions of the Federal Reserve System?

48)

The 12 Federal Reserve Banks perform what functions?

49) How do Federal Reserve Banks generate income? Do they require supplemental funding from Congress?

50) Why did the Fed switch from increasing rates prior to 2007 to reducing interest rates in 2007 and 2008?

51)

What are the main responsibilities of the FOMC?

13

52)

Explain how a change in open market operations can affect a new college graduate.

53) How have changes in discount window credit programs affected the use of this tool for monetary policy over time?

54)

Explain how the deposit multiplier works.

55) The Fed wishes to expand the money supply. What three things can it do? Which has the most predictable effect? Be specific.

56) Is there a trade-off between controlling domestic inflation and maintaining a sustainable pattern of international trade?

14

57) Suppose that oil prices hit an all-time high of $200 a barrel, driving U.S. inflation up to 7 percent per year. At the same time, weak U.S. growth and increasing foreign competition have generated unacceptably high levels of unemployment in the United States. You are the chair of the Federal Reserve. What do you suggest?

58) What does the 2004 Check 21 Act allow? Why was this law passed? Does it benefit the customer or banks? Explain.

59)

What supervisory and regulatory authority does the Fed have under current law?

60) Why do changes in reserve requirements have less predictable effects on the money supply in comparison to changes in open market operations?

15

Answer Key Test name: Chap 04_8e 1) FALSE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) FALSE 9) TRUE 10) FALSE 11) FALSE 12) TRUE 13) FALSE 14) TRUE 15) FALSE 16) E 17) E 18) B 19) A 20) B 21) A 22) C 23) A 24) D 25) E 26) D 16

27) A 28) D 29) B 20 + (20 × 0.90) + (18 × 0.90) 30) C (1/0.07) × $900 million

31) A 32) A 33) B 34) D 35) C (1/0.14) × $750 million 36) C (1/0.10) × $75 million 37) C 38) E The Federal Open Market Committee is the correct answer.

39) B 40) D 41) E Required = 10% ($770); Excess = $85 − 10% ($770) 42) E 43) B 44) C 45) D 46) E

17

47) 1.Conducts monetary policy 2.Supervises and regulates depository institutions 3.Maintains the stability of the financial system 4.Provides payment and other services to institutions 48) 1.Assist in monetary policy 2. Supervise and regulate district state-chartered member banks and bank holding companies 3. Write regulations to implement consumer protection laws and establish programs to promote access to credit and community development 4. Serve as commercial banks for the U.S. Treasury 5.Distribute and replace currency 6.Provide check clearing services 7.Provide wire transfer services 8.Provide economic research for monetary policy 49) They generate income by: ● Interest earned on government securities acquired in open market transactions ● Interest earned on reserves that banks are required to deposit at the Fed ● Fees from services and membership fees The Fed does not need supplemental funding from Congress.

18

50) The growing problems in the housing markets led to problems in the subprime mortgage markets. Many financial institutions held or guaranteed mortgage-backed securities, which were becoming increasingly risky in 2007 and early 2008. It became apparent that banks had made too many risky mortgage-backed loans with borrowed funds.

Lenders to these institutions were wary of accepting mortgage collateral, causing short-term funding problems at banks and investment banks.

The Fed began to aggressively cut interest rates to help the mortgage market, particularly the subprime portion, and to encourage economic growth. Banks were cutting risky lending because of the problems in their mortgage loans and mortgage-backed securities, and the resulting "credit crunch" (banks’ unwillingness to lend) led to rapidly slowing economic growth.

51) Promote full employment; promote economic growth; promote price stability; promote sustainable pattern of international trade.

52) If the Fed increases bank reserves by buying securities, interest rates on all loan types will be affected. For instance, when interest rates fall, corporations will likely have more projects with positive NPVs, leading to more spending and more jobs. A college graduate is then more likely to get hired, and your interest rates on new cars, homes, and so forth, will likely be lower, not to mention that the value of your stock holdings would probably go up.

19

53) In the past, the discount rate was kept below the Fed funds rate to allow troubled banks that could not obtain private credit to borrow on an emergency basis. Changes in the announced discount rate signaled to investors about the way the Fed wanted interest rates to move. Under the new rules, however, the discount rate is generally tied to the current Fed funds rate target. This largely eliminates the use of the discount rate as a signal to the market. In recent years the FOMC has announced a target Fed funds target rate and the discount rate is adjusted as the Fed funds target is changed.

In early 2008, the Fed opened the discount window to nonbank brokers and dealers who were experiencing liquidity problems in their mortgage portfolios. Securities firms could exchange some of their illiquid mortgage assets with the Fed for liquid Treasury securities.

54) Suppose the Fed increases bank reserves via open market operations.

The bank now has too many excess reserves that earn no interest, so it seeks to loan out the funds. The lent funds are deposited in another bank.

The second bank keeps some funds in the form of required reserves and lends the rest. The second loan is also redeposited at another bank and a portion of those funds is lent again, and so forth. At the limit, a change in reserves increases deposits by the amount equal to Δreserves × 1/reserve requirement.

55) The Fed can expand money supply by: ● Buying U.S. government securities. ● Decreasing the discount rate. ● Decreasing reserve requirements.

Buying U.S. government securities has the most predictable effect.

20

56) Yes. If the United States curtails money supply growth to the point that U.S. inflation is lower than inflation elsewhere, the dollar will tend to appreciate against foreign currencies. With a strong dollar, the United States will tend to import more and export less, possibly leading to a large and potentially unsustainable trade deficit.

57) This is a very difficult scenario for the Fed chair. It is called stagflation and the combination of high inflation and unemployment reduces the effectiveness of any monetary policy action to provide sustained relief to the economy's problem. Increasing bank excess reserves and lowering interest rates may reduce unemployment temporarily, but these actions will also likely exacerbate inflation, drive up wages, and with a higher labor supply cost, will eventually drive unemployment back up. The end result is that the employed and the unemployed face higher prices. Alternative policy actions may include fiscal spending, removing the factor(s) causing the problems (such as a supply constraint causing a lack of oil availability), or perhaps stimulating greater global growth to help U.S. domestic demand to begin growing.

21

58) The Check 21 Law authorizes the use of an electronic image as a substitute document for a paper check and helps move the financial system toward paperless, electronic transfers. It was passed because of the September 11 attacks that grounded cargo planes that fly checks all over the country. Switching to electronic check images saves an estimated $3 billion per year for the banking industry. If these cost savings are passed on to customers in the form of better deposit rates or reduced checking fees, customers benefit. However, the law facilitates speedier clearing of checks that reduces customer's ability to "play the float." The float is the time period between tendering a check and your account being debited, which used to be as many as several days.

Checks may now instantly clear.

59) The Fed has the authority to: 1.conduct examinations and inspections of member banks, bank holding companies, and foreign bank offices by teams of bank examiners.

2. require banks to suspend bank activities deemed excessively risky or in violation of federal laws.

3. approve or not allow mergers and acquisitions and other line-ofbusiness restrictions for both banks and bank holding companies.

60) Changing the reserve requirements changes the multiplier effect and large changes in the money supply may result. However, it is difficult to predict the level of excess reserves held by banks, the willingness of banks to make loans instead of investments, and the uncertainty about how much money the public will redeposit into the banking system.

Therefore, the true new multiplier is difficult to estimate; hence, the net effect on the money supply is somewhat unpredictable.

22

Chapter 5: Money Markets TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Everything else equal, an effective annual rate will be greater than the bond equivalent yield on the same security. ⊚ ⊚

2)

true false

Money markets exist to help reduce the opportunity cost of holding cash balances. ⊚ ⊚

true false

3) The majority of money market securities are low-denomination, low-risk investments designed to appeal to individual investors with excess cash. ⊚ ⊚

true false

4) Commercial paper is a short-term obligation of the U.S. government issued to cover government budget deficits and to refinance maturing government debt. ⊚ ⊚

true false

5) Commercial paper, Treasury bills, and banker's acceptance rates are all quoted as discount yields. ⊚ ⊚

6)

true false

Euro commercial paper is a short-term obligation of the European Central Bank. ⊚ ⊚

true false

1

7) The U.S. Treasury switched from a discriminating price auction to a single price auction because the latter lowered the average price paid by investors. ⊚ ⊚

8)

In the T-bill secondary market, the ask yield will normally be less than the bid yield. ⊚ ⊚

9) bills.

true false

The largest secondary money market in the United States is the secondary market for T-

⊚ ⊚

10)

true false

true false

Fed funds are short-term unsecured loans while repos are short-term secured loans. ⊚ ⊚

true false

11) 360/ n times the difference between the face value and the current value divided by the face value gives you the discount yield on an instrument. ⊚ ⊚

12)

true false

The bond equivalent yield times 365/360 is equal to the single payment yield. ⊚ ⊚

true false

13) LIBOR is the rate that would be charged when banks borrow from other banks in Eurodollar market.

2

⊚ ⊚

14)

Maturities on Eurodollar CDs are usually more than one year. ⊚ ⊚

15)

true false

true false

In general, the federal funds rate is slightly lower than the LIBOR. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) For the purposes for which they are used, money market securities should have which of the following characteristics? 1.I. Low trading costs 2.II. Little price risk 3.III. High rate of return 4.IV. Life greater than one year

A) I and III B) II and IV C) III and IV D) I and II E) I, II, and III

17) Money market securities exhibit which of the following? 1.I. Large denomination 2.II. Maturity greater than one year 3.III. Low default risk 4.IV. Contractually determined cash flows

3

A) I, II, and III B) I, III, and IV C) II, III, and IV D) II and IV E) I, II, III, and IV

18)

A repo is, in essence, a collateralized:

A) banker's acceptance.

B) certificate of deposit.

C) Fed funds loan.

D) commercial paper loan.

E) Eurodollar deposit.

19)

A short-term unsecured promissory note issued by a company is:

A) commercial paper.

B) a T-bill.

C) a repurchase agreement.

D) a negotiable CD. E) a banker's acceptance.

20)

A time draft payable to a seller of goods with payment guaranteed by a bank is a:

A) commercial paper security.

B) T-bill.

C) repurchase agreement.

D) negotiable CD. E) banker's acceptance.

4

21) In the T-bill auction process, the competitive bidder is guaranteed a a noncompetitive bidder is guaranteed a .

and

A) minimum price; maximum price.

B) maximum price; minimum price.

C) maximum price; given quantity.

D) minimum price; maximum quantity.

E) None of these choices are correct.

22) A dealer is quoting a $10,000 face value, 180-day T-bill quoted at 2.75 bid, 2.65 ask. You could buy this bill at or sell it at .

A) $9,869.23; $9,864.36.

B) $9,864.36; $9,869.23.

C) $9,867.50; $9,862.50.

D) $9,862.50; $9,867.50.

E) None of these choices are correct.

23)

Rates on federal funds and repurchase agreements are stated:

A) on a bond equivalent basis with a 360-day year.

B) on a bond equivalent basis with a 365-day year.

C) as a discount yield with a 360-day year.

D) as an EAR. E) as a discount yield with a 365-day year.

24) The discount yield on a T-bill differs from the T-bill's bond equivalent yield (BEY) because: 1.I. the discount yield is the return per dollar of face value and the BEY is a return per dollar originally invested.

2.II. a 360-day year is used on the discount yield and the BEY uses 365 days.

3.III. the discount yield is calculated without compounding, and the BEY is calculated with compounding.

5

A) I only B) II only C) I and II only D) II and III only E) I, II, and III

25) The following formula is used to calculate the investment.

of a money market

A) EAR B) APR C) single-payment yield D) discount yield E) BEY

26)

The rate of return on a repo is:

A) determined by the rate of return on the underlying collateral.

B) strongly affected by the current Fed funds rate at the time of the repo.

C) determined at the time of the repo.

D) determined by the rate of return on the underlying collateral and determined at the time of the repo.

E) strongly affected by the current Fed funds rate at the time of the repo and is determined at the time of the repo.

27) Which one of the following statements about commercial paper is not true? Commercial paper issued in the United States:

6

A) is an unsecured short-term promissory note.

B) has a maximum maturity of 270 days.

C) is virtually always rated by at least one ratings agency.

D) has no active secondary market.

E) carries an interest rate above the prime rate.

28)

A negotiable CD:

A) is a bank-issued transactions deposit.

B) is a registered instrument.

C) is a bank-issued time deposit.

D) has denominations ranging from $50,000 to $10 million.

E) pays discount interest.

29) A 180-day $3 million CD has a 4.25 percent annual rate quote. If you buy the CD, how much will you collect in 180 days?

A) $3,047,439 B) $3,045,678 C) $3,062,877 D) $3,063,750 E) $3,127,500

30)

A banker's acceptance is:

A) a time draft drawn on the exporter's bank.

B) a method to help importers evaluate the creditworthiness of exporters.

C) a liability of the importer and the importer's bank.

D) an add-on instrument.

E) for a maturity of greater than one year.

7

31)

The most liquid of the money market securities are:

A) commercial paper.

B) banker's acceptances.

C) T-bills.

D) Fed funds.

E) repurchase agreements.

32)

In dollars outstanding in 2019, the largest money market security was

A) commercial paper.

B) banker's acceptances.

C) T-bills.

D) Fed funds and repos.

33) You buy a $10,000 par Treasury bill at $9,575 and sell it 60 days later for $9,675. What was your EAR?

A) 4.44% B) 6.29% C) 6.35% D) 6.52% E) 6.67%

34) LIBOR is generally are generally

the Fed funds rate because foreign bank deposits than domestic bank deposits.

A) greater than; less risky B) less than; more risky C) the same as; equally risk D) greater than; more risky E) less than; less risky

8

35) A U.S. exporter sells $150,000 of furniture to a Latin American importer. The exporter requires the importer to obtain a letter of credit. When the bank accepts the draft, the exporter discounts the 120-day note at a 5.25 percent discount. What is the exporter's true effective annual financing cost?

A) 5.52% B) 5.42% C) 5.34% D) 5.29% E) 5.25%

36) A Chinese exporter sells $200,000 of toys to a French importer. The Chinese exporter requires the French importer to obtain a letter of credit. When the bank accepts the draft, the exporter discounts the 90-day note at a 4 percent discount. What is the exporter's true effective annual financing cost?

A) 4.00% B) 4.04% C) 4.10% D) 4.16% E) 4.22%

37) If a $10,000 par T-bill has a 3.75 percent discount quote and a 90-day maturity, what is the price of the T-bill to the nearest dollar?

A) $9,625 B) $9,906 C) $9,908 D) $9,627 E) None of these choices are correct.

38) A 90-day T-bill is selling for $9,900. The par is $10,000. The effective annual return on the T-bill is: 9

A) 4.00 percent.

B) 4.16 percent.

C) 4.10 percent.

D) 4.04 percent.

E) 4.21 percent.

39) Suppose that $10 million face value commercial paper with a 270-day maturity is selling for $9.55 million. What is the BEY on the paper?

A) 4.71% B) 6.42% C) 6.37% D) 6.28% E) 4.50%

40) A $2 million jumbo CD is paying a quoted 3.55 percent interest rate on 180-day maturity CDs. How much money will you have at maturity if you invest in the CD?

A) $2,000,000 B) $2,035,014 C) $2,035,500 D) $2,071,000 E) $2,088,400

41) From 1990 to 2019, which one of the following money market securities actually declined in terms of dollar amount outstanding?

A) Commercial paper B) Treasury bills C) Federal funds and repos D) Negotiable CDs E) Banker's acceptances

10

42) A 50-day maturity money market security has a bond equivalent yield of 3.60 percent.

The security's EAR is:

A) 3.69 percent.

B) 3.61 percent.

C) 3.55 percent.

D) 3.87 percent.

E) 3.66 percent.

43)

In a Treasury auction, preferential bidding status is granted to:

A) competitive bidders.

B) noncompetitive bidders.

C) short sale committed bidders.

D) commercial bank bidders.

E) no group of bidders.

44)

If your firm enters into an overnight reverse repurchase agreement, your firm is:

A) borrowing Fed funds temporarily.

B) selling a security now while agreeing to buy it back tomorrow.

C) giving an unsecured loan to the counterparty.

D) procuring a banker's acceptance.

E) None of these choices are correct.

45)

Eurodollar CDs would include:

11

A) CDs denominated in Euros.

B) dollar investments by European entities in the United States.

C) dollars deposited in Caribbean banks only.

D) dollars deposited in Europe only.

E) both dollars deposited in Caribbean banks and dollars deposited in Europe.

46)

Which of the following descriptions does not apply to money market securities?

A) Shortterm B) Lowrisk C) Highly liquid D) Long maturity E) High denominations

47)

The most active and important participant in the U.S. money market:

A) is the U.S. Treasury.

B) are the large banks.

C) are the investment banks.

D) are the insurance companies.

E) is the Federal Reserve.

48)

The most significant borrower in the U.S. money markets is(are):

A) commercial banks.

B) large corporations.

C) the U.S. Treasury.

D) the investment banks.

E) the insurance companies.

49)

A noncompetitive bid for a Treasury bill auction provides:

12

A) all noncompetitive bidders the same price.

B) all competitive bidders the same price.

C) all noncompetitive bidders the same quantity.

D) all noncompetitive bidders a lower price than that provided for the competitive bidders.

E) all competitive bidders the same quantity.

50) What is the price of a 182-day money market security with a face value of $7,000 if the BEY is 3.574%?

A) $6,877.44 B) $6,925.48 C) $6,634.47 D) $6,725.36 E) $6,452.39

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) Why do most money market securities have large denominations?

52) Given the functions of the money markets, why is it necessary for money market securities to have a maturity of one year or less and low default risk?

53) What is the difference between a discriminating auction and a single price auction? How is the final price determined in a single price auction? Why did the Treasury switch to a single price auction?

13

54) A government securities dealer needs to make a 7 percent pretax annual return on $10 million of capital employed to make it worthwhile to make a market in T-bills. If the bid discount on $10,000 face value, 90-day T-bills is 3.50 percent, and the dealer can expect to do 5,200 round trip deals today, what must the ask discount be? Hint: A round trip is a buy and a sell transaction. (Do not perform intermediate rounding.)

55)

How does a repo differ from a Fed funds transaction? How do their rates compare?

56) As a corporate treasurer who is unsure how soon funds will be needed, which type of money market investment might you prefer? Explain the trade-offs. Would your answer differ if you had a definite time period during which you would not need the money? Explain.

57) A corporate treasurer is looking to invest about $4 million for 60 days. Commercial paper rates are a 3.65 percent discount and CD rates are 3.66 percent. Comparing the bond equivalent yields over a 365-day year, which is the best alternative? What is the opportunity cost of leaving the funds idle? (Do not perform intermediate rounding.)

14

58)

How does a banker's acceptance help create more international trade?

59)

Who are the major participants in money markets?

60) One-hundred-eighty-day commercial paper can be bought at a 3.75 percent discount.

What are the bond equivalent yield and the effective annual rate on the commercial paper? Why do these rates differ?

61) You are a corporate treasurer for Esso Oil. The quoted rate on dollar-denominated euro commercial paper has recently experienced a brief downturn. Your firm can issue $10 million of 180-day euro commercial paper in the London markets at 3.45 percent. You can also invest the proceeds in the United States in comparable maturity negotiable dollar-denominated CDs, which are quoting 3.95 percent. Ignoring any transactions costs, how much money, if any, can Esso make by borrowing in the euro markets and investing in the United States? Is this a good deal or not? Should you expect it to last? Explain.

15

Answer Key Test name: Chap 05_8e 1) TRUE 2) TRUE 3) FALSE 4) FALSE 5) TRUE 6) FALSE 7) FALSE 8) TRUE 9) TRUE 10) TRUE 11) TRUE 12) FALSE 13) TRUE 14) FALSE 15) TRUE 16) D 17) B 18) C 19) A 20) E 21) C 22) C Buy at 10,000 × [1 − (0.0265 × 180/360)]; sell at 10,000 × [1 − (0.0275 × 180/360)].

23) A

16

24) C 25) C 26) E 27) E 28) C 29) D $3 million × [1 + (0.0425 × 180/360)] 30) C 31) C 32) D 33) D ($9,675/$9,575)(365/60) − 1 = 0.06524, or 6.52% 34) D 35) A $150,000 × [1 − (0.0525 × 120/360)] = $147,375; then ($150,000/$147,375)365/120 − 1 = 0.0552, or 5.52% 36) D $200,000 × [1 − (0.04 × 90/360)] = $198,000; then ($200,000/$198,000)365/90 − 1 = 0.0416, or 4.16% 37) B $10,000 × [1 − (0.0375 × 90/360)] = $9,906 38) B ($10,000/$9,900)(365/90) − 1 = 0.0416, or 4.16% 39) C [($10 million/$9.55 million) − 1] × (365/270) = 0.0637, or 6.37% 40) C $2,000,000 × [1 + (0.0355 × 180/360)] 17

41) E 42) E EAR = {1 + [0.0360/(365/50)]})365/50 − 1 = 0.0366, or 3.66% 43) B 44) E 45) E 46) D 47) E 48) C 49) A 50) A ($7,000 − P)/P × 365/182 = 0.03574 ($7,000 − P)/P = 0.01782 P = $6,877.44 51) The market has developed for institutional investors because institutional investors have large enough quantities of money to make it costly for them to not invest their excess funds. For most individual investors, the dollars lost by not keeping fully invested in interestbearing assets is very minimal.

52) Because these markets are designed to provide safe investments with little or no chance of principal loss. If you could lose principal, you would be very unlikely to invest funds that are needed in the short term.

Low default risk implies that the promised cash flows will in all likelihood be paid in full and on time. The short maturity ensures that the value of these securities will be relatively insensitive to interest rate changes and, also, there is not much time for the issuer's condition to change—this also limits the risk.

18

53) In a discriminating price auction, different bidders pay a different price for the same securities. In a single price auction, all successful bidders pay the same price, regardless of the specific price they bid. The final price is set as the lowest price of the competitive bids accepted.

The Treasury switched to single price auctions because they found that in single price auctions, there tended to be more winning bidders and that bidders bid more aggressively (made higher bids), resulting in overall higher bid prices and revenues for the government.

54) Bid Price = $10,000 × [1 − 0.035 × (90/360)] = $9,912.50 $10 million × (0.07/365) = (Required Ask Price − $9,912.50) × 5,200 deals Required Ask = $9,912.87 Ask Discount = [($10,000 − $9,912.87)/$10,000] × (360/90) = 0.03485, or 3.485% 55) A repo is basically a collateralized loan, whereas Fed funds are uncollateralized. The repo rate will typically be slightly below the equivalent maturity Fed funds rate because the repos are collateralized.

Repos are likely to be for longer maturity than Fed funds, although both may involve transfers of deposits held at the Fed. Fed funds loans can be arranged more quickly because no change of title of securities is involved.

56) If liquidity is a primary concern, then T-bills may be the best choice because they are by far the most liquid. They also typically offer the lowest rate of return because of government backing and high liquidity.

If you knew for certain (or with high probability) that the funds will not be needed, then term repos, commercial paper, or banker's acceptances may offer better rates of return.

19

57) Find the BEY on each CP: Price = $4 million × [1 − 0.0365 × (60/360)] = $3,975,667 [($4 million/$3,975,667) − 1] × (365/60) = 0.037233, or 3.7233% BEY CD: $4 million × [1 + 0.0366 × (60/360)] = $4,024,400 [($4,024,400/$4 million) − 1] × (365/60) = 0.037108, or 3.7108% BEY The best deal is the CP and the opportunity cost is 3.7233%.

58) Importers do not wish to pay until they receive the goods and exporters do not wish to ship until they receive payment. The creation of a banker’s acceptance allows the exporter to ship prior to receipt of payment, while substituting the creditworthiness of a large international bank for the unknown creditworthiness of the importer.

59) The major participants are as follows: ● The U.S. Treasury ● Commercial banks ● The Federal Reserve ● Brokers and dealers ● Corporations ● Other financial institutions

20

60) Commercial paper price/100 of par = 100 × [1 − (0.04 × 180/360)] = 98 Effective annual rateCP = (100/98)365/180 − 1 = 0.04182, or 4.182% Bond equivalent yield = [(100 − 98)/98] × 365/180 = 0.04138, or 4.138% The discount quote is an annual quote calculated as (Par − Price)/Par, assuming that there are 360 days in a year. The bond equivalent yield is an annual rate calculated as (Par − Price)/Price, which is the normal way to express a percentage return (dollar return per dollar invested), assuming that there are 365 days in the year. The effective annual return, or EAR, is the same as the bond equivalent yield, except that the EAR annualizes the rate of return assuming the proceeds from each 180-day period are reinvested during the next 180-day period, and so on.

61) Initial proceeds from issuing euro commercial paper (CP) = $10 million × [1 − (0.0345 × 180/360)] = $9,827,500; invest the proceeds of $9,827,500 in 180-day CDs and you will have $9,827,500 × [1 + (0.0395 × 180/360)] = $10,021,593.

Repay the $10,000,000 owed on the CP and Esso will clear $21,593.

If the CDs are not very risky, then this represents an arbitrage opportunity for Esso; because they are not using their own money, the rate of return is infinite. Since this is an arbitrage strategy, we would not expect this big difference in the rates to persist. (For another real-world example, research Exxon. The company constructed a similar arbitrage several years ago using euro commercial paper and T-bills.)

21

Chapter 6: Bond Markets TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) TIPS are a Treasury offering that protects investors from unexpected increases in inflation. ⊚ ⊚

true false

2) A callable bond is one where the issuer is required to retire a certain amount of the outstanding bonds each year to ensure that all the bond principal is paid by final maturity. ⊚ ⊚

3)

true false

Treasury notes, Treasury bonds, and municipal bonds are default risk free. ⊚ ⊚

true false

4) "On the run" Treasury notes and bonds are newly issued securities and "off the run" Treasuries are securities that have been previously issued. ⊚ ⊚

true false

5) T-notes and T-bonds are issued in minimum denominations of $100, or multiples of $100. ⊚ ⊚

6)

true false

The dirty price plus accrued interest is called the clean price of the security. ⊚ ⊚

true false

1

7) Accrued interest owed to the bond seller increases as the next coupon payment date approaches. ⊚ ⊚

8)

true false

Revenue bonds are backed by the full revenue of the municipality. ⊚ ⊚

true false

9) In a Treasury bond quote with a $1,000 face value, you find the bid is equal to 100-24 and the ask is equal to 100-26. You could buy this bond for $1,008.125. ⊚ ⊚

true false

10) An unsecured bond that has no specific collateral other than the general creditworthiness of the issuing firm is called a debenture. ⊚ ⊚

true false

11) With TIPS, the security's coupon rate is changed every six months by the inflation rate as measured by the CPI. ⊚ ⊚

true false

12) During the financial crisis, China and Japan bought hundreds of billions of dollars of debt issued by the U.S. Treasury as a chance to build up their foreign reserves. ⊚ ⊚

13)

true false

Bonds rated below Baa by Moody's or BBB by S&P are junk bonds.

2

⊚ ⊚

true false

14) Eurobonds are bonds denominated in the issuer's home currency, but are issued outside their home country. ⊚ ⊚

true false

15) All else held constant, callable bonds have lower required yields than similar convertible bonds. ⊚ ⊚

16)

Capital markets are markets where securities are traded. ⊚ ⊚

17)

true false

Sovereign bonds are long-term debt issued by governments of foreign countries. ⊚ ⊚

19)

true false

Debt securities with maturities of one year or less are traded in capital markets. ⊚ ⊚

18)

true false

true false

Sovereign bonds have high risk because the repayment cannot be forced by creditors. ⊚ ⊚

true false

3

20)

"Off the run" Treasury securities are considered to be more risky. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) You buy a principal STRIP maturing in five years. The price quote per hundred of par for the STRIP is 75.75 percent. Using semiannual compounding, what is the promised yield to maturity on the STRIP?

A) 5.632% B) 5.712% C) 2.816% D) 2.945% E) 4.566%

22) A T-bond with a $1,000 par is quoted at 97-14 bid, 97-15 ask. The clean price for you to buy this bond is:

A) $974.38.

B) $975.42.

C) $974.69.

D) $975.77.

E) None of these choices are correct.

23) The quoted ask yield on a 14-year $1,000 par T-bond with a 7 percent semiannual payment coupon and a price quote of 98-15 is:

A) 7.00 percent.

B) 7.18 percent.

C) 7.30 percent.

D) 3.59 percent.

E) 3.63 percent.

4

24) A Treasury security in which periodic coupon interest payments can be separated from each other and from the principal payment is called a:

A) STRIP. B) T-note.

C) T-bond.

D) GO bond.

E) Revenue bond.

25)

An 18-year T-bond can be stripped into how many separate securities?

A) 18 B) 19 C) 36 D) 37 E) 38

26) A life insurer owes $550,000 in eight years. To fund this outflow, the insurer wishes to buy STRIPS that mature in eight years. The STRIPS have a $5,000 face value per STRIP and pay a 6 percent APR with semiannual compounding. How much must the insurer spend now to fully fund the outflow (to the nearest dollar)?

A) $110,000 B) $342,742 C) $355,224 D) $362,355 E) $370,890

27) The ask yield on a 6 percent coupon Treasury bond maturing in eight years is 5.488 percent. If the face value is $1,000, what should be the QUOTED cost of the bond today using semiannual compounding?

5

A) 103-6 B) 103-7 C) 103-8 D) 103-9 E) 103-10

28) All else held constant, which one of the following bonds is likely to have the highest required rate of return?

A) AAA-rated noncallable corporate bond with a sinking fund B) AA-rated callable corporate bond with a sinking fund C) AAA-rated callable corporate bond with a sinking fund D) High-quality municipal bond E) AA-rated callable corporate bond without a sinking fund

29) On July 1, 2012, you purchase a $10,000 par T-note that matures in five years. The coupon rate is 8 percent and the price quote is 98-6. The last coupon payment was May 1, 2012, and the next payment is November 1, 2012 (184 days later). The accrued interest is:

A) $132.61.

B) $101.00.

C) $50.54.

D) $40.65.

E) $35.67.

30) On September 1, 2012, an investor purchases a $10,000 par T-bond that matures in 12 years. The coupon rate is 6 percent and the investor buys the bond 70 days after the last coupon payment (110 days before the next). The ask yield is 7 percent. The dirty price of the bond is:

6

A) $9,295.45.

B) $9,300.55.

C) $9,313.75.

D) $9,321.82.

E) $9,333.24.

31) Interest income from Treasury securities is municipal bonds is always .

, and interest income from

A) exempt from federal taxes; exempt from all taxes B) taxable at the state level only; exempt from state taxes only C) taxable at the federal level only; exempt from federal taxes D) taxable at the state level; taxed at the federal level E) tax-exempt; exempt from state taxes

32) An investor is in the 28 percent federal tax bracket and pays a 9 percent state tax rate and 4 percent in local income taxes. For this investor, a municipal bond paying 6 percent interest is equivalent to a corporate bond paying interest.

A) 11.79 percent B) 10.17 percent C) 9.08 percent D) 9.68 percent E) 8.47 percent

33) An investor is trying to decide between a muni paying 5.75 percent or an equivalent taxable corporate paying 8.25 percent. What is the minimum marginal tax rate the investor must have to consider buying the municipal bond?

7

A) 80.00% B) 20.00% C) 25.00% D) 66.67% E) 30.00%

34)

Standard revenue bonds are:

A) backed by the full taxing authority of the municipality.

B) collateralized by the earnings from a specific project.

C) backed by mortgages.

D) backed by the U.S. Treasury.

E) always offered with a best efforts offering.

35) When an investment banker purchases an offering from a bond issuer and then resells it to the public, this is known as a:

A) rights offering.

B) private placement.

C) firm commitment.

D) best efforts.

E) standby offering.

36)

As of 2018, the largest holder of U.S. municipal bonds was

.

A) financial firms B) household C) foreign investors D) the government E) nonfinancial businesses

8

37) Which of the following is/are true about callable bonds? 1.I. Must always be called at par 2.II. Will normally be called after interest rates drop 3.III. Can be called by either the bond holder or the bond issuer 4.IV. Have higher required returns than noncallable bonds

A) I and II only B) II and IV only C) II and III only D) I, II, and III only E) I, II, III, and IV are true.

38)

SEC Rule 144 A does which of the following?

A) Allows privately placed investments to be traded on a limited basis B) Allows bond issuers to call their bonds when desired C) Determines the limits of responsibility of bond covenants D) Requires that bonds traded on the NYSE bond market utilize the ABS system E) None of these choices are correct.

39) Convertible bonds are: 1.I. options attached to bonds that give the bond holder the right to purchase stock at a preset price without giving up the bond.

2.II. bonds in which the issue matures (converts) a little each year.

3.III. bonds collateralized with certain types of automobiles.

4.IV. bonds that may be converted to a certain number of shares of stock determined by the conversion ratio.

A) I only B) I and II only C) I, II, and III D) IV only E) I and III only

9

40) A holder of Rainbow Funds convertible bonds with a $1,000 par and a $1,100 price can convert the bond to 25 shares of common stock. The stock is currently priced at $36 per share.

By what percent does the stock price have to rise to make conversion potentially attractive?

A) 10.00% B) 14.73% C) 22.22% D) 23.64% E) 25.69%

41) With respect to private placements of bonds, which of the following is correct? 1.I. Issuers of privately placed bonds tend to be less well known than public bond issuers.

2.II. Interest rates on privately placed debt tend to be higher than for similar public issues.

3.III. Purchasers of privately placed debt have assets of at least $1 million.

4.IV. Once bonds have been privately placed, the original buyers must hold the bonds until maturity.

A) I only B) I and III only C) I, II, and III only D) I, III, and IV only E) I, II, III, and IV

42) Which of the following statements about Eurobonds is/are true? 1.I. The issuer chooses the currency of denomination.

2.II. Spreads on firm commitment offers are lower for Eurobonds than for U.S. bonds.

3.III. Eurobonds typically have denomination of $5,000 and $10,000.

4.IV. Eurobonds are bearer bonds.

10

A) I and II only B) I, III, and IV only C) II, III, and IV only D) II and III only E) I, II, III, and IV are true.

43)

Bearer bonds are bonds:

A) with coupons attached that are redeemable by whoever has the bond.

B) where the registered owner automatically receives bond payments when scheduled.

C) in which the issue matures on a series of dates.

D) issued in a different currency than the bond issuer's home currency.

E) issued in a different country than the bond issuer's home country.

44) A T-bond with a $1,000 par is quoted at a bid of 105-7 and an ask of 105-9. If you sell the bond, you will receive: A) $1,052.81.

B) $1,052.19.

C) $1,057.22.

D) $1,059.22.

E) None of these choices are correct.

45) A T-bond with a $10,000 par is quoted at a bid of 92-11 and an ask of 92-17. If you bought the bond and then immediately sold it at the same quotes, how much money would you gain or lose (ignore commissions)?

A) $12.50 B) − $12.50 C) − $18.75 D) $18.75 E) $0.00

11

46) The quoted ask yield on a 30-year $1,000 par T-bond with a 6.25 percent coupon and a price quote of 106-16 is (use semiannual compounding).

A) 2.94 percent B) 2.90 percent C) 5.79 percent D) 5.87 percent E) 4.95 percent

47) An investor buys a $10,000 par, 4.25 percent annual coupon TIPS security with three years to maturity. If inflation every six months over the investor's holding period is 2.50 percent, what is the final payment the TIPS investor will receive?

A) $10,213.00 B) $10,869.28 C) $11,822.25 D) $11,843.37 E) $12,201.11

48) A bond investor has a 99 percent chance of receiving all of her promised payments on a particular bond issue in the first year of holding the bond, but only a 98 percent chance in the second year, and a 97 percent chance in the third year and beyond. What is the cumulative default probability over the first three years she holds the bond?

A) 3.75% B) 4.24% C) 5.89% D) 6.85% E) 7.33%

49) You purchase a $1,000 face value convertible bond for $975. The bond can be converted into 150 shares of stock. The stock is currently priced at $5.25. At what minimum stock price would you be willing to convert?

12

A) $4.50 B) $5.26 C) $6.50 D) $7.10 E) $7.25

50) You purchased a five-year annual payment 6 percent coupon bond for $1,000 and you planned on holding it to maturity. However, right after you bought the bond, it was called at $1,043.29 when all interest rates fell to 5 percent and remained there for the full five years. You reinvested the money for the full five years. What was your annual compound rate of return off your original investment?

A) 6.00% B) 5.89% C) 5.75% D) 5.23% E) 5.00%

51) Which of the following situations would require an increase in the coupon rate for a bond selling at par?

A) The addition of a call provision B) The addition of a convertibility option C) The increase in the rating from BBB to AA D) The addition of a sinking fund provision E) All of these choices are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

52) What ratings comprise investment-grade bonds and what ratings are used for junk bonds?

What are the primary differences between the two? In particular, why are investment-grade bonds more marketable and why are junk bonds issued at all?

13

53) The total sale proceeds from selling the stripped components of a Treasury security can sometimes be greater than the fair present value of the Treasury security. Why might this happen?

54)

What do bond rating agencies look at in setting a bond's rating?

55) A municipal bond holder buys a 5 percent coupon, annual payment muni bond at a price of $4,900. The bond has a $5,000 face value. In one year, she sells the bond for $4,975. The appropriate capital gains tax rate is 15 percent and her ordinary income tax rate is 28 percent.

What is her after-tax rate of return?

56)

What is the difference between general obligation and revenue bonds?

14

57) You are considering purchasing five-year corporate bonds as an investment. You have a choice of terms available. All else held constant, which of the following terms would you find desirable? How does each feature affect the bond's required rate of return? Explain. a.Call feature b.Convertible feature c.Warrants d. Sinking fund e.Debenture

58) You find the following quote for a corporate bond ($1,000 par, paying interest semiannually): Issue Symbo Coupo Maturit Moody's/S&P/Fitc High r l n y h Name Home HD.GF 4.625 August Depot % 2015

Low

Last Chang Yield e %

Baal/BBB+/BBB+ 98.28 97.36 97.72 0.286 5.49% 1 2 6

a.What was the range of the price for the given day? b.How many dollars would you receive from each coupon payment? c.Approximately what risk level is implied by the bond rating? d.What would have been the closing price on the day before?

59) A bond holder purchased a 9 percent coupon, $1,000 par three-year bond at a 9 percent yield. Interest rates then immediately fell to 7 percent and his bond was called at a price of $1,040. He reinvested his money and earned 7 percent on the $1,040 for three years. Did the call help or hurt the bond holder? What was his three-year rate of return on his original investment?

15

60) An investor is holding a $1,000 par, 10-year 9 percent coupon convertible bond with a 9 percent required bond yield. The bond is convertible into 40 shares of stock. Each share is worth $30. The bond has a current market value of $1,200. If interest rates don't change, what is the maximum gain and loss on the bond?

61) You are an investment banker and one of your large U.S. corporate clients has come to you asking for help deciding on the best market in which to place a sizable issue of bonds. You could try to issue dollar-denominated bonds, or euro- or yen-denominated bonds. You could also issue in the United States or overseas. What major factors should you consider in advising your client on where to market the issue?

16

Answer Key Test name: Chap 06_8e 1) TRUE 2) FALSE 3) FALSE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) FALSE 9) TRUE The value of the bond is (100 + 26/32) × (1,000/100) = $1,008.125 10) TRUE 11) FALSE 12) TRUE 13) TRUE 14) TRUE 15) FALSE 16) TRUE 17) FALSE 18) TRUE 19) TRUE 20) TRUE 21) A

17

[(100/75.75)(1/(5 × 2)) − 1] × 2 = 0.05632, or 5.632% Using the financial calculator: PV = −75.75 FV = 100 PMT = 0 N = 10 Solve for I/Y then multiply with 2. I/Y = 2.816%; Yield to maturity = 2 × 2.816 = 5.632% 22) C [97 + (15/32)] × (1,000/100) = 974.6875 which is approximated as $974.69 23) B [98 + (15/32)] × (1,000/100) = 984.688 Then, using the financial calculator: PV = −984.688 FV = 1,000 PMT = 35 N = 28 Solve for I/Y then multiply with 2. I/Y = 3.588%; Yield to maturity = 2 × 3.588% = 7.175%, which is rounded to 7.18%.

24) A 25) D There are 18 × 2 = 36 semiannual payments plus the final principal payment = 36 + 1 = 37.

26) B

18

(5,000/1.0316) × (550,000/5,000) = $342,741.817, which rounds to $342,742.

Using a financial calculator: Find the present value of $550,000 over 8 years with semiannual compounding and 6% interest rate.

FV = −550,000 N = 16 I=3 PMT = 0 Solve for PV = 342,741.817.

27) D $60 × PVIFA (0.05488/2, 16) + $1,000 × PVIF (0.05488/2, 16) = $1,032.79488; To convert to a fraction quote, do the following: Rounddown ($1,032.79488/10) + Round {($1,032.79488/10) Round-down ($1,032.79488/10)] × 32} = 103 9/32, which is 103-9.

Using the financial calculator: FV = −1,000 PMT = −30 N = 16 I/Y = 2.744 Solve for the PV to get 1,032.79488 as the value of the bond. In the quotation system used for bonds, the price is quoted as percent of par, and the decimal portion is converted to an x/32 fraction. First 1,032.79488 × (100/1,000) = 103.279488; and then 0.279488 × 32 = 8.94 which is approximately 9. The quoted price will be 103 9/32.

28) E 29) A [(8%/2) × 10,000] × (61 days since last coupon/184) = $132.61

19

30) C $300 × PVIFA (3.5%, 24) + $10,000 × PVIF (3.5%, 24) = $9,197.08; $300 × (70/180) = $116.67; $9,197.08 + $116.67 = $9,313.75 Using the financial calculator: FV = −10,000 PMT = −300 N = 24 I/Y = 3.5 Solve for PV to get the clean price of $9,197.08; The accrued interest is (70/180) × 300 = $116.67. The dirty price is $9,197.08 + $116.67 = $9,313.75.

31) C 32) B 0.06/[1 − (0.28 + 0.09 + 0.04)] 33) E 1 − (0.0575/0.0825) = 0.3030 which is approximated as 30% 34) B 35) C 36) A 37) B 38) A 39) D 40) C

20

[($1,100/25)/$36] − 1 = 0.2222, or 22.22% Another way we can solve this is to understand that, at the current share price level, the value of each converted bond comes to 25 × $36 = $900 while the value of the bond is $1,100; this is a loss of $1,100 − $900 = $200, so it is not attractive to convert. If the stock price goes up to $44, then 25 × $44 = $1,100, and at this price the conversion is possible. The increase in the price from $36 to $44 is ($44 − $36)/$36 = 0.2222, or 22.22%.

41) C 42) B 43) A 44) B You will sell it at the bid value. 7/32 = 0.21875 added to 105 gives 105.21875 as the quoted price in percent of par. The dollar value will be $1,052.19.

45) C [92 + (11/32)] × (10,000/100) = $9,234.38; and [92 + (17/32)] × (10,000/100) = $9,253.13; then $9,234.38 − $9,253.13 = −$18.75 46) C [106 + (16/32)] × (1,000/100) = $1,065.00 = $31.25 × PVIFA (r%, 60) + $1,000 × PVIF (r%, 60); use trial and error or financial calculator to solve for r%.

Using the financial calculator: PV = −1,065 FV = 1,000 PMT = 31.25 N = 60 Solve for I/Y then multiply with 2. I/Y = 2.895%; Yield to maturity = 2 × 2.895% = 5.791% which is rounded to 5.79%.

47) D 21

($10,000 × 1.0256) × (1 + (0.0425/2)) 48) C 1 − [0.99 × 0.98 × 0.97] = 0.0589, or 5.89% 49) C ($975/150) = $6.50 50) B [(1,043.29 × 1.055)/1,000]1/5 − 1 = 0.0589, or 5.89% Using the financial calculator: PV = −1,043.29 PMT = 0 N=5 I/Y = 5 Solve for FV to get 1,331.53. In the second step, find the rate of return that you should earn so that $1,000 becomes $1,331.53 in 5 years.

FV = 1,331.53 PV = −1,000 N=5 PMT = 0 Solve for I/Y to get 5.89%.

51) A

22

52) Investment-grade bonds are bonds rated AAA (Aaa) down to and including BBB- (Baa3) by S&P and Moody's, respectively. All lower ratings are considered speculative grade, or junk bonds. Investmentgrade bonds have a lower amount of default risk, particularly during strong economic times. Investment-grade bonds have lower required returns than junk bonds although the credit spreads or default risk premiums (DRPs) vary inversely with economic performance.

Investment-grade bonds are more marketable because many institutions are allowed to hold few to no junk bonds. Junk bonds carry significantly higher interest rates and are less marketable, but they are still used when a firm cannot obtain a higher rating and still wants to employ debt financing. Junk bonds are used to finance takeovers or so-called highlylevered transactions where the acquirer purchases a target firm by borrowing a high percentage of the purchase price. The acquirer usually hopes to be able to quickly buy back some of the debt to reduce the risk.

Use of junk bonds allows for a larger aggregate level of takeover activity and allows takeovers of larger firms.

53) STRIPS are useful tools to minimize interest rate risk. Because they are zero-coupon bonds, a STRIP held to maturity has no interest rate risk; the investor is certain of the nominal rate of return. Investors are apparently willing to pay a small premium to eliminate this uncertainty.

54) 1.Profitability of operations 2.Competitive position in the industry 3.Overall financial strength 4. Ability to pay interest and principal in full and on time 5.Issuer's liquidity and additional debt capacity 6.Specific collateral and other bond provisions such as protection provided to bond holders in the event of bankruptcy, takeover, and so forth 23

55) ((4,975 − 4,900)(1 − .15)) + 250/4,900 = 0.0640, or 6.40% 56) Both are bonds issued by state or local municipalities. General obligations (GOs)s are backed by the full revenue stream of the municipality. They typically require voter approval. Revenue bonds are backed by a specific project's revenues, but not the general tax revenues of the municipality. Revenue bonds are thus riskier than GOs.

24

57) a.The call feature favors the bond issuer and unless the issue offers the investor a sufficiently higher rate of return, he would not want this feature. b.The convertible feature allows the bond holder to convert to stock if he or she so chooses. This sounds like a good deal but the quid pro quo is a reduced promised yield. This may be desirable if you believe the stock will increase sufficiently in price. c.Warrants allow the bond holder to purchase stock at a fixed price, and unlike convertible bonds, the bond holder does not have to surrender the bond. Offering warrants allows the bond issuer to offer a lower interest rate. Warrants may be desirable to the bond holder if he or she believes the stock will increase sufficiently in price. d.Sinking funds help ensure that the bond issuer will be able to pay off the principal when due. If these are term bonds and the issuer sets aside money each year to ensure availability of funds when the principal is due, then the bond holders clearly benefit from this feature. Of course, this reduces the required promised yield. If the sinking fund requires retiring a certain percentage of the bonds each year, then the idea is not unambiguously better for bond holders. It may be that your bond is retired when rates have fallen and you must then reinvest at lower interest rates. e.The term debenture indicates that the bond has no specific collateral (other than the earnings and cash flows of the firm). The lack of security adds to bond holder risk and may imply a higher required rate of return than bonds with better collateral.

25

58) a.The high price was 98.281% × $1,000 = $982.81; the low price for the day was 97.362% × $1,000 = $973.62 for a range of $9.19. b.$ per Coupon = (4.625%/2) × $1,000 = $23.125 received every six months. c.The bond rating implies that this is a medium grade bond that lacks outstanding protection characteristics; in other words, the bond issuer may have difficulty making the promised payments in full and on time, particularly if the economy does not perform well. d.The closing price on the day prior is the “Last” column in the quote, which is 97.726 and the change was +0.286, so the prior close price was 97.726 − 0.286 = 97.44, or 97.44% × $1,000 = $974.40.

59) $1,040 (1.07)3 = $1,274.04 $1,000 (1 + r)3 = $1,274.04 r = 0.0841, or 8.41%; so the bond holder lost 9.00% − 8.41% = 0.59%, which means he earned 59 fewer basis points in rate of return.

Using the financial calculator: PV = −1,040 PMT = 0 N=3 I/Y = 7 Solve for FV to get 1,274.04. In the second step, find the rate of return that you should earn so that $1,000 becomes $1,274.04 in 3 years.

FV = 1,274.04 PV = −1,000 N=3 PMT = 0 Solve for I/Y to get 8.41%; so the bond holder lost 9.00% − 8.41% = 0.59%, which means he earned 59 fewer basis points in rate of return.

26

60) The maximum gain is unlimited; the bond's price will increase with the stock, which could increase an unlimited amount. The maximum loss on the bond, given no interest rate change, is $1,200 − $1,000 = $200.

The bond has a floor price equal to its value as a bond, and with a 9 percent coupon and 9 percent yield that gives a $1,000 minimum value.

61) Some of the key variables would include the following: 1.Interest rates in the various markets 2. Underwriter spreads on different types of bonds 3. Expected changes in currency values; borrowers do not wish to borrow in currencies that are expected to appreciate in value.

4. Regulations and taxes in the various countries 5. Ability to market large-size issues in a given currency or country

27

Chapter 7: Mortgage Markets TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) The largest category of mortgages by dollar volume is commercial mortgages. ⊚ ⊚

true false

2) The process of mortgage securitization results in a separation between mortgage origination and mortgage financing. ⊚ ⊚

true false

3) A subprime mortgage is a mortgage made to a borrower who has a below normal credit rating. ⊚ ⊚

4)

true false

Federally insured mortgages are called conventional mortgages. ⊚ ⊚

true false

5) Private mortgage insurance (and hence, that part of the homeowner's monthly payment) is automatically removed from a mortgage when the loan-to-value ratio on the mortgage falls below 80 percent. ⊚ ⊚

true false

6) A borrower using a conventional mortgage willtypically have to put up at least a 20 percent down payment or purchase private mortgage insurance. ⊚ ⊚

true false

1

7)

Discount points are paid to reduce the down payment required. ⊚ ⊚

true false

8) On a fixed-rate mortgage the dollars of interest the homeowner pays falls each year the mortgage is outstanding. ⊚ ⊚

true false

9) A larger portion of the mortgage payment goes towards the principal during the early life of a mortgage loan versus the later life of the loan. ⊚ ⊚

true false

10) Subprime mortgage borrowers usually have poorer credit ratings or lower income levels compared to conventional mortgage borrowers. ⊚ ⊚

11)

Pass-through mortgage securities are for primary market investors. ⊚ ⊚

12)

true false

The role of GNMA is to provide insurance to pass-through mortgage securities. ⊚ ⊚

13)

true false

true false

Risk attributes of collateralized mortgage obligations differ based on tranches.

2

⊚ ⊚

true false

14) In synthetic securitization, the transfer of risk on a pool of assets is achieved by the use of credit derivatives or guarantees to a third party. ⊚ ⊚

true false

15) For CMOs, prepayment risk is the risk that a borrower may prepay the mortgage before maturity when interest rates decrease. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) Rank the following types of mortgages by amount outstanding from largest to smallest.

1.I. Home mortgages 2.II. Multifamily mortgages 3.III. Farm mortgages 4.IV. Commercial mortgages

A) I, II, III, IV B) I, II, IV, III C) II, I, IV, III D) IV, II, III, I E) I, IV, II, III

17) The process of packaging and/or selling mortgages that are then used to back publicly traded debt securities is called:

3

A) collateralization.

B) securitization.

C) market capitalization.

D) stock diversification.

E) mortgage globalization.

18) A placed against mortgaged property ensures that the property cannot be sold (except by the lender) until the mortgage is paid off.

A) collateral B) lien C) writ of habeas corpus D) down payment E) writ of certiorari

19) If a borrower makes a 20 percent down payment on a conventional mortgage, she will be required to obtain:

A) FHA insurance.

B) VA insurance.

C) private mortgage insurance.

D) GNMA payment guarantees.

E) None of these choices are correct.

20) All else held constant, mortgage payments are mortgage than on a 30-year fixed-rate mortgage, and mortgage than on a 30-year mortgage.

on a 15-year fixed-rate is paid on a 15-year

4

A) lower; less interest B) lower; less principal C) higher; less interest D) higher; more principal E) higher; more interest

21) With a fixed-rate mortgage, the bears the interest rate risk and with an ARM the bears the interest rate risk.

A) borrower; lender B) borrower; borrower C) lender; lender D) lender; borrower E) federal government; pool organizer

22) The schedule showing how monthly mortgage payments are split into principal and interest is called a(n):

A) securitization schedule.

B) balloon payment schedule.

C) graduated payment schedule.

D) amortization schedule.

E) growing equity schedule.

23) You purchase a $255,000 house and you pay 20 percent down. You obtain a fixed-rate mortgage where the annual interest rate is 5.85 percent and there are 360 monthly payments.

What is the monthly payment?

5

A) $1,215.27 B) $1,203.48 C) $1,194.45 D) $1,367.22 E) $1,504.35

24) You obtain a $265,000, 15-year fixed-rate mortgage. The annual interest rate is 6.25 percent. In addition to the principal and interest paid, you must pay $275 a month into an escrow account for insurance and taxes. What is the total monthly payment (to the nearest dollar)?

A) $2,272 B) $1,632 C) $2,547 D) $1,907 E) $2,311

25) You purchase a $325,000 town home and you pay 25 percent down. You obtain a 30-year fixed-rate mortgage with an annual interest rate of 5.75 percent. After five years you refinance the mortgage for 25 years at a 5.1 percent annual interest rate. After you refinance, what is the new monthly payment (to the nearest dollar)?

A) $1,422 B) $1,401 C) $1,366 D) $1,335 E) $1,296

26) A borrower took out a 30-year fixed-rate mortgage of $2,250,000 at a 7.2 percent annual rate. After five years, he wishes to pay off the remaining balance. Interest rates have fallen to 7 percent. How much must he pay to retire the mortgage (to the nearest dollar)?

6

A) $2,122,426 B) $2,225,330 C) $2,015,678 D) $2,212,041 E) $1,999,998

27) A home buyer bought a house for $245,000. The buyer paid 20 percent down but decided to finance closing costs of 3 percent of the mortgage amount. If the borrower took out a 30-year fixed-rate mortgage at a 5 percent annual interest rate, how much interest will the borrower pay over the life of the mortgage?

A) $224,655 B) $180,622 C) $228,477 D) $188,265 E) $248,575

28) A homeowner could take out a 15-year mortgage at a 5.5 percent annual rate on a $195,000 mortgage amount, or she could finance the purchase with a 30-year mortgage at a 6.1 percent annual rate. How much total interest over the entire mortgage period could she save by financing her home with the 15-year mortgage (to the nearest dollar)?

A) $230,408 B) $190,105 C) $155,612 D) $144,325 E) $138,612

29) A homeowner can obtain a $250,000, 30-year fixed-rate mortgage at a rate of 6.0 percent with zero points or at a rate of 5.5 percent with 2.25 points.

If you will keep the mortgage for 30 years, what is the net present value of paying the points (to the nearest dollar)?

7

A) $9,475 B) $8,360 C) $7,564 D) $7,222 E) $6,578

30) A homeowner can obtain a $250,000, 30-year fixed-rate mortgage at a rate of 6.0 percent with zero points or at a rate of 5.5 percent with 2.25 points.

How long must the owner stay in the house to make it worthwhile to pay the points if the payment saving is invested monthly?

A) 7.15 years B) 3.33 years C) 6.04 years D) 5.90 years E) More than 30 years

31) A homeowner can obtain a $250,000, 30-year fixed-rate mortgage at a rate of 6.0 percent with zero points or at a rate of 5.5 percent with 2.25 points.

How long must the owner stay in the house to make it worthwhile to pay the points if the payment saving is not invested?

A) 7.15 years B) 3.33 years C) 6.04 years D) 5.90 years E) More than 30 years

32)

The least used form of mortgage securitization is the

.

8

A) second mortgage B) mortgage-backed bond C) mortgage pass-through D) CMO E) home equity loan

33) You want to buy a $250,000 house and you will use a conventional mortgage. What is the minimum down payment you have to make to avoid having to purchase mortgage insurance?

A) $10,000 B) $20,000 C) $30,000 D) $40,000 E) $50,000

34)

The FHA charges the homeowner

to insure an FHA mortgage.

A) nothing B) 0.5 percent of the loan amount C) $500 D) 1 percent of the loan amount E) $1,500

35) A(n) is used to help retired people receive monthly income in exchange for the equity in their home.

A) SAM B) Equity Participation Mortgage C) RAM D) PLAM E) GEM

9

36) Which of the following statements about mortgage markets is/are true? 1.I. Mortgage companies service more mortgages than they originate.

2.II. Servicing fees typically range from 2 percent to 4 percent.

3.III. Most mortgage sales are with recourse.

4.IV. The government is involved in the residential mortgage markets.

A) I, III, and IV only B) II, III, and IV only C) I, II, and IV only D) II and III only E) I and IV only

37) Which of the following statements about GNMA is/are true? 1.I. GNMA provides timing insurance.

2.II. GNMA creates pools of mortgages and issues securities.

3.III. GNMA insures only FHA, VA, HUD’s Office of Indian and Public Housing, and USDA Rural Development loans.

4.IV. GNMA requires that all mortgages in the pool have the same interest rate.

A) I, II, III, and IV are true.

B) I, III, and IV only C) I, II, and III only D) II, III, and IV only E) III and IV only

38) A $25,000 face value GNMA pass-through quote sheet lists a spread to average life of 103, PSA of 220, and a price of 101-09. This means that: 1.I. the pass-through yield is 103 basis points above the comparable maturity Treasury bond.

2.II. the pass-through is being prepaid more quickly than standard PSA. 3.III. the pass-through is priced at $25,272.50.

10

A) I, II, and III are correct.

B) I and II only C) I and III only D) II and III only E) III only

39) Mortgage fees paid by the homeowner at, or prior to, closing on the purchase of a house typically include all but which one of the following?

A) Application fee B) Title search fee C) Title insurance fee D) Appraisal fee E) Prepayment penalty

40) An MBB differs from a CMO or a pass-through in that: 1.I. the MBB does not result in the removal of mortgages from the balance sheet.

2.II. an MBB holder has no prepayment risk.

3.III. cash flows on an MBB are not directly passed through from mortgages.

A) I, II, and III B) I and II only C) II and III only D) I and III only E) I only

41) One fixed-rate mortgage pool has a 750 PSA and a second fixed-rate pool has a 150 PSA. The pool with the higher PSA than the pool with the lower PSA. 1.I. probably has a higher coupon 2.II. probably has lower default risk 3.III. will mature more quickly

11

A) I, II, and III B) I and II only C) II and III only D) I and III only E) I only

42) As compared to fixed-rate mortgages, ARMs result in which of the following for the lender? 1.I. Higher interest rate risk 2.II. Lower default risk 3.III. Greater prepayment penalty fees

A) I, II, and III B) I and II only C) II and III only D) I and III only E) None of these choices are correct.

43) Which one of the following types of mortgages is likely to become more popular as the average age of the U.S. population increases?

A) GEM B) GPM C) SAM D) PLA E) RAM

44) Which one of the following entities is an actual government-owned enterprise dealing with mortgages?

12

A) GNMA B) FNMA C) FHLMC D) PIP E) CMO

45) A fixed-rate mortgage originator is adversely affected by borrower is adversely affected by interest rates.

interest rates while the

A) increasing; decreasing B) increasing; increasing C) decreasing; decreasing D) decreasing; increasing E) stable; decreasing

46) An adjustable rate mortgage originator is adversely affected by while the borrower is adversely affected by interest rates.

interest rates

A) increasing; decreasing B) increasing; increasing C) decreasing; decreasing D) decreasing; increasing E) stable; decreasing

47) The borrower of an amortized mortgage makes most of the payment during the early life of the mortgage:

A) towards the principal.

B) towards the interest.

C) equally towards the principal and interest.

D) mostly towards the principal rather than interest.

E) None of these choices are correct.

13

48)

A collateralized mortgage obligation (CMO) has:

A) no interest rate risk.

B) no default risk.

C) no prepayment risk.

D) a high degree of interest rate risk.

E) no default, no prepayment, and no interest rate risks.

49) If the current interest environment is low, lenders tend to prefer a(n) borrowers tend to prefer a(n) .

; while

A) ARM; fixed-rate mortgage B) ARM; ARM C) fixed-rate mortgage; fixed-rate mortgage D) fixed-rate mortgage; ARM E) None of these choices are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

50) Construct an amortization schedule for the first three months and the final three months of payments for a 30-year, 7 percent mortgage in the amount of $90,000. What percentage of the third payment is principal? What percentage of the final payment is principal? What do these differences imply? ( Hint: The balance after the 357th payment is $1,775.56.)

Amortization Table: #

Payment

Interest

Principal

Balance $ 90,000.00

0 1 2 3 ...

$ 598.77 $ 598.77 $ 598.77

$ 525.00 $ 524.57 $ 524.14

$ 73.77 $ 74.20 $ 74.64

$ 89,926.23 $ 89,852.03 $ 89,777.39

358 359

$ 598.77 $ 598.77

$ 10.36 $ 6.93

$ 588.41 $ 591.85

$ 1,187.15 $ 595.30

14

360

$ 598.77

$ 3.47

$ 595.30

$ 0.00

51) All else held constant, why do mortgage lenders prefer ARMs while many borrowers prefer fixed-rate mortgages.

52) A homeowner is looking to buy a home in Marvin Gardens. The most he can afford to pay in total is $1,800 per month. Yearly property taxes will be about $3,000 (escrowed monthly) and insurance is $110 per month. There are no other costs.

If mortgage rates are 6.25 percent for a 30-year fixed-rate mortgage, how large can his mortgage be?

53) A homeowner is looking to buy a home in Marvin Gardens. The most he can afford to pay in total is $1,800 per month. Yearly property taxes will be about $3,000 (escrowed monthly) and insurance is $110 per month. There are no other costs.

If his parents give him $20,000 for a down payment, what is the most he can pay for a house with a 15-year mortgage if the interest rate is 5.50 percent?

54) What three major ways has the federal government assisted the mortgage markets?

Explain.

15

55) Why were FNMA and Freddie Mac, considered government-sponsored enterprises (GSEs), in the news throughout the first decades of the century? Explain.

56) Who are the major buyers of mortgages after they have been originated? What is the difference between selling with recourse or without recourse? Which is most common?

57)

How does GNMA improve mortgage marketability?

58)

Explain each term of the following pass-through quote:

15-year FMAC Gold 7.0%

Price 97-31

Average Life 5.9

PSA 150

59) You bought your house five years ago and you believe you will be in the house only about five more years before it gets too small for your family. Your original home value when you bought it was $250,000, you paid 20 percent down, and you financed closing costs equal to 3 percent of the mortgage amount. The mortgage was a 30-year fixed-rate mortgage with a 6.5 percent annual interest rate. Rates on 30-year mortgages are now at 5 percent if you pay 2 points.

Your refinancing costs will be 1.5 percent of the new mortgage amount (excluding points). You won't finance the points and closing costs this time. A new down payment is not required.

Should you refinance? Ignore all taxes and show your work.

16

60)

Why were CMOs created?

17

Answer Key Test name: Chap 07_8e 1) FALSE 2) TRUE 3) TRUE 4) FALSE 5) FALSE 6) TRUE 7) FALSE 8) TRUE 9) FALSE 10) TRUE 11) FALSE 12) TRUE 13) TRUE 14) TRUE 15) TRUE 16) E 17) B 18) B 19) E 20) C 21) D 22) D 23) B

18

0.80 × $255,000 = Pmt × PVIFA (0.0585/12, 360 months); Pmt = $1,203.48 Calculator Solution: Amount borrowed is 0.80 × $255,000 = 204,000 PV = −204,000 N = 360 FV = 0 I = 0.0585/12 = 0.4875 Solve for PMT to get $1,203.48.

24) C $265,000 = [Pmt × PVIFA (0.0625/12, 180 months)] + $275 = $2,547 Calculator Solution: PV = −265,000 N = 180 FV = 0 I = 6.25/12 = 0.52083 Solve for PMT to get $2,272.17; the total monthly payment will be $2,272.17 + $275 = $2,547.17.

25) D

19

0.75 × $325,000 = Pmt × PVIFA (0.0575/12, 360 months); Balance after five years = $226,107.8; New Pmt = 226,107.8/PVIFA (0.051/12,300 months) = $1,335.01 Calculator Solution: PV = −243,750 N = 360 FV = 0 I = 5.75/12 = 0.47917 Solve for PMT to get $1,422.46; in the amortization schedule of the financial calculator, use P1 = 1 and P2 = 60 to find the balance at the end of the 5th year, which is $226,107.83.

The refinanced mortgage will be: PV = −226,107.83 N = 300 FV = 0 I = 5.1/12 = 0.425 Solve for PMT to get $1,335.01.

26) A

20

$2,250,000 = Pmt × PVIFA (0.072/12, 360 months); Pmt = $15,272.73; New Balance = $15,272.73 × PVIFA (0.072/12, 300 months) = $2,122,425.62 Calculator Solution: PV = −2,250,000 N = 360 FV = 0 I = 7.2/12 = 0.6 Solve for PMT to get $15,272.73; in the amortization schedule of the financial calculator, use P1 = 1 and P2 = 60 to find the balance at the end of the 5th year, which is $2,122,425.62.

27) D 0.80 × $245,000 × 1.03 = Pmt × PVIFA (0.05/12, 360 months); Pmt = $1,083.74; Total interest = (360 × $1,083.74) − (0.80 × $245,000 × 1.03) = $188,265 Calculator Solution: Amount borrowed is 0.80 × $245,000 = $196,000.

Points to be financed 0.03 × $196,000 = $5,880.

For a total of $196,000 + $5,880 = $201,880.

PV = −201,880 N = 360 FV = 0 I = 5/12 = 0.4167 Solve for PMT to get $1,083.74; in the amortization schedule of the financial calculator, use P1 = 1 and P2 = 360 to find the total interest paid for this loan, which is $188,264.78.

28) E

21

$195,000 = Pmt × PVIFA (0.055/12, 180 months); Pmt of $1,593.31 × 180 − $195,000 = $91,796; $195,000 = Pmt × PVIFA (0.061/12, 360 months); Pmt of $1,181.69 × 360 − $195,000 = $230,408; $230,408 − $91,796 = $138,612 Calculator Solution: First find the total interest on the 30-year mortgage: PV = −195,000 N = 360 FV = 0 I = 6.1/12 = 0.5083 Solve for PMT to get $1,181.69; in the amortization schedule of the financial calculator, use P1 = 1 and P2 = 360 to find the total interest paid for this loan, which is $230,408.34.

Next find the total interest on the 15-year mortgage: PV = −195,000 N = 180 FV = 0 I = 5.5/12 = 0.4583 Solve for PMT to get $1,593.31; in the amortization schedule of the financial calculator, use P1 = 1 and P2 = 180 to find the total interest paid for this loan, which is $91,796.29.

The amount of interest saved is: $230,408.34 − $91,796.29 = $138,612.05.

29) B

22

No Points: Pmt = $250,000/PVIFA (0.06/12, 360 months); Pmt = $1,498.88; Pay Points: Pmt = $250,000/PVIFA (0.055/12, 360 months); Pmt = $1,419.47; Pmt savings = $1,498.88 − $1,419.47 = $79.40; NPV of points: [$79.40 × PVIFA (0.055/12, 360 months)] − (0.0225 × $250,000) = $8,359.74 Calculator Solution: The amount of points to be paid is 0.0225 × $250,000 = $5,625.

First find the difference in the payments for mortgage without points and with points: Without points PV = −250,000 N = 360 FV = 0 I = 6.0/12 = 0.5 Solve for PMT to get $1,498.88.

With points PV = −250,000 N = 360 FV = 0 I = 5.5/12 = 0.45833 Solve for PMT to get $1,419.47.

Payment savings = $1,498.88 − $1,419.47 = $79.40.

The difference is savings of $79.40 over 30 years with monthly payments. Find the Present value of this annuity stream: PMT = 79.40 N = 360 FV = 0 I = 5.5/12 = 0.45833 Solve for PV = $13,984.74.

23

Finally, the difference between this savings and the points paid is $13,984.74 − $5,625 = $8,359.74.

30) A

24

No Points: Pmt = $250,000/PVIFA (0.06/12, 360 months); Pmt = $1,498.88; Pay Points: Pmt = $250,000/PVIFA (0.055/12, 360 months); Pmt = $1,419.47; Pmt savings = $1,498.88 − $1,419.47 = $79.40; the amount of points to be paid is 0.0225 × $250,000 = $5,625. $5,625 points cost = $79.40 payment savings × PVIFA (0.055/12, N); N = 85.85 months/12 = 7.15 years Calculator Solution: The amount of points to be paid is 0.0225 × $250,000 = $5,625.

First find the difference in the payments for mortgage without points and with points: Without points PV = −250,000 N = 360 FV = 0 I = 6.0/12 = 0.5 Solve for PMT to get $1,498.88.

With points PV = −250,000 N = 360 FV = 0 I = 5.5/12 = 0.45833 Solve for PMT to get $1,419.47.

Payment savings = $1,498.88 − $1,419.47 = $79.40.

PV = − 5,625 PMT = 79.41 I = 5.5/12 = 0.45833 FV = 0 Solving for N you get 85.85 months which is 7.15 years.

31) D

25

No Points: Pmt = $250,000/PVIFA (0.06/12, 360 months); Pmt = $1,498.88; Pay Points: Pmt = $250,000/PVIFA (0.055/12, 360 months); Pmt = $1,419.47; Pmt savings = $1,498.88 − $1,419.47 = $79.40; the amount of points to be paid is 0.0225 × $250,000 = $5,625; $5,625 points cost/79.40 payment savings = N = 70.84 months/12 = 5.90 years 32) B 33) E 20% of $250,000 is $50,000 34) B 35) C 36) E 37) B 38) B 39) E 40) A 41) D 42) E 43) E 44) A 45) A 46) D 47) B 48) D 49) A

26

50) 12.46 percent of the third payment is principal and 99.42 percent of the last payment is principal. In a long-term amortized loan, the early payments are almost entirely interest, and the borrower's equity position grows only slowly at first, but, over time, more and more of the payment goes to principal.

51) With an ARM, the homeowner bears most of the interest rate risk (not the total risk, because the ARM is capped). From the lender's perspective, if deposit rates change, hopefully the ARM rate will change and the lender's net profit will remain about the same. If deposit rates rise, the homeowner's payments are also likely to rise, preserving at least some of the institution's profit margin. With a fixed-rate mortgage, the homeowner bears no out of pocket interest rate risk, but the lender's profit margin will normally fall if rates rise, as their fund's cost will rise but mortgage income stays the same.

52) Max monthly payment = $1,800 − $3,000/12 − $110 = $1,440 PV = $1,440 × PVIFA (0.0625/12,360 months) = $233,873.60 Calculator Solution: PMT = −1,440 N = 360 FV = 0 I = 6.25/12 = 0.5208 Solve for PV = $233,873.60.

27

53) Max monthly payment = $1,800 − $3,000/12 − $110 = $1,440 PV = $1,440 × PVIFA (0.0550/12,180 months) = $176,236.59 + $20,000 = $196,236.59 Calculator Solution: PMT = −1,440 N = 180 FV = 0 I = 5.50/12 = 0.4583 Solve for PV = $176,236.59 and add the $20,000 down payment to get $196,236.59.

54) The federal government has provided assistance by: 1.providing insurance for homeowners. This assists resale and securitization of mortgages because secondary buyers don't have to engage in credit analysis of homeowners.

2. sponsoring or creating pools of mortgages for securitization. This provides a national source of funds to all regions of the economy.

3. directly providing mortgage credit.

28

55) In the early 2000s, the agencies were in the news for excessive interest rate risk caused by large derivatives positions, for overcharging lenders for services provided, and for accounting irregularities designed to smooth earnings and/or generate bonuses for employees. Former Fed Chairman Greenspan has also stated that these institutions were a source of risk for the economy because of their ties to government and their extensive use of debt to finance growth. FNMA and FHLMC (or Freddie Mac) were also embroiled in the subprime mortgage crisis. In 2007, the value of their mortgage assets fell sharply. Shut out of the equity capital markets, FNMA and Freddie Mac were still able to recapitalize by borrowing at favorable rates in public debt markets (because of their quasi-government status [i.e., government-sponsored enterprise (GSE)], they had low perceived credit risk). Even so, because of their inability to raise needed capital in the public equity markets, their long-term viability remained a question. Finally, in September of 2008, the Federal Housing Finance Agency (FHFA), newly created by the Housing and Economic Recovery Act of 2008, placed FNMA and FHLMC into conservatorship, which effectively handed over operational control to the FHFA. Dividends were suspended and both GSEs were delisted from the NYSE.

29

56) The major buyers are: 1.investment banks.

2.vulture funds.

3.domestic banks.

4.foreign banks.

5.insurance companies.

6.pension funds.

7.closed-end bank loan mutual funds.

8.nonfinancial corporations.

Selling with recourse means the buyer of the mortgage can require the mortgage seller to repay the mortgage if the homeowner defaults. A sale without recourse means the seller has no legal liability in the event the homeowner defaults. Most sales are without recourse.

57) GNMA sponsors pools of FHA- or VA-insured mortgages and provides timing insurance to investors (ensures the timely receipt of promised cash flows in the event of homeowner default). GNMA allows private pool organizers to issue securities backed by the mortgage pool that bear GNMA's name. The GNMA name tells investors there is no credit risk and that the securities are actively traded.

58) FMAC Gold 7.0 percent: a pass-through issued by Freddie Mac; maximum payment delay is 55 days. The coupon rate is 7.0 percent.

97-31 price on pass-through (paid monthly) is (97 + 31/32) = 97.9688 percent of par.

5.9 years average life of security based on prepayment patterns.

PSA 150 means that the mortgage holders are prepaying at a rate 50 percent faster than the benchmark prepayment rate (PSA = 100).

30

59) First find the original payment and then find what you owe now: 0.80 × 250,000 × 1.03 = Pmt × PVIFA (0.065/12,360 months); Pmt = $1,302.06 Balance now = $1,302.06 × PVIFA(0.065/12,300 months); Balance now = $192,838.61 New payment if you refinance will be: $192,838.61 = Pmt × PVIFA (0.05/12,360 months); Pmt = $1,035.20 Pmt savings = $1,302.06 − $1,035.20 = $266.86 per month Refinancing costs = (2% + 1.5%) × $192,838.61 = $6,749.35 Find breakeven time: $6,749.35 = $266.86 × PVIFA (0.05/12, N); N = 26.78 months/12 ≈ 2.23 years. You plan on being in the house for five more years, so it is worthwhile to refinance.

Calculator Solution: 0.80 × 250,000 × 1.03 = $206,000 PV = −206,000 I = 6.5/12 = 0.5417 N = 360 FV = 0 Solve for PMT to get $1,302.06; using P1 = 1 and P2 = 60, find the balance left on this loan which is $192,838.61.

The new loan will have a payment of: PV = −192,838.61 I = 5/12 = 0.4167 N = 360 FV = 0 Solve for the PMT to get $1,035.20.

So the savings on monthly payments will be $1,302.06 − $1,035.20 = $266.86.

31

The refinancing costs on the new mortgage will be 0.035 × $192,838.61 = $6,749.35. If you will live in this house only 5 more years, find whether $6,749.35 is worth paying today.

Solve for the number of years required to recover this $6,749.35 cost today: PV = − 6,749.35 I = 5/12 = 0.4167 PMT = 266.86 FV = 0 Solve for N to get 26.78 months which is equivalent to 2.23 years. This is less than the 5 years you intend to stay in the house, so it is worth refinancing.

60) Some investors desired more protection from prepayment risk than offered by pass-throughs. The creation of different payment tranches in a CMO allows investors to better tailor their prepayment risk exposure.

32

Chapter 8: Stock Markets TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) A type of absentee ballot that allows a representative to vote on behalf of the stockholder is called a proxy. ⊚ ⊚

2)

true false

An order to buy shares of stock at a specified price or better is called a limit order. ⊚ ⊚

true false

3) Stock splits change the divisor in a price-weighted index but do not result in any net change in the divisor of a value-weighted index. ⊚ ⊚

true false

4) A long-term investor in a high marginal tax bracket will normally prefer a dollar of capital gain to a dollar of dividend yield. ⊚ ⊚

true false

5) In the event of bankruptcy, a firm's janitor must be paid all of the salary owed to him before stockholders receive anything. ⊚ ⊚

true false

6) At year-end, a firm has assets of $100 and debts due of $120. In this situation, the stockholders must pay an additional $20 out of their own pocket. ⊚ ⊚

true false

1

7) In cumulative voting, a stockholder who owns 51 percent of the shares can be assured of the ability to elect the entire board of directors. ⊚ ⊚

true false

8) The Dow Jones Industrial Average is a price-weighted index of 30 stocks chosen to represent the overall market. ⊚ ⊚

9)

true false

Preferred stockholders have a claim senior to common stock but junior to bond holders. ⊚ ⊚

true false

10) The market in which firms sell new securities to raise cash is called the secondary market. ⊚ ⊚

true false

11) The NYSE merged with the London Stock Exchange to form the merged company NYSE Euronext. ⊚ ⊚

12)

true false

Dual class stock refers to firms with both common and preferred stock outstanding. ⊚ ⊚

true false

2

13) If the stock markets are semi-strong efficient, stock prices reflect all historic and current public information about a firm but prices do not reflect inside information. ⊚ ⊚

true false

14) A seasoned equity offering occurs when an issuer that already has publicly-traded equity issues new shares to the public. ⊚ ⊚

15)

true false

International stock markets provide the potential of diversification to the investor. ⊚ ⊚

true false

16) From a U.S. investor perspective, diversifying in the international stock markets adds foreign exchange risk and political risk to the portfolio. ⊚ ⊚

17)

true false

A participating preferred stock has a fixed dividend payment every year. ⊚ ⊚

true false

18) A rights offering provides existing stockholders the opportunity to purchase shares of new issues to maintain their proportional ownership in the corporation. ⊚ ⊚

true false

19) Individuals and households indirectly invest in corporate stock through investments in mutual funds and pension funds.

3

⊚ ⊚

20) fast.

true false

Compared to the market order, a limit order may not be executed if the market is moving

⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) You buy a stock for $34 per share and sell it for $36 after you collect a $1.00 per share dividend. Your pretax capital gain yield is and your pretax dividend yield is .

A) 2.94 percent; 2.78 percent B) 8.82 percent; 0.00 percent C) 5.88 percent; 2.94 percent D) 5.56 percent; 2.78 percent E) 4.65 percent; 3.17 percent

22) Common stocks typically have which of the following that bonds do not have? 1.I. Voting rights 2.II. Fixed cash flows 3.III. Set maturity date 4.IV. Tax deductibility of cash flows to investors

A) I only B) I, II, and IV only C) II, III, and IV only D) IV only E) I, II, III, and IV

4

23) You buy a stock for $30 per share and sell it for $33 after holding it for slightly over a year and collecting a $0.75 per share dividend. Your ordinary income tax rate is 28 percent and your capital gains tax rate is 20 percent. Your after-tax rate of return is .

A) 8.00 percent B) 10.25 percent C) 12.50 percent D) 9.80 percent E) 8.75 percent

24) An investor has a 38 percent ordinary income tax rate and a 20 percent long-term capital gains tax rate. The investor holds stock in a firm that could pay its usual $1 per share dividend or reinvest the cash in the firm. The stock price is currently $30 per share. If the firm does not pay the dividend, the share price will rise. If it pays the dividend, the share price will stay the same.

By how much must the share price rise if the dividend is not paid in order to make the investor indifferent between receiving the dividend or not?

A) $1.00 B) $0.59 C) $0.78 D) $0.97 E) $0.50

25) With voting, all directors up for election are voted on by the shareholders at the same time in one general election.

A) straight B) participating C) nonparticipating D) proxy E) cumulative

5

26) If all preferred dividend payments that have been missed must be paid before any common stock dividend can be paid, the preferred stock is called preferred stock.

A) cumulative B) participating C) nonparticipating D) voting E) dual class

27)

In 2007 the NYSE merged with

.

A) NASDAQ B) Euronext C) American Exchange D) Chicago Mercantile Exchange E) London Stock Exchange

28)

If the net proceeds are greater than the gross proceeds in an underwritten offering, then:

A) the investment banker made a profit on the spread.

B) the issuing company underpriced its securities.

C) the issue fails to occur.

D) the SEC rescinds the issue.

E) None of these choices are correct.

29)

The preemptive right is designed to:

6

A) allow management to diffuse stock ownership of any voting power.

B) allow managers to preempt a stock offering if they do not like the terms of the deal.

C) allow existing shareholders the right to sell their existing shares before the new offer.

D) allow existing shareholders to buy shares of the new offering if they desire.

E) None of these choices are correct.

30) The NASDAQ automatic order execution system for individual traders placing buy or sell orders of 1,000 or fewer shares is called the:

A) ECN Network.

B) SOES. C) NASDAQ/AMEX Joint Program.

D) Instinet Network.

E) E*Trade Online Program.

31) The preliminary version of a security offer that is circulated to potential buyers before SEC approval (registration) is obtained is called a:

A) final prospectus.

B) shelf registration statement.

C) due diligence draft.

D) waiting period offer.

E) red herring prospectus.

32) A shelf registration allows firms the opportunity to avoid the normal day waiting period by allowing preregistration of securities for up to

years.

A) 20-; two B) 10-; one C) 15-; three D) 20-; one E) 30-; two

7

33) Which of the following is/are true about specialists? 1.I. Investment banks generally cannot be specialists.

2.II. Specialists are used by the NASDAQ system.

3.III. Market and limit orders are transacted at specialist posts, but the specialist's own account orders are executed elsewhere.

4.IV. Specialists help maintain continuous trading.

A) I, II, and III only B) I and IV only C) II, III, and IV only D) I only E) III only

34) As of December 2005, trading licenses are required to conduct trades on the floor of the NYSE. Which of the following statements about these trading licenses is/are correct? 1.I. Licenses are auctioned off in a special type of auction called a Dutch auction.

2.II. Only a member organization of the NYSE is eligible to bid for a trading license.

3.III. The SEC determines the maximum bid price.

4.IV. Trading licenses are good for 10 years.

A) II and III only B) I and II only C) I and III only D) II and IV only E) I, II, III, and IV

35) Which of the following information is not usually found in a Wall Street Journal stock quote?

8

A) Dividend yield B) Price-earnings ratio C) Closing price of the stock D) Stock rating E) Ticker symbol

36) In terms of volume of trading and market value of firms traded, the largest U.S. stock market. In terms of number of firms traded, the the United States.

is the is the largest in

A) NYSE; NYSE B) NASDAQ; NYSE C) NYSE; AMEX D) NYSE; NASDAQ E) NASDAQ; AMEX

37)

On the NASDAQ system, the inside quotes are the:

A) lowest ask and lowest bid.

B) lowest bid and highest ask.

C) highest bid and highest ask.

D) highest bid and lowest ask.

E) None of these choices are correct.

38)

NYSE listing has traditionally benefited a firm by:

9

A) improving the stock's price.

B) generating increased publicity for the firm.

C) providing easier access to primary market capital.

D) generating increased publicity for the firm and providing easier access to primary market capital.

E) improving the stock’s price, generating increased publicity for the firm, and providing easier access to primary market capital.

39) Which of the following indexes are value-weighted? 1.I. NYSE Composite 2.II. S&P 500 3.III. NASDAQ Composite 4.IV. Dow Jones Industrial Average

A) I, II, III, and IV B) I only C) II only D) II, III, and IV only E) I, II, and III only

40)

The largest single type of holder of common stock (by dollar holding) is:

A) pension funds.

B) households.

C) mutual funds.

D) brokers and dealers.

E) life insurance firms.

41) A firm is using cumulative voting and four director spots are up for election. There are 3.6 million shares outstanding. How many shares must a minority owner own or control to ensure that he or she can gain control of one seat on the board of directors?

10

A) 900,001 B) 880,001 C) 720,001 D) 1,800,001 E) 1,750,001

42) Today, Stock A is worth $20 and has 1,000 shares outstanding. Stock B costs $30 and has 500 shares outstanding. Stock C is priced at $50 per share and has 1,200 shares outstanding. If tomorrow Stock A is priced at $22, Stock B at $35, and Stock C is worth $48, what would the value-weighted index amount equal? (The index has a base period value of 100.)

A) 35.00 B) 105.00 C) 108.44 D) 101.45 E) 102.21

43) Suppose that over the last 10 to 15 years significantly large numbers of investors have been able to earn abnormal returns from using the firm's publicly-available financial information to forecast growth in earnings and dividends. This would be evidence that the markets are not: 1.I. weak form efficient.

2.II. semistrong form efficient.

3.III. strong form efficient.

A) I only B) I and II only C) III only D) II and III only E) I, II, and III

44) In a the next two years.

the firm preregisters with the SEC any securities it wishes to sell over

11

A) rights B) full underwritten C) general cash D) shelf registration E) best efforts

45) The stamp on a prospectus accompanying a new issue that indicates the issue has not yet been approved for sale by the SEC is called the:

A) green hornet.

B) seal of approval.

C) red herring.

D) eagle stamp.

E) Reg FD.

46) The NYSE specialists are charged with: 1.I. trading for their own account.

2.II. ensuring public limit orders are executed.

3.III. facilitating the processing of public market orders.

A) I only B) I and II only C) II and III only D) I and III only E) I, II, and III

47) The age group that held the least stock from 2009 through 2017 was the group.

12

A) 18–29 B) 30–49 C) 50–64 D) 65 and older

48)

The electronic-based market for less actively traded U.S. securities is the:

A) ADR market.

B) OTC bulletin board.

C) Pink Sheet stocks.

D) NYSE Low-Volume Market.

E) ECN Market.

49) Computerized markets that automatically match orders between buyers and sellers and are used primarily by institutional traders are called:

A) OTC bulletin boards.

B) SPIDRS. C) index markets.

D) ECNs. E) specialists.

50) Ethanol Lawn Mowers issued 500,000 shares to the public. The gross proceeds were $31.25 million and the net proceeds were $30 million. Merrel Bench was the lead underwriter and deal negotiator, but 10 other investment bankers (one of which was Golden Sax) were also used to put up capital and help sell the issue. Which of the following statements is/are correct?

1.I. The public paid $62.50 a share.

2.II. Golden Sax was the originating house.

3.III. The spread per share was $3.50.

4.IV. Merrel Bench is the originating house.

5.V. This offer was a syndicated deal.

13

A) I, II, and IV only B) III and V only C) I, IV, and V only D) II and III only E) I and V only

51)

Which of the following ADRs is considered the most risky type of ADR?

A) Level 1 ADR B) Level 2 ADR C) Level 3 ADR D) Level 4 ADR E) Level 5 ADR

52)

According to the strong form of efficient market hypothesis:

A) private information is of no help in earning abnormally high returns.

B) using past price and volume information one can earn abnormally high returns from stocks.

C) using insider information one can earn abnormally high returns from stocks.

D) financial statement analysis can be used to earn abnormally high returns from stocks.

E) equity analysts are always correct in predicting the best stocks.

53) A publicly-traded company gave its existing shareholders the opportunity to purchase from the new stocks that it will issue. The existing shareholders can purchase 3 new shares at a price of $10 per share for every 8 shares held. This is an example of:

A) private placement.

B) rights offering.

C) shelf registration.

D) initial public offering.

E) syndicate offering.

14

54) Suppose you own 500,000 shares of common stock in a firm with 40 million total shares outstanding. The firm announces a plan to sell an additional 5 million shares through a rights offering. The market value of the stock is $32.5 before the rights offering and the new shares are being offered to existing shareholders at a $2.50 discount. If you exercise your preemptive rights, how many of the new shares can you purchase?

A) 100,000 shares B) 50,000 shares C) 62,500 shares D) 32,500 shares E) 45,000 shares

55) Suppose a firm has 10 million shares of common stock out-standing and seven candidates are up for election to three seats on the board of directors. If the firm uses cumulative voting to elect its board, what is the minimum number of votes needed to ensure elec-tion to the board?

A) 3,000,000 B) 4,285,715 C) 5,000,000 D) 7,500,001 E) 10,000,000

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

56) Data show that since 1942, only 8 of the 14 recessions predicted by the stock market actually occurred. Although stocks are a leading economic indicator, what are some reasons why a stock price decline might not indicate an upcoming recession?

57) What are weak form, semistrong form, and strong form efficiency? Does one form of efficiency imply another?

15

58)

Answer the following questions concerning the given partial stock quote:

Name Symbol Close Abbott Laboratories ABT $53.75

Volume 4,905,983

Dividend P/E YTD %Change $1.30 44 10.3

a.What was the dividend yield? b.What were the earnings per share for the most recent four quarters? c.Valued at the closing price, what was the total dollar volume of shares traded? d.What was the stock price at the beginning of the year?

59) What are the advantages and disadvantages of foreign investing? How does an ADR help overcome the disadvantages?

60) As a small (minority) stockholder would you prefer to have cumulative voting or straight voting shares? As a majority shareholder?

61)

When would preferred stock be a better investment choice than common stock or bonds?

16

62)

What are ECNs? How are they changing trading in the traditional markets?

63)

In what major ways do stocks differ from bonds?

64) A firm desires to sell stock to the public. The underwriter charges $0.45 million in fees and offers to buy six million shares from the firm at a price of $35 per share. In addition, registration and audit fees total $130,000, and marketing and miscellaneous fees add up to another $75,000. The underwriter expects to earn gross proceeds per share of $38. What is the issuing firm's out-of-pocket dollar transaction cost to issue the stock? Immediately after the stock was issued, the stock price rose to $40. What is the issuing firm's opportunity cost? What is the total issuance cost, including opportunity costs, as a percentage of the total funds available to the issuing firm?

65) What are the major effects of the Sarbanes-Oxley (SOX) Act of 2002 on the stock markets? What else has the NYSE done to improve corporate governance?

66) Why have international stock prices fallen as a result of the subprime crisis in the United States?

17

67) You own 500 shares of common stock in a firm that has 2,000,000 shares outstanding.

The firm announces a plan to sell an additional 500,000 shares through a rights offering. a.How many rights to purchase new shares will you receive? b.Suppose that the market price per share is $30, but each right allows you to purchase a share of stock for $27. What should be the value of one right? c.If you sold your rights, how much money should you make?

18

Answer Key Test name: Chap 08_8e 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) FALSE 7) FALSE 8) TRUE 9) TRUE 10) FALSE 11) FALSE 12) FALSE 13) TRUE 14) TRUE 15) TRUE 16) TRUE 17) FALSE 18) TRUE 19) TRUE 20) TRUE 21) C Pretax capital gain yield = ($36 − $34)/$34 = 0.0588, or 5.88%; pretax dividend yield = $1/$34 = 0.0294, or 2.94% 22) A 23) D

19

[(($33 − $30) × (1 − 0.20)) + ($0.75 × (1 − 0.28))]/$30 = $2.94/$30 = 0.098, or 9.8% 24) C Change in share price required = [$1× (1 − 0.38)]/($1 − 0.20) = $0.78 25) E 26) A 27) B 28) E 29) D 30) B 31) E 32) A 33) B 34) B 35) D 36) D 37) D 38) E 39) E 40) B 41) C [((1/(4 + 1))) × 3.6 million] + 1 42) E {($22 × 1,000) + ($35 × 500) + ($48 × 1,200)}/{($20 × 1,000) + ($30 × 500) + ($50 × 1,200)} × 100 = 102.21 43) B 44) D 45) C

20

46) E 47) A 48) B 49) D 50) C $31,250,000/500,000 = $62.50 51) A 52) A 53) B 54) C Current ownership is 500,000/40,000,000 = 0.0125, or 1.25% With the preemptive rights you can purchase 0.0125 × 5,000,000 = 62,500 shares at $30 each.

55) D Number of votes available 3 × 10million = 30 million votes The minimum number of votes needed to ensure one election on the board is [(1 × 30,000,000 )/4] + 1 = 7,500,001 votes, because no matter how the other votes are casted among the rest of the six candidates, the candidate with 7,500,001 votes will be elected on the board.

56) Stock prices might drop because equity risk premiums temporarily rise, depressing stock prices without foreshadowing lower growth. It may also be that current stock prices are overly optimistic about future growth; when the over-optimism is corrected, stock prices fall, sometimes sharply. This may occur even if no change in underlying economic growth takes place. One might also observe slower growth than expected that does not result in a recession. More succinctly, expectations may change more rapidly than actual economic growth rates.

21

57) Weak form efficiency implies that past price and trading information is contained in today's stock price and is of no value to an investor.

Semistrong form efficiency implies that an investor cannot use any publicly-available information to predict tomorrow's price change.

Strong form efficiency implies that public and inside information is of no value in predicting tomorrow's price change. Strong form efficiency implies that the markets are also weak and semistrong form efficient.

Likewise, semistrong form efficiency implies that the markets are also weak form efficient.

58) a.The dividend yield = $1.30/$53.75 = 0.024, or 2.4% b.The most recent four quarters of earnings per share = $53.75/EPS = 44; EPS = $1.22 c.Valued at the close, the total dollar volume of shares traded = $53.75 × 4,905,983 = $263,696,586 d.The stock price at the beginning of the year was ($53.75 − Pbegin)/Pbegin = 0.103; Pbegin = $53.75/(1 + 0.103) = $48.73 59) International investing can reduce risk by generating additional diversification benefits. These benefits have been small lately because the United States has dominated the rest of the world in economic performance, but this is not likely to continue indefinitely. International investing also introduces foreign exchange risk, information risk, and sovereign risk, as well as trading and tax complexities. The ADRs limit foreign exchange risk and other trading complexities. Foreign firms are also required to meet U.S. disclosure requirements when ADRs are issued, although the amount of disclosure varies with the level of the ADR.

22

60) Cumulative voting gives a small shareholder a better chance of electing a given board member because the shareholder doesn’t have to own (or control by proxy) a majority of shares. As a controlling stockholder, you can ensure that you will always be able to elect the entire board of your choice if you have straight voting.

61) Preferred stocks have higher yields than bonds and much higher dividend yields than stocks. One will not get capital gains with preferred stock, however. Thus, if steady high pretax yields are desired, with little or no chance of capital gains, and a tax-sheltered investment vehicle such as an IRA is available, preferred may be an ideal choice.

62) ECNs are electronic communication networks. These computerized trading systems automatically match buy and sell orders. Since they are electronic, ECNs allow for extended trading hours. As fewer humans and physical overheads are required, ECNs provide a potentially cheaper trading platform than the exchanges. Institutions use ECNs to solicit trading interest on large blocks of shares. The rule changes that require publishing all quotes from different markets mean that ECN market share is likely to grow at the expense of the NYSE and NASDAQ (hence, a rationale for the mergers between NYSE and Archipelago, and NASDAQ and Instinet).

23

63) Stocks have the following characteristics: 1.Discretionary cash flows (dividend payments). The board of directors may choose to pay or not to pay a dividend.

2. Residual claim in the event of bankruptcy.

3. No maturity date; thus, there is no guarantee of a return of your principal.

4. Voting rights. As a stockholder you are part owner of the company and typically have a voice in company decisions.

5. Depth of trading. Stock markets are deeper and more actively traded than bond markets.

64) Out-of-pocket cost = $450,000 + $130,000 + $75,000 = $655,000 Opportunity cost = 6 million shares × ($40 − $35) = $30,000,000 Actual funds available to firm: (6 million × $35) − $655,000 = $209,345,000 Percentage cost = ($30,000,000 + $655,000)/$209,345,000 = 0.1464, or 14.64%

24

65) The SOX Act: ● created an independent auditing oversight board under the SEC. ● increased penalties for corporate wrongdoing. ● required more extensive accounting disclosure. ● increased ability of aggrieved shareholders to seek recourse from management.

The NYSE changed listing requirements to ensure that: ● listed firms have a majority of independent directors. ● boards institute and implement codes of ethics for the board and top management. ● shareholder approval of equity-based compensation plans is implemented. ● CEOs annually certify the information given to stockholders.

66) U.S. economic growth slowed as a result of the subprime crisis and the resulting credit crunch. Slower U.S. growth often results in poorer economic performance overseas. This is one reason why foreign stock prices have not performed well even though most overseas countries with the exception of Great Britain have not had similar mortgage problems. Problems in the United States also engendered a flight to quality until the extent of the crisis could be known. As money moved out of equity markets to safer securities, stock prices fell. Another way to say the same thing is to note that risk premiums increased, resulting in stock price declines.

67) a.(500,000/2,000,000) × 500 = 125 rights b.[(500 × 30) + (125 × 27)]/(500 + 125) = 18,375/625 = 29.40; 29.40 − 27 = $2.40 c.$2.40 × 125 = $300

25

26

Chapter 9: Foreign Exchange Markets TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) If a foreign currency appreciates, that country's goods and services become relatively more expensive for U.S. buyers. ⊚ ⊚

true false

2) A U.S. firm agrees to import textiles from Hong Kong and pay in 90 days. The invoice requires payment in Hong Kong dollars. The U.S. importer could hedge this currency risk by buying the Hong Kong dollar forward. ⊚ ⊚

true false

3) In 1971, the Bretton Woods Agreement established that, for the first time, currency values would be fixed against one another within narrow bands. ⊚ ⊚

true false

4) In 1973, the Smithsonian Agreement II eliminated fixed exchange rates for the major economies. ⊚ ⊚

true false

5) If you can convert 150 Swiss francs to $90, the exchange rate is 1.67Swiss francs per dollar. ⊚ ⊚

true false

6) If the dollar is initially worth 120 yen and then the exchange rate changes so that the dollar is now worth 115 yen, the value of the yen has depreciated.

1

⊚ ⊚

7)

true false

If the euro per yen ratio falls, the value of the yen has risen. ⊚ ⊚

true false

8) If the United States has inflation of 3 percent and Europe has inflation of 5 percent, the value of the euro should increase, all else held constant. ⊚ ⊚

true false

9) A U.S. bank has made £12 million worth of loans and £10 million worth of deposits in Britain. The bank would benefit from a drop in the value of the pound against the dollar. ⊚ ⊚

true false

10) A country with lower interest rates than another country is likely to see its currency appreciate if parity holds. ⊚ ⊚

true false

11) During much of the 1800s, developed nations employed what came to be known as the Bretton Woods international monetary system to manage exchange rates. ⊚ ⊚

true false

12) New York is the global center of foreign exchange trading with the largest daily volume of currency trading.

2

⊚ ⊚

true false

13) A drop in value of the dollar hurts U.S. importers and helps U.S. exporters, all else held constant. ⊚ ⊚

14)

true false

The dollar's value increased when the Fed cut interest rates in late 2007. ⊚ ⊚

true false

15) The ongoing accumulation of foreign currency reserves by foreign monetary authorities contributed to the dollar's drop in 2006. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) Foreign exchange trading in 2019 averaged about per day.

A) $101 million B) $8.3 trillion C) $101 billion D) $1.88 trillion E) $101 trillion

17) In 2019, the U.S. imported goods and services worth about about leading to a current account .

and exported

3

A) $2.5 trillion; $1.7 trillion; deficit B) $3.2 trillion; $3.4 trillion; surplus C) $3.4 trillion; $3.2 trillion; surplus D) $3.2 trillion; $3.4 trillion; deficit E) $3.0 trillion; $3.0 trillion; balance

18) A U.S. investor has borrowed pounds, converted them to dollars, and invested the dollars in the United States to take advantage of interest rate differentials. To cover the currency risk, the investor should:

A) sell pounds forward.

B) buy dollars forward.

C) buy pounds forward.

D) sell pounds spot.

E) None of these choices are correct.

19) A U.S. bank borrowed dollars, converted them to euros, and invested in eurodenominated CDs to take advantage of interest rate differentials. To cover the currency risk the investor should:

A) sell dollars forward.

B) sell euros forward.

C) buy euros forward.

D) sell euros spot.

E) None of these choices are correct.

20) A U.S. firm has £50 million in assets in Britain that they need to repatriate in six months.

They could hedge the exchange rate risk by:

4

A) buying pounds forward.

B) selling pounds forward.

C) borrowing pounds.

D) both selling pounds forward and borrowing pounds.

E) both buying pounds forward and borrowing pounds.

21) A U.S. firm has borrowed £50 million from a British firm. The borrower will need to convert dollars to pounds to repay the loan when it is due. The U.S. firm could hedge the exchange rate risk by:

A) buying pounds forward.

B) selling pounds forward.

C) borrowing pounds.

D) both selling pounds forward and borrowing pounds.

E) both buying pounds forward and borrowing pounds.

22) A U.S. bank converted $1 million to Swiss francs to make a Swiss franc loan to a valued corporate customer when the exchange rate was 1.2 francs per dollar. The borrower agreed to repay the principal plus 5 percent interest in one year. The borrower repaid Swiss francs at loan maturity and when the loan was repaid the exchange rate was 1.3 francs per dollar. What was the bank's dollar rate of return?

A) 26.00% B) −2.69% C) 7.14% D) −3.08% E) 5.00%

23) A Swiss bank converted 1 million Swiss francs to euros to make a euro loan to a customer when the exchange rate was 1.85 francs per euro. The borrower agreed to repay the principal plus 3.75 percent interest in one year. The borrower repaid euros at loan maturity and when the loan was repaid the exchange rate was 1.98 francs per euro. What was the bank's franc rate of return?

5

A) 7.75% B) 11.04% C) 9.94% D) −2.82% E) 5.71%

24) A Japanese investor can earn a 1 percent annual interest rate in Japan or about 3.5 percent per year in the United States. If the spot exchange rate is 101 yen to the dollar, at what one-year forward rate would an investor be indifferent between the U.S. and Japanese investments?

A) ¥100.58 B) ¥98.56 C) ¥101.68 D) ¥97.42 E) ¥103.50

25) A European investor can earn a 4.75 percent annual interest rate in Europe or 2.75 percent per year in the United States. If the spot exchange rate is $1.58 per euro, at what oneyear forward rate would an investor be indifferent between the U.S. and Japanese investments?

A) $1.5484 B) $1.6108 C) $1.5335 D) $1.5498 E) $1.5977

26) An investor starts with $1 million and converts it to 0.75 million pounds, which is then invested for one year. In a year the investor has 0.7795 million pounds, which she then converts to dollars at an exchange rate of 0.72 pounds per dollar. The U.S. dollar annual rate of return earned was .

6

A) 4.97 percent B) 5.27 percent C) 6.45 percent D) 7.69 percent E) 8.26 percent

27) An investor starts with €1 million and converts it to £694,500, which is then invested for one year. In a year the investor has £736,170, which she then converts back to euros at an exchange rate of 0.68 pounds per euro. The annual euro rate of return earned was .

A) 7.55 percent B) 6.00 percent C) 7.45 percent D) 8.13 percent E) 8.26 percent

28)

Banks’ net foreign exposure is equal to:

A) net foreign assets.

B) net FX bought.

C) net foreign assets + net FX bought.

D) assets − liabilities.

E) None of these choices are correct.

29) If a firm has more foreign currency assets than liabilities, and no other foreign currency transactions, it has:

A) positive net exposure.

B) negative net exposure.

C) a fully balanced position.

D) zero net exposure.

7

30) The levels of foreign currency assets and liabilities at banks have years, and the level of foreign currency trading has .

in recent

A) increased; increased B) decreased; decreased C) increased; decreased D) decreased; increased E) decreased; stayed the same

31) The agreement that ended the era of fixed exchange rates for the major economies was called the:

A) Louvre Accord.

B) Bretton Woods Agreement.

C) Smithsonian Agreement I. D) Smithsonian Agreement II. E) Plaza Accord.

32) If interest rate parity holds and the annual German nominal interest rate is 3 percent and the U.S. annual nominal rate is 5 percent, and real interest rates are 2 percent in both countries, then inflation in Germany is about than in the United States.

A) 1 percent higher B) 2 percent higher C) 1 percent lower D) 4 percent lower E) 2 percent lower

33) At the beginning of the year the exchange rate between the Brazilian real and the U.S. dollar was 2.2 reals per dollar. Over the year, Brazilian inflation was 12 percent and U.S. inflation was 4 percent. If purchasing power parity holds, at year-end the exchange rate should be approximately dollars per real.

8

A) 2.3913 B) 0.4895 C) 2.8498 D) 0.4182 E) 0.3440

34) The spot rate for the Argentine peso is $0.3600 per peso. Over the year, inflation in Argentina is 10 percent and U.S. inflation is 4 percent. If purchasing power parity holds, at yearend the exchange rate should be approximately dollars per real.

A) 0.2987 B) 0.3614 C) 0.2875 D) 0.3384 E) 0.3015

35)

The largest center for trading in foreign exchange is:

A) New York.

B) London.

C) Tokyo.

D) Hong Kong.

E) Geneva.

36) A negotiated OTC agreement to exchange currencies at a fixed date in the future but at an exchange rate specified today is a:

A) currency swap agreement.

B) forward foreign exchange transaction.

C) currency futures contract.

D) currency options contract.

E) spot foreign exchange transaction.

9

37) Which of the following conditions may lead to a decline in the value of a country's currency? 1.I. Low interest rates 2.II. High inflation 3.III. Large current account deficit

A) I only B) I and II only C) II and III only D) II only E) III only

38)

The large U.S. current account deficit implies that:

A) U.S. interest rates are too high.

B) the value of the dollar is too weak.

C) dollar foreign currency reserves at Asian central banks are too low.

D) the presidential administration desires to improve growth of overseas economies.

E) the United States must rely on foreigners to be willing to invest in the United States.

39)

A current account deficit implies that:

A) more goods and services are exported than are imported.

B) more goods and services are imported than are exported.

C) there is excessive consumption of foreign financial assets.

D) the value of the dollar will rise.

E) the country is going bankrupt.

40) Which of the following are likely to lead to an appreciation of the U.S. dollar (all else held constant)? 1.I. Higher real U.S. interest rates 2.II. Lower U.S. inflation 3.III. Higher nominal U.S. interest rates

10

A) II and III only B) I and III only C) I and II only D) II only E) I, II, and III

41) You can buy or sell the £ spot at $1.98 to the pound. You can buy or sell the pound oneyear forward at $2.01 to the pound. If U.S. annual interest rates are 5 percent, what must be the approximate one-year British interest rate if interest rate parity holds?

A) 4.00% B) 5.25% C) 2.75% D) 3.43% E) 5.65%

42) You can buy or sell the yen spot at ¥102 to the dollar. You can buy or sell the yen oneyear forward at ¥104 to the dollar. If U.S. annual interest rates are 4 percent, what must be the approximate one-year Japanese interest rate if interest rate parity holds?

A) 6.04% B) 3.20% C) 2.75% D) 4.73% E) 6.80%

43) A U.S. bank has £120 million in loans to corporate customers and has £70 million in deposits it owes to customers with the same maturity. The bank has also sold £20 million pounds forward. The bank's net exposure is:

11

A) £210 million.

B) £30 million.

C) £70 million.

D) £170 million.

E) £190 million.

44) The measures the net flows of imports and exports of goods, services, income payments, and unilateral transfers.

A) current account B) capital account C) change in official reserves D) statistical discrepancy E) basic balance account

45)

The concept underlying purchasing power parity is the:

A) Fisher effect.

B) Bretton Woods Agreement.

C) law of one price.

D) Big Mac Index.

E) balance of payments concept.

46) has

The value of the British pound changed from $1.40 to $1.15. We can say that the pound and the dollar has .

A) depreciated; appreciated B) appreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated E) None of these choices are correct.

12

47) has

The value of the British pound changed from $1.23 to $1.32. We can say that the pound and the dollar has .

A) depreciated; appreciated B) appreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated E) None of these choices are correct.

48)

The value of the euro changed from $1.15 to $1.25. We can say that the dollar has and the euro has .

A) depreciated; appreciated B) appreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated E) None of these choices are correct.

49)

The value of the euro changed from $1.20 to $1.14. We can say that the dollar has and the euro has .

A) depreciated; appreciated B) appreciated; appreciated C) appreciated; depreciated D) depreciated; depreciated E) None of these choices are correct.

50)

If the dollar appreciates relative to the euro then:

13

A) European cars will become less expensive in the United States.

B) American cars will become less expensive in Europe.

C) the price of cars will not be affected.

D) European cars will become more expensive in the United States.

E) American cars will become less expensive in the United States.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) What are the major purposes of the foreign exchange markets?

52) A U.S. FI has US$200 million worth of one-year loans earning an average rate of return of 6 percent. The FI also has one-year single-payment Canadian dollar loans of C$110 million earning 8 percent. The FI's funding source is $300 million in US$ one-year CDs, on which they are paying 4 percent. Initially the exchange rate is C$1.10 per US$1. The one-year forward rate is C$1.14 per US$1. What is the bank's dollar percent spread if they hedge fully using forwards?

53) A British bank has borrowed dollars in the United States, but is now concerned about its currency risk. What alternatives does it have to limit its risk? Be specific.

54) A bank has committed to deliver yen in six months to a corporate customer. The spot rate is 110 yen to the dollar and the six-month forward rate is 105 yen per dollar. Are there costs to hedging this exposure with the forward market? Explain.

14

55) An FI's position in FX markets generally reflects four trading activities. What are they, and which one(s) cause the FI to bear FX risk?

56) Is it reasonable to expect real rates of interest to be identical across countries? Explain.

What does this imply about parity?

57) What are the major differences between the interbank foreign exchange market and the foreign currency exchanges?

58) Why does the size of the U.S. current account deficit put pressure on the value of the dollar to decline? How does the size of the capital account affect that pressure? Explain.

59) A U.S. bank has made £50 million loans in Britain and has £40 million in deposits. The bank's currency trading desk has also contracted to buy £20 million and has short positions of £15 million. What is the bank's net exposure? How could they use forward contracts to hedge the exposure? If the bank has exposures in euros and yen, would you recommend they use the forward hedge? Why or why not?

15

60) Explain how a drop in the value of the dollar could affect the U.S. import and export sectors.

16

Answer Key Test name: Chap 09_8e 1) TRUE 2) TRUE 3) FALSE 4) TRUE 5) TRUE 150 Swiss francs/$90 = 1.67 Swiss francs per dollar 6) FALSE 7) FALSE 8) FALSE 9) FALSE 10) TRUE 11) FALSE 12) FALSE 13) TRUE 14) FALSE 15) FALSE 16) B 17) A 18) C 19) B 20) D 21) A 22) D {[($1 million × SFr 1.2 × 1.05)/SFr 1.3/$]/$1 million} − 1 = 0.0308, or 3.08%

17

23) B {[((SFr1 million × €/SFr 1.85) × 1.0375) × SFr 1.98/€]/SFr1 million} − 1 = 0.1104, or 11.04% 24) E (1 + 0.035) = 1 /101 × (1 + 0.01) X; X = ¥103.50 X = ¥103.5 25) D (1.0275/1.0475) × $1.58 = $1.5498 26) E [(0.7795 million pounds/0.72)/$1 million] − 1 = 0.0826, or 8.26% 27) E [(£736,170/0.68)/€1 million] − 1 = 0.0826, or 8.26% 28) C 29) A 30) A 31) D 32) E 33) D [(4% − 12%) × (1/2.2)] + (1/2.2) = 0.4182 34) D [(4% − 10%) × 0.36] + 0.36 = 0.3384 35) B 36) B 37) C 38) E 39) B 18

40) C 41) D Using IRPT formula: 1 + 0.05 = (1/1.98) × (1 + iUK) × 2.01 and solve for iUK = 0.03433, or 3.433%.

42) A Using IRPT: 1 + 0.04 = (1/(1/102)) × (1 + iJ) × 1/104 and solve for iJ = 0.06039, or 6.039%.

43) B £120 million − £20 million − £70 million = £30 million 44) A 45) C 46) A 47) C 48) A 49) C 50) A 51) Foreign exchange markets facilitate: 1.international trade and global payments systems.

2.global access to capital.

3.hedging currency risk.

4.speculating on currency values.

19

52) Hedge by selling C$ forward. The current C$ amount is C$110 million. In one year these loans will be worth $110 million × 1.08 = C$118,800,000. Selling this amount forward, C$118,800,000/C$1.14 will give US$104,210,526. This gives a rate of return of [US$104,210,526/US$100,000,000] − 1 = 0.04211, or 4.211%.

Average rate of return = (2/3 × 6%) + (1/3 × 4.211%) = 0.05404, or 5.404% The cost rate = 4%, so the spread = 5.404% − 4% = 1.404% 53) The bank could buy dollars (sell pounds) forward for when the loan(s) is(are) due. The bank could also sell the appropriate number of pound futures contracts. Finally, the bank could acquire dollar assets either by lending dollars or by acquiring dollar-denominated real assets.

54) The bank could hedge by buying the yen forward, but there are costs. At the forward rate, the dollar buys less yen than today. The bank may wish to consider buying the yen today and incurring the financing cost if the net cost is less than the loss from using the forward market. If the bank does not buy the yen forward, the spot may turn out to be greater than 105 or even 110 yen, in which case the yen would cost less than the hedged position.

55) (1) Buying and selling foreign currencies that allow customers to complete international trade transactions. (2) Buying and selling foreign currencies to allow customers to take positions on foreign real and financial investments. (3) Buying and selling currencies to hedge bank positions arising from (1) and (2). (4) Speculating on currency movements for the bank's own account. (1), (2), and (4) add to the bank's risk.

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56) Among developed economies, real interest rates are probably similar, but not identical. Real interest rates will differ across countries due to differences in risk (sovereign, exchange, credit, and liquidity risks) and due to differences in taxation, tariffs, capital controls, and so forth. The difference between real interest rates in developed and lesserdeveloped economies will be quite a bit greater. In these cases, the simple parity conditions may not hold or may have little practical significance.

57) In the interbank market, the deals are negotiated. The interbank market can operate pretty much around the clock and has no set location.

Counterparty credit risk is important in the interbank market and generally no cash changes hands until contract maturity. Spot and forward transactions predominate in this market. The exchanges offer standardized currency futures and options contracts. They offer greater anonymity and liquidity and the exchanges guarantee performance on all contracts so credit risk is not a worry. The exchanges only offer a limited number of contracts on the major currencies and contract terms are not negotiable. Exchanges require gains and losses to be recognized daily. Most futures and options contracts do not result in an actual exchange of currency, whereas most interbank contracts do.

58) A current account deficit means that a country is buying more goods and services from overseas than it is selling to foreigners; or more simply, the country's constituents are spending more than their income.

Anyone who spends more than they make must either borrow (from foreigners, in this case), or sell their assets (to foreigners), both of which imply that foreign entities must be willing to supply funds to the United States via capital account inflows. If foreigners become less willing to hold so many dollar assets, the value of the dollar may well decline.

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59) Net exposure = (FX assetsi − FX liabilitiesi) + (FX boughti − FX soldi) = (£50 − £40) + (£20 − £15) = £15 million. The bank has positive (or asset) exposure of £15 million. This could be hedged by selling £15 million pounds forward. If the bank has offsetting exposures in other currencies, you may not wish to use the suggested forward hedge because the other exposures may be offsetting, which reduces the need to hedge, depending on the correlations of the currencies involved and their relationships to the U.S. dollar.

60) If the dollar drops in value, imports to the United States become more expensive. If the imports are foreign currency-denominated, U.S. buyers must spend more dollars to buy the same good after the dollar declines. If the imports are dollar-denominated, as most are, it is more complicated. The foreign supplier may raise the dollar price to preserve the amount of foreign currency per sale earned. If this happens, U.S. imports again become more expensive. Likewise, U.S. exports become cheaper for foreign buyers after a dollar decline. The net result should be a decrease in U.S. imports and an increase in U.S. exports. Some economists believe this helps create or keep more jobs in the United States.

22

Chapter 10: Derivative Securities Markets TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) A credit forward is a forward agreement that hedges against an increase in default risk on a loan after the loan has been created by a lender. ⊚ ⊚

2)

true false

Forward contracts are marked to market daily. ⊚ ⊚

true false

3) Futures or option exchange members who take positions on contracts for only a few moments are called scalpers. ⊚ ⊚

true false

4) The purchaser of a T-bond futures contract priced at 101-16 at the time of sale agrees to deliver $100,000 face value Treasury bonds in exchange for receiving $101,500 at contract maturity. ⊚ ⊚

true false

5) A negotiated non-standardized agreement between a buyer and seller (with no third-party involvement) to exchange an asset for cash at some future date with the price set today is called a forward agreement. ⊚ ⊚

true false

6) Marking to market of futures contracts is the process of realizing gains and losses each day as the futures contract changes in price.

1

⊚ ⊚

7)

true false

European-style options are options that may only be exercised at maturity. ⊚ ⊚

true false

8) In a futures contract, if funds in the margin account fall below the maintenance margin requirement, a margin call is issued. ⊚ ⊚

true false

9) You would expect the price quote for a put option to be at least $10 if the put had an exercise price of $40 and the underlying stock was selling for $50. ⊚ ⊚

10)

A clearinghouse backs the buyer's and seller's positions in a forward contract. ⊚ ⊚

11)

true false

true false

American options can only be exercised at maturity. ⊚ ⊚

true false

12) If you think that interest rates are likely to rise substantially over the next several years, you might sell a T-bond futures contract or buy an interest rate cap to take advantage of your expectations. ⊚ ⊚

true false

2

13)

Writing a put option results in a potentially limited gain and a potentially unlimited loss. ⊚ ⊚

true false

14) The buyer of a call option on stock benefits if the underlying stock price rises or if the volatility of the stock's price increases. ⊚ ⊚

true false

15) An in-the-money American call option increases in value as expiration approaches, but an out of-the-money American call option decreases in value as expiration approaches. ⊚ ⊚

16)

true false

U.S. markets and currencies dominate global derivative securities markets. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

17) Of the following, the most recent derivative security innovations are:

A) foreign currency futures.

B) interest rate futures.

C) stock index futures.

D) stock options.

E) credit derivatives.

18)

By convention, a swap buyer on an interest rate swap agrees to:

3

A) periodically pay a fixed rate of interest and receive a floating rate of interest.

B) periodically pay a floating rate of interest and receive a fixed rate of interest.

C) swap both principal and interest at contract maturity.

D) back both sides of the swap agreement.

E) act as the dealer in the swap agreement.

19) An increase in which of the following would increase the price of a call option on common stock, all else held constant?

1.I. Stock price 2.II. Stock price volatility 3.III. Interest rates 4.IV. Exercise price

A) II only B) II and IV only C) I, II, and III only D) I, III, and IV only E) I, II, III, and IV

20)

Which of the following is true?

A) Forward contracts have no default risk.

B) Futures contracts require an initial margin requirement be paid.

C) Forward contracts are marked to market daily.

D) Forward contract buyers and sellers do not know who the counterparty is.

E) Futures contracts are only traded over the counter.

21) A professional futures trader who buys and sells futures for his own account throughout the day but typically closes out his positions at the end of the day is called a:

4

A) floor broker.

B) day trader.

C) position trader.

D) specialist.

E) hedger.

22) You have agreed to deliver the underlying commodity on a futures contract in 90 days.

Today the underlying commodity price rises and you get a margin call. You must have:

A) a long position in a futures contract.

B) a short position in a futures contract.

C) sold a forward contract.

D) purchased a forward contract.

E) purchased a call option on a futures contract.

23) You find the following current quote for the March T-bond contract: $100,000; Points 32 nd, of 100 percent.

Open 89-12

High 89-24

Low 88-22

Settle 89-22

Open Interest 55,210

You went long in the contract at the open. Which of the following is/are true?

1.I. At the end of the day, your margin account would be increased.

2.II. 55,210 contracts were traded that day.

3.III. You agreed to deliver $100,000 face value T-bonds in March in exchange for $89,120.

4.IV. You agreed to purchase $100,000 face value T-bonds in March in exchange for $89,375.

A) I, II, and III only B) I, II, and IV only C) I and III only D) I and IV only E) IV only

5

24) A contract that gives the holder the right to sell a security at a preset price only immediately before contract expiration is a(n):

A) American call option.

B) European call option.

C) American put option.

D) European put option.

E) knockout option.

25) A higher level of which of the following variables would make a put option on common stock more valuable, all else held constant?

1.I. Stock price 2.II. Stock price volatility 3.III. Interest rates 4.IV. Exercise price

A) II only B) II and IV only C) I, II, and III only D) I, III, and IV only E) I, II, III, and IV

26) A speculator may write a put option on stock with an exercise price of $15 and earn a $3 premium only if he thought:

A) the stock price would stay above $12.

B) the stock volatility would increase.

C) the stock price would fall below $18.

D) the stock price would stay above $15.

E) the stock price would rise above $18 or fall below $12.

6

27) You have taken a stock option position and, if the stock's price drops, you will get a level gain no matter how far prices fall, but you could go bankrupt if the stock's price rises. You have .

A) bought a call option B) bought a put option C) written a call option D) written a put option E) written a straddle

28) You have taken a stock option position and, if the stock's price increases, you could lose a fixed small amount of money, but if the stock's price decreases, your gain increases. You must have .

A) bought a call option B) bought a put option C) written a call option D) written a put option E) purchased a straddle

29) In a bear market, which option positions make money?

1.I. Buying a call 2.II. Writing a call 3.III. Buying a put 4.IV. Writing a put

A) I and II B) I and III C) II and IV D) II and III E) I and IV

7

30)

The higher the exercise price, the the value of a call.

the value of a put and the

A) higher; higher B) lower; lower C) higher; lower D) lower; higher

31) the:

Measured by the amount outstanding, the largest type of derivative market in the world is

A) futures market.

B) forward market.

C) swap market.

D) options market.

E) credit forward market.

32) A stock has a spot price of $55. Its May options are about to expire. One of its puts is worth $5 and one of its calls is worth $10. The exercise price of the put must be and the exercise price of the call must be .

A) $50; $45 B) $55; $55 C) $60; $45 D) $60; $50 E) One cannot tell from the information given.

33) An agreement between two parties to exchange a series of specified periodic cash flows in the future based on some underlying instrument or price is a(n):

8

A) forward agreement.

B) futures contract.

C) interest rate collar.

D) option contract.

E) swap contract.

34) An investor has unrealized gains in 100 shares of Amazin stock for which he does not wish to pay taxes. However, he is now bearish on the stock for the short term. The stock is at $76 and he buys a put with a strike of $75 for $300. At expiration the stock value is $68. What is the net gain or loss on the entire stock/option portfolio?

A) $700 B) −$800 C) −$400 D) −$200 E) −$100

35)

New futures contracts must be approved by:

A) the CFTC. B) the SEC. C) the Warren Commission.

D) the NYSE. E) the Federal Reserve.

36) An investor is committed to purchasing 100 shares of World Port Management stock in six months. She is worried the stock price will rise significantly over the next six months. The stock is at $45 and she buys a six-month call with a strike of $50 for $250. At expiration the stock is at $54. What is the net economic gain or loss on the entire stock/option portfolio?

9

A) −$500 B) −$750 C) −$900 D) $400 E) $500

37) A bank with short-term, floating-rate assets funded by long-term, fixed-rate liabilities could hedge this risk by: 1.I. buying a T-bond futures contract.

2.II. buying options on a T-bond futures contract.

3.III. entering into a swap agreement to pay a fixed rate and receive a variable rate.

4.IV. entering into a swap agreement to pay a variable rate and receive a fixed rate.

A) I and III only B) I, II, and IV only C) II and IV only D) III only E) IV only

38) A bank with long-term, fixed-rate assets funded with short-term, rate-sensitive liabilities could do which of the following to limit their interest rate risk?

1.I. Buy a cap.

2.II. Buy an interest rate swap.

3.III. Buy a floor.

4.IV. Sell an interest rate swap.

A) I and II only B) III only C) I and IV only D) II and III only E) III and IV only

10

39) An interest rate floor is designed to protect an institution from: 1.I. falling interest rates.

2.II. falling bond prices.

3.III. increased credit risk on loans.

4.IV. swap counterparty credit risk.

A) I and IV B) II and III C) I and III D) II and IV E) I only

40)

An interest rate collar is:

A) writing a floor and writing a cap.

B) buying a cap and writing a floor.

C) an option on a futures contract.

D) buying a cap and buying a floor.

E) None of these choices are correct.

41) My bank has a larger number of adjustable-rate mortgage loans outstanding. To protect our interest rate income on these loans, the bank could: 1.I. enter into a swap to pay fixed and receive variable.

2.II. enter into a swap to pay variable and receive fixed.

3.III. buy an interest rate floor.

4.IV. buy an interest rate cap.

A) I and III only B) I and IV only C) II and III only D) II and IV only

11

42) A contract wherein the buyer agrees to pay a specified interest rate on a loan that will be originated at some future time is called a(n):

A) forward rate agreement.

B) futures loan.

C) option on a futures contract.

D) interest rate swap contract.

E) currency swap contract.

43)

Two competing fully electronic derivatives markets in the United States are:

A) CME Globex and Eurex.

B) Philadelphia Exchange and AMEX. C) NYSE and ABS. D) CME and Pacific Exchange.

E) D-Trade and IMM.

44) Your firm enters into a swap agreement with a notional principal of $40 million wherein the firm pays a fixed rate of interest of 5.50 percent and receives a variable rate of interest equal to LIBOR plus 150 basis points. If LIBOR is currently 3.75 percent, the NET amount your firm will receive (+) or pay (−) on the next transaction date is:

A) − $2,200,000.

B) $2,625,000.

C) $125,000.

D) − $100,000.

E) − $875,000.

45) Refer to the Listed Stock Option Price Quotebelow from February and assume it is now January: IRQ Expiration

STRIKE

Call

Underlying stock price $45.23 Put

12

March June

50 50

LAST

VOLUME

?

2.25

102 35

OPEN INTEREST 12,578 1,062

LAST

VOLUME

6.55 ?

80 48

OPEN INTEREST 11,175 909

Based on the option quote, the March call should cost:

A) more than $477.

B) more than $102.

C) less than $665 but more than $477.

D) less than $225.

E) $0.

46) Refer to the Listed Stock Option Price Quote below from February and assume it is now January: IRQ Expiration

STRIKE LAST

March June

50 50

?

2.25

Underlying stock price $45.23 Call Put VOLUME OPEN LAST VOLUME OPEN INTEREST INTEREST 102 12,578 6.55 80 11,175 35 1,062 ?

48 909

Based on the option quote, the June put should cost: 1.I. more than $477.

2.II. more than $655.

3.III. more than the March and June 50 calls.

4.IV. more than the March 50 call but no more than the June 50 call.

A) I only B) I, II, and IV only C) I, II, and III only D) I and III only E) IV only

13

47) Refer to the Listed Stock Option Price Quote below from February and assume it is now January: IRQ Expiration

March June

STRIKE

50 50

Underlying stock price $45.23 Put

Call LAST

VOLUME

?

2.25

102 35

OPEN INTEREST 12,578 1,062

LAST

VOLUME

6.55 ?

80 48

OPEN INTEREST 11,175 909

If you buy the March put and don't exercise before contract maturity, you will make a profit if the stock price at maturity from today's price.

A) increases by more than 9.65 percent B) increases by more than 4.57 percent C) decreases by more than 3.94 percent D) decreases by more than 11.99 percent E) does not decrease by more than 5.64 percent

48) A bank has made a risky loan to a midsize consumer goods manufacturer. With the weaker economy, the borrower is expected to have trouble repaying the loan. The bank decides to purchase a digital default option. Which one of the following payout patterns does a digital option provide?

A) The option seller pays a stated amount to the option buyer, usually the par on the loan or bond, in the event of a default on the underlying credit.

B) The option seller pays the buyer if the default risk premium or yield spread on a specified benchmark bond of the borrower increases above some exercise spread.

C) If the option buyer makes fixed periodic payments to the option seller, the seller will pay the option buyer if a credit event occurs.

D) If the option buyer makes periodic payments to the seller and delivers the underlying bond or loan, the seller pays the par value of the security.

E) If interest rates change, the option seller will begin making fixed-rate payments to the option buyer.

14

49) A bank lender is concerned about the creditworthiness of one of its major borrowers. The bank is considering using a swap to reduce its credit exposure to this customer. Which type of swap would best meet this need?

A) Interest rate swap B) Currency swap C) Equity linked swap D) Credit default swap E) DIF swap

50)

The type of swap most closely linked to the subprime mortgage crisis is the .

A) interest rate swap B) currency swap C) equity linked swap D) credit default swap E) DIF swap

51) The total notional amount of outstanding OTC contracts was to exchange traded contracts which totaled in 2018.

in 2018 compared

A) $212 trillion; $104 trillion B) $104 trillion; $212 trillion C) $544 trillion; $95 trillion D) $95 trillion; $544 trillion E) $104 trillion; $95 trillion

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

52) What determines the success or failure of an exchange-traded derivative contract? Why were currency and interest rate futures introduced in the early and late 1970s, respectively?

15

53) A U.S. firm has a European subsidiary that earns euros. The subsidiary has borrowed dollars at a floating rate of interest. What kind of risk does the subsidiary have? What kind of swap could be used to limit the subsidiary's risk? Be specific.

54)

When would a forward contract be better for hedging than a futures contract?

55) When might an option on a futures contract be preferable to an option on the underlying instrument?

56)

How does a futures or option clearinghouse assist traders?

57) Buying an "at-the-money" call option and writing an "at-the-money" put option are two ways to make money when prices rise. When would each be the preferable strategy?

16

58) A stock is priced at $27. An American call option on this stock with a $25 strike must be worth at least how much? Numerically show why.

59) FNMA has direct holdings of 30-year, fixed-rate mortgages financed by three- to fiveyear agency securities sold to the public.

What kind of interest rate swap could FNMA use to limit their interest rate risk? Explain.

60) FNMA has direct holdings of 30-year, fixed-rate mortgages financed by three- to fiveyear agency securities sold to the public.

What kind of interest rate option could FNMA use to limit the interest rate risk? Explain how this would work. Explain how a collar could also be used.

61) Using the Black-Scholes model, explain what happens to the value of a call as S, T, and 2 σ change. Why is the relationship between risk and price different for options than for other securities?

1. As S increases, C (the call premium) increases because the right to buy at the fixed price E has more value as the sale price S rises.

2. As T increases, C increases and as T decreases, C decreases. The less time remaining on the option, the lower its value since there is less time during which the option right is available.

3. As σ increases, C increases.

17

62)

When would an option hedge be better than a futures or forward hedge?

63) Suppose a stock is priced at $50. You are bullish on the stock and are considering buying March calls with an exercise price of $45 and $55, respectively. The 45 call is priced at $8.50 and the 55 call is quoted at $2.75. What should you consider in deciding which to purchase if you do not plan on exercising prior to maturity? Be specific.

64) A stock is priced at $33.25. The stock has call options with an exercise price of $35 that expire in 60 days. The underlying stock price volatility is 39 percent per year and the annual riskfree rate is 4.5 percent. According to the Black-Scholes option pricing model, what is the most you should be willing to pay for this call option?

Using the NORMSDIST function in Excel to find N(dx) C0 = ($33.25 × 0.42131) − [$35e−0.045(60/365) × 0.3607]= $1.4781, or $147.81 per contract

18

19

Answer Key Test name: Chap 10_8e 1) TRUE 2) FALSE 3) TRUE 4) FALSE 5) TRUE 6) TRUE 7) TRUE 8) TRUE 9) FALSE 10) FALSE 11) FALSE 12) TRUE 13) TRUE 14) TRUE 15) FALSE 16) TRUE 17) E 18) A 19) C 20) B 21) B 22) B 23) D Value to exchange for = [$100,000 × (89 + 12/32)]/100 = $89,375 24) D

20

25) B 26) A 27) C 28) B 29) D 30) C 31) C 32) C 33) E 34) C [[($68 − $76) × 100] + (($75 − $68) × 100)] − $300 = − $400 35) A 36) B [[($45 − $54) × 100] + (($54 − $50) × 100)] − $250 = − $750 37) B 38) A 39) E 40) B 41) C 42) A 43) A 44) D ((3.75% + 1.50%) − 5.50%) × $40 million = − $100,000 45) D The March call price must be less than the June call price quote * 100.

46) C

21

The June put price must be greater than the intrinsic value of ($50 − $45.23) × 100, it must be worth more than the March put price, and it must be worth more than both the March and June 50 calls.

47) C [($50 − $6.55)/$45.23] − 1 = −0.0394, or −3.94% 48) A 49) D 50) D 51) C 52) The success of derivative contracts depends upon trading volume (or trader interest), which is in turn dependent on price volatility in the underlying security or commodity value. Currency futures were introduced in the early 1970s in response to the collapse of fixed exchange rates as Bretton Woods collapsed. Exchange rates quickly proved themselves very volatile. Interest rate futures were needed once the Federal Reserve stopped targeting interest rates and began targeting non-borrowed reserves in 1979, allowing interest rates to float and interest rate volatility to increase.

53) The subsidiary faces both currency risk and probably interest rate risk. If the euro drops in value, the subsidiary will have to use more euros to repay the dollar debt. If interest rates rise, the subsidiary's financing costs will also rise. The subsidiary may be able to set up a currency/rate swap whereby the subsidiary pays euros at a fixed rate of interest and receives dollars at a variable rate of interest. This would reduce both types of risks.

22

54) A forward contract is better suited for a nonstandard agreement where specific terms need to be negotiated or when there are no suitable futures contracts available (e.g., hedging an LDC currency). Forwards also avoid the daily liquidity problems that marking to market on futures contracts can cause. Forward contracts are generally not marketable, so the participant should be sure the contract is needed and must be willing to take or make delivery. Forwards require each party to assess the creditworthiness of the counterparty, so one needs enough information about the other party to assess the likelihood of default. Default risk is not an issue for futures contracts.

55) In general, the option on the futures will be preferable if it is cheaper and/or easier to deliver the futures contract rather than the underlying instrument. This can occur when the futures contract is more liquid than the underlying instrument, or if delivery of the underlying instrument is more difficult and costly.

56) The clearinghouse interposes itself between every buyer and seller.

For example, an option buyer buys from the clearinghouse; an option seller sells to the clearinghouse. Should one party not perform as promised, the clearinghouse performs instead. Thus, market participants do not need to evaluate the creditworthiness of the counterparty since the clearinghouse guarantees all trades. The clearinghouse nets all transactions so that once a long participant sells the same contract, the clearinghouse nets their position to zero.

57) If spot prices rise by a lot, then buying the call is preferable. If spot prices rise by only a little, then writing the put is preferable. In general, in low-volatility markets writing options will be the preferred strategy, but in high-volatility markets buying options will give larger gains and avoid catastrophic losses. Buying options is also the more risk-averse strategy.

23

58) It must be worth at least $2 per share or $200 per contract. Suppose the premium is instead only $1 per share. You could buy the call for $1 and sell the stock short simultaneously at $27, exercise the call immediately, and buy the stock for $25. Your "all in" cost of the stock per share is $25 + $1 = $26, and you sell the stock for $27, a $1 gain that involves no risk and no investment (although you will have to post margin on the short sale). As everyone does this, the option's price will rise until the option premium is at least equal to the difference between the stock price and the exercise price.

59) FNMA's risk is from rising interest rates because the bonds mature more quickly than the mortgages (the mortgage duration is greater).

Rising interest rates will increase FNMA's funding cost, but the mortgage income will stay the same. To offset this risk, FNMA could agree to pay a fixed rate of interest on a given notional principal and receive a variable rate of interest. If rates rose, FNMA would receive more interest income, but pay out the same fixed rate on the swap. The swap gain could then offset any loss on the balance sheet.

60) A cap could be used since FNMA's risk is from rising interest rates.

Caps generate income to the buyer if interest rates rise above some minimum value. For example, a 10 percent cap pays the holder i - 10% times the notional principal if i > 10%. This additional income could be used to offset higher funding costs of the agency securities when rates rose. Buying caps can be expensive. To help offset the purchase price of the cap, FNMA could also sell a floor. The income from selling the floor would help offset the price of the cap. Buying a cap and selling a floor is termed a "collar."

24

61) Unlike virtually all other securities, risk and price move in the same direction with options. The reason is the option feature of the contract. If bad outcomes occur, you do not exercise the option, but you do exercise if the good outcomes occur. Greater risk increases the odds of seeing either the very good or very bad outcomes, but, because you get all the gain from a stock price run-up and none of the loss of a stock decline, this means that risk increases the option's value.

62) An option hedge is better than a futures or forward hedge when you want the choice of whether or not to use the derivative instrument and you are willing to pay to have that choice. Futures and forward hedges limit losses but also limit profit opportunities. Because options are a right, rather than a commitment, using options to hedge preserves the upside potential foregone with other hedging methods. Options require the payment of a nonrefundable premium to acquire, whereas forwards, futures, and swaps do not have this outright cost.

63) The 45 is in the money and could be exercised right away, although the exerciser would lose the ($8.50 − $5) $3.50 time value of the call by exercising. The stock has to move up to $58.50 before the call buyer recovers the purchase price. Buying the 55 call is cheaper; the quote is $2.75 (or $275). This is because the call is currently out of the money. If you buy the 55 call, the stock price has to move up to ($55 + $2.75) $57.75 before you make a profit. You have a lower breakeven than with the more expensive in-the-money call, but your profit is considerably less ($10 per share to be exact) with the out of-the-money call. You can also lose much less with the out of-the-money call ($275 versus $850).

There is no definitive answer as to which is better; it depends on your perception of how the stock price will move (and the underlying stock volatility) and your own risk-return trade-off.

25

64) Note to Instructor: This is an Appendix question and it requires either a cumulative normal density table or access to the Excel function NORMSDIST to find N(dx).

26

Chapter 11: Commercial Banks TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) The proportion of commercial and industrial loans in the banks’ asset portfolio has been declining since 2000. ⊚ ⊚

2)

Loans comprise the single largest asset category for a bank. ⊚ ⊚

3)

true false

true false

Banks have an average total debt ratio of about 88.7 percent. ⊚ ⊚

true false

4) On average, bank liabilities tend to have shorter maturities and greater liquidity than bank assets. ⊚ ⊚

5)

Nontransaction deposits at banks include NOW accounts and demand deposits. ⊚ ⊚

6)

true false

true false

The majority of banks are nationally chartered and insured by the FDIC. ⊚ ⊚

true false

7) Since 1980, the number of banks in the United States has been increasing dramatically due to deregulation of the industry.

1

⊚ ⊚

8)

true false

Small banks control about 70 percent of banking industry assets. ⊚ ⊚

true false

9) Off-balance-sheet activities consist of issuing financial instruments such as various types of guarantees and engaging in derivative trading to generate additional revenue. ⊚ ⊚

true false

10) The financial crisis of 2008 demonstrated that activities such as trading in financial futures and interest rate swaps have low risk. ⊚ ⊚

true false

11) International expansion for financial institutions coming from highly-integrated countries maximizes the risk diversification. ⊚ ⊚

true false

12) A bank's balance sheet equates the value of total assets to the sum of total liabilities and equity capital. ⊚ ⊚

13)

true false

Negotiable certificates of deposit (CDs) do not have an active secondary market. ⊚ ⊚

true false

2

14)

Financial institutions generally do not face liquidity risk. ⊚ ⊚

15)

true false

In a bankruptcy situation, the Federal Reserve acts as the liquidator of the bank. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) Banking may be subdivided into at least three categories of banks. Match the definitions with the appropriate name. 1.I. A bank that specializes in retail or consumer banking in a local market 2.II. A bank that engages in a complete array of wholesale commercial banking activities and usually also provides retail banking services 3.III. A bank that is located in a financial center and relies on nondeposit or borrowed sources of funds for a significant portion of its liabilities

A) Money center bank; community bank; superregional bank B) Community bank; money center bank; superregional bank C) Superregional bank; money center bank; community bank D) Money center bank; superregional bank; community bank E) Community bank; superregional bank; money center bank

17) Bank assets tend to have bank liabilities.

maturities and

liquidity than/as

3

A) longer; greater B) longer; lower C) shorter; greater D) shorter; lower E) equal; equal

18)

In comparison to small banks, larger banks typically have:

A) more equity capital.

B) more core deposits.

C) more off-balance-sheet activities.

D) larger net interest margins.

E) All of these choices are correct.

19)

In terms of profitability, a well-run bank usually has an ROA of:

A) 0.5–3 percent.

B) 3–5 percent.

C) 5–10 percent.

D) 10–15 percent.

E) 15–20 percent.

20)

Which of the following could result in a negative NIM?

A) Growth in net interest income B) Lower non interest expense C) Decline in net interest income D) Higher non interest income E) Positive net interest spread

4

21) Most of the changes in size, structure, and composition of the banking industry in recent years are due to:

A) bank failures.

B) increasing regulations.

C) new charters granted.

D) declines in the number of branch offices.

E) mergers and acquisitions.

22) About of federally insured banks are nationally chartered and about of federally insured banks are members of the Federal Reserve.

A) 77 percent; 65 percent B) 65 percent; 77 percent C) 34 percent; 22 percent D) 21 percent; 36 percent E) 40 percent; 60 percent

23)

Nationally chartered banks receive chartering and merger approval from the:

A) Federal Deposit Insurance Corporation.

B) Office of Comptroller of the Currency.

C) Federal Reserve System.

D) Office of Thrift Supervision.

E) All of these choices are correct.

24) State chartered banks and nationally chartered banks

be members of the Federal Reserve System be members of the Federal Reserve System.

5

A) must; may B) must; must C) may; must D) may; may

25)

The largest single category of loans on the typical bank's balance sheet in 2019 was:

A) U.S. government securities.

B) commercial and industrial loans.

C) consumer loans.

D) real estate loans.

E) interbank loans.

26) Equity capital at commercial banks in 2019 comprised about and equity.

of liabilities

A) 25 percent B) 21 percent C) 55 percent D) 11 percent E) 5 percent

27) Commercial banks are the States as measured by asset size.

financial intermediary in the United

A) largest B) second-largest C) third-largest D) fourth-largest E) fifth-largest

6

28) The provision of banking services to other banks, such as check clearing, foreign exchange trading, and so forth, is an example of:

A) correspondent banking.

B) trust services.

C) off-balance-sheet assets.

D) economies of scope.

E) credit derivatives.

29) Off-balance-sheet activities include issuing various types of guarantees, which often have a strong insurance underwriting element. One such example is a:

A) swap agreement.

B) standby letter of credit.

C) forward contract.

D) loan commitment.

E) commitment to buy foreign exchange.

30) A contingent item that may eventually be placed on the right-hand side of the balance sheet or expensed on the income statement is a(n):

A) loan commitment.

B) off-balance-sheet liability.

C) off-balance-sheet asset.

D) net charge-off.

E) loan sold without recourse.

31) Reasons behind the drop in bank profitability in the late 2000s include: 1.I. flattening of the yield curve.

2.II. increase in competitive pressures on asset pricing.

3.III. increases in foreclosures in the mortgage market.

4.IV. increases in net interest margin.

7

A) I only B) II and III only C) I, II, and III only D) II, III, and IV only E) III and IV only

32) Loans past due 90 days or more and loans that are not accruing interest because of problems of the borrower are called:

A) loan losses.

B) net charge-offs.

C) provisional loans.

D) noncurrent loans.

E) contra loans.

33)

Which of the following is the primary regulator of bank holding company activities?

A) Federal Bank Holding Company Board B) FDIC C) Federal Reserve D) State regulatory agency in the chartering states E) U.S. Treasury

34) Banks differ from other types of depository institutions in that: 1.I. banks have more diversified asset portfolios.

2.II. banks obtain funds from more different types of sources.

3.III. the average size bank is larger than other depository institutions.

8

A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III

35)

Advantages of going global for U.S. banks include all but which one of the following?

A) Diversification of earnings B) Greater opportunities to exploit economies of scale C) Greater sources of funds D) Conducting business in less regulated environments E) Low fixed costs involved in international expansion

36)

An ILC is a type of:

A) finance company.

B) thrift institution.

C) credit card bank.

D) nonbank bank.

E) foreign-owned loan corporation.

37) A bank has an interest rate spread of 150 basis points on $30 million in earning assets funded by interest-bearing liabilities. However, the interest rate on its assets is fixed and the interest rate on its liabilities is variable. If all interest rates go up 50 basis points, the bank's new pretax net interest income will be .

A) $600,000 B) $450,000 C) $300,000 D) $250,000 E) $175,000

9

38) A bank is earning 6 percent on its $150 million in earning assets and is paying 4.75 percent on its liabilities. The bank's interest rate spread is .

A) 6.00 percent B) 4.75 percent C) 1.25 percent D) 10.75 percent E) 1.26 percent

39)

An example of off balance sheet activity includes:

A) lending money to a depositor.

B) borrowing from another bank.

C) borrowing from the Federal Reserve.

D) purchasing a futures contract.

E) All of these choices are correct.

40)

Suppose you deposit $100 in a bank, which of the following will occur?

A) The bank’s assets will increase by $100.

B) The bank’s liabilities will decrease by $100.

C) The bank’s liabilities will increase by $200.

D) The bank’s reserves will increase by $200.

E) The bank’s reserves will decrease by $100.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

41) The ROA for financial institutions such as banks is typically quite low as compared to nonfinancial firms. Why? With such low ROAs, how can banks attract stockholders?

10

42) Why are loans such a high percentage of total assets at the typical bank? What four broad classes of loans do banks engage in?

43) Most nonfinancial firms would never hold as much of their assets in safe liquid securities as banks do. Why do banks maintain such a high percentage of investment in securities?

44) What are the major sources of funds for banks? Provide a breakdown of all the major sources of funds at a bank and briefly describe the different types of deposit/nondeposit sources.

45) What are the major advantages a bank gains by expanding into international bank services? What are three disadvantages of international expansion?

46)

Why are banks different from other depository institutions?

11

47) Discuss the major differences between large banks and small banks. Which have had higher ROAs? Why?

48)

Why did bank profitability decline beginning in late 2006 and through 2008?

12

Answer Key Test name: Chap 11_8e 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) FALSE 6) FALSE 7) FALSE 8) FALSE 9) TRUE 10) FALSE 11) FALSE 12) TRUE 13) FALSE 14) FALSE 15) FALSE 16) E 17) B 18) C 19) A 20) C 21) E 22) D 23) B 24) C 25) D 26) D 13

27) A 28) A 29) B 30) B 31) C 32) D 33) C 34) E 35) E 36) D 37) C (1.50% − 0.50%) × $30 million = $300,000 38) C 6% − 4.75% = 1.25% 39) D 40) A 41) Microeconomics tells us that firms earn positive net present values by producing a good or service that not enough other firms can perfectly duplicate, at least not at the same cost. Because the major assets of a bank are pieces of paper (loans and securities), it is difficult for a bank to generate substantially positive NPVs and earn a large ROA. For instance, an ROA of 2 percent for a bank is outstanding. Trying to convince your stockholders that a 2 percent return on their investment is outstanding is, however, quite difficult! To get an acceptable ROE, (the rate of return to the shareholder) banks must resort to using a very high amount of leverage. The debt/asset ratio at a bank is usually over 90 percent.

14

42) Loans are the highest earning asset on the bank's balance sheet. In order to compete and reward its shareholders, banks must invest heavily in their highest returning asset. Prior to deregulation and increased competition, banks held much lower percentages of loans.

The four major loan categories are commercial and industrial loans (loans to businesses), real estate loans, individual/consumer loans, and the ubiquitous "other" category.

43) To answer this we must look at the right-hand side of the balance sheet as well as the left-hand side. A major portion of bank funds is raised through short-term deposits that people can choose to withdraw at short notice. Consequently, banks must plan for withdrawals and keep a significant portion of their assets in cash or near cash investments.

Likewise, banks must have cash available for loan customers and to honor previous loan commitments. So even though much of the investment portfolio earns only low rates of interest, banks must maintain liquid reserves to meet loan demand and deposit withdrawals.

44) The main source of funding include: ● Equity: Common stock, paid-in capital, and retained earnings ● Deposits: ● Transaction accounts are composed of demand deposits (pay no interest) or NOW accounts (negotiable order of withdrawal or an interest-bearing checking account). ● Retail savings and time deposits (< $100,000 in size) savings have no fixed maturity, while time deposits have a set maturity date. ● Large time deposits (> $100,000) are negotiable certificates of deposit that can be resold to other investors prior to maturity. ● Nondeposit liabilities include loans from other banks, repurchase agreements, and bonds.

15

45) Advantages include: ● better diversification by expanding beyond the home market. ● greater economies of scale and scope. ● more sources of funds. ● a greater ability to provide banking services to large international corporate customers. ● the ability to move into other product lines not allowed in the home country ● avoiding domestic regulations and oversight.

Disadvantages include: ● higher exposure to risk. In particular, foreign lending has been quite risky and has experienced much higher default rates than other loan types. It is often difficult to properly assess a borrower's risk in other countries with less stringent accounting practices, for example. ● risk of having one's assets expropriated. Foreign banks are often used as scapegoats when economic problems emerge. ● high fixed costs of establishing foreign operations, which increases the riskiness of foreign expansion.

46) Banks are the main conduit of monetary policy; they are also critical in operating the nation's payments system. The banking industry constitutes the nation's largest intermediary and is one of the major methods of allocating credit in the economy. Banks provide risk, liquidity, and maturity intermediation that encourages savers to make their money available to the system and thus encourages economic growth.

16

47) Large banks tend to have: ● lower equity (%). ● easier access to capital markets; hence they often hold a lower percentage of liquid securities. ● more business loans; business borrowers often have greater bargaining power so profitability on these loans can be low. ● lower interest rate spreads. ● more off-balance sheet activities. ● higher salaries. ● more noninterest income (and expense). ● more diversification. ● more aggressive management. ● The picture that emerges is that smaller banks tend to operate in less-competitive markets and are more conservatively managed. In terms of profitability, large banks will tend to have lower ROAs but may often have higher ROEs when banks are performing well because they take more risks and have less equity. ● In periods of poorer bank performance, the more conservative tactics of smaller banks are likely to result in better ROA and ROE than large banks.

17

48) Increased loan loss provisions, reduced servicing income, and lower trading revenue all contributed to lower net income for banks in 2006.

Further, rising funding costs outstripped increases in asset yields for a majority of banks. Mortgage delinquencies, particularly subprime mortgage delinquencies, surged in the fourth quarter of 2006. By 2008, industry net income was at its lowest annual earnings total since 1989, with almost one in four institutions reporting negative net income. Sharp declines in noninterest income, primarily driven by trading losses, a decline in securitization income, and a drop in proceeds from sales of loans, foreclosed properties, and other assets also contributed to the decline in profitability. Finally, net loan and lease charge-offs hit record highs in the fourth quarter of 2007.

18

Chapter 12: Commercial Banks’ Financial Statements and Analysis TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) A wholesale bank is one that focuses its business activities on commercial banking relationships. ⊚ ⊚

2)

Composite rating 5 is the rating for the soundest financial institutions. ⊚ ⊚

3)

true false

true false

Banks have higher leverage than most manufacturing firms. ⊚ ⊚

true false

4) Loans to consumers and to individuals are jointly termed C&I loans on a bank's balance sheet. ⊚ ⊚

true false

5) MMDAs are a type of savings account that has some limited checking features. These accounts were designed to help banks compete with MMMFs. ⊚ ⊚

true false

6) C&I loans are loans to businesses used to finance capital needs, equipment purchases, and plant expansions. ⊚ ⊚

true false

1

7) The provision for loan loss account is the actual loan losses less loan recoveries in a given time period. ⊚ ⊚

true false

8) The allowance for loan and lease losses is bank management's estimate of the amount of gross loans and leases that will not be repaid to the bank. ⊚ ⊚

9)

true false

In ratio analysis, the profit margin times the asset utilization ratio equals return on assets. ⊚ ⊚

true false

10) Loans are the major asset on a bank's balance sheet, and they generate the largest amount of revenue. ⊚ ⊚

true false

11) Both retail and wholesale CDs are negotiable instruments despite their different denominations. ⊚ ⊚

12)

true false

Banks generally pay higher interest rates on NOW accounts than on MMDAs. ⊚ ⊚

true false

13) Wholesale CDs obtained from an investment house rather than directly from a customer are referred to as brokered deposits.

2

⊚ ⊚

true false

14) At almost all banks noninterest expense is greater than noninterest income; hence, the overhead efficiency ratio is usually greater than 100 percent. ⊚ ⊚

15)

true false

Rate-sensitive funding sources at a bank are termed core deposits. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) Core deposits are deposits that are:

A) at the bank solely for the interest rate earned.

B) very stable funds sources.

C) typically for larger denominations than hot money sources.

D) very frequently turned over.

17) A construction firm cannot obtain the necessary permits to begin building a shopping mall until it can show it either has or will have the necessary funding to complete the project.

The firm may ask a bank for which of the following to allow it to obtain the permits?

1.I. Commercial letter of credit 2.II. Loan commitment 3.III. Credit line 4.IV. Repurchase agreement

3

A) I or II B) II or III C) II or IV D) III or IV E) I or IV

18)

Which one of the following is the definition of the net interest margin?

A) (Net interest income − Net noninterest income)/Earning assets B) Net interest income/Interest-bearing liabilities C) (Interest income − Interest expense)/Earning assets D) (Interest income − Interest expense)/Interest-bearing liabilities E) (Interest income/Earning assets) − (Interest expense/Interest-bearing liabilities)

19) Uniform principles, standards, and report forms for depository institutions are prescribed by the:

A) FDIC. B) Federal Reserve.

C) Federal Financial Institutions Examination Council.

D) Office of Comptroller of Currency.

20) Bank A has a higher ROA than Bank B. Both banks have similar interest income to asset ratios and noninterest income to asset ratios. We know that: 1.I. Bank A has a higher profit margin than Bank B. 2.II. Bank A has a higher AU ratio than Bank B. 3.III. Bank A must have a higher provision for loan loss to operating income ratio.

4

A) I only B) II only C) I and II only D) III only E) I, II, and III

21) Fernando Bank has interest expense of $150 million, earning assets of $1,400 million and a net interest margin of 5.00 percent. The bank also has interest-bearing liabilities of $1,100 million. Fernando Bank's spread is:

A) 1.10 percent.

B) 1.65 percent.

C) 1.94 percent.

D) 2.08 percent.

E) 2.16 percent.

22)

Cash in the process of collection:

A) is a deposit at another financial institution.

B) is a Fed funds transaction.

C) are checks the bank owes other institutions that have not yet been paid.

D) are checks that the bank is owed but has not yet collected.

E) is equity capital.

23) Blue Ridge Bank has a PM of 12 percent, an interest income to total assets ratio of 6.00 percent, and a noninterest income to assets ratio of 1.50 percent. Blue Ridge also has $9 in assets per dollar in equity capital. Blue Ridge's ROE is:

5

A) 7.50 percent.

B) 9.00 percent.

C) 8.10 percent.

D) 6.48 percent.

E) 5.75 percent.

24) Interest-bearing retail accounts with limited checking features designed to compete with money market mutual fund investments are called .

A) NOWs B) retail CDs C) MMDAs D) special savings deposits E) negotiable CDs

25) Oceanside Bank converts a dollar of equity into 10 cents of net income and has $9.50 in assets per dollar of equity capital. Oceanside also has a profit margin of 15 percent. What is Oceanside's AU ratio?

A) 1.05% B) 3.55% C) 5.56% D) 6.45% E) 7.02%

26)

Purchased funds include all but which one of the following?

A) Brokered deposits B) Wholesale CDs C) Fed funds purchased D) Repurchase agreements E) Demand deposits

6

27)

Core deposits typically include all except which one of the following?

A) Demand deposits B) NOW accounts C) MMDAs D) Eurodollar deposits E) Passbook savings accounts

28) A bank has interest income to total assets ratio of 5.45 percent and has noninterest income of $45 million and total assets of $700 million. What is the bank's asset utilization ratio?

A) 5.45% B) 6.43% C) 9.67% D) 15.02% E) 11.88%

29) The lower the interest expense ratio, the provision for loan loss ratio, the noninterest expense ratio, and the tax ratio, the the .

A) lower; PM B) higher; PM C) lower; AU D) higher; AU E) lower; EM

30) Plains National Bank has interest income of $250 million, interest expense of $110 million, noninterest income of $40 million, and noninterest expense of $65 million on earning assets of $3,900 million. What is Plains' overhead efficiency ratio?

7

A) 61.54% B) 44.00% C) 9.23% D) 42.45% E) 37.46%

31)

The largest source of income at a typical bank is:

A) interest income on securities held for sale.

B) interest income on securities held for investment.

C) interest income on loans and leases.

D) noninterest income.

E) dividends or stock.

32) A municipal bond is paying a 6 percent annual yield. An equivalent risk corporate bond is paying 7 percent. Investors with a tax rate of or higher would prefer the municipal bond.

A) 65.13% B) 14.29% C) 25.00% D) 80.75% E) 25.75%

33) The First Bank of the Ozarks generates $0.0155 dollars of net income per dollar of assets and it has a profit margin of 12.25 percent. How much operating income per dollar of total assets does First Bank generate?

8

A) 12.50% B) 12.65% C) 12.75% D) 12.85% E) 12.95%

34) Bank A (Dollars in Millions) Assets Cash Securities Loans

Liability and Equity $ 850 1,925 5,400

Others

975

Total

$ 9,150

Deposits Other Borrowing Equity

$ 6,475 1,645 1,030

Total

$ 9,150

Income Statement Interest income on loans Interest income on securities Interest expense Noninterest income Nonincome expense Provision for loan loss Taxes

$ 450 95

NI

$ 115

246 78 112 35 115

The bank's ROA is:

A) 1.31 percent.

B) 1.78 percent.

C) 1.26 percent.

D) 0.89 percent.

E) None of these choices are correct.

9

35) Bank A (Dollars in Millions) Assets Cash Securities Loans

Liability and Equity $ 850 1,925 5,400

Others

975

Total

$ 9,150

Deposits Other Borrowing Equity

$ 6,475 1,645 1,030

Total

$ 9,150

Income Statement Interest income on loans Interest income on securities Interest expenses Noninterest income Nonincome expenses Provision for loan loss Taxes

$ 450 95

NI

$ 115

246 78 112 35 115

The bank's ROE is:

A) 15.65 percent.

B) 13.21 percent.

C) 19.55 percent.

D) 11.17 percent.

E) 12.67 percent.

36) Bank A (Dollars in Millions) Assets Cash Securities

Liability and Equity $ 850 1,925

Deposits Other Borrowing

$ 6,475 1,645

10

Loans

5,400

Equity

1,030

Others

975

Total

$ 9,150

Total

$ 9,150

Income Statement Interest income on loans Interest income on securities Interest expenses Noninterest income Nonincome expenses Provision for loan loss Taxes

$ 450 95

NI

$ 115

246 78 112 35 115

The bank's profit margin is:

A) 27.27 percent.

B) 23.08 percent.

C) 21.31 percent.

D) 18.46 percent.

E) None of these choices are correct.

37) Bank A (Dollars in Millions) Assets Cash Securities Loans

Liability and Equity $ 850 1,925 5,400

Others

975

Total

$ 9,150

Deposits Other Borrowing Equity

$ 6,475 1,645 1,030

Total

$ 9,150

Income Statement Interest income on loans Interest income on

$ 450 95

11

securities Interest expenses Noninterest income Nonincome expenses Provision for loan loss Taxes NI

246 78 112 35 115 $ 115

The bank's asset utilization ratio is:

A) 58.04 percent.

B) 6.12 percent.

C) 5.46 percent.

D) 4.29 percent.

E) 6.81 percent.

38) Bank A (Dollars in Millions) Assets Cash Securities Loans

Liability and Equity $ 850 1,925 5,400

Others

975

Total

$ 9,150

Deposits Other Borrowing Equity

$ 6,475 1,645 1,030

Total

$ 9,150

Income Statement Interest income on loans Interest income on securities Interest expenses Noninterest income Nonincome expenses Provision for loan loss Taxes

$ 450 95

NI

$ 115

246 78 112 35 115

12

If the average net interest margin for this type of bank is 4.65 percent, then, all else held constant, this particular bank is performing:

A) the same as average because this bank has a net interest margin of 4.65 percent.

B) better than average because this bank has a net interest margin of 6.55 percent.

C) poorer than average because this bank has a net interest margin of 4.08 percent.

D) better than average because this bank has a net interest margin of 5.23 percent.

E) The bank’s performance cannot be determined with the information given.

39) Bank A (Dollars in Millions) Assets Cash Securities Loans

Liability and Equity $ 850 1,925 5,400

Others

975

Total

$ 9,150

Deposits Other Borrowing Equity

$ 6,475 1,645 1,030

Total

$ 9,150

Income Statement Interest income on loans Interest income on securities Interest expenses Noninterest income Nonincome expenses Provision for loan loss Taxes

$ 450 95

NI

$ 115

246 78 112 35 115

If the typical bank of this type has an overhead efficiency ratio of 0.65, then this particular bank than the typical bank, all else held constant.

13

A) is doing a poorer job generating profitable off-balance-sheet activities B) is doing a better job time managing noninterest income and expenses C) is paying higher taxes D) has fewer loan losses E) None of these choices are correct.

40) If a bank has more purchased funds than the average bank, you would not be surprised to see a higher than average ratio.

A) provision for loan loss B) tax C) noninterest expense D) interest expense E) None of these choices are correct.

41) The AU ratio measures the bank's ability to bank's ability to .

and the PM ratio measures the

A) control expenses; generate income from assets B) generate income from assets; control expenses C) maximize interest revenue; minimize interest expense D) control leverage; minimize physical plant E) None of these choices are correct.

42)

Investment securities plus

is equal to a bank's earning assets.

A) net loans and leases B) gross loans and leases C) property, plant, and equipment D) securities held for trading E) purchased accounts

14

43) Net loans and leases plus loans and leases.

plus

equals gross

A) earned income; provision for loan and lease losses B) unearned income; the allowance for loan and lease losses C) net charge-offs; provision for loan and lease losses D) provision for loan and lease losses; allowance for loan and lease losses E) None of these choices are correct.

44)

The largest market available for purchased funds is the

.

A) wholesale CD market B) Eurodollar deposit market C) banker's acceptances market D) discount window purchases E) Fed funds market

45)

A(n)

is a contra asset account.

A) loan commitment B) provision for loan and lease losses C) allowance for loan and lease losses D) net charge-off

46) All but which one of the following is an example of noninterest income or noninterest expense?

15

A) Income from service charges on deposits B) Income from trust services C) Gains and losses from trading account assets D) Earnings on securities held for investment E) Salaries and benefits paid to employees

47)

Which of the following is not an off-balance sheet activity?

A) Commercial letter of credit B) Standby letter of credit C) Swap transaction D) Futures contract E) Consumer loans

48)

A bank can raise capital by:

A) offering long-term CDs. B) issuing stock.

C) retaining earnings.

D) both issuing stocks and offering long-term CDs. E) both issuing stocks and retaining earnings.

49)

What is the largest operating expense for a bank?

A) Employee salaries B) Interest paid on loans from Federal Reserve C) Interest paid on deposits D) Interest paid on loans borrowed from other banks E) Employee benefits

50)

Which of the following assets are used to increase a bank’s liquidity position?

16

A) Commercial loans B) Treasury securities C) Personal loans D) Mortgage loans E) Corporate bonds

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) Assets

Securities

Amount Interest rate of return $ 475 4.5%

Liabilities & Equity

Amount

Interest Cost

Liabilities

$ 1,175 125

3.0%

Loans

725

7.5%

Equity

Non-earning

100

0.0%

Total

Total First National Bank ROE Tax rate Noninterest Expense Provision for Loan Losses Industry Average NIM Overhead Efficiency Average Loan Rate (ALR)

$ 1,300

$ 1,300

12% 21% $ 30 $ 3

3.54% 0.85 7.5%

17

What is the bank's net interest margin? Is the bank performing better or worse than average? In what area is the bank performing better or worse than average? How could the bank improve if necessary?

NIM = (Interest revenue − Interest expense)/(Securities + Loans) [($475 × 0.045) + ($725 × 0.075) − ($1,175 × 0.03)]/($475 + $725) = 0.03375, or 3.375%

52) Assets

Securities

Amount Interest rate of return $ 475 4.5%

Liabilities & Equity

Amount

Interest Cost

Liabilities

$ 1,175 125

3.0%

Loans

725

7.5%

Equity

Non-earning

100

0.0%

Total

Total First National Bank (FNB) ROE Tax rate Noninterest Expense Provision for Loan Losses Industry Average NIM Overhead Efficiency Average Loan Rate (ALR)

$ 1,300

$ 1,300

12% 21% $ 30 $ 3

3.54% 0.85 7.5%

18

What must net noninterest income (net of noninterest expense) be in order for FNB to have a 12 percent ROE? Based on your answer, must FNB be performing better or worse than the industry average in this area? Explain.

53) Assets

Securities

Amount Interest rate of return $ 475 4.5%

Liabilities & Equity

Amount

Interest Cost

Liabilities

$ 1,175 125

3.0%

Loans

725

7.5%

Equity

Non-earning

100

0.0%

Total

Total First National Bank ROE Tax rate

$ 1,300

$ 1,300

12% 21%

Noninterest Expense Provision for Loan Losses Industry Average NIM

$ 30

Overhead Efficiency

0.85

Average Loan Rate (ALR)

6.5%

$ 3

3.54%

If the net noninterest income were to increase to −$16, what would the average loan rate (ALR) have to be to generate a 12 percent ROE? Compared to the industry, does this ALR appear feasible? If not, what options does FNB have?

19

54) What are the major sources of purchased funds? Can using purchased funds change a bank's profitability? Its risk level? Explain.

55) What is the difference between net charge-offs (NCOs, sometimes called write-offs) and the provision for loan loss (PLL)? What is the purpose of the PLL account?

56) How has the negotiable feature of wholesale CDs improved banks’ ability to manage their liquidity?

57) At the start of the quarter a bank has $55 million (gross) in its loan portfolio, and has $1 million in its allowance for loan loss account. During the quarter, loan audits indicate that an additional $300,000 of loans will not be paid as promised. These loans have not yet been written off as uncollectible, however. What are the starting and ending gross and net loan amounts and the provision for loan loss account, and what is the effect on the bank's quarterly earnings?

Gross Loans Less: Allowance loan losses Net Loans

Beginning of End of quarter quarter $ 55,000,000 $ 55,000,000 $ 1,000,000 $ 1,300,000 $ 54,000,000 $ 53,700,000

20

58)

What are the differences between purchased funds and core deposits?

59)

What is the difference between a loan commitment and a letter of credit?

21

Answer Key Test name: Chap 12_8e 1) TRUE 2) FALSE 3) TRUE 4) FALSE 5) TRUE 6) TRUE 7) FALSE 8) TRUE 9) TRUE 10) TRUE 11) FALSE 12) FALSE 13) TRUE 14) FALSE 15) FALSE 16) B 17) B 18) C 19) C 20) A 21) D [(0.05 × $1,400) + $150]/$1,400 − ($150/$1,100) = 0.0208, or 2.08% 22) D 23) C 0.12 × (0.06 + 0.0150) × 9 = 0.0810, or 8.10%

22

24) C 25) E (0.10/9.5)/0.15 = 0.0702, or 7.02% 26) E 27) D 28) E 0.0545 + ($45 million/$700 million) = 0.1188, or 11.88% 29) B 30) A $40 million/$65 million = 0.6154, or 61.54% 31) C 32) B 1 − (0.0600/0.0700) = 0.1429, or 14.29% 33) B $0.0155/$0.1225 = 0.1265, or 12.65% 34) C $115/$9,150 = 0.0126, or 1.26% 35) D $115/$1,030 = 0.1117, or 11.17% 36) D $115/($450 + $95 + $78) = 0.1846, or 18.46% 37) E ($450 + $95 + $78)/$9,150 = 0.0681, or 6.81% 38) C NIM = ($450 + $95 − $246)/($1,925 + $5,400) = 0.0408, or 4.08%

23

39) B Overhead efficiency ratio = $78/$112 = 0.6964, or 69.64% 40) D 41) B 42) A 43) B 44) E 45) C 46) D 47) E 48) E 49) C 50) B 51) The bank is performing more poorly than the average bank in generating a large enough spread between interest income and interest expense. The bank may need to increase loan rates, shift to more profitable loans, or seek lower-cost deposits.

24

52) NI/Equity = 0.12; NI/$125 = 0.12, so required NI = $15.00 Interest Revenue = ($475 × 0.045) + ($725 × 0.075) = $75.75 Interest Expense = $1,175 × 0.03 = $35.25 NI = {Interest revenue − Interest expense + Net noninterest income − Provision for loan losses} × (1 − Tax rate) $15.00 = {$75.75 − $35.25 + Net noninterest income − $3} × (1 − 0.21) Net noninterest income must be = −$18.51 Noninterest Expense = $30, so noninterest income must be $30 + (−$18.51) = $11.49 FNB Overhead Efficiency Ratio = $11.49/$30 = 0.3829, industry average = 0.85. Thus, FNB must be doing a poorer job of generating noninterest income while controlling noninterest expense than the industry average.

53) NI/Equity = 0.12; NI/$125 = 0.12 so NI = $15.00 NI = {Interest revenue - Interest expense + Net noninterest income − Provision for loan losses} × (1 − Tax rate) $15 = [($475 × 0.045) + ($725 × ALR) − ($1,175 × $0.030) − $16 − $3] x (1 − 0.21) ALR = 6.65% The required ALR is probably not feasible since the industry average is only 6.5 percent. FNB may attempt to shift toward more profitable loans but probably also needs to generate more noninterest income per dollar of noninterest expense. They need to either seek more profitable offbalance-sheet activities or reprice those activities. The managers should examine salary expense, as this is usually a major component of noninterest expense. FNB may also wish to consider increasing fees on checking, another large source of noninterest expense.

25

54) The major sources of purchased funds are brokered deposits, wholesale CDs, deposits at foreign offices, Fed funds purchased, RPs, and subordinated notes and debentures. These fund sources tend to be more expensive than core deposits and more volatile. However, if a bank can count on obtaining these funds when needed, the bank can hold fewer low-earning liquid securities and increase the percentage of loans on the balance sheet. Hence, using purchased funds can increase profitability, but usually at the expense of increasing the interest sensitivity of profits and increasing the probability of liquidity problems if the purchased funds become unavailable due to bank or market problems.

55) The PLL account is forward looking; it is management's estimate of the loans that will default in the upcoming period. NCOs are records of actual loans that defaulted. The PLL is used to reduce current earnings estimates so that interest income (accrual based) more accurately reflects the actual cash that is likely to be received. The allowance account on the balance sheet provides a cushion against equity write-downs if loans default.

56) Time deposits carry a substantial interest penalty for early withdrawals (usually forfeiting all current period interest). This penalty would make them unsuitable investments for corporations that are unsure whether the funds will be needed prior to maturity. The bank can also withhold the funds prior to maturity if the bank cannot immediately provide the funds. The ability to resell the CD to a third party without any interest penalty encourages corporate use of wholesale CDs, giving banks another source of funds that can be tapped via a deposit broker if needed.

57) The provision for loan loss will be increased by $300,000. This will be a charge against (i.e., reduction to) earnings for the quarter.

26

58) Purchased funds are very sensitive to the interest rate earned. They are usually high denomination ($100,000 and over) and have high turnover, particularly as other investment opportunities become more attractive. Core deposits are usually retail deposits made primarily by individuals. They are usually low-denomination, low-turnover accounts that are not very interest-sensitive and are at the bank for convenience reasons. They are normally a less-volatile, low-interest cost source of funds to the bank. Transaction accounts can be quite expensive to the bank; many banks now pass on these costs to the customer via fees.

59) A loan commitment is a promise made by a bank that allows a customer to borrow up to a specified maximum for the remaining time of the commitment. The bank normally charges a commitment fee and a fee for any unused portion of the commitment. It is expected that the customer will borrow (draw down) at least a portion of the commitment.

Letters of credit are insurance policies sold for a fee that state that the bank will pay in event of nonpayment by the party that draws the line of credit. It is not expected that bank funds will be necessary to cover the letter except in unusual circumstances.

27

Chapter 13: Regulation of Commercial Banks TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Banks are generally prohibited from making loans exceeding more than 15 percent of their own equity capital to any one company or borrower. ⊚ ⊚

true false

2) The layers of regulation imposed on banks to protect depositors against bank failure are termed credit allocation regulations. ⊚ ⊚

true false

3) The CRA of 1977 and the HMDA of 1975 are examples of consumer protection regulations. ⊚ ⊚

true false

4) The difference between the private costs of regulations and the private benefits for the producers of financial services is called the net regulatory burden. ⊚ ⊚

true false

5) The quantity of notes and coin in the economy is called inside money but the bulk of the money supply is outside money. ⊚ ⊚

true false

6) The Investment Company Act of 1940 and the Securities Acts of 1933 and 1934 are examples of investor protection regulations. ⊚ ⊚

true false 1

7) A financial intermediary that can engage in a broad range of financial service activities is termed a universal FI. ⊚ ⊚

true false

8) A securities subsidiary of a bank holding company that engages in investment banking is called a Riegle-Neal affiliate. ⊚ ⊚

9)

The Financial Services Modernization Act first allowed Section 20 affiliates. ⊚ ⊚

10)

true false

true false

The FDIC insures bank deposits and the OTS insures thrift deposits. ⊚ ⊚

true false

11) Unit banking states are states that do not allow interstate branch banking but allow the creation of intrastate branch banks. ⊚ ⊚

true false

12) The Financial Services Modernization Act allowed bank holding companies to open insurance underwriting affiliates and allowed insurance companies to open banks. ⊚ ⊚

true false

2

13) The Glass-Steagall Act came about due to concerns about excessive risk taking at banks and conflicts of interest between commercial and investment banking activities. ⊚ ⊚

14)

true false

A bank holding company that only has one bank is termed a unit bank. ⊚ ⊚

true false

15) There were a greater number of bank failures from 1980 to 1990 inclusive than from 1934 to 1979. ⊚ ⊚

true false

16) The 1993 Basel Agreement explicitly incorporated the different credit risks of assets into capital adequacy measures. ⊚ ⊚

true false

17) Management of liquidity risk is the major reason why commercial banks are subject to reserve requirements. ⊚ ⊚

true false

18) In the United States, commercial banks are among the least regulated financial institutions. ⊚ ⊚

true false

3

19) Periods of high interest rates create the disintermediation phenomena in commercial banks. ⊚ ⊚

true false

20) The FBSEA Act of 1991 extended federal regulatory authority over foreign banking orga-nizations in the United States. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) A bank that has an equity to asset ratio equal to 12 percent can normally lend no more than of its assets to any one borrower.

A) 1.20 percent B) 1.50 percent C) 1.80 percent D) 12.00 percent E) 15.00 percent

22)

The term disintermediation refers to:

A) the policy of not closing insolvent institutions in hopes that they can eventually turn around their performance.

B) the withdrawal of deposits from depository institutions that are reinvested in other types of intermediaries.

C) the policy of regulating the minimum rate of return institutions can pay on deposits.

D) chartering restrictions that limit the ability of new banks to enter into a local market.

E) the policy of not allowing banks to grow by creating a de novo branch outside their traditional market area.

4

23) The reduction in deposit funds cost to an individual bank brought about by government insurance is an example of the:

A) social benefit of regulation.

B) private cost of regulation to DIs. C) private benefits of regulation to DIs. D) net regulatory burden.

E) None of these options are correct.

24) U.S. depository institutions may be subject to as many as regulators.

separate

A) four B) five C) six D) seven E) eight

25) FDIC deposit insurance is generally limited to bank.

per depositor per

A) $50,000 B) $100,000 C) $150,000 D) $200,000 E) $250,000

26) In the post-Depression era the largest number of bank failures occurred in which time period?

5

A) 1955–1965 B) 1965–1975 C) 1975–1985 D) 1985–1995 E) 1995–2005

27) Major provisions of the Financial Services Modernization Act of 1999 include all of the following except:

A) allowing bank holding companies to open insurance underwriting affiliates and vice versa.

B) allowing bank holding companies to open or merge with investment banks.

C) creating one regulator to oversee all activities of financial service firms.

D) All of these choices are correct.

E) None of these options are correct.

28) Which of the following would increase the value of a bank charter? 1.I. Tightening restrictions on new charters 2.II. Broadening the activities banks can engage in 3.III. Increasing reserve requirements 4.IV. Doubling capital adequacy requirements

A) I and II only B) II only C) III and IV only D) I and IV only E) II and III only

29)

The law that largely repealed the Depression era banking laws was the:

6

A) Depository Institution Deregulation and Monetary Control Act of 1980.

B) Financial Services Modernization Act. C) FIRREA. D) International Banking Act. E) None of these options are correct.

30)

Which act led to interstate banking in the United States?

A) Glass-Steagall Act B) DIDMCA C) McFadden Act D) Riegle-Neal Act E) Financial Services Modernization Act

31) Among other things, the Financial Institutions Reform, Recovery, and Enforcement Act stipulated the creation of the:

A) FDIC. B) OTS. C) OCC. D) Warren Commission.

E) CRA.

32) Areas of commercial bank regulation dealing with preventing banks from discriminating unfairly in lending are termed regulations.

A) safety and soundness B) consumer protection C) investor protection D) credit allocation E) monetary policy

7

33) Areas of commercial bank regulation designed to encourage banks to lend to socially important sectors such as housing and farming are termed regulations.

A) safety and soundness B) consumer protection C) investor protection D) credit allocation E) monetary policy

34) All banks located in the European Union offer deposits that are insured for euros, although depositors are subject to a in the event of loss.

A) 100,000; 2.5 percent insurance premium B) 50,000; 95 percent recovery rate C) 50,000; 10 percent deductible D) 45,000; 5 percent fine E) 75,000; 90 percent recovery rate

35) To be classified as an adequately capitalized bank, the bank must have a leverage ratio of at least percent, a Tier I capital to credit risk-adjusted asset ratio of at least percent, and a total capital to credit risk-adjusted assets ratio of at least percent.

A) 4; 6; 8 B) 5; 6; 10 C) 3; 3; 8 D) 4; 8; 4 E) 4; 6; 10

36) To be well-capitalized, a bank must have a leverage ratio of at least percent, Tier I capital to credit risk-adjusted asset ratio of at least total risk-based capital ratio of at least percent.

percent, and a

8

A) 4; 4; 8 B) 5; 8; 10 C) 3; 3; 8 D) 4; 8; 4 E) 4; 6; 10

37) The FDIC may require an undercapitalized bank to: 1.I. provide the FDIC with a capital restoration plan.

2.II. cease acquiring brokered deposits.

3.III. obtain FDIC approval for all acquisitions.

4.IV. suspend dividends and management fees.

5.V. suspend payments on subordinated debt.

A) I and II only B) III only C) I, II, III, and IV only D) I, II, III, IV, and V E) I, II, III, and V only

38) Recent regulation such as the Riegle-Neal Act of 1994 has removed some of the federal banking laws that formerly constrained profitable opportunities for commercial banks. The Riegle-Neal Act removes the major restrictions on banks' abilities to .

A) diversify geographically B) diversify their product line C) engage in securities underwriting D) engage in insurance underwriting E) engage in loan brokerage

9

39) Tier I (core) capital includes at least some part of which of the following? 1.I. Common stockholders' equity 2.II. Retained earnings 3.III. Subordinated debt 4.IV. Allowance for loan and lease losses

A) I only B) I and II only C) I and IV only D) II and III only E) I, II, III, and IV

40) A bank has Tier I capital of $90 million and Tier II capital of $70 million. The bank has total assets of $2,522 million and risk-weighted assets of 2,017.6 million. This bank is:

A) critically undercapitalized.

B) significantly undercapitalized.

C) undercapitalized.

D) adequately capitalized.

E) well-capitalized.

41)

Requiring foreign banks to operate under the same rules as domestic banks is termed:

A) favored status.

B) IBA clause.

C) national treatment.

D) NAFTA. E) post-patriotism requirement.

42) In the United States, regulators currently use a reserve balances.

to calculate required

10

A) lagged reserve accounting system B) contemporaneous reserve system C) homoscedastic reserve system D) two-day computation period E) accrual accounting period

43) Among other things, the services to foreign shell banks.

prohibits U.S. banks from providing banking

A) International Banking Act B) Financial Services Modernization Act C) USA Patriot Act D) Foreign Bank Supervision Enhancement Act E) Foreign Banking Activity Powers Enforcement Act

44) The introduced the prompt corrective action policy that requires federal intervention when a bank's capital falls below certain minimums.

A) Federal Deposit Insurance Corporation Improvement Act B) Financial Services Modernization Act C) USA Patriot Act D) Foreign Bank Supervision Enhancement Act E) Foreign Banking Activity Powers Enforcement Act

45) Tier II (supplementary) capital includes which of the following? 1.I. Allowance for loan and lease losses, up to 1.25 percent of risk-weighted assets 2.II. Subordinated debt 3.III. Common stock and retained earnings 4.IV. Nontransaction deposits

11

A) II and III only B) I and IV only C) I and II only D) I, II, and III only E) I, III, and IV only

46)

The FDIC is required to establish a plan to restore the DIF if the reserve ratio falls below of insured deposits.

A) 1.00 percent B) 1.35 percent C) 1.50 percent D) 1.75 percent E) 2.00 percent

47) Which act allowed the establishment of full-service financial institutions in the United States?

A) Riegle-Neal Act B) Financial Services Modernization Act C) USA Patriot Act D) Foreign Bank Supervision Enhancement Act E) Foreign Banking Activity Powers Enforcement Act

48) The average daily net transaction accounts of a local bank during the most recent reserve computation period is $687 million. The amount of average daily reserves at the Fed during the reserve maintenance period is $35.23 million, and the average daily vault cash corresponding to the main-tenance period is $12.74 million. What is the average daily reserve balance required to be held by the bank during the maintenance period?

12

A) $40.12 million B) $47.79 million C) $54.64 million D) $60.53 million E) $62.34 million

49) The average daily net transaction accounts of a local bank during the most recent reserve computation period is $687 million. The amount of average daily reserves at the Fed during the reserve maintenance period is $35.23 million, and the average daily vault cash corresponding to the main-tenance period is $12.74 million. Is this bank in compliance with reserve requirements?

A) Yes, the bank has excess daily reserves of $2.45 million.

B) Yes, the bank has excess daily reserves of $11.71 million.

C) No, the bank is short on daily reserves by $12.56 million.

D) No, the bank is short on daily reserves by $4.36 million.

E) No, the bank is short on daily reserves by $9.17 million.

50) The average daily net transaction accounts of a local bank during the most recent reserve computation period is $589 million. The amount of average daily reserves at the Fed during the reserve maintenance period is $73.31 million, and the average daily vault cash corresponding to the main-tenance period is $8.36 million. What is the average daily reserve balance required to be held by the bank during the maintenance period and is this bank in compliance with reserve requirements?

A) $42.37 million; yes B) $46.79 million; yes C) $55.14 million; no D) $60.83 million; no E) $62.11 million; no

13

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) Discuss the four layers of regulation designed to preserve the safety and soundness of DIs.

52) (a) What are the mandatory Prompt Corrective Action (PCA) Provisions for an undercapitalized bank? Explain why these provisions are required. (b) Why does one of the mandatory PCA Provisions for a critically undercapitalized bank include appointing a receiver/conservator within 90 days?

53) (a) A bank has risk-weighted assets of $175 and equity of $12.5. If regulators require a minimum risk-weighted capital ratio of 5 percent given the current level of equity, how many new assets with a 100 percent risk weight can the bank add? How many with a 50 percent risk weight can the bank add? (b) If the bank had 20 percent more equity, how many new assets with a 100 percent risk weight could the bank add? How many with a 50 percent risk weight can the bank add? How does having more equity affect a bank's ability to grow? How is this growth affected by the riskiness of the bank's assets?

54) Cite one law or regulation per each of the following categories: ● Safety and Soundness Regulation ● Monetary Policy Regulation ● Credit Allocation Regulation ● Consumer Protection Regulation ● Investor Protection Regulation

14

55) Why have some states placed restrictions on intrastate and interstate branches? What historical laws gave this right to states? What law changed these restrictions?

56) Why were the FIRREA of 1989 and the FDICIA of 1991 passed? What were their major provisions? How did these laws differ from earlier acts of the 1980s?

57) A financial service holding company operates a nationally chartered bank, an insurance firm, a securities firm, and a federal savings bank. Who is the primary regulator for this company? Explain.

58) How do risk-based deposit insurance premiums and risk-based capital requirements help reduce the moral hazard problem of deposit insurance? ( Hint: Moral hazard means that because of deposit insurance, banks may take on excessive amounts of risk.)

59) What changes to foreign bank operations in the United States have been brought about by the Foreign Bank Supervision and Enhancement Act of 1991?

15

60) A Bank has the following balance sheet (in millions), with the risk weights in parentheses.

Assets

Liabilities and Equity

Cash (0%) Mortgage loans (50%) Consumer loans (100%) Reserve for loan losses

$ 19 $ 65 $ 115 ($ 4)

Deposits Subordinate debt (>5 years) Equity

$ 171 $ 8 $ 16

Total Assets

$ 195

Total Liability and Equity

$ 195

In addition, the bank has $30 million in commercial direct-credit substitute standby letters of credit to a public corporation and $30 million in 10-year FX forward contracts that are in the money by $2 million. a.What are the risk-adjusted on-balance-sheet assets of the bank as defined under the Basel III? b.What are the common equity Tier I (CET1) risk-based capital ratio, Tier I risk-based capital ratio, and the total risk-based capital ratio? c.Disregarding the capital conservation buffer, does the bank have sufficient capital to meet the Basel requirements?

16

Answer Key Test name: Chap 13_8e 1) TRUE 2) FALSE 3) TRUE 4) TRUE 5) FALSE 6) TRUE 7) TRUE 8) FALSE 9) FALSE 10) FALSE 11) FALSE 12) TRUE 13) TRUE 14) FALSE 15) TRUE 16) TRUE 17) TRUE 18) FALSE 19) TRUE 20) TRUE 21) C 0.15 × 0.12 = 0.018, or 1.8% 22) B 23) C 24) A

17

25) E 26) D 27) C 28) B 29) B 30) D 31) B 32) B 33) D 34) C 35) A See Table 13-3.

36) B See Table 13-3.

37) C 38) A 39) B 40) C TC/RWA = ($90 million + $70 million)/$2,017.6 million = 0.0793, or 7.93%; Tier I/RWA = $90 million/$2,017.6 million = 0.0446,or 4.46%; TC/TA = ($90 million + $70 million)/$2,522 million = 0.0634, or 6.34%, the first ratio puts the bank in the undercapitalized zone.

41) C 42) A 43) C 44) A 45) C 46) B 47) B 18

48) B Reserve requirements = (0 × $15.2 million) + ($110.2 million − $15.2 million)(0.03) + ($687 million − $110.2 million)(0.10) = 0 + $2.85 million + $57.68 million = $60.53 million The target average daily reserve balance that the bank needs to maintain will be $60.53million − $12.74 million = $47.79 million.

49) C Reserve requirements = (0 × $15.2 million) + ($110.2 million − $15.2 million)(0.03) + ($687 million − $110.2 million)(0.10) = 0 + $2.85 million + $57.68 million = $60.53 million.

The target average daily reserve balance that the bank needs to maintain will be $60.53 million − $12.74 million = $47.79 million.

The target average daily reserve balance that the bank needs to maintain is $47.79 million, this bank has only $35.23 million average reserve at the Fed. The bank is short by $47.79 −$35.23 = $12.56 million to meet the requirement.

50) A Reserve requirements = (0 × $15.2 million) + ($110.2 million − $15.2 million)(0.03) + ($589 million − $110.2 million)(0.10) = 0 + $2.85 million + $47.88 million = $50.73 million. The target average daily reserve balance that the bank needs to maintain will be $50.73 million − $8.36 million = $42.37 million. The target average daily reserve balance that the bank needs to maintain is $42.37 million. This bank has $73.31 million average reserves at the Fed. The bank meets the requirement.

19

51) ● Imposing lending limits that require diversification. ● Implementing minimum capital requirements that provide a minimum level of protection against insolvency. Risk-based capital requirements force banks to monitor the amount of risk undertaken, particularly in generating growth. ● Providing deposit insurance which forces the government to monitor DI safety because of the large contingent liability created by the insurance. As a result, the FDIC has broad powers to force bank managers to limit risk. ● Requiring monitoring and surveillance including on-site examinations and regular reporting requirements help ensure compliance and maintenance of sound banking practices.

20

52) (a) The mandatory PCA provisions for an undercapitalized bank are as follows: ● Suspend dividends and management fees. ● Require a capital restoration plan. ● Restrict asset growth. ● Require approval for acquisitions. ● Prohibit use of brokered deposits.

These restrictions are designed to force the institution to quickly restore capital adequacy. Dividends reduce retained earnings and, hence, a dividend cut can help build equity more quickly. Bank managers should not be receiving large fees at an ailing bank. Restricting growth and acquisitions is needed because these can be risky activities that hide problems and allow poor asset allocation decisions to continue.

Prohibiting brokered deposits restricts liquidity and, ultimately, growth.

The capital restoration plan must be approved by the appropriate regulator, and will have set time policies and time lines for restoring capital adequacy. (b) The requirement to appoint a receiver or conservator even before bankruptcy occurs is used to prevent losses from growing. Once bank management makes the decision that the institution is likely to go bankrupt, managers may engage in high-risk activities, hoping they may "get lucky." This can make losses greater for the deposit insurer. This requirement was added because of the regulatory forbearance policies in place during the 1980s S&L crisis that allowed suffering and even insolvent institutions to continue to operate and generate even larger losses that were eventually borne by the government.

21

53) (a) 100 percent risk weight [$175 + New Assets] × 0.05 = equity [$175 + New Assets] × 0.05 = $12.5 New Assets = $75 Maximum Total Assets = $250 50 percent risk weight [$175 + 0.50 × New Assets] × 0.05 = equity [$175 + 0.50 × New Assets] × 0.05 = $12.5 New Assets = $150 Maximum Total Assets = $325 (b) 100 percent risk weight [$175 + New Assets] × 0.05 = old equity × 1.2 [$175 + New Assets] × 0.05 = $12.5 × 1.2 New Assets = $125 Maximum Total Assets = $300 (a 20 percent increase from before, thus demonstrating that having more equity allows a bank to grow) 50 percent risk weight [$175 + 0.50 × New Assets] × 0.05 = Equity [$175 + 0.50 × New Assets] × 0.05 = $15 New Assets = $250 Maximum Total Assets = $425 (For a given capital base, the bank can grow faster if it acquires lower risk assets.)

22

54) ● Safety and Soundness Regulation: Possible answers include lending limits, minimum capital requirements, deposit insurance, riskbased deposit insurance premiums, and on-site examinations ● Monetary Policy Regulation: Reserve requirements ● Credit Allocation Regulation: QTL test, SBA lending ● Consumer Protection Regulation: Community Reinvestment Act, Home Mortgage Disclosure Act ● Investor Protection Regulation: Investment Company Act, Securities Acts 55) States have limited branching to protect small banks that feared that larger, more powerful banks would quickly force the small ones out of business. Some large banks that provided correspondent banking services to small banks also opposed branching, fearing a loss of correspondent business. The McFadden Act of 1927 originally gave the states the right to establish branching and interstate restrictions. The Douglas Amendment of the Bank Holding Company Act closed a potential loophole to interstate banking. In 1994, the Riegle-Neal Act allowed interstate branching via consolidation of affiliates or by merger.

23

56) These two important laws were passed to improve the safety and soundness of the thrift and banking industries. The FIRREA recapitalized the thrift insurance fund, eliminated the FSLIC, stripped the FHLBB of its power, and created the new Office of Thrift Supervision. It also eliminated deceptive accounting practices at savings associations and increased penalties for fraud. The FDICIA increased capital requirements at all depository institutions (DIs), set up prompt corrective actions for banks with insufficient capital, increased FDIC reserves, and created risk-based deposit insurance premiums. These laws were different from those of the early 1980s because they added restrictions to these industries instead of granting new powers to DIs. 57) Under the FSMA of 1999, financial conglomerates are functionally regulated. That is, the national bank would be regulated by the Federal Reserve and the Comptroller of the Currency, the insurance firm would be regulated by the appropriate state agency, the securities firm would be regulated by the SEC (and the NASD), and the federal savings bank would be regulated by the Office of Thrift Supervision.

58) Both force bank managers to be cognizant of the risk level they are undertaking and impose a penalty function on managers who engage in additional risk. This helps replace the lost market discipline (higher borrowing rates for banks that take on more risk) brought about by deposit insurance and the "too big to fail" practice.

24

59) ● Entry: Foreign banks must now have the Fed's approval to establish a U.S. operation. The Fed will not grant such approval unless the foreign bank is subject to home country supervision. The Fed also requires the home country regulators to supply information about the applicant bank to the Fed. ● Closures: The Fed may close the U.S. operations of a foreign bank (as they did with Daiwa). ● Examinations: The Fed will examine each U.S. operation of a foreign bank. ● Deposit taking: Only foreign banks with access to FDIC insurance can take retail deposits. ● Activity powers: State-licensed foreign banks must adhere to federal standards.

25

60) a. Risk-adjusted on-balance-sheet assets: ($19million × 0) + ($65million × 0.5) + ($115million × 1) = $147.5 million b. Total risk-adjusted on- and off-balance-sheet assets = $147.5million + ($30million × 1) + {[($30million × 0.075) + 0] × 1} = $179.75 million CET1 capital = $16 million Tier I capital = $16 million Tier II capital = $28 million CET1 Risk-based capital ratio = $16 million/$180.75 million = 0.0890, or 8.90% > 6.5% Tier I Risk-based capital ratio = $16 million/$180.75million = 0.0890, or 8.90% > 8% Total Risk-based capital ratio = $28 million/$180.75 million = 0.1558, or 15.58% > 10% c. Yes, the bank is well capitalized and does have sufficient total capital to meet the Basel requirements since the three ratios, common equity Tier I (CET1) risk-based capital ratio, Tier I risk-based capital ratio, and total risk-based capital ratio, are all higher than the required Basel III levels for well capitalized banks.

26

Chapter 14: Other Lending Institutions TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Of all the depository institutions, as a percentage of assets, credit unions rely the most on deposit sources of funds. ⊚ ⊚

true false

2) The policy employed in the 1980s of not closing economically insolvent savings institutions was called regulatory forbearance. ⊚ ⊚

3)

true false

After deposits, the second largest source of funds at savings institutions is FHLB loans. ⊚ ⊚

true false

4) Savings institutions must have at least 65 percent of their assets in mortgage-related areas in order to maintain their thrift charter. ⊚ ⊚

5)

true false

In a mutual organization, the depositors are owners of the institution. ⊚ ⊚

true false

6) Traditionally, most credit union members had a common employer, but increasingly the required commonality is a common location of either residence or workplace. ⊚ ⊚

true false

1

7) Savings institution deposits and bank deposits are backed by two different insurance funds. ⊚ ⊚

true false

8) Credit unions are not taxed and, as a result, well-run credit unions are often able to charge lower loan rates and pay slightly higher deposit rates than banks. ⊚ ⊚

true false

9) The National Credit Union Administration is the primary regulator of federally chartered credit unions. ⊚ ⊚

true false

10) There are more credit unions than other types of thrifts, but credit unions are generally smaller than other types of thrifts. ⊚ ⊚

11)

true false

The largest U.S. banks are larger than the entire credit union industry. ⊚ ⊚

true false

12) Because of the differences in the makeup of their major loan types, finance companies typically have shorter-term loans than banks. ⊚ ⊚

13)

true false

Sales finance institutions specialize in loan sales to banks and thrifts.

2

⊚ ⊚

true false

14) Generally, consumer finance companies make loans to borrowers who have been refused loans at banks due to low income or poor credit. ⊚ ⊚

true false

15) Generally, a captive finance company is wholly owned by major manufacturing companies with the purpose of providing financing to customers purchasing the parent company's products. ⊚ ⊚

true false

16) Factoring is the term used when a finance company purchases accounts receivable from corporate customers at a premium. ⊚ ⊚

true false

17) A floor plan loan is a type of short-term loan to finance high priced inventory in which the purchased inventory is placed as collateral for the loan. ⊚ ⊚

true false

18) Finance companies are regulated at the federal and state levels similar to commercial banks. ⊚ ⊚

true false

19) Finance companies rely primarily on bank loans and commercial paper as sources of funding.

3

⊚ ⊚

true false

20) On average, finance companies have higher capital-to-total-asset ratios than commercial banks. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) Which of the following trends in the number and industry assets of savings institutions is/are correct? 1.I. The number of savings institutions has fallen over time.

2.II. The number of savings institutions has increased over time.

3.III. Total industry assets fell during the recession of the late 2000s.

4.IV. Total industry assets are falling over time.

5.V. Total industry assets are stable but the number of savings institutions has fallen.

A) II and III only B) I and III only C) I and IV only D) II and IV only E) V only

22)

The QTL test requires that thrifts:

4

A) limit the amount of mortgage-related assets on the balance sheet to improve diversification.

B) invest in a minimum percentage of government-backed securities to protect their mortgage loans.

C) lend no more than 80 percent of the value of a home to a borrower to ensure mortgage safety.

D) keep 35 percent of their assets in safe liquid investments to ensure adequate deposit liquidity.

E) invest at least 65 percent of their assets in mortgages or mortgage-related assets.

23) Which one of the following has the highest concentration of mortgage-related assets on the balance sheet?

A) Savings institutions B) Commercial banks C) Credit unions D) Finance companies E) Pension funds

24)

After 2011, savings institutions have primarily been regulated by the:

A) Federal Home Loan Bank Board.

B) Federal Deposit Insurance Corporation.

C) Office of Thrift Supervision.

D) National Credit Union Administration.

E) Office of the Comptroller of the Currency.

25)

In 2019, the largest U.S. savings institution was:

5

A) USAA Federal Savings Bank.

B) Synchrony Bank.

C) Navy Federal.

D) Hudson City Bancorp.

E) Charles Schwab Bank.

26)

The predominant liabilities for savings institutions are:

A) commercial deposits and FHLB borrowings.

B) wholesale money market notes and reserves at the Fed. C) transaction accounts and small time and savings deposits.

D) checking accounts and money market mutual funds.

27)

Historically, most savings institutions were established as:

A) mutual organizations.

B) stockholder organizations.

C) partnerships.

D) charitable organizations.

E) banks.

28) Deposits at savings banks are backed by the institutions are backed by the .

and deposits at savings

A) BIF; BIF B) BIF; SAIF C) SAIF; BIF D) SAIF; SAIF E) DIF; DIF

6

29) are the most diversified of depository institutions and are on average the largest depository institutions.

A) Banks; savings institutions B) Credit unions; commercial banks C) Credit unions; credit unions D) Commercial banks; commercial banks E) Savings institutions; commercial banks

30) Credit unions are: 1.I. mutual associations.

2.II. not open to the general public.

3.III. for profit institutions.

A) I only B) II only C) I and II only D) I, II, and III E) II and III only

31)

The U.S. Central Credit Union and the corporate credit union:

A) are the primary regulators of the credit union industry.

B) provide investment and liquidity services to corporate credit unions.

C) serve as the trade organization for the industry.

D) charter credit unions.

E) provide deposit insurance for credit unions.

7

32) Credit unions have several advantages over banks. These include the following: 1.I. Credit unions are not taxed.

2.II. Credit unions are better diversified than banks.

3.III. Credit unions can collectively pool funds.

4.IV. Due to regulations, credit unions have better economies of scale and scope than banks.

5.V. Because of their ties to employers, credit unions have better personnel expertise than banks.

A) I and II only B) I and III only C) III and IV only D) III, IV, and V only E) I, III, and V only

33) As a percentage of total assets, credit unions invest in securities than savings institutions and in consumer loans than commercial banks.

A) more; more B) less; less C) more; less D) less; more E) less; about the same

34) SI profitability declined in the mid-2000s due to: 1.I. the yield curve becoming more positively sloped.

2.II. decreases in the NIM ratio.

3.III. increases in the NIM ratio.

4.IV. the yield curve becoming flatter and even inverted.

8

A) I and II only B) II and III only C) II and IV only D) III and IV only E) I and III only

35) Rank the following from greatest to smallest in terms of industry asset size in 2019. 1.I. Banks 2.II. Savings institutions 3.III. Credit unions 4.IV. Finance companies

A) IV, I, II, III B) I, IV, III, II C) I, II, IV, III D) I, II, III, IV E) II, IV, III, I

36) In 2019, of assets and

had on average the greatest amount of equity as a percentage had the lowest.

A) savings institutions; credit unions B) banks; credit unions C) credit unions; finance companies D) finance companies; credit unions E) finance companies; banks

37)

Factoring is:

9

A) equipment leasing.

B) servicing mortgage factors.

C) purchasing corporate accounts receivables at a discount.

D) financing automobile purchases.

E) making installment loans to customers.

38)

Sales finance companies:

A) specialize in making loans to customers of a specific retailer or manufacturer.

B) specialize in making installments and other loans to whatever consumers are interested.

C) specialize in providing loans to businesses.

D) specialize in international factoring and forfeiting.

E) None of these options are correct.

39)

A finance company that makes loans to high-risk customers is called a:

A) subprime lender.

B) commercial bank.

C) factor.

D) warehouse lender.

E) credit lender.

40) Finance companies enjoy several advantages over banks. These include all but which one of the following?

10

A) Finance companies can offer various types of products and services without regulatory interference.

B) Many finance companies have considerable knowledge and expertise about specific industries and products.

C) Finance companies can accept riskier customers than banks.

D) Finance companies generally have lower overhead than banks.

E) Finance companies have lower funds costs than banks.

41)

A captive finance company is one that:

A) is owned by a retailer or manufacturer.

B) is owned by a bank holding company.

C) is owned by its depositors.

D) lends only to high-risk individuals that cannot obtain loans elsewhere (i.e., captives).

E) is regulated at the federal level.

42)

A loan agreement between Ford Motor Credit and a local Ford dealer is an example of:

A) floor plan financing.

B) a business equipment loan.

C) factoring of receivables.

D) a depreciation loan.

E) None of these options are correct.

43) Home equity loans are popular with finance companies. Which one of the following statements about home equity loans is not correct?

11

A) These loans allow customers to borrow on a line of credit secured with a second mortgage.

B) Interest payments on home equity loans are not tax deductible.

C) Bad debt expenses on home equity loans are lower than on many other types of finance company loans.

D) In 2007–2008 there was a sharp increase in defaults among home equity borrowers.

E) If the borrower defaults on the home equity loan, the finance company can seize the house.

44)

For the finance company industry as a whole, the largest single loan type is:

A) business loans.

B) consumer loans.

C) real estate loans.

D) high-risk consumer loans.

E) credit card loans.

45) Aggregate finance company profitability was poor in the late 2000s primarily due to which segment of the finance company industry?

A) Business factoring B) Equipment loans C) Equipment leasing D) Securitization of auto loans E) Subprime lending

46)

Which one of the following utilizes the least amount of deposits as a source of funds?

12

A) Banks B) Credit unions C) Finance companies D) Savings associations E) Savings banks

47)

Finance companies obtain a significant portion of their short-term financing from:

A) time and savings deposits.

B) transaction accounts.

C) long-term bonds.

D) issuing commercial paper.

E) equity.

48)

Which one of the following institutions is the least regulated?

A) Banks B) Credit unions C) Finance companies D) Savings associations E) Savings banks

49)

In 2019, the biggest type of loans issued by credit unions was

.

A) mortgages B) business loans C) consumer loans D) home equity loans E) government loans

13

50) In 2019, years.

percent of the investment portfolio of credit unions had maturities of 1-3

A) 30.3 B) 33.2 C) 34.9 D) 38.9 E) 42.3

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) Explain why low interest rates and strong mortgage markets help keep profitability high at savings institutions.

52) A savings institution (SI) has funded $12 million of 30-year fixed-rate mortgages with an average interest rate of 5.75 percent. These assets are funded with time deposits with an average maturity of six months. The deposits are currently paying 3.5 percent. Assume it is now six months in the future and the Fed has raised interest rates twice and the depositors now must be paid 4.25 percent. What has happened to the SI's ROA and NIM? How would your answer change if the SI normally sells the mortgages every six months and originates additional new mortgage loans?

53)

What are the major advantages that credit unions enjoy over banks?

14

54)

What are the major disadvantages that credit unions face versus banks?

55) How do the primary risks of credit unions differ from banks? From savings institutions (SIs)? From finance companies?

56) The American Bankers Association and others are seeking to limit growth of credit unions. What is the basis for the bankers' concern? What does the credit union industry argue?

What kind of limits on credit unions are the bankers seeking?

57) Why have larger credit unions experienced greater profitability than smaller credit unions? Do you expect this to continue? Why or why not?

58) What are home equity loans? Why do finance companies prefer home equity loans to unsecured debt?

59) What are the advantages of a finance company or a bank leasing equipment to a small business customer rather than financing the customer's purchase of the equipment?

15

60) How do sales finance companies differ from personal credit and business credit institutions? List an example of each.

61) What are the advantages finance companies (FCs) have over banks in the area of business lending? What disadvantages do they have?

62) Has the importance of foreign nonbank financial lending been increasing or decreasing in recent years? Provide some examples to back up your answer.

16

Answer Key Test name: Chap 14_8e 1) TRUE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) TRUE 7) FALSE 8) TRUE 9) TRUE 10) TRUE 11) TRUE 12) TRUE 13) FALSE 14) TRUE 15) TRUE 16) FALSE 17) TRUE 18) FALSE 19) TRUE 20) TRUE 21) B 22) E 23) A 24) E 25) E 26) C 17

27) A 28) E 29) D 30) C 31) B 32) B 33) A 34) C 35) B 36) D 37) C 38) A 39) A 40) E 41) A 42) A 43) B 44) B 45) E 46) C 47) D 48) C 49) A 50) C

18

51) Low interest rates have helped savings institutions (SIs) maintain profitability because many thrifts fund long-term mortgages with shortterm deposits. Low interest rates have encouraged mortgage refinancing and new home buying; both activities allow thrifts to earn origination and servicing fees and to profit on the spread between interest earned on the mortgages and costs paid on deposits. Because SIs concentrate in mortgages, the health of the housing industry will strongly affect their profitability. Because many mortgages are sold, the default risk may not lie with the originating SI, but defaults will result in tighter origination standards and less fees for the originating institution. Higher default rates will affect the mortgage portfolio that SIs keep and can result in impaired capital and poor profitability.

52) The original gross profit margin was 5.75% − 3.5% = 2.25%, and after six months the profit margin on these loans falls to 5.75% − 4.25% = 1.50%. This will reduce the SI's ROA and NIM, all else held constant.

If the SI is selling the mortgages every six months, however, the new mortgage rates may be sufficiently higher to offset the rising deposit interest rates, thus preserving the profit margin and ROA and ROE.

19

53) Advantages of credit unions are as follows: ● Credit unions are not taxed because of their nonprofit status. The CU should be able to offer either lower loan rates or pay higher deposit rates because of the tax advantage. ● Credit unions are allowed to pool funds with each other and invest their funds collectively in money and capital markets through the corporate central and U.S. central credit unions. Credit unions may obtain loans from these entities and receive management advice.

The following three are not in the text: ● Employer-based credit unions may require loan payments to be directly deposited to the credit union, reducing processing and collection costs. ● Credit unions often receive donated services and donated facilities that help keep their costs down. ● Credit union regulators are not as adversarial as bank regulators.

They act to promote as well as regulate the industry.

20

54) Disadvantages of credit unions are as follows: ● Credit unions are under-diversified due to the common bond requirement. An employerbased credit union could experience simultaneous loan defaults and deposit withdrawals due to employer default layoffs or strikes. ● Credit unions are much smaller than the average bank. Credit unions may have to operate well below the size that would generate optimal economies of scale and scope. ● Credit unions lack the skills necessary to offer other financial services such as insurance, brokerage, and so forth. ● Credit unions lack expertise to evaluate business loans and cannot offer many of the services larger banks can. ● Not in text: Credit unions have difficulty attracting quality personnel to serve as managers. Often, the board of directors and/or senior personnel serve on a voluntary basis.

21

55) Credit unions face credit risk on consumer loans, but banks have credit risk on consumer and business loans and many off-balance-sheet activities. Business loan evaluation is more complex, and banks are generally involved in riskier loans than either credit unions or SIs (with the possible exception of SI involvement in commercial real estate). The lack of diversification of a credit union also adds to its risk. Bank deposits, particularly large deposits and business accounts, are likely to be more sensitive to interest rates than credit union deposits.

Credit union customers exhibit more loyalty than typical bank and SI customers. Credit unions hold more liquid assets (%) than banks or SIs, and they can afford to do so because of the lack of a profit motive. SI loans are usually well collateralized but longer term than their liabilities, generating interest rate risk. Credit unions do not normally have a large imbalance between the maturity of their assets and liabilities. Credit unions face regulatory risk because of the historical lawsuits by banks attempting to limit the growth of credit unions.

Some finance companies lend to higher-risk consumers; some are much more extensively involved in business loans than credit unions. Finance companies are larger so they may provide services more cost-effectively than the small credit unions. Finally, finance companies cannot take deposits so they are denied the steady, low-cost source of funds that credit unions enjoy.

22

56) The bankers are arguing that credit unions can unfairly compete with banks for consumer loans and deposits because credit unions are not taxed. The tax advantage allows credit unions to offer higher rates on deposits and lower rates on loans in most cases. The common bond requirement is designed to limit competition among credit unions (each other) and between banks and credit unions. Historically, credit union members were sponsored primarily by an employer, and most people could not participate in a credit union. The weakening of the common bond requirement and the growth of credit unions have brought this industry into more direct competition with banks for consumer banking services. Banks are seeking to limit the growth of credit unions by limiting credit unions' abilities to accept new members and to limit the number of community-based credit unions. Community-based credit unions represent the greatest threat to banks because their "common bond" is very broad, namely it only requires members to live and/or work in a given community.

57) Larger credit unions have been more profitable because they have a larger customer base over which they can spread their fixed costs and they tend to be better diversified and thus are more able to weather tougher economic times. Larger credit unions are likely to continue to be more profitable due to economies of scale and scope and the advent of technology (a major fixed-cost investment) in the financial services industry.

58) Home equity loans are loans that pledge the equity value of the home as collateral Finance companies prefer home equity loans to unsecured credit because the collateral reduces the need for an extensive credit check and provides the lender with better collateral in the event of default.

23

59) ● It is easier for the bank or finance company to repossess the equipment in the event of default with a lease because it retains title to it. ● Lease agreements are easier to sell to companies because many do not have required down payments. ● By retaining ownership, the bank or finance company gets a tax deduction for depreciation of the equipment leased. In some cases the small business will not be able to use the full amount of the depreciation tax shield due to insufficient income, whereas the bank or finance company can.

60) Sales finance companies, such as Ally Financial (formerly GMAC) or Ford Motor Credit, specialize in making loans to customers of a specific retailer or manufacturer; personal credit institutions specialize in loans to consumers, usually to riskier customers. An example of the latter is HSBC Finance. Business credit institutions such as IBM Global Financing provide financing to corporations via leasing and factoring.

24

61) Finance company advantages include the following: ● Banks have extensive product regulations and FCs do not. ● In many cases FCs have extensive information about company products and the industry because of their ties to manufacturers. ● FCs can lend to riskier customers than banks and, if they are good at credit analysis, can earn a higher rate of return on these customers. ● FCs have lower overhead than banks, because they do not seek retail sources of funds that require substantial investments in brick and mortar (branches).

Bank advantages include the following: ● Many banks are larger and have more expertise in providing a wider range of financial services.

These two factors imply that banks can exploit economies of scale and scope and may have higher profitability than finance companies (FCs). ● Banks obtain a major portion of their funds (deposits) at a subsidized cost because of federal deposit insurance. This lowers their funds cost and allows them to carry less equity on the balance sheet, potentially improving the shareholders' return on equity. ● Consumer finance companies have the reputation for providing high-risk loans and tend to attract those types of customers. Subprime and consumer FCs are sensitive to the economy because their customers' finances are often hurt by economic downturns, as occurred in late 2007 and 2008.

25

62) Nonbank financial lending has gained as a percentage of total lending in many foreign countries including low-income mortgage lending in Mexico, credit card lending in Thailand, and leasing and factoring in Eastern Europe. In Latin America from 1994 to 2010, the percent of aggregate financing provided by nonbank FIs grew from 22 percent to 35 percent. The corresponding numbers for growth in Central Europe are from 4 percent to 15 percent.

26

Chapter 15: Insurance Companies TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) A man has what he believes is a mild heart attack but he doesn't go to the hospital.

Instead he calls his insurance agent and doubles the amount of his life insurance. This is an example of the moral hazard problem in insurance. ⊚ ⊚

true false

2) In a typical variable life policy, the policyholder may vary the premium payments and the maturity date of the policy. ⊚ ⊚

true false

3) In a universal life policy, the cash value of the contract grows at a fixed rate set by the life insurer. ⊚ ⊚

true false

4) A 65-year-old person has saved $1,250,000 and wishes to receive 10 annual annuity payments, beginning in one year. If the annuity rate is 5.75 percent, he can expect to receive $167,829 per year. ⊚ ⊚

true false

5) Premiums on standard annual renewable term life will generally increase as the policyholder ages. ⊚ ⊚

6)

true false

Policy reserves are the primary asset of the typical life insurer.

1

⊚ ⊚

7)

Life insurers write over 50 percent of all health insurance premiums. ⊚ ⊚

8)

true false

true false

Life insurance policy reserves are the estimated current worth of expected future payouts. ⊚ ⊚

true false

9) The cash surrender value of a life insurance policy is the present value of expected future payouts on the policy. ⊚ ⊚

10)

true false

The McFadden Act grants states the primary right to regulate insurance companies. ⊚ ⊚

true false

11) The National Association of Insurance Commissions (NAIC) examines and regulates insurance companies. ⊚ ⊚

12)

true false

Most states maintain a permanent reserve fund to resolve insurance company failures. ⊚ ⊚

true false

2

13)

The top 10 property and casualty firms underwrite half of all the P&C premiums written. ⊚ ⊚

14)

The primary asset for P&C insurers is bonds. ⊚ ⊚

15)

true false

Liability lawsuits related to asbestos claims are an example of long tail losses. ⊚ ⊚

17)

true false

Property loss risk is generally easier to estimate than liability loss risk. ⊚ ⊚

16)

true false

true false

Liability losses are more subject to social inflation than property losses. ⊚ ⊚

true false

18) Insurance companies charge different premiums to people based on preexisting health conditions in order to reduce the adverse selection problem. ⊚ ⊚

true false

19) A whole life insurance policy pays the face value of the contract on death of the policyholder to the beneficiaries. ⊚ ⊚

true false

3

20) The adverse selection problem arises in situations when the policyholders engage in risky activities that increase the probability of an insurance payoff. ⊚ ⊚

21)

Insurance services are classified into two major groups: 1) life and 2) property-casualty. ⊚ ⊚

22)

true false

true false

The United States, China, and western Europe dominate the global insurance market. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

23) Worldwide, was the costliest year for the worldwide insurance industry; natural disasters cost insurers a record in losses.

A) 2018; $120 million B) 2017; $120 billion C) 2018; $138 billion D) 2017; $138 billion E) 2017; $110 million

24)

Policy reserves are a(n):

4

A) balance sheet liability.

B) balance sheet asset.

C) separate account item.

D) insurance guarantee fund payment.

E) income statement revenue item.

25)

Which of the following type(s) of life insurance policies do not have a savings feature?

A) Term life B) Whole life C) Variable life D) Universal life E) Both variable life and universal life

26)

In property and casualty insurance the combined ratio is equal to divided by total premiums written.

A) the sum of the loss ratio plus loss adjustment expenses B) the sum of the loss ratio plus the expense ratio C) the operating ratio minus dividends paid to policyholders D) the nominal ratio plus the real ratio E) 1 minus the operating ratio

27)

The term "variable" in a variable life policy refers to the

A) policyholder's ability to vary the premiums.

B) insurer's ability to vary the rate of return on the policy.

C) variable growth rate of the cash value of the policy.

D) insurer's ability to vary the premiums.

E) the policyholder's ability to cancel the plan.

5

28)

The primary regulator of insurance firms is the:

A) NAIC. B) McCarran-Ferguson Commission.

C) FDIC. D) state insurance regulator.

E) SEC.

29) true?

Which one of the following statements concerning annuities offered by insurers is not

A) Interest on annuities is not taxed until the investor receives the payments.

B) Annuity payments may be fixed or variable.

C) Annuity contributions are not capped by the IRS. D) Annuities can be deferred or immediate.

E) Annuity payments must cease upon the policyholder's death.

30) An investor has $25,000 that he can invest today. In addition to this amount, he can also invest $12,000 per year for 30 years (beginning one year from now) at which time he will retire.

He plans on living for 25 years after he retires. If interest rates are 8 percent, what size annual annuity payment can he obtain for his retirement years? (All annuity payments are at year-end.

Round your answer to the nearest dollar.)

A) $64,439 B) $192,501 C) $150,913 D) $161,096 E) $173,488

31) A policyholder wishes to annuitize the cash value of her insurance policy at retirement.

She desires an annual payment of $95,000 per year and the cash value is expected to be $1,100,000 at retirement. Approximately how many payments can she expect to receive if annuity interest rates are 5.122 percent?

6

A) 18 B) 16 C) 14 D) 12 E) 10

32) The largest asset category of life insurers is category is .

and the largest liability

A) bonds; separate account items B) separate account items; current policy claims C) bonds; policy reserves D) policy reserves; mortgage loans E) common stock; dividend reserve

33) The most important federal legislation affecting the regulation of life insurance companies prior to 1999 was the

A) McCarran-Ferguson Act. B) McFadden Act. C) Investment Company Act. D) SEC Act. E) Insurance Freedom Act.

34) Which of the following statements are true? 1.I. Catastrophe bonds may be used as a form of reinsurance.

2.II. Catastrophe bonds are structured so that if an insured event results in large losses for an insurer, the bond's required payments increase.

3.III. Buyers of catastrophe bonds benefit if the adverse event occurs.

4.IV. When issued, catastrophe bonds will have promised yields above the risk-free rate.

7

A) I and II only B) I and IV only C) II and III only D) II and IV only E) III and IV only

35) was

In 2018, the average combined ratio after dividends for the P&C industry .

A) 100.01 B) 105.6 C) 107.2 D) 99.9 E) 93.5

36) Hurricane damage in a given area is an example of a it is difficult to predict loss exposure.

for which

A) low-severity, low-frequency event B) high-severity, high-frequency event C) low-severity, high-frequency event D) high-severity, low-frequency event E) low-frequency, high-frequency event

37) Property and casualty insurers hold because property and casualty loss rates are rates.

short-term assets than life insurers predictable than life insurance loss

8

A) more; more B) more; less C) less; less D) less; more E) no; highly

38)

The operating ratio is calculated as:

A) the loss ratio minus the underwriting cycle lag.

B) the loss ratio plus the loss adjustment expense ratio plus the commission to premium ratio.

C) the combined ratio after dividends minus the investment yield.

D) the combined ratio minus the loss ratio.

E) none of these options are correct.

39) An insurance line has a loss ratio of 72 percent and an expense ratio of 35 percent, and the firm pays 2 percent of premiums to policyholders as dividends. What level of investment yield is needed to make the P&C firm break even?

A) 5% B) 7% C) 9% D) 11% E) 18%

40)

The two major components of expense risk for P&C insurers are:

A) the combined ratio and the premium ratio.

B) loss adjustment expenses and variations in commission and other expenses.

C) investment yield and premiums earned.

D) dividend ratio and investment yield.

E) none of these options are correct.

9

41) At P&C insurers, if the combined ratio is less than 100 percent, the premiums charged were sufficient to cover:

A) losses only.

B) expenses only.

C) both losses and expenses.

D) losses, expenses, and investment returns on premiums.

42)

For P&C insurers, if the combined ratio is more than 100 percent, that firm:

A) could not have been profitable.

B) must have been profitable.

C) may have been profitable if investment returns were high enough.

D) was profitable if the LAE was low enough.

43) Estimates of the cost of the September 11, 2001, terrorist attacks on the World Trade Center indicate that the cost to insurance companies was as high as:

A) $20 billion.

B) $30 billion.

C) $40 billion.

D) $50 billion.

E) $60 billion.

44) A policyholder wishes to annuitize the cash value of her insurance policy at retirement.

The cash value is $725,000. What payment (to the nearest dollar) can he expect if he wishes to receive 15 years of payments (starting next year) and interest rates are 5.25 percent?

10

A) $43,333 B) $55,555 C) $71,033 D) $60,524 E) $29,250

45) An insurance line has a loss ratio of 62 percent and an expense ratio of 35 percent; the firm pays 2 percent of premiums to policyholders as dividends and has an investment yield to premium ratio of 9 percent. The operating ratio for this line is:

A) 86.

B) 90.

C) 95.

D) 106.

E) 109.

46) An insurance line has a pure loss ratio of 65 percent, LAE of 16 percent, and an expense ratio of 26 percent; the firm pays 3 percent of premiums to policyholders as dividends and has an investment yield to premium ratio of 6 percent. Which one of the following statements is true?

A) The line is profitable because the operating ratio is greater than 100.

B) The line is profitable because the operating ratio is less than 100.

C) The line is not profitable because the operating ratio is greater than 100.

D) The line is profitable because the combined ratio after dividends is greater than 100.

E) The line is profitable because the combined ratio after dividends is less than 100.

47)

In terms of dollar costs, the worst U.S. catastrophe since 2000 was caused by:

11

A) the terrorist attacks on the World Trade Center and the Pentagon.

B) Hurricane Katrina.

C) the California fires of 2007.

D) the Florida hurricanes of 2004.

E) Hurricane Rita of 2005.

48)

Premiums received before the coverage period are termed:

A) unearned premiums.

B) lagged premiums.

C) loss-adjustment expenses.

D) loss reserves.

E) policyholder's surplus.

49)

Which one of the following would provide an example of social inflation?

A) Large malpractice awards beyond the level of damages incurred B) Increases in costs on auto physical damage claims C) Increases in prescription drug cost claims D) Losses to repair damages caused by hurricanes in Florida E) Rising costs of funeral expenses due to inflation

50) The P&C loss ratio on an insurance line contains: 1.I. payouts on claims.

2.II. brokerage commissions incurred to market the claims.

3.III. costs associated with settling claims.

4.IV. dividend payouts to policyholders.

12

A) I and II only B) I, III, and IV only C) I and III only D) II and IV only E) III and IV only

51) The best underwriting performance since 1936 in terms of the combined ratio occurred during for property and casualty insurers.

A) 1999 and 2000 B) 2001 and 2002 C) 2002 and 2003 D) 2004 and 2005 E) 2006 and 2007

52) State Farm and other P&C insurers came into conflict with policyholders over claims filed as a result of Hurricane Katrina that resulted in lawsuits. The conflict resulted from:

A) insurers’ refusal to pay until reinsurance funds were collected.

B) policyholders’ fraudulent claims.

C) insurers' insistence that the Katrina storm surge resulted in flood damage that was not covered.

D) insurers overcharging for hurricane insurance.

53) Insurance companies face the problem of when people with highest probability of getting the insurance payoffs are the ones who purchase insurance.

A) moral hazard B) adverse selection C) fraud D) over-insurance E) agency costs

13

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

54) How do insurance guarantee funds differ from bank deposit insurance funds?

55) What additional flexibilities are provided by variable and universal life as compared to a standard whole life or endowment policy?

56) A 65-year-old wishes to convert the cash value of his insurance policy into an annuity.

He can select an annuity that will last 15 years or one that lasts 20 years. If the cash value is $450,000 and interest rates are 5.25 percent, how much less per year will he receive if he chooses the 20-year annuity?

57)

What three main sources of underwriter risk exist for P&C insurers?

58) Why are P&C insurers dependent on investment yields? Is this an argument for changing how this industry operates and/or how we regulate the industry? Explain.

14

59)

What is separate account business? How important is it to life insurers?

60)

What are the main lines of P&C insurance?

61) Annual Data Premiums earned Losses incurred Expenses/commissions Dividends paid to policyholders Investment income on premiums

Thousands of Dollars $ 35,600 $ 26,760 $ 9,125 600 $ 1,525

What is the combined ratio after dividends for this line? Are premiums sufficient to generate profitability for this line? Why or why not?

Combined ratio after dividends = $26,760 + $9,125 + $600/$35,600 = 1.0249, or 102.49%

62) Annual Data Premiums earned Losses incurred Expenses/commissions Dividends paid to policyholders

Thousands of Dollars $ 35,600 $ 26,760 $ 9,125 $ 600

15

Investment income on premiums

$ 1,525

What is the operating ratio for this line? Is the line profitable?

Combined ratio after dividends = $26,760 + $9,125 + $600/$35,600 = 1.0249, or 102.49% Operating Ratio = Combined ratio after dividends − (Investment income/Premiums earned) = 102.49% − ($1,525/$35,600) = 0.9831, or 98.31%

63) Annual Data Premiums earned Losses incurred Expenses/commissions Dividends paid to policyholders Investment income on premiums

Thousands of Dollars $ 35,600 $ 26,760 $ 9,125 $ 600 $ 1,525

Everything else constant, what is the maximum expected loss ratio that would yield a profitable line after including investment income?

Maximum $ Loss + $9,125 + $600 − $1,525/$35,600 = 100%; Maximum $ Loss = $27,400

64) Halliburton was allowed to bankrupt one of its subsidiaries in settlements of lawsuits on asbestos cases. What are the pros and cons of allowing a firm to limit its liability by shifting the liability to only one subsidiary rather than placing all of the corporation's assets at risk?

16

65) Why do P&C insurers place a large percentage of their investments in bonds and maintain large surpluses?

17

Answer Key Test name: Chap 15_8e 1) FALSE 2) FALSE 3) FALSE 4) TRUE With a financial calculator, input PV = −1,250,000, N = 10, I = 5.75, FV = 0 and solve for PMT to get 167,829.

5) TRUE 6) FALSE 7) TRUE 8) TRUE 9) FALSE 10) FALSE 11) FALSE 12) FALSE 13) TRUE 14) TRUE 15) TRUE 16) TRUE 17) TRUE 18) TRUE 19) TRUE 20) FALSE 21) TRUE 22) FALSE 23) D

18

24) A 25) A 26) B 27) C 28) D 29) E 30) C [($25,000 × 1.0830) + ($12,000 × FVIFA (8%, 30 yrs.))]/PVIFA (8%, 25 yrs.)

Financial Calculator Solution: First find the FV of the accumulated amount: PV = −25,000, PMT = −12,000, N = 30, I = 8 and solve for FV to get 1,610,965. The amount the investor will have when he retires is $1,610,965. Now, convert this amount into a 25-year annuity: PV = −1,610,965, N = 25, I = 8, FV = 0 and solve for PMT to get 150,913.

31) A $1,100,000/$95,000 = PVIFA (5.122%, N yrs.); N = 18; log rule or financial calculator required Financial Calculator Solution: Input PV = −1,100,000, I = 5.122, PMT = 95,000, FV = 0 and solve for N to get 17.99996 which is 18.

32) C 33) A 34) B 35) D 36) D 37) B 38) C 19

39) C The combined ratio is 72% + 35% + 2% = 109%, therefore, to break even it needs to earn 109% − 100% = 9% on its investments.

40) B 41) C 42) C 43) C 44) C Payment = $725,000/PVIFA (15 yrs., 5.25%) With a financial calculator: Input PV = −725,000, N = 15, I = 5.25, FV = 0 and solve for PMT to get 71,033.43.

45) B Operating ratio = 62 + 35 + 2 − 9 46) C Operating ratio = 65 + 16 + 26 + 3 − 6 = 104 47) B 48) A 49) A 50) C 51) E 52) C 53) B

20

54) ● The insurance funds are administered by the insurance firms, not the government, unlike the FDIC. ● No permanent fund to back policyholder claims exists, whereas bank deposits are backed by a permanent fund that the FDIC can draw on. ● The size of the required contributions that surviving insurance firms must make varies widely from state to state. In some states the required payments in any one year may be capped, so policyholders may encounter delays in recovering their claims. This is not true for bank deposit insurance. ● Not all states require insurers to have guarantee funds, but most bank deposits have federal insurance.

55) Variable life allows the policyholder to choose among various mutual fund investments where their cash value is invested. The choice allows policyholders to choose what level of risk they wish to bear.

Universal life and variable universal life allow the policyholders to vary the amount of premiums paid and the maturity of the contract. Premiums can even be skipped. Traditional policies lack these flexibilities.

21

56) 15-year: $450,000 = PMT15 × PVIFA (N = 15, r = 5.25%) PMT15 = $44,090 20-year: $450,000 = PMT20 × PVIFA (N = 20, r = 5.25%) PMT20 = $36,879 Difference: He receives $7,211 less per year with the 20-year annuity.

Financial Calculator Solution: For the 15-year annuity selection: Input PV = −450,000, N = 15, I = 5.25, FV = 0 and solve for PMT to get 44,089.72.

For the 20-year annuity selection: Input PV = −450,000, N = 20, I = 5.25, FV = 0 and solve for PMT to get 36,878.53.

The difference is $7,211.19 per year less for the 20-year annuity.

57) ● Unexpected increases in loss rates ● Unexpected increases in expenses ● Unexpected decreases in investment yields

22

58) High loss ratios and expense ratios have made many of the main P&C lines unprofitable in certain years due to high payouts, high loss adjustment expenses, and large commissions. The combined ratio after dividends has often been above 100, indicating that payouts are greater than premiums paid in. In this case, the insurer must have sufficiently high investment yields on premiums invested to make up for the unprofitable lines and still pay a sufficient rate of return to stockholders so that the industry can attract capital. These results indicate the need for P&C insurers to increase premiums on many lines, to better diversify to cut losses, or to be able to better minimize moral hazard and adverse selection. Perhaps insurance premiums should be fully deregulated and determined by the market, although this would raise costs of insurance and possibly social costs to deal with a greater number of uninsured people. Alternatively, commissions could be cut in order to cut costs and/or tax advantages given to P&C insurers.

59) Assets managed by the life insurer on behalf of a client, such as pension fund assets, are separate account business. In 2019, about 35.6 percent of assets were separate accounts—quite a significant portion of their business.

60) Fire and allied lines, homeowners multiple peril, commercial multiple peril, automobile liability and physical damage, and liability insurance other than auto.

61) Premiums are not sufficient to generate profitability for this since the combined ratio is greater than 100.

62) Since the operating ratio is less than 100, the line is profitable but only after including investment income on premiums.

63) Maximum Loss ratio = $27,400/$35,600 = 0.7697, or 76.97%

23

64) The pros are probably limited to cost arguments. It may keep the cost of liability insurance down to allow a firm to protect the assets of unrelated subsidiaries. The cons are the reduced ability to collect damages. The asbestos-related damages are huge and the ability of claimants to recover losses and punitive damages is reduced by this decision. There is probably also a moral hazard problem since firms may be more likely to engage in risky or unethical practices because they can protect more corporate assets than would otherwise be the case.

65) P&C insurers need stable cash flows to offset potentially volatile loss ratios. In many years it is only the investment returns that make a P&C insurer profitable, hence the need for a stable investment.

Similarly, the large surpluses are needed for years when losses are running higher than anticipated and/or investment returns are less than expected. Moreover, in some years, catastrophe losses have been quite large and the large surpluses are needed to absorb losses.

24

Chapter 16: Securities Firms and Investment Banks TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) For securities firms, income from investment management is more stable than income from underwriting or trading activities. ⊚ ⊚

true false

2) Diversified full-line investment banks act as both broker-dealers and securities underwriters. ⊚ ⊚

true false

3) An example of a national full-line investment banker that specializes in corporate finance is Goldman Sachs. ⊚ ⊚

true false

4) The process of creating a secondary market for securities or contracts is termed brokerage. ⊚ ⊚

true false

5) In a best efforts offering, the investment banker acts as an agent for the issuer rather than as a principal. ⊚ ⊚

true false

6) A market maker buys IBM at $185 for his own account and sells the stock later in the day at $187. He is acting as a broker in this transaction. ⊚ ⊚

true false 1

7) Buying large blocks of securities and holding them until the price rises sufficiently to warrant a sale is an example of pure arbitrage. ⊚ ⊚

true false

8) An example of a pure arbitrage strategy is to simultaneously buy and sell the same security in two different markets at different prices. ⊚ ⊚

9)

true false

A stockbroker acts as a principal on behalf of the customer. ⊚ ⊚

true false

10) Cash management accounts offered by a securities firm allow investors to write checks on funds invested in money market securities. ⊚ ⊚

true false

11) Program trading is the simultaneous buying and selling of at least 15 stocks worth a total of $1 million or more. ⊚ ⊚

true false

12) If you buy 100 shares of IBM stock in anticipation that earnings will increase by more than anticipated, you are engaging in what is termed a risky arbitrage. ⊚ ⊚

true false

2

13) Although an investor can write checks on a cash management account held with a broker, regulations prevent the use of ATMs or debit cards on these accounts. ⊚ ⊚

14)

true false

Profitability at investment banking firms has been very stable each year since 2001. ⊚ ⊚

true false

15) The Securities Investor Protection Corporation protects investors against losses due to unfavorable market moves of up to $500,000. ⊚ ⊚

true false

16) Angel venture capitalists have invested more in start-up firms than institutional venture capital firms. ⊚ ⊚

true false

17) Brokerage commission income and stock market valuations tend to move inversely in most years, including in 2010. ⊚ ⊚

true false

18) FINRA is a government agency that has a mandate to protect America’s investors by making sure the securities industry operates fairly and honestly. ⊚ ⊚

true false

3

19) An advantage of private placements is that there is no requirement to register with the SEC since the placements are made only to large, sophisticated investors; therefore, the cost of issuance is lower. ⊚ ⊚

true false

20) Firms underwriting securities assist corporate clients in selling them in secondary markets. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) Diversified full-line securities firms engage in all but which one of the following?

A) Trading and brokerage of existing securities B) Corporate restructuring and advice C) Issuing new securities D) Raising money via insured deposits

22)

A best efforts offering is one in which:

A) the underwriter bears the risk of an unsuccessful offering.

B) the bid-ask spread is exceptionally high, but the investment banker does his best to sell the issue anyway.

C) the investment banker acts as a principal for the issuer.

D) the investment banker acts only as a distribution agent.

E) the issue can only be privately placed.

23) If an underwriter overestimates the demand for a firm's securities in a firm commitment offering, the underwriter can: 4

A) sell the shares back to the issuing firm at a discount.

B) lower the bid price to the issuing firm.

C) increase the fees charged to the issuing firm.

D) cancel the issue and refund the fees paid by the issuing firm.

E) None of these options are correct.

24) Investment firms that pool money from individuals and/or institutions and invest equity funds in start-up firms are called:

A) top-tier bankers.

B) Section 20 affiliates.

C) venture capital firms.

D) ECNs. E) discount brokerage houses.

25) You buy euros in New York from Deutsche Bank and simultaneously sell them in London to Barclays for a gain. This is an example of:

A) position trading.

B) program trading.

C) risk arbitrage.

D) pure arbitrage.

E) hedging.

26)

An unregistered issue sold to a few large institutional buyers is an example of a(n):

A) best efforts offering.

B) fully underwritten public offering.

C) shelf offering.

D) private placement.

E) SEC Rule 415 offering.

5

27) An investment banker agrees to a firm commitment offering of two million shares of Ace stock. The offer price is set at $55 and the spread is 50 cents per share. If the stock is actually sold to the public at $53.80, what is the investment banker's gain or loss?

A) $1,400,000 gain B) $1,400,000 loss C) $500,000 gain D) $500,000 loss E) None of these options are correct.

28) Day-to-day trading practices of securities firms currently may be regulated by which of the following? 1.I. FINRA 2.II. SEC 3.III. Federal Reserve 4.IV. SIPC

A) I only B) II only C) I and II only D) I and III only E) II and IV only

29) Firms in the securities industry are required to maintain a net worth to assets minimum capital ratio of .

A) 2 percent.

B) 4 percent.

C) 6 percent.

D) 8 percent.

E) 10 percent.

6

30) An investment banker agrees to a firm commitment offering of 1.2 million shares of Bally stock. The offer price is set at $25.50 and the spread is 30 cents per share. If the stock is actually sold to the public at $26.00, what is the amount of funds Bally receives? (Ignore any other fees or expenses.)

A) $31,200,000 B) $30,600,000 C) $30,240,000 D) $29,280,000 E) $28,120,000

31)

The major result of the NSMIA was to:

A) reduce state regulatory powers over securities firms.

B) establish the SIPC. C) create the NASD. D) All of these choices are correct.

E) None of these choices are correct.

32) An investment banker agrees to a best efforts offering of 2.5 million shares of Crew stock. The offer price is set at $35 per share. If the stock is actually sold to the public at $34.50 and the banker charges a 3.45 cent commission per share sold, what is the amount of funds Crew receives? (Ignore any other fees or expenses.)

A) $88,750,000 B) $87,500,000 C) $86,163,750 D) $85,176,430 E) $84,122,560

33) banking services.

are examples of investment bankers offering traditional commercial

7

A) Online brokers B) Cash management accounts C) Underwriting corporate debt and equity offers D) Venture capital funds E) Mergers and acquisition services

34) The trading activity involving purchases of large blocks of securities on the expectation of a favorable price move over the next several weeks or months is called:

A) program trading.

B) pure arbitrage.

C) day trading.

D) position trading.

E) hedging.

35) An entrepreneur looking for financing to get her small personally owned business up and running should probably consider:

A) an IPO. B) a seasoned stock offering.

C) a public debt offering.

D) a venture capitalist.

E) a syndicated loan.

36)

Which one of the following statements about venture capitalists is not correct?

A) Venture capitalists contribute to equity financing rather than make loans.

B) Venture capitalists are passive investors.

C) Most private venture capitalists are organized as limited partnerships.

D) The federal government licenses some private firms to provide lower-cost funds to entrepreneurs.

E) Angel venture capitalists are wealthy individuals who fund business start-ups.

8

37) In 2018, the greatest dollar volume of U.S. corporate underwriting occurred for which type of security?

A) Straight corporate debt B) Asset-backed debt C) Common stock D) Preferred stock E) Convertible debt

38) The insures losses of funds deposited with securities firms in the event of failure of a securities firm.

A) SEC B) NASD C) SIA D) SIPC E) FDIC

39) In 2019, the top five underwriters engaged in about issues.

of global equity

A) 15.8 percent B) 22.4 percent C) 38.5 percent D) 44.7 percent E) 56.2 percent

40)

Which one of the following securities firms' activities is normally the most risky?

9

A) Best efforts offering B) Private placement C) Firm commitment offering D) Pure arbitrage E) Program trading

41)

The largest asset on the typical broker-dealers’ balance sheet in 2016 was:

A) receivables from other broker-dealers.

B) long positions in securities and commodities.

C) reverse repurchase agreements.

D) repurchase agreements.

E) cash.

42)

The largest liability of broker-dealers in 2016 was:

A) bank loans payable.

B) short positions in securities and commodities.

C) subordinated debt.

D) repurchase agreements.

E) equity.

43) As a result of the alleged conflicts of interest between analysts and underwriting, which of the following changes were implemented? 1.I. Analysts cannot participate in nor attend certain presentations to potential investors conducted by investment bankers associated with underwriting an issue.

2.II. Analyst compensation can no longer be tied to the amount of underwriting business a firm generates.

3.III. Securities firms must divest stock research divisions to ensure independence from their investment banking business.

10

A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III

44)

Underwriting new securities issuance requires that the investment bank:

A) buys the issue at a certain price and then sells it in the primary market.

B) provides research and legal advice only to the issuing company.

C) buys the issue at a certain price and then sells it in the secondary market.

D) provides its best effort to sell the securitiesand the unsold portion goes back to the issuer.

E) purchases securities in the secondary market when they are undervalued.

45) When the investment banker sells the new securities on commission without guaranteeing the sale of the whole issue, the process is called:

A) private placement.

B) best effort.

C) brokered sale.

D) underwriting.

E) syndicate offering.

46) An investment manager directs a certain client’s orders to a certain broker for execution in exchange for research from the broker. This arrangement is referred to as a:

A) soft dollar arrangement.

B) best effort arrangement.

C) position trading.

D) private placement.

E) commission trades.

11

47)

Security dealers who will buy or sell securities at any time in the market are called:

A) brokers.

B) program traders.

C) underwriters.

D) market makers.

E) dealers.

48) A company issued 5 million new shares of stock. An invest-ment bank agrees to underwrite these shares on a best efforts basis. The investment bank is able to sell 3.7 million shares for $34.50 per share, and it charges commission of $0.52 per share sold. How much money will the company receive?

A) $125,726,000 B) $127,650,000 C) $130,000,000 D) $169,900,000 E) $172,500,000

49) An investment bank agrees to pay $26.75 for 5 million shares of a company in a firm commitment stock offer-ing. It then can sell those shares to the public for $25.50 per share. What is the profit to the investment bank?

A) Profit of $6,250,000 B) Loss of $6,250,000 C) Loss of $5,000,000 D) Loss of $7,500,000 E) Profit of $1,000,000

50) An investment bank agrees to underwrite a $100 million, 15-year, 10percent semiannual bond issue for a company on a firm commitment basis. The investment bank pays the company on Monday and plans to begin a public sale on Tuesday. If interest rates rise 0.5percent, or fifty basis points, overnight, what will be the impact on the profits of the investment bank?

12

A) $4,258,365 loss B) $4,258,365 gain C) $3,735,975 loss D) $3,735,975 gain E) $1,239,175 gain

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) What are the major types of firms in the investment banking industry? Briefly describe each.

52) Why is capital a more important measure of the size of a securities firm than the amount of assets? What other measures would be useful, given the diversity of this industry?

53) Describe an agency transaction (brokerage) and a principal transaction (dealer) that is involved in trading. What determines profits in each activity? Which is riskier?

54) Classify the following trading activities as either a position trade, a pure arbitrage trade, or a risk arbitrage trade. 1.I. Buy Intel at $120 and hold it for six months in hopes of a price rise.

2.II. Buy GE on the NYSE and immediately sell it at a higher price on the Pacific Exchange.

3.III. Short sell Dell in anticipation of a poor quarterly earnings report.

13

55) What are soft dollar fees or commissions? How can these lead to conflicts of interest for investment bankers?

56) Why did profitability of security firms drop precipitously in 2005 and rebound in 2006 only to fall again in 2007?

57) Darby Minerals wants to hire an investment banker to sell two million shares of stock to the public. Darby is considering using either a firm commitment or a best efforts offering. (a) If Darby goes with a firm commitment, the offer price will be $15.00 per share and the spread will be 25 cents a share and all two million shares will be sold. The actual sale price to the public is $14.55. (b) Suppose that Darby uses a best efforts offering. The actual sale price to the public is again $14.55 and the investment banker charges 4 cents per share sold as commission. Assume that in the best efforts offer only 1.85 million shares can be sold.

What are the proceeds to Darby from the sale of stock in the firm commitment and the best efforts and what is the investment banker's gain or loss in each case? Ignore any other costs and expenses.

14

Answer Key Test name: Chap 16_8e 1) TRUE 2) TRUE 3) TRUE 4) FALSE 5) TRUE 6) FALSE 7) FALSE 8) TRUE 9) FALSE 10) TRUE 11) TRUE 12) TRUE 13) FALSE 14) FALSE 15) FALSE 16) TRUE 17) FALSE 18) FALSE 19) TRUE 20) FALSE 21) D 22) D 23) E 24) C 25) D 26) D 15

27) B [$53.80 − ($55.00 − $0.50)] × 2,000,000 = −$1,400,000 28) A 29) A 30) C ($25.50 − $0.30) × 1,200,000 = $30,240,000 31) A 32) C ($34.50 − $0.0345) × 2,500,000 = $86,163,750 33) B 34) D 35) D 36) B 37) A 38) D 39) C 40) C 41) A 42) D 43) B 44) A 45) B 46) A 47) D 48) A 3,700,000 × ($34.50 − $0.52) = $125,726,000 49) B ($25.5 − $26.75) × 5,000,000 = −$6,250,000

16

50) C With a financial calculator: Input N = 30, I = 5.25, PMT = −5,000,000, FV = −100,000,000 and solve for PV to get $96,264,025.

The value of the investment went down from $100,000,000 to $96,264,025 for a loss of $3,735,975.

51) Diversified full-line investment banks that serve retail customers via trading activities and corporate customers in underwriting securities.

Full-line national firms that specialize in corporate finance activities such as underwriting, mergers, and acquisitions.

Various specialized types of firms ranging from regional investment bankers to commercial bank subsidiaries to Internet brokerage firms, and venture capital firms that specialize in start-up and small businesses.

52) The size of investment banking and securities trading is not properly measured by industry assets because, unlike loans or insurance policies, investment bankers and securities firms do not need to permanently hold securities. Their purpose is to turn them over quickly. Equity capital measures a firm's ability to turn over large issues, since firms will only risk limited amounts of their capital at one time.

Other measures may include these: ● Level of underwriting volume in particular categories ● Number of brokers/dealers, availability of electronic trading (securities firms trading activities) ● Number of corporate relationships (M&A and consulting activities) ● Amount of global presence such as overseas offices and foreign transactions

17

53) Market makers act as agents by processing buy and sell orders from the public and they profit by charging a small commission on each order.

A large amount of trading volume is required to generate substantial profits, but the agent takes on no risk.

In a principal transaction market makers buy and sell securities for their own account. They can profit in two ways. First, market makers charge a slightly higher price to sell securities while buying at a lower price. As with the broker, a high volume of either buys or sells or both can thus lead to high profits. The principal carries an inventory of securities and does bear the risk of a large price move, so the principal has more risk than the broker. Market makers can also take on even more risk by taking larger bullish or bearish positions if they believe they can predict the direction of the security's price change. This kind of speculative market making activity is more risky but can lead to larger profits.

54) 1.I. Position trade; II. Pure arbitrage; III. Risk arbitrage 55) The term "soft dollar" can mean different things, but it can refer to fees allocated to pay for research and advisory services provided to clients. In the past, independent investment houses specialized in providing research services, but in many cases today the investment banker has his/her own analysts that provide research. This can lead to the tendency to reward analysts for research that helps the banker in encouraging customers to buy the stock regardless of whether the analyst really thinks the stock is a good buy. The customer believes he or she is receiving an objective analysis when in fact he or she may not be. This is an obvious conflict of interest.

18

56) Underwriting and trading income remained high in the mid-2000s, but increasing interest rates also increased interest expense on borrowed funds used to finance their securities inventory and this kept profits down in 2005. Revenue increases in 2006 pushed profits back up. The subprime fallout in 2007 dramatically reduced profitability. Many securities firms had extensive investments in mortgage-backed securities and had even acquired mortgage originators to facilitate the securitization process. When subprime default rates rose dramatically in 2007 these investments and acquisitions performed very poorly.

57) (a) Firm Commitment Option: Firm Proceeds: ($15.00 − $0.25) × 2,000,000 = $29,500,000 Investment Banker's Gain or Loss = ($14.55 − $14.75) × 2,000,000 = −$400,000 (b) Best Efforts Option: Firm Proceeds ($14.55 − $0.04) × 1,850,000 = $26,843,500 Investment Banker's gross profits = ($0.04 × 1,850,000) = $74,000

19

Chapter 17: Investment Companies TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Funds that specialize in municipal bonds and certain types of real estate to minimize tax liabilities are called hybrid funds. ⊚ ⊚

2)

true false

Hedge funds can short sell securities, whereas most mutual funds cannot. ⊚ ⊚

true false

3) A hedge fund that goes long in a convertible bond and short in the equity of the same firm is employing a market neutral arbitrage strategy. ⊚ ⊚

true false

4) The shares of a closed-end fund with market value assets of $200 million and two million shares outstanding will always trade at a market value of $100 per share. ⊚ ⊚

true false

5) If you invest $10,000 in a mutual fund with an NAV of $50 per share and a 5.5 percent back-end load, you will receive less than 200 shares in the fund. ⊚ ⊚

true false

6) Because of their ability to hedge, the subprime mortgage crisis did not cause any significant losses to hedge funds. ⊚ ⊚

true false

1

7) Offshore hedge funds are not subject to taxation on fund distributions nor to U.S. estate taxes. ⊚ ⊚

true false

8) The market value of a fund's net assets divided by the number of mutual fund shares outstanding is called the NAV of the fund. ⊚ ⊚

9)

true false

Open-end fund shares often trade at a discount or premium relative to NAV. ⊚ ⊚

true false

10) Load funds typically provide investors with higher rates of return and offer more services such as check writing, transfers between funds, and so forth, than no-load funds. ⊚ ⊚

11)

A 12b-1 fee is an implicit load charge. ⊚ ⊚

12)

true false

true false

Households are the largest owners of money market mutual funds. ⊚ ⊚

true false

2

13) Hedge funds and REITS often employ significant amounts of leverage, but standard open-end mutual funds do not. ⊚ ⊚

true false

14) The Federal Mutual Fund Commission (FMFC) is the primary regulator of the mutual fund industry. ⊚ ⊚

true false

15) Unit investment trusts (UITs) issue only a fixed number of shares redeemable at a specific termination date. ⊚ ⊚

true false

16) Load funds charge one-time sales commissions that can be paid either upfront or at end of the investing period in the mutual fund. ⊚ ⊚

17)

true false

The price of an ETF is determined once a day when the market closes. ⊚ ⊚

true false

18) ETFs are private investment pools, which are exempt from SEC regulations and have the ability to pursue diverse investment choices. ⊚ ⊚

19)

true false

Index funds have the highest cost among the different types of mutual funds.

3

⊚ ⊚

20)

Money market mutual funds consist of a mixture of bonds and money market securities. ⊚ ⊚

21)

true false

true false

Barriers to entry overseas are typically lower than in the U.S. in the mutual fund industry. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

22) Open-end mutual funds guarantee:

A) investors a minimum rate of return.

B) investors a minimum NAV. C) to redeem investor's shares upon demand at the current NAV. D) to earn the rate promised in the prospectus.

E) None of these options are correct.

23) Hedge funds charge expense fees and performance fees. The average performance fee on hedge funds is .

A) 5 percent B) 10 percent C) 15 percent D) 20 percent E) 25 percent

24)

ETFs are a direct competitor to

.

4

A) hedge funds B) money market mutual funds C) REITS D) index funds E) market neutral funds

25) As the economy weakens, one would expect investment in funds to increase and investment in funds to decrease, all else held constant.

A) money market mutual; equity B) equity; bond C) municipal bond; money market mutual D) corporate bond; municipal bond E) long-term; short-term

26)

Hybrid mutual funds normally invest significant amounts in:

A) common stock.

B) commercial paper.

C) long-term bonds.

D) treasury bills.

E) both common stock and long-term bonds.

27) Money market mutual funds (MMMFs) have caused disintermediation at banks at times.

This is because MMMFs:

A) sometimes pay higher interest rates than bank deposits.

B) are less risky than bank deposits.

C) are now federally insured, like bank deposits.

D) offer guaranteed rates of return.

E) None of these options are correct.

5

28) Actively managed funds find it difficult to consistently earn higher risk-adjusted returns than a broad stock market index. The difference in return between actively managed funds and passively managed index funds can be explained by which of the following? 1.I. Lower expense ratios for index funds 2.II. Higher turnover ratios for index funds 3.III. Differences in returns in sectors of the market and the overall market return

A) II only B) I and III only C) I and II only D) II and III only E) I, II, and III

29)

By type of fund, there are more

funds than any other.

A) equity B) bond C) taxable money market D) tax-exempt money market E) hybrid

30)

The largest proportion of long-term mutual fund assets is held by .

A) bank trusts and estates B) the household sector C) nonfinancial corporate business D) private pension funds E) life insurance firms

31) The market value of a mutual fund's assets divided by the number of fund shares outstanding is equal to the: 6

A) load charge.

B) NAV. C) expense ratio.

D) 12b-1 fee.

E) management fee.

32) Rank the following in asset size from largest to smallest in 2019. 1.I. Mutual funds 2.II. Insurance companies 3.III. Depository institutions

A) I, II, III B) I, III, II C) II, III, I D) III, II, I E) III, I, II

33) You have $10,000 to invest and you are considering investing in a fund. The fund charges a front-end load of 5.75 percent and an annual expense fee of 1.25 percent of the average asset value over the year. You believe the fund's gross rate of return will be 11 percent per year.

If you make the investment, what should your investment be worth in one year?

A) $10,135.48 B) $10,337.46 C) $10,461.75 D) $10,556.23 E) $10,578.92

34) A fund has an NAV of $30 per share but the shares are currently selling for $32. This fund must be:

7

A) an open-ended fund.

B) a closed-end fund.

C) a balanced fund.

D) an aggressive growth fund.

E) a money market mutual fund.

35) An open-end mutual fund owns 1,500 shares of Krispy Kreme priced at $12. The fund also owns 1,000 shares of Ben & Jerry's priced at $43, and 2,000 shares of Pepsi priced at $50.

The fund itself has 3,500 of its own shares outstanding. What is the NAV of a fund's share?

A) $66 B) $56 C) $46 D) $36 E) $26

36) You have $16,000 to invest in a mutual fund with an NAV = $45. You choose a fund with a 4 percent front load, a 1 percent management fee, and a 0.25 percent 12b-1 fee. Assume that the management and 12b-1 fees are charged on year-end assets. The gross annual return on the fund's shares was 9 percent. What was your net annual rate of return to the nearest basis point?

A) 3.33% B) 7.64% C) 6.25% D) 4.52% E) 4.64%

37)

Investors pay load charges to receive:

8

A) higher returns on their investments.

B) additional services from funds.

C) voting shares of stock.

D) advice on which fund to buy.

E) 12b-1 remunerations.

38) A money market mutual fund's total assets increase from $100 to $105 when the fund has 100 shares outstanding. Which of the following will happen?

A) The fund's NAV will rise from $100 to $105.

B) The fund's NAV per share will rise from $1 to $1.05.

C) The fund will issue a total of five new shares.

D) The fund's NAV will fall 5 percent.

E) The fund will close to new investors.

39)

The primary regulator of mutual funds is the:

A) NASD. B) CFTC. C) NYSE. D) SEC. E) NSMIA.

40) You have $12,500 to invest and you are considering investing in Fund X. The fund charges a front-end load of 3 percent and an annual expense fee of 2.25 percent of the ending asset value over the year. You believe the fund's gross rate of return will be 8 percent per year. If you make the investment, what should your investment be worth in one year?

9

A) $12,125.20 B) $13,095.00 C) $12,654.80 D) $12,800.36 E) $13,162.50

41) You have $15,000 to invest in a mutual fund. You choose a fund with a 3.5 percent front load, a 1.75 percent management fee, and a 0.5 percent 12b-1 fee. Assume, for simplicity, that the management and 12b-1 fees are charged on year-end assets. The gross annual return on the fund's shares was 12.50 percent. What was your net annual rate of return to the nearest basis point?

A) 9.97% B) 6.12% C) 9.25% D) 5.42% E) 8.56%

42)

Which one of the following fund types is likely to have the lowest annual expense ratio?

A) Index funds B) Equity funds C) Bond funds D) Balanced funds E) Hybrid funds

43) A(n) fund must hold substantial cash reserves in order to meet fund redemptions from shareholders.

10

A) closed-end B) REIT C) open-end mutual D) ETF E) unit trusts

44) You wish to invest $17,445 in a mutual fund with an NAV of $26.03. The fund charges a front-end load of 4.50 percent. How many fund shares will you receive?

A) 595 B) 640 C) 616 D) 668 E) 628

45) A fund that has a fixed number of shares outstanding and is traded on an exchange is called a(n):

A) open-end mutual fund.

B) hybrid fund.

C) market timing fund.

D) index fund.

E) closed-end fund.

46) ETFs have several advantages over index funds, including the ability to: 1.I. trade throughout the day at continuously updated prices.

2.II. purchase ETF shares on margin.

3.III. sell ETF shares short.

4.IV. sell the shares back to the fund.

11

A) I, II, and III only B) I, III, and IV only C) II, III, and IV only D) II and III only E) I, II, III, and IV

47) You are considering purchasing shares in a typical mutual fund that has three classes of shares outstanding: Class A, Class B, and Class C. If you purchase Class A shares, you will pay:

A) a back-end load and no 12b-1 fees.

B) a front-end load and a small 12b-1 fee.

C) no front-end load but a back-end load.

D) a back-end load and full 12b-1 fees.

E) a front-end load and full 2b-1 fees.

48) You are considering purchasing shares in a typical mutual fund that has three classes of shares outstanding: Class A, Class B, and Class C. If you purchase Class C shares, you will pay:

A) a back-end load and no 12b-1 fees.

B) a front-end load and a small 12b-1 fee, but eventually your shares will be converted to Class A shares.

C) no front-end load but a back-end load.

D) a back-end load and full 12b-1 fees.

E) a front-end load and full 12b-1 fees.

49) One of the historical trading abuses in the mutual fund industry was allowing selected investors to rapidly trade in and out of a mutual fund in order to profit on stale prices. This practice is called:

12

A) diluted brokerage.

B) front running.

C) directed order flow.

D) soft dollar commissions.

E) market timing.

50)

Which of the following is not considered an abusive activity in mutual funds investing?

A) Market timing B) Late trading C) Directed brokerage D) Indexing E) Improper assessment of fees

51)

Which of the following is not an advantage of a mutual fund?

A) Cheaper transactions costs B) Diversification C) Monitoring activities at lower costs D) No default risk E) All of these choices are correct.

52) In 2019, combined assets in non-U.S. mutual funds were approximately invested in U.S. mutual funds alone.

that

A) 13.6 percent greater than B) 13.6 percent less than C) 12.7% greater than D) 12.7% less than E) equal to

13

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

53) Why are mutual funds popular with individual investors?

54) What is the purpose of index funds? How does this differ from other equity mutual funds? Why are index funds growing in popularity?

55)

How are money market mutual funds similar to and different from bank deposits?

56)

How do closed-end investment companies differ from open-end mutual funds?

57) What are the four main categories of mutual fund trading abuses mentioned in the text?

Explain the problem with each.

14

58) On Monday, an equity mutual fund has cash of $150 and stocks worth $900. The fund has 100 shares outstanding. On Tuesday, the stocks fall in value to $800 and 10 shares are then redeemed by the fund. Assuming that the fund uses its cash first to cover redemptions, what is the one-day rate of return to the remaining fund shareholders, and how much cash and stock does the fund now have?

59) An investor is considering two mutual funds. Fund A has a 5.75 percent front-end load and a 1.25 percent expense ratio. Fund B is no-load but has a 2.25 percent expense ratio. If the investor plans on being in either fund for six years, which should they choose given that they have $16,000 to invest and both funds have gross returns of 12 percent per year? Fees are applied at each year-end to year-end asset values, but the load is taken out up front only once.

60) Why do many mutual funds now offer three different classes of shares? What are the differences and what should you consider in choosing the classes?

61)

Why is it important to regulate the mutual fund industry?

62)

In what ways are hedge funds different from mutual funds?

15

63)

What new rules have resulted from the mutual fund trading abuses?

64) What are the primary differences between index funds and ETFs? What are two examples of ETFs?

65) Hedge funds may be classified into three types based on their investment strategies and risk levels. What are the three types and the broad risk level of each? Many different strategies exist in each type. List one example strategy in each type.

66) How are hedge fund expenses different from mutual fund expenses? What are hurdle rates and high water marks at a hedge fund? Why are these used?

16

Answer Key Test name: Chap 17_8e 1) FALSE 2) TRUE 3) TRUE 4) FALSE The fund’s market value can be at premium or discount based on the demand for its shares.

5) FALSE A back-end load is not paid until fund shares are sold.

6) FALSE 7) TRUE 8) TRUE 9) FALSE 10) FALSE 11) TRUE 12) TRUE 13) TRUE Mutual fund leverage is limited by regulation.

14) FALSE 15) TRUE 16) TRUE 17) FALSE 18) FALSE 19) FALSE 20) FALSE

17

21) FALSE 22) C 23) D 24) D 25) A 26) E 27) A 28) B 29) A 30) B 31) B 32) B 33) B Investment amount = $10,000 × (1 − 0.0575) = $9,425; FV1: $9,425 × 1.11 = $10,461.75 Average assets = ($10,461.75 + $9,425)/2 = 9,943.375; $9,943.375 × 0.0125 = $124.29; $10,461.75 − $124.29 = $10,337.46 34) B 35) C [(1,500 × 12) + (1,000 × 43) + (2,000 × 50)]/3,500 fund shares = $46 36) A {{[$16,000 × (1 − 0.04) × 1.09] × (1 − 0.0125)}/$16,000} − 1 = 0.0333, or 3.33% 37) D 38) C 39) D 40) D

18

Investment amount = $12,500 × (1 − 0.03) = $12,125; FV1: $12,125 × 1.08 = $13,095; After expenses: $13,095 × (1 − 0.0225) = $12,800.36 41) B {{[$15,000 × (1 − 0.035) × 1.125] × [1 − (0.0175 + 0.005))]}/$15,000} − 1 = 0.0612, or 6.12% 42) A Unmanaged funds have lower expense ratios.

43) C 44) B ((1 − 0.045) × $17,445)/$26.03 = 640.03 45) E 46) A 47) B 48) D 49) E 50) D 51) D 52) A 53) They provide: opportunities for small investors to obtain low-cost diversification; professional fund management according to specific objectives; economies of scale in investing (lower commissions and research costs); higher rates of return than available on bank deposits; and convenience services such as switching funds, low-cost reinvestment, and sometimes even check-writing capabilities.

19

54) The purpose of index funds is to mimic the performance of the underlying index such as the S&P 500. Their purpose is to provide investors with a rate of return similar to the stock market as a whole.

Other equity mutual funds are actively managed; that is, fundmanagers conduct research and pick individual stocks they believe will perform better than the market as a whole. They are increasingly popular because they have very low expense ratios and because the performance of managed funds (after expenses) has not been sufficiently better than index funds to warrant incurring the higher fees. Also, more widespread education about market efficiency has probably encouraged more investors to choose indexing.

55) Both are safe and earn fairly low rates of return. However, bank deposits are insured by the FDIC, and money market mutual funds are not. That is the biggest difference, but money market mutual funds almost never experience financial difficulty. Because banks may have to meet reserve requirements to back their deposits and pay deposit insurance premiums, bank deposits typically pay a lower rate of return than money market funds. Money funds also typically require higher minimum balances.

20

56) Open-end funds create new fund shares when investors buy more fund shares; the fund also redeems the shares upon demand, so liquidity is provided by the fund. The number of fund shares fluctuates daily, but fund shares trade at the net asset value. Closed-end funds trade over the counter or on an exchange. The fund has a fixed supply of shares outstanding, and an investor wishing to purchase shares must find someone willing to sell their shares. Imbalances in supply and demand of the shares of the closed-end fund can cause the shares to trade at prices different from the fund's net asset value. Discounts from net asset value are common. Because a closed-end fund does not have to redeem shares from investors, it does not have to hold as large of cash reserves as an open-end mutual fund must hold.

57) 1. Market timing: Allowing selected traders to conduct in and out trading of a mutual fund that is holding overseas securities in order to exploit price changes in the overseas accounts.

2. Late trading: Similar to timing, allowing selected traders to place or cancel orders after the NAV is posted for the day because of new information coming out after close. Both of these practices allow certain investors to profit at the expense of longer-term fund investors.

3. Directed brokerage arrangements: Mutual fund managers use certain brokers to execute the fund's buy/sell orders and, in exchange, the brokers advise their clients to buy that fund. This is a conflict of interest that may result in funds paying higher brokerage costs and investors not getting objective advice about which fund to invest in.

4. Improper fee assessments: Some brokers do not disclose load charges on funds and/or do not give the appropriate discounts to qualified customers, thus overcharging (cheating) the customer.

21

58) The fund pays the selling shareholders the NAV of ($800 + $150)/100 = $9.50 per share or $9.50 × 10 = $95. This reduces the fund's cash balance. The fund is then left with $800 in stocks and $150 − $95 = $55 in cash. The ending NAV is still ($800 + $55)/90 shares = $9.50.

Because the initial NAV was $10.50, and after the price drop the NAV is $9.50, the one day return is thus ($9.50 − $10.50)/$10.50 = −0.0952, or −9.52%.

59) Fund A: $16,000 × (1 − 0.0575) = $15,080 initial investment $15,080 × 1.12 = $16,889.60 Year 1 value before expenses 1.25% × 16,889.60 = $211.12 Year 1 expenses $16,889.60 − $211.12 = $16,678.48 Year 1 after expenses Net annual return for each year will be ($16,678.48/$15,080) − 1 = 0.1060, or 10.60% FV in six years: $15,080 × 1.10606= $27,601.46 Fund B: $16,000 × 1.12 = $17,920 Year 1 value before expenses 2.25% × $17,920 = $403.20 Year 1 expenses $17,920 − $403.20 = $17,516.80 Net annual return for each year will be ($17,516.80/$16,000) − 1 = 0.0948, or 9.48% FV in six years: $16,000 × 1.09486 = $27,550.45 The future value of Fund B is less than the future value of Fund A, so choose Fund A.

22

60) Class A shares pay a front-end load and usually incur a small 12b-1 fee. Class B shares typically have no front load, but incur a back-end load and a larger 12b-1 fee; after a set period of time, such as six to eight years, the Class B shares convert to Class A and thus incur the smaller 12b-1 fee. Class C shares have no front-end load, and a back-end load is incurred only if shares are sold within a set number of years. These shares do not normally convert to Class A and thus carry the full 12b-1 fee for the entire holding period. Although an investor must consider the specific cases, as a general rule, investors should probably avoid Class A shares because the up-front deduction of funds implies that less money is invested and compounded through time. Class B shares may be preferable to Class C shares if the shares will be held for a sufficiently long time. This is because Class C shares face the higher annual 12b-1 fee forever.

61) All financial firms must be regulated to prevent fraud, embezzlement, and various abuses. Mutual funds need to be regulated to ensure that investors have enough valid information to evaluate the fund, and to ensure that the fund does what it promises the investor it will do.

For example, the fund could claim to invest in low-risk assets, but instead buy higher-risk assets and keep the additional return for themselves if it were not regulated.

23

62) The primary differences are as follows: 1. Hedge fund investors must be institutions or accredited investors. To qualify, an individual investor must have a net worth of at least $1,000,000 or have an annual income of at least $200,000 ($300,000 if married). Hedge funds may only be sold via private placements.

2. Hedge funds are not nearly as regulated as mutual funds and generally take on considerable risk, including a high amount of leverage.

Disclosure requirements are also quite a bit lower than for mutual funds.

All hedge fund performance disclosures are voluntary. In fact, it is probably correct to say that no authority is monitoring the normal activities of hedge funds.

3. Fees on hedge funds are higher than on mutual funds. Fees include standard management fees and a quite large performance fee if the fund performs well.

4. Hedge funds take on a broader scope of risks than the typical mutual fund and do not invest according to a publicized strategy. Fund gains and losses can be substantially greater than with typical mutual funds.

Many employ mathematical models to predict relationships between prices or interest rates in different markets and make levered bets to profit on aberrations from normal prices. Many are not fully diversified on purpose. A well-managed hedge fund may be able to generate better returns in poor market conditions than mutual funds. (Note: In fact, an investor may be best served by having a hedge fund investment during poorer market conditions when mutual funds are constrained by their investment objectives and must remain invested in struggling markets.)

24

63) New rules include those requiring: ● Improved governance. ● Keeping client trades and holdings confidential. ● Greater disclosures including: ● Disclosing rules on fair value pricing. ● Requiring brokers to disclose to customers any tie in arrangements with specific funds. ● Mandating funds to have a chief compliance officer (CCO) that answers to the board. ● Requiring shareholder reports to disclose all fees shareholders paid as well as management's discussion of fund performance over the period. ● Note: PROPOSED by SEC, but not approved: "Hard closing" on buy/sell order processing as of 4:00 PM EST daily.

64) ETFs are exchange-traded versions of index funds. Advantages of ETFs include the ability to be traded throughout the day at continuously updated prices, and they can be purchased on margin and sold short, unlike index funds. ETFs have no capital gains distributions to add to the tax liability in a given year. Examples include SPDRs on the AMEX and Vanguard's Large-Cap VIPERS funds.

25

65) The three main types and the applicable risk strategy of each are as follows: ● Market directional funds that seek high returns using leverage by using risk arbitrage strategies such as taking positions on how the prices will move. Market timers and funds that invest heavily in certain sectors of the economy would fit into this category. These funds take on high risk. ● Market neutral or value-oriented funds limit their exposure to market risk and may engage in a combination of risky and less risky investment strategies. Examples in this category would include funds of funds and funds that specialize in distressed securities (e.g., vulture funds). Capital preservation is often a major priority of these funds. ● Market neutral or risk-avoidance funds seek moderate and stable returns. These funds are more likely to engage in lower-risk arbitrage strategies and classic hedging. They still use leverage but focus on reducing correlations in the portfolio and exploiting temporary mispricing. They often look for out-of-favor stocks and small differences in spreads on bonds that appear to be misaligned.

66) Hedge funds charge the normal annual management expenses similar to mutual funds, but hedge funds also charge performance fees.

Performance fees give the fund managers a percentage of any positive returns on the fund. These fees average 20 percent and have been as high as 30 percent! Because these fees are so large and because having them might tempt managers to seek exorbitant risk levels, fund investors require a hurdle rate, which is a minimum rate of return the fund must earn before the performance fee can be assessed. Likewise, many funds have a requirement that the hedge fund NAV must be at an all-time high (high-water mark) before the performance fee can be assessed.

26

Chapter 18: Pension Funds TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Of the different types of defined benefit plans, plans using the final pay method will usually produce the biggest retirement benefit to employees. ⊚ ⊚

2)

A Keogh plan is designed for self-employed individuals. <u></u> ⊚ ⊚

3)

true false

There are now Roth versions of 401(k) plans and 403(b) plans as well as Roth IRAs. ⊚ ⊚

5)

true false

Pension plans administered by the federal government are called insured pension plans. ⊚ ⊚

4)

true false

true false

Most state and local pension funds are underfunded. ⊚ ⊚

true false

6) Noninsured pension plans generally invest in riskier assets than insured pension plans invest in. ⊚ ⊚

true false

7) If you believe that taxes are going to go up and you will likely have to pay a high tax rate when you retire, you will probably be better off with a Roth IRA than with a traditional IRA. 1

⊚ ⊚

true false

8) If you are terminated before you are fully vested in an employer-sponsored plan, you may not get to keep previous contributions to your pension made by your employer. ⊚ ⊚

true false

9) In a defined benefit plan, the retirement benefit will vary according to rates of return on pension fund reserves. ⊚ ⊚

true false

10) In terms of assets managed and numbers of plans, defined contribution plans are becoming more predominant and defined benefit plans are declining. ⊚ ⊚

true false

11) In 2019, pension fund reserves held by life insurance companies represent about 42.6 percent of the typical life insurer's assets. ⊚ ⊚

true false

12) Pension contributions paid to insured pension funds and the assets purchased with these funds become the legal property of the insurance company and are not the legal property of the individual pension fund contributors. ⊚ ⊚

true false

2

13) A defined benefit pension plan expects to pay out $25 million per year over the next 10 years to pensioners. The fund currently has $155 million in pension assets that are earning 10 percent per year. This plan is underfunded. ⊚ ⊚

true false

14) If you are married and you and your spouse make $160,000 total per year, you are not allowed to contribute to an IRA. ⊚ ⊚

15)

true false

Assets in 401(k) plans are now greater than assets in private defined benefit plans. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) A pension plan has promised to pay out $25 million per year over the next 15 years to its employees. Actuaries estimate the rate of return on the fund's assets will be 5.50 percent. What amount of pension fund reserves (to the nearest dollar) are needed for the plan to be fully funded?

A) $375,000,000 B) $310,945,678 C) $250,939,524 D) $202,345,555 E) $198,466,231

17) Private pension funds are funds administered by: 1.I. the federal government.

2.II. state and local governments.

3.III. insurance companies.

4.IV. banks and mutual funds .

3

A) I and II only B) II and III only C) III and IV only D) II, III, and IV only E) I and III only

18) In general terms, which one of the following plan types is the riskiest for an employee on a year-to-year basis?

A) Defined contribution plan invested in fixed-income securities B) Defined contribution plan invested in equities C) Final pay defined benefit plan D) Career average defined benefit plan E) Overfunded defined benefit plan

19) In recent years defined contribution plans have grown faster than defined benefit plans in which of the following areas? 1.I. Fund assets 2.II. Number of funds 3.III. Number of plan participants

A) I only B) I and II only C) II and III only D) I, II, and III E) II only

20) Congratulations, you have just been employed! You now have a choice between a flat benefit at retirement equal to $4,000 times your years of service, or a career average formula of 3.50 percent of your average salary times your years of service. You expect to work 40 years. At what average salary would you be indifferent between the two alternatives?

4

A) $160,000 B) $145,444 C) $114,286 D) $101,104 E) $98,976

21) At your new job you estimate that your average salary over your working years will be $95,000 per year. How many more years would you have to work to receive as much benefit from a flat benefit of $3,000 times years of service as you would receive from 3.75 percent of your average salary times years of service?

A) 1.33 times as many years B) 0.75 times as many years C) 1.19 times as many years D) 2.40 times as many years E) 1.50 times as many years

22) An employee who has worked for his firm for 30 years can retire right now and receive a constant annual benefit of $45,000. He has a final pay plan that pays his average salary over his final five years times 2 percent times his years of service. He has decided he will keep working five more years but only if by doing so his retirement benefits will grow at 6 percent per year.

How much would his expected average salary (to the nearest dollar) have to be over the next five years to keep him working?

A) $54,198 B) $86,029 C) $51,617 D) $66,911 E) $53,147

23) The main advantage of a profit sharing Keogh plan over a money sharing Keogh plan is that profit sharing plans:

5

A) are eligible for PBGC insurance and money sharing plans are not.

B) have higher maximum contributions than money sharing plans.

C) can have contributions that vary from year to year with profits, while money sharing plan contributions are a fixed percentage of the employee’s income.

D) profit sharing Keogh plans are eligible for PBGC insurance and money sharing plans are not, and they have higher maximum contributions than money sharing plans.

E) None of these options are correct.

24) The Pension Protection Act of 2006 requires companies to correct funding shortfalls in their defined benefit plans within:

A) one year.

B) three years.

C) five years.

D) 10 years.

E) 20 years.

25) Under ERISA, pension fund managers are required to invest fund assets as wisely as if they were investing their own money. This requirement is called the:

A) owl rule.

B) vesting requirement.

C) 403(b) requirement.

D) prudent person rule.

E) funding rule.

26) A(n) plan does not require the employer to guarantee retirement benefits nor to maintain a minimum level of pension reserves.

6

A) defined benefit B) insured pension C) corporate pension D) uninsured pension E) defined contribution

27) Which of the following statements about 401(k) plans are true? 1.I. They are defined benefit plans.

2.II. They allow employer and employee contributions.

3.III. Earnings accrue tax-free during the employee's working years.

4.IV. They allow employee discretion in asset allocation.

5.V. They always have minimum guaranteed rates of return.

A) I, IV, and V only B) I, II, and V only C) II and III only D) II, III, and IV only E) All of these choices are correct.

28) An employee contributes 9 percent of his salary to his 401(k) plan and the employer matches with 40 percent of the first 6 percent of the employee's salary. The employee earns $90,000 and is in a 28 percent tax bracket. If the employee earns 10 percent on the plan investments, what is his one-year rate of return relative to the net amount of money he invested?

A) 16.28 percent B) 51.25 percent C) 90.07 percent D) 93.52 percent E) 29.72 percent

7

29) Employee plus employer contributions to a 401(k) are $15,000 per year. Equity funds are earning 15 percent, bond funds 8 percent, and money market funds 6 percent. The employee wants to retire as soon as possible with $1 million in retirement assets. If he puts 50 percent of his money in stocks, 30 percent in bonds, and 20 percent in money funds, how long until he can expect to retire?

A) 3.3 years B) 9.7 years C) 20.2 years D) 2.4 years E) 12.2 years

30) Which of the following statements are true about a traditional IRA? 1.I. Subject to an income limit, in 2019 a single person could contribute up to $6,000 per year ($7,000 if over 50 years old) of pretax income to an IRA. 2.II. All withdrawals are tax-free.

3.III. Earnings on the IRA account are not taxed until withdrawn.

4.IV. You must begin withdrawals at age 59½.

5.V. Withdrawal(s) can be a lump sum or installments.

A) I, II, IV B) I, II, IV, and V C) I, III, and V D) II, IV, and V E) III, IV, and V

31) Which of the following is/are true about a Roth IRA? 1.I. Contributions are tax deductible.

2.II. Qualified withdrawals after retirement are not taxed.

3.III. You must begin withdrawals at age 70½.

4.IV. Employers match contributions.

5.V. They are only available to individuals earning less than $50,000, or households earning less than $90,000.

8

A) I, II, and IV B) II, IV, and V C) I, III, and IV D) II only E) V only

32)

A retirement account specifically designed for self-employed persons is a:

A) Roth IRA. B) traditional IRA. C) Keogh.

D) Penny Benny.

E) public pension plan.

33)

Under ERISA the maximum time period allowed for vesting is

years.

A) three B) five C) eight D) 10 E) 15

34)

ERISA established all but which one of the following?

A) Prudent man rule B) Maximum vesting times C) Minimum funding requirements D) Insurance for pension plan participants E) Minimum payouts for defined contribution plans

9

35) The PBGC: 1.I. insures participants of defined benefit plans if plan funds are insufficient to meet contractual pension obligations.

2.II. insures participants of defined contribution plans if investment returns are insufficient to meet expected pension obligations.

3.III. regulates day-to-day pension fund operations.

A) I only B) II only C) I and III only D) II and III only E) I, II, and III

36) A defined benefit pension plan has expected payouts of $15 million per year for eight years and then $20 million per year over the following 15 years. Actuaries have estimated that the fund can be expected to earn an average of 5.25 percent on its assets. The fund currently has reserves of $185,475,000. The plan is by about million.

A) underfunded; $100 B) underfunded; $59 C) overfunded; $30 D) overfunded; $24 E) underfunded; $46

37) An employee contributes 6 percent of her salary to her 401(k) plan and her employer contributes another $1,900. The employee earns $75,000 and is in a 28 percent tax bracket. If the employee earns 8.50 percent on all funds invested each year and her salary does not change, how much will she have in her account in 20 years?

A) $195,369 B) $213,133 C) $244,667 D) $289,055 E) $309,613

10

38) Employee plus employer contributions to a 401(k) are $11,000 per year. Equity funds are earning 10 percent; bond funds, 5 percent; and money market funds, 3 percent. The employee will retire in 30 years. How much money will he have if he earns the average return from putting 65 percent of his money in equities, 30 percent in bond funds, and the rest in money market funds?

A) $1,838,526 B) $1,280,925 C) $1,654,320 D) $1,978,565 E) $1,248,550

39) You want to have $1,200,000 when you retire and you are in a defined contribution plan.

You can earn 9 percent per year on the money invested and you will retire in 25 years. Your employer also contributes to your plan. The employer will match contributions up to 4 percent of what you put into the plan each year. How much do you have to contribute per year to meet your goal?

A) $18,435.43 B) $17,654.87 C) $16,879.32 D) $13,622.60 E) $15,999.44

40)

Vesting refers to:

11

A) how long until an employee owns any employer contributions to the employee's pension plan.

B) how long until an employee can transfer any of his own contributions to a new plan if he switches jobs.

C) eligibility requirements to retire early.

D) restrictions on asset allocations within a defined contribution plan.

E) the extent to which an employee materially participated in a given business in a given year.

41)

IRAs are:

A) self-directed investment vehicles designed to provide supplemental retirement income.

B) corporate retirement plans for self-employed individuals and small businesses.

C) specific classes of investments such as equities or bonds issued by certain corporations.

D) investment vehicles created by ERISA. E) special types of life insurance policies.

42) A country where the link between public pension benefits and amount of taxes paid in is weak is:

A) Sweden.

B) Italy.

C) Great Britain.

D) Chile.

E) France.

43)

Social Security began running a deficit for the first time in what year?

12

A) 1990 B) 1995 C) 2000 D) 2005 E) 2010

44)

Social Security is a: A) fully funded pension plan.

B) federally insured private pension plan.

C) pay-as-you-go system.

D) government backed private pension plan.

E) overfunded pension plan.

45)

What is the main asset held by private pension funds?

A) Corporate bonds B) U.S. Government bonds C) Municipal bonds D) Corporate equities E) Money market securities

46)

In general, in a defined benefit pension plan, the risk of shortfall is borne by the ; while in a defined contribution pension plan, the risk of the shortfall is borne by the .

A) plan administrator; employee B) employee; employer C) employer; employee D) government; employer E) employer; government

13

47) Which of the following formulas is not used to determine pension benefits for defined benefit pension funds?

A) Flat-benefit formula B) Career-average formula C) Final-pay formula D) Career-contribution formula E) All of these choices are correct.

48)

Which of the following is not one of the principal features of ERISA?

A) Vesting of benefits B) Employee termination C) Fiduciary responsibility D) Transferability E) Funding

49) Your company sponsors a 401(k) plan into which you deposit 8percent of your $95,000 annual income. Your company matches 65percent of the first 10percent of your earnings. You expect the fund to yield 9percent next year. If you are cur-rently in the 30percent tax bracket, what is your one-year return?

A) 95.358% B) 64.136% C) 112.135% D) 135.518% E) 182.232%

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

50) Why do insured pension plans invest in less risky assets than uninsured pension plans?

14

51) A 55-year-old has just changed jobs and has a choice between a defined benefit plan (final pay) and a defined contribution plan. He will work for 10 more years. What should he consider in making his decision?

52) Suppose that a corporate defined benefit plan had decided it will keep pension fund reserves equal to the present value of expected future pension benefits to be fully funded. The plan has expected payouts of $12 million per year for 15 years and then $22 million per year for the subsequent 10 years. All payments are at year-end. At the current 5.75 percent rate of return on the plan's assets, the plan is currently fully funded. If the plan can increase the proportion of stock investments the fund holds and raise the expected rate of return to 8.00 percent, how many dollars of pension assets can be freed up by the corporation?

53) Why do employees increasingly prefer defined contribution plans to defined benefit plans?

54) You are 30 years old and you make $110,000 per year. You calculate that you cannot retire until you have accumulated a lump sum amount of $2,000,000 to live on after retirement.

You contribute 6 percent of your salary to your 401(k) and your employer matches contributions of up to 3 percent of your salary. You plan on investing 65 percent of your funds in equities on which you expect to earn an average rate of return of 10 percent, and the rest in bonds projected to earn 5 percent. If your salary does not grow, how old will you be when you can retire?

15

55) An individual is considering contributing $4,000 per year to either a traditional or a Roth IRA. Payments would begin in one year. If she uses the traditional IRA, her contributions would be fully deductible. She is 40 years old and is in a 28 percent tax bracket. On either IRA she can earn 7 percent. When she retires at age 65, she believes she will be in a 15 percent tax bracket.

Which type of IRA should she choose if she invests not only the $4,000 per year, but any tax savings due to the deductibility of her contributions in a taxable investment earning a pretax rate of 7 percent? She will withdraw all her money upon retirement and may owe taxes then, depending on the type of IRA chosen.

56) An individual is considering contributing $4,000 per year to either a traditional or a Roth IRA. Payments would begin in one year. If she uses the traditional IRA, her contributions would be fully deductible. She is 40 years old and is in a 28 percent tax bracket. On either IRA she can earn 7 percent. When she retires at age 65, she believes she will be in a 28 percent tax bracket.

Which type of IRA should she choose if she invests not only the $4,000 per year, but any tax savings due to the deductibility of her contributions in a taxable investment earning a pretax rate of 7 percent? She will withdraw all her money upon retirement and may owe taxes then, depending on the type of IRA chosen.

57) How is Social Security different from a private defined benefit plan? When and why is Social Security projected to become insolvent?

16

58) How sound is the PBGC? How much do firms pay for pension fund insurance? Describe the Pension Protection Act of 2006.

59)

What are the main provisions of ERISA?

60) How do public pension plans differ in other countries? Has privatization worked overseas?

17

Answer Key Test name: Chap 18_8e 1) TRUE 2) TRUE 3) FALSE 4) TRUE 5) TRUE 6) TRUE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) TRUE 12) TRUE 13) FALSE 14) FALSE 15) TRUE 16) C $25,000,000 × PVIFA (5.50%, 15 years) = $250,939,523.59 With a Financial Calculator: Input N = 15, I = 5.5, PMT = 25,000,000 and FV = 0 and calculate PV to get 250,939,523.59 17) C 18) B 19) D 20) C ($4,000 × 40)/(0.035 × 40) = $114,286

18

21) C (0.0375 × $95,000)/$3,000 = 1.19 22) B ($45,000 × 1.065)/(0.02 × 35) = $86,028.78 23) C 24) C It was 20 years before the law went into effect.

25) D 26) E 27) D 28) D FV1 = $90,000 × [9% + (40% × 6%)] × 1.10 = $11,286; Employee aftertax contribution = $90,000 × [9% × (1 − 28%)] = $5,832; HPR = ($11,286/$5,832) − 1 = 0.9352, or 93.52% 29) C Rate of return = (15% × 0.5) + (8% × 0.3) + (6% × 0.2) = 11.10%; $1,000,000/$15,000 = FVIFA (11.10%, N); solve for N with financial calculator or use log rule and annuity formula.

With a financial calculator: PMT = − 15,000, FV = 1,000,000, I = 11.10 and PV = 0 and solve for N to get 20.218.

30) C 31) D 32) C 33) D 34) E 35) A 36) E 19

$185.475million − [$15million × PVIFA (5.25%, 8) + $20 million × PVIFA (5.25%, 15)/PVIF (5.25%, 8)] = −$46.1 million With a financial calculator, use the CF functions to solve for the NPV of the fund: Input CF1 to CF8 = 15,000,000 and CF9 to CF23 = 20,000,000, then I = 5.25 and solve for NPV to get $231,534,937.

The fund is underfunded by $185,475,000 − $231,534,937 = $46,059,937 37) E [(6% × $75,000) + $1,900] × FVIFA (8.50%, 20) = $309,613 With a financial calculator: Input N = 20, I = 8.5, PMT = 6,400, PV = 0 to solve for FV 309,612.88.

38) B r = (65% × 10%) + (30% × 5%) + (5% × 3%) = 8.15%; FV30 = $11,000 × FVIFA (8.15%, 30) = $1,280,925.

With a financial calculator: Input N = 30, I = 8.15, PMT = 11,000, PV = 0 to solve for FV 1,280,924.83.

39) D $1,200,000/FVIFA (9 percent, 25 years) = $14,167.50 total annual payment required. Your contribution must be $14,167.50/1.04 = $13,622.60 With a financial calculator solve for the payment amount first: FV = 1,200,000, N = 25, I = 9, PV = 0 and solve for PMT to get 14,167.5. The employee’s contribution will be 14,167.50/1.04 = $13,622.60

20

40) A The book uses the word vesting in a different manner to refer to the time until one is eligible to receive any pension benefits.

41) A 42) E 43) E 44) C 45) D 46) C 47) D 48) B 49) E Your annual investment is: Employee’s gross contribution = $95,000 × 0.08 = Tax Savings = $7,600 × 0.30 = Employee’s net of tax cost Employer’s match = $95,000 × 0.65 × 0.10 = Total 401(k) investment at year’s start = $7,600 + $6,175 = Your one-year return is: 1-year earnings = $13,775 × 0.09 = Total 401(k) investment at year-end

$ 7,600 2,280 $ 5,320 $ 6,175 $ 13,775

$ 1,239.75 $ 15,014.75

Employee’s 1-year return = ($15,014.75 − $5,320)/$5,320 = 1.82232, or 182.232%

21

50) Insured pension plans are plans that are managed by insurance companies; pension plan assets are owned by the insurance company, not the pension plan. The life insurer promises to pay a rate of return to the plan and is liable for losses, which makes them leery of risk. In a noninsured plan, the fund owns its own assets and the fund advisers are often willing to take on more risk in hopes of earning a higher rate of return and thereby minimizing the corporate employer's required contribution.

51) He should consider the final pay formula, his expected salary over the final pay period, and whether that salary will keep up with and hopefully surpass inflation. For the defined contribution plan, the variables include his tax bracket, contribution amount by him and his employer, and rates of return offered in the markets. The amount of choice in asset allocation and the short length of time to invest may also be a factor. The individual's level of risk aversion would also play a part in the decision.

22

52) Current fund assets = [$12 million × PVIFA (5.75%, 15 years)] + [$22 million × PVIFA (5.75%, 10 years) × PVIF (5.75%, 15 years)] = $189,311,572.37 Assets required at 8% = [$12 million × PVIFA (8%, 15 years)] + [$22 million × PVIFA (8%, 10 years) × PVIF (8%, 15 years)] = $149,250,289.27 Assets freed up by rate change= $189,311,572.37 − $149,250,289.27 = $40,061,283 (Note: In the real world, actuaries have to approve rate changes. Actual calculations may be more complicated than this but this is a good time value example.)

With a financial calculator, use the CF functions to solve for the NPV of the fund when I = 5.75%.

Input CF1 to CF15 = 12,000,000 and CF16 to CF25 = 22,000,000, then I = 5.75 and solve for NPV to get 189,311,572.37.

Find the value of the fund when I = 8%.

Input CF1 to CF15 = 12,000,000 and CF16 to CF25 = 22,000,000, then I = 8.0 and solve for NPV to get 149,250,289.27.

The amount that can free up is the difference 189,311,572.37 − 149,250,289.27 = 40,061,283.10

23

53) Employees like the chance to manage their own retirement portfolios in hopes of earning more. The public is better educated about investments today than at any time in the past and employees wish to incur greater amounts of risk in the hope of earning higher retirement benefits than defined benefit plan sponsors can promise. The strong bull markets of the 1990s also significantly contributed to the interest in defined contribution plans in the past. The strong rebound in the stock market following the 2008–2009 financial crisis has also increased interest in these plans.

54) Employee contribution per year Employer match Total contribution per year

$ 6,600 = (6% × 110,000) $ 3,300 = (3% × 110,000) $ 9,900

Expected rate of return = (0.65 × 0.10) + (0.35 × 0.05) = 0.0825, or 8.25% $9,900 × [(FVIFA(8.25%, N)] = $2,000,000 N = 36.2 years so you will be 66.2 years old when you hit your retirement goal.

Expected return = (0.65 × 10%) + (0.35 × 5%) = 8.25% Employee contribution is 0.06 × 110,000 = 6,600 Employer contribution is 0.03 × 110,000 = 3,300 Total contribution = $9,900 With a financial calculator, input PMT = −9,900, I = 8.25, FV = 2,000,000, PV = 0 and solve for N to get 36.2. You will be 66.2 when you hit your retirement goal.

24

55) Traditional IRA + Taxable investment Amount invested per year is $4,000 Tax Savings = (0.28 × $4,000) = $1,120 The IRA earns 7%, and the taxable investment earns 7% × (1 − 0.28) = 5.04% after tax.

After-tax future value of the IRA + Future value of the invested deductions (after tax): [$4,000 × (FVIFA7%, 25year) × (1− 0.15)] + [$1,120× (FVIFA5.04%, 25year)] = $215,046.73 + $53,750.08 = $268,796.81 With a financial calculator, first find the after-tax value of the IRA: Input PMT = 4,000, N = 25, I = 7, PV = 0 and solve FV to get $252,996.15 and on an after-tax basis $252,996.15 × (1 − 0.15) = $215,046.73 Second, find the future value of the after-tax deductions: input PMT = 1,120, N = 25, I = 5.04, PV = 0 and solve FV to get 53,750.08.

The after-tax future value of the IRA + Future value of the invested deductions (after tax): $215,046.73 + $53,750.08 = $268,796.81 Roth IRA: $4,000 × (FVIFA7%, 25year) = $252,996.15 The expected FV of the Roth IRA is less than the expected FV of the traditional IRA plus the invested tax savings, so she should choose the traditional IRA and invest the tax savings.

25

Find the future value of Roth contributions: input PMT = 4,000, N = 25, I = 7, PV = 0 and solve FV to get $252,996.15.

26

56) Traditional IRA + Taxable investment Amount invested per year is $4,000 Tax Savings = (0.28 × $4,000) = $1,120 The IRA earns 7%, and the taxable investment earns 7% × (1 − 0.28) = 5.04% after tax.

After-tax future value of the IRA + Future value of the invested deductions (after tax): [$4,000 × (FVIFA7%, 25year) × (1 − 0.28)] + [$1,120 × (FVIFA5.04%, 25year)] = $182,157.23 + $53,750.08 = $235,907.31 With a financial calculator, first find the after-tax value of the IRA: input PMT = 4,000, N =25, I = 7, PV = 0 and solve FV to get $252,996.15 and on after-tax basis $252,996.15 × (1 − 0.28) = $182,157.23 Second, find the future value of the after-tax deductions: input PMT = 1,120, N = 25, I = 5.04, PV = 0 and solve FV to get 53,750.08.

The after-tax future value of the IRA + Future value of the invested deductions (after tax): $182,157.23 + 53,750.08 = $235,907.31 Roth IRA: $4,000 × (FVIFA7%, 25year) = $252,996.15 Find the future value of Roth contributions: input PMT = 4000, N = 25, I = 7, PV = 0 and solve FV to get $252,996.15.

The expected FV of the Roth IRA is greater than the expected FV of the traditional IRA plus the invested tax savings, so she should choose the

27

Roth IRA. (Note the break-even tax rate is about 21.25 percent in retirement; above this rate you would prefer the Roth IRA and below it you would prefer the standard IRA.) 57) Social Security is a "pay as you go" plan that has not been required to maintain fund reserves to meet expected future payouts the way that private defined benefit plans are. Social Security will be imperiled because longer life spans mean more payouts, fewer workers, and an increasing number of retirees as the population ages, which means that the plan will not generate sufficient revenue to meet planned payouts.

According to current data and estimates, the plan began facing shortfalls in 2010 and will go bankrupt in 2034.

58) In 2012 and 2013, underfunded pension liabilities for singleemployer plans were $823 billion and $759 billion respectively, the largest up to those dates. As of 2019, the PBGC was responsible for the pensions of approximately 1,500,000 people from more than 4,900 failed single-employer plans. The PBGC does not have the resources it needs and generally operates at a deficit. The Pension Protection Act of 2006 required an increase in premiums from $19 to $30 for fully funded plans and larger cost increases for underfunded plans tied to the amount of underfunding. As of 2019, premiums have been increased to $80 ($29) per participant for single-employer (multi-employer) plans.

Underfunded pension plans incur an additional variable charge of $43 per $1,000 of unfunded vested benefits. Disclosure to employees about the extent of the deficit is also required and firms are now required to reduce the underfunding over five years rather than over 20 years as was the case before the law.

28

59) Funding requirements for defined benefit plans; maximum time to vesting of benefits; prudent man rule establishment; transferability of pension credits from plan to plan; insurance provided by the Pension Benefit Guarantee Corporation (PBGC).

60) In Europe, some countries do not have a strong link between the amount paid in and the benefit received, notably France and Germany, and their pension plans are having funding difficulty. Other countries like Italy, Britain, and Sweden have tied benefits more closely to contributions. Britain and Sweden have partially privatized their public pensions with some success. Chile has successfully privatized their pension program. Tying benefits to contributions and the trend toward privatization help keep spending down as a percent of GDP.

29

Chapter 19: Fintech Companies TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) As of 2020, global venture capital backed fintech funding reached $35 billion. ⊚ ⊚

2)

true false

The average fintech adoption rate has steadily declined in recent years. ⊚ ⊚

true false

3) In 1865, a device known as the telegraph was invented by Giovanni Caseli and is now widely regarded as the first step in the journey towards fintech. ⊚ ⊚

true false

4) In 1918, the Fedwire was established by the Federal Reserve Banks to transfer funds and connect all 12 Reserve Banks by telegraph using the Morse code-based system. ⊚ ⊚

true false

5) In an environment of declining interest rates, financial institutions generally have a decreased incentive to focus on cost-cutting measures. ⊚ ⊚

true false

6) The global financial crisis of 2008 led to heightened sensitivity around protection of personal data and hindered the growth of fintechs. ⊚ ⊚

true false

1

7)

The rise of fintechs has led some to question whether banks will exist in the future. ⊚ ⊚

8)

true false

Fintechs carry the disadvantage of heavy regulation. ⊚ ⊚

true false

9) In comparing fintechs to banks, one of the main differences is that fintechs are agile and flexible due to their very low capital requirements whereas banks have very intricate capital structures. ⊚ ⊚

true false

10) Within the payments, clearing and settlement category, retail payment services firms represented the majority of fintech firms identified in an informal survey of the BCBS members. ⊚ ⊚

11)

true false

As of 2018, Square Cash had the most active accounts of any peer-to-peer payment app. ⊚ ⊚

true false

12) Credit scoring is a way of raising money through the collective effort of family, friends, individual investors, and customers. ⊚ ⊚

true false

13) A fintech charter is a special-purpose bank charter for non-bank fintech companies to operate in the banking system providing preemption from many state laws.

2

⊚ ⊚

true false

14) General Data Provided Recognition (GDPR) is the world’s strongest set of data protection rules. ⊚ ⊚

true false

15) The Payment Services Directive 2 is regulation established to make payments more secure in Europe, boost innovation, and help services adapt to new technologies. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) What measures the fintech users as a percentage of the digitally active population?

A) Fintech scale B) Fintech data usage C) Fintech popularity score D) Fintech ace rating E) Fintech adoption rate

17) The Financial Stability Board defines fintech as “technology-enabled innovation in financial services that could result in new business models, applications, processes or products with an associated effect on the provision of financial services.”

A) undeterminable B) minor C) moderate D) material E) negative

3

18)

Open Banking standards do all but which of the following?

A) Make it possible to pass on information to third parties B) Eliminate all risk in the online banking system C) Streamline access to bank data D) Make it easier to find banks with disabled access E) Enable comparison of the features of different personal and business accounts

19) Open Banking and PSD2 have catalyzed the development of financial APIs to help incumbent banks comply and compete.

which provide

A) recourse networks B) adjoined fintechs C) discoverable networks D) fintech utilities E) unstructured fintechs

20) are online services that use algorithms to automatically perform many investment tasks done by a human financial advisor.

A) Fintechs B) Copier traders C) Computer drones D) Investment techs E) Robo-advisors

21) Which of the following regarding banking-as-a-service is/are true?

1.I. It has restricted the financial transparency options for account holders.

2.II. It is an end-to-end process that allows fintechs and other third parties to connect with banks’ systems directly via APIs. 3.III. The process begins with a fintech or other third-party provider paying a fee to access the platform.

4

A) I only B) II only C) II and III only D) I and II only E) I, II, and III

22) The advantages of the establishment of the NASDAQ include which of the following?

1.I. It helped reduce the bid-ask spread.

2.II. It ended fixed securities commissions.

3.III. It led to the proliferation of ATMs.

A) I only B) II only C) II and III only D) I and II only E) I, II, and III

23) The number of bank branches in the U.S. grew steadily from approximately 1948 to over in 2008.

in

A) 575; 900 B) 1,995; 33,450 C) 4,200; 82,400 D) 5,000; 100,000 E) 8,000; 125,000

24) The , which was first released in June 2007, is attributed with launching the mobile revolution.

5

A) PayPal app B) iPhone C) Android D) USB E) NASDAQ

25) Which of the following is not one of the advantages that retail banks maintain over fintechs?

A) Banks have tens of millions of trusting customers who interact with them daily.

B) The cost of capital for banks is close to zero.

C) Banks have decades of compliance experience.

D) Banks have more experienced legal teams.

E) Banks are known for having greater agility and a more innovative mindset.

26)

Which of the following is true regarding the digital crypto exchange platforms?

A) Crypto-to-crypto exchanges are the most easy to establish of the platforms.

B) An investor cannot lose his/her entire investment in a cryptocurrency exchange.

C) Due to regulation, fiat exchanges have limited trading pairs.

D) If an individual wishes to buy a niche altcoin, then he/she must purchase insurance.

E) Crypto exchanges create systems that hinder stability in the blockchain ecosystem.

27) A is an application that runs exactly as programmed without any possibility of downtime, censorship, fraud, or third-party interference.

A) hyperledger B) no-fault contract C) smart contract D) robo-advisor E) tested contract

6

28) In 1966, the replaced the communication of information.

as the standard for long-distance instantaneous

A) telex network; telegraph B) telegraph; telex network C) telex network; telephone D) telephone; telegraph E) internet; telegraph

29) The financial crisis of 2008 eventually led to the growth of fintech. Which of the following is a true statement regarding this causal relationship?

A) Mobile technology retreated due to the crises, which allowed banks to regain footing and resulted in fintech companies exiting the marketplace.

B) Deregulation led to more banks competing and fewer, newly-established fintechs having success in the marketplace.

C) The high interest rate environment put upward pressure on profits, which decreased the incentive for fintech companies to enter the marketplace.

D) The pullback of banks during the crises was due to increases in regulatory burdens and risk aversion, which allowed new fintech players to enter the marketplace.

E) Subprime mortgages defaulted, which led to fintech companies retreating from the marketplace.

30)

By 2019, global smartphone penetration reached:

A) 53.8 percent.

B) 60.9 percent.

C) 66.9 percent.

D) 72.2 percent.

E) 77.6 percent.

31) In 2011, the introduction of Google Wallet (which later became Google Pay) allowed consumers to use smartphones equipped with near-field communication chips to make: 7

A) hit payments.

B) calls to banks.

C) instapayments.

D) bump transfers.

E) tap payments.

32) In a 2015 survey of global CEOs by PwC, percent of the executives surveyed believed that some part of their business was at risk to fintech.

A) 66 B) 76 C) 79 D) 84 E) 95

33) The launch of Marcus by Goldman Sachs is an example of which stage of the evolving relationship between banks and fintech?

A) The “rent a bank” stage.

B) Banks taking stake in fintech startups.

C) Fintech firms providing technology and infrastructure to banks.

D) Banks developing in-house fintech arms.

E) Banks divesting fintech arms.

34) The development of the relationship between Marlette Funding and Cross River Bank is an example of which stage of the evolving relationship between banks and fintech?

A) The “rent a bank” stage.

B) Banks taking stake in fintech startups.

C) Fintech firms providing technology and infrastructure to banks.

D) Banks developing in-house fintech arms.

E) Banks divesting fintech arms.

8

35) The partnership of Avant and Regions Bank to underwrite unsecured loans is an example of which stage of the evolving relationship between banks and fintech?

A) The “rent a bank” stage.

B) Banks taking stake in fintech startups.

C) Fintech firms providing technology and infrastructure to banks.

D) Banks developing in-house fintech arms.

E) Banks divesting fintech arms.

36) BNP Paribas’ acquisition of Compte-Nickel is an example of which stage of the evolving relationship between banks and fintech?

A) The “rent a bank” stage.

B) Banks taking stake in fintech startups.

C) Fintech firms providing technology and infrastructure to banks.

D) Banks developing in-house fintech arms.

E) Banks divesting fintech arms.

37)

Since gaining a high level of interest in 2015, the interest in

has cooled.

A) wealth management B) mobile wallets C) cryptocurrency D) blockchain E) real estate investment

38)

The two main monetization strategies of BaaS include:

9

A) advertising to users and charging a la carte for each service used.

B) charging clients a monthly fee and charging a la carte for each service used.

C) charging clients a monthly fee and advertising to users.

D) charging clients a daily fee and advertising to users.

E) charging clients a daily fee and charging a la carte for each service used.

39) Based on the BCBS survey discussed in the text, the category with the highest number of providers was which of the following?

A) Payments, clearing and settlement services B) Credit, deposit and capital-raising services C) Investment management services D) Market support services

40) Bitcoin and other digital currencies are underpinned by technology, which is an electronic ledger or database that records and verifies transactions made using the currency.

A) hidden matrix B) complex drafting C) bitmap D) distributed ledger E) ethercode

41) The 2018 Cryptocurrency Crash rocked the crypto market. Experts said that this dramatic drop was due largely to the speculative nature of cryptocurrency and point out that cryptocurrency differs from money on three main accounts. Which of the following are noted as the main differences?

1.I. Cryptocurrency is not a good means of payment.

2.II. Cryptocurrency is not a good unit of account.

3.III. Cryptocurrency cannot be held as an investment.

4.IV. Cryptocurrency is not a suitable store of value.

10

A) I and IV only B) I and II only C) II, III, and IV only D) I, II, and IV only E) All are noted as differences.

42) is a particular type of DLT that organizes data into batches of transactions which are held together in an append-only data structure.

A) Starform B) Bitcoin C) Blockchain D) Treasurystock E) Walletpay

43) DLT can be found on the capital markets infrastructure value chain in all but which of the following?

A) Trade execution B) Bid-ask spread setting C) Post-trade services D) Operations and technology E) Access to capital

44) The application of computational tools to address tasks traditionally requiring human sophistication is broadly termed:

A) smart contracting.

B) cryptocurrency.

C) robo-advising.

D) artificial intelligence.

E) digital distribution.

11

45) In 2017, former Citigroup chief Vikram Pandit predicted that jobs could be wiped out by artificial intelligence by 2022.

percent of banking

A) 15 B) 25 C) 30 D) 35 E) 45

46) The term refers to the billions of physical devices around the world that are now connected to the internet, all collecting and sharing data.

A) worldwide web B) intermatrix C) internet-of-things D) web-of-goods E) internet marketplace

47)

The OCC fintech charter would do all but which of the following?

A) Allow non-bank fintech companies to become special purpose national banks B) Allow non-bank fintech companies to pay checks C) Allow non-bank fintech companies to lend money D) Allow non-bank fintech companies to take deposits E) Allow non-bank fintech companies to be preempted from state laws

48) In September 2018, Bank of Lithuania launched its regulatory sandbox seeking fintech startups, which enabled startups to obtain an e-money or payment license in , which is two to three times faster than in other EU jurisdictions.

12

A) 15 days B) 30 days C) 45 days D) 60 days E) 90 days

49) The Payment Services Directive 2 (PSD2) is a European regulation for electronic payments services. The purpose of the PSD2 is to regulate the emerging payment services industry and increase competition by:

A) allowing investors to enter the market.

B) allowing participation by non-banks.

C) providing a way for stock traders to trade cryptocurrency.

D) reducing restrictions on data privacy.

E) eliminating the central banking system structure.

50)

In Europe, a fintech can get access to all bank APIs through registering as either an or a .

A) AISP; PISP B) EEIC; PPPE C) IOT; GDPR D) AISS; PSD2 E) IOT; TAB

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) Discuss the demand factors that have led to the growth in fintechs.

13

52) Though fintechs are growing in popularity, why might banks still remain relevant in the evolving financial atmosphere?

53) Why might digital ledger technology (DLT) be beneficial to the financial industry? What impact may DLT have on transparency? Are there any risks to DLT?

54)

Discuss the use cases for artificial intelligence (AI) and machine learning.

55) What are the supply factors that have led to the growth in fintechs? Briefly describe each factor and its role in the emergence of fintechs.

56) Why are some critics cautious of cryptocurrency as a substitute for money? Are their concerns justified?

57) What is the internet-of-things and what has been the easiest “win” for banks in this area thus far?

14

58) Why has high frequency trading (HFT) lost favor over the past few decades? What implications does the HFT evolution have for fintechs?

59) What is a regulatory sandbox and how have regulatory sandboxes been introduced globally in the past few decades?

60) Explain the European Union (EU) regulations: Payment Services Directive 2 (PSD2) and General Data Protection Regulation (GDPR). How are fintechs impacted by the regulations?

15

Answer Key Test name: Chap 19_8e 1) TRUE 2) FALSE 3) FALSE 4) TRUE 5) FALSE 6) FALSE 7) TRUE 8) FALSE 9) FALSE 10) TRUE 11) FALSE 12) FALSE 13) TRUE 14) FALSE 15) TRUE 16) E 17) D 18) B 19) D 20) E 21) C 22) D 23) C 24) B 25) E 26) C 16

27) C 28) A 29) D 30) C 31) E 32) B 33) D 34) A 35) C 36) B 37) D 38) B 39) A 40) D 41) D 42) C 43) B 44) D 45) C 46) C 47) D 48) E 49) B 50) A

17

51) There are two main demand factors that have led to the growth in fintechs: 1.1. The increasing prevalence of mobile technology.

Smartphones and apps have enabled consumers to have a bank at their fingertips. It also has led to penetration in countries all over the world, including developing nations.

2.2. Changing demographics. Millennials became the largest generation in the labor force as of 2016. As a result, the financial, economic, and sociopolitical prominence of the millennials is growing rapidly. Millennials have grown up using technology and are optimistic about its uses.

52) Retail banks maintain a hold in the industry as a result of three main factors, often referred to as the “big Cs”: customers, compliance, and capital. Compared to fintechs, banks have tens of millions of customers, decades of compliance experience and trusted legal teams, and a cost of capital that is close to zero. Fintech companies are still relatively new and untested. Fintechs also generally have much higher cost because of their capital funding structures.

18

53) Advantages of DLT include: ● Reduction in complexity. ● Improvement of end-to-end processing speed and thus availability of assets and funds. ● Reduction in the need for reconciliation across multiple recordkeeping infrastructures. ● Increase in transparency and immutability in transaction record keeping. ● Improvement in network resilience through distributed data management. ● Reduction in operational and financial risks.

DLT may aid in market transparency as information on the ledger is shared with participants, authorities, and other stakeholders.

Risks of DLT include: ● Potential uncertainty about operational and security issues arising from the technology. ● The lack of interoperability with existing processes and infrastructures. ● Ambiguity relating to settlement finality. ● Questions regarding the soundness of the legal underpinning for DLT implementations. ● The absence of an effective and robust governance framework. ● Issues related to data integrity, immutability, and privacy.

19

54) There are several potential use cases discussed in the text. They include: ● FIs and vendors are using AI and machine learning methods to assess credit quality, to price and market insurance contracts, and to automate client interaction. ● FIs are optimizing scarce capital with AI and machine learning techniques, as well as back-testing models and analyzing the market impact of trading large positions. ● Hedge funds, broker-dealers, and other firms are using AI and machine learning to find signals for higher and uncorrelated returns and to optimize trading execution. ● Both public and private sector institutions may use these technologies for regulatory compliance, surveillance, data quality assessment, and fraud detection.

55) There are two main supply factors that have led to the growth in fintechs: 1.1. The global financial crisis of 2008. The crisis left the brand image of banks fractured. Banks faced added regulatory burdens and developed heightened risk aversion, leading them to retreat from some lending activities. This allowed newer fintech players to enter the market. Fintechs used innovative technologies that overcame some of the advantages held by incumbent banks.

2.2. Changing macroeconomic conditions. This was made most evident by the low interest rate environment that put downward pressure on profits and increased cost-cutting at incumbent banks. The use of technology by fintechs helped them to streamline processes thereby reducing costs.

20

56) As discussed in the text, the general manager of BIS, Agustin Carstens, is skeptical of cryptocurrencies because they do not fulfill the three purposes of money: to serve as payment, to establish a unit of account, and to store value. These concerns seem to be justified because the value of cryptocurrencies fluctuates so rapidly that it would be difficult to establish an asset’s value. Imagine if the price of each item at the grocery store changed value instantaneously throughout the day. It seems that a reduction in speculation regarding cryptocurrency and an increase in stability of cryptocurrency is needed before it can seriously be considered as a replacement for money.

57) The internet-of-things encompasses everything connected to the internet, but, particularly, how these things talk to each other. It refers to the billions of physical devices around the world that are connected to the internet and share data. Connecting all of these devices and adding sensors to them provides digital intelligence and real-time data without having to involve humans. The easiest “win” so far for banks has been in the wearables space. The growth in this space has been huge and there is relatively low cost for consumers to get started using them. Many banks now offer apps that are compatible with the wearable devices and some banks have even launched their own devices.

21

58) High frequency trading has enabled very rapid placements of buy and sell orders, with some trades being made in micro-seconds. As of 2005, HFT accounted for 21 percent of all U.S. equity market volume but grew to 61 percent by 2009, before dropping back to only 50 percent by 2018. The recent decrease in HFT popularity led to some companies exiting the market altogether. Proprietary trading companies are finding it increasingly difficult to compete on speed alone and there is little else that can differentiate them. This trend may foreshadow the fintech environment. Because customers have access to many competing companies at their fingertips, fintechs will have to find unique ways to differentiate themselves to avoid facing the same fate as HFT companies.

59) A regulatory sandbox is a framework set up by a financial regulator to allow early-stage fintech startups to test out their offerings in a controlled environment under the regulator’s supervision. The first regulatory sandbox was launched by the UK Financial Conduct Authority in 2015. There are now sandboxes that are in development across Hong Kong, Australia, Indonesia, Malaysia, Singapore, Switzerland, Thailand, and United Arab Emirates. In 2018, Arizona became the first U.S. state to launch a sandbox.

22

60) PSD2 is a regulation for electronic payment services. It seeks to make payments more secure in Europe, boost innovation, and help banking services adapt to new technologies. GDPR is the world’s strongest set of data protection rules, which enhance how people can access information about them and places limits on what organizations can do with personal data. PSD2 has greatly benefited fintechs because it regulates the emerging payment services industry and increases competition by allowing participation of fintechs. The primary purpose of GDPR is to protect consumer data. Heightened protection measures make it easier for fintechs to gain trust among consumers. By gaining trust and requiring an opt-in model for data collections, the GDPR will increase the amount of data available which will benefit fintechs in determining usage patterns and aiding in their development of new products targeted at their consumer base.

23

Chapter 20: Types of Risks Incurred by Financial Institutions TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) The risk that an FI may not have enough capital to offset a sudden decline in the value of its assets is called operational risk. ⊚ ⊚

true false

2) Risk arising from unhedged positions in securities, currencies, and derivatives is called market risk. ⊚ ⊚

true false

3) Loan charge-offs do not lead to insolvency risk because when loans are written off both loans and liabilities are reduced. ⊚ ⊚

4)

true false

Maintaining a diversified loan portfolio helps a bank reduce systematic credit risk. ⊚ ⊚

true false

5) A corporate borrower failing to repay a loan on time due to equipment breakdowns is an example of firm specific credit risk. ⊚ ⊚

6)

true false

The subprime crisis is a good example of the credit risk faced by financial institutions. ⊚ ⊚

true false

1

7) Many intermediaries, such as banks, cannot be asset transformers and match maturities of their assets and liabilities at the same time. ⊚ ⊚

true false

8) A bank that has made floating rate loans funded by longer-maturity deposits is at risk from falling interest rates. ⊚ ⊚

true false

9) Rising interest rates decrease the value of fixed-income assets and increase the value of fixed-income liabilities. ⊚ ⊚

true false

10) A U.S. bank has £900 million in loans it has made to corporate customers and it has £750 million in deposits when the exchange rate is £1 = $1.98. The bank will have a net foreign exchange loss on these accounts if the exchange rate moves to £1 = $1.95. ⊚ ⊚

true false

11) Assets in a bank's trading book tend to be held for a longer time than assets held in the banking book. ⊚ ⊚

true false

12) A U.S. bank has £700 million in loans it has made to corporate customers and it has £850 million in deposits. The net foreign exchange exposure from these accounts may be hedged by selling 150 million pounds forward. ⊚ ⊚

true false

2

13) Breakdowns of ATMs and fraudulent use of information stored on a bank's computer system are examples of operational risk. ⊚ ⊚

14)

true false

Nationalization of private financial institutions is an example of sovereign risk. ⊚ ⊚

true false

15) Reinvestment risk occurs when a financial institution holds longer-term assets relative to liabilities and faces uncertainty about the interest rate at which it can reinvest funds borrowed over a longer period. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

16) A bank has total assets of $620 million and $68.2 million in equity. The managers of the bank realize that $18.6 million of its $372 million loan portfolio will not be repaid. After the bank charges off these unexpected bad loans, the bank's equity to asset ratio will be .

A) 11.00 percent B) 10.64 percent C) 9.77 percent D) 8.25 percent E) 8.00 percent

17) The risk that an unanticipated increase in liability withdrawals may cause an FI to have to sell assets at fire sale prices is an example of:

3

A) credit risk.

B) liquidity risk.

C) interest rate risk.

D) sovereign risk.

E) technology risk.

18)

Interest rate risk is probably greatest at which of the following intermediaries?

A) Commercial banks B) Savings institutions C) Life insurers D) Pension funds

19) Second Bank now offers web banking services. Last week a computer glitch posted all web deposit transfers to the wrong accounts. This is an example of:

A) credit risk.

B) liquidity risk.

C) stupidity risk.

D) technological risk.

E) operational risk.

20) MONDEX spent $50 million to develop the Smart Card, but tests of prototypes in New York and Canadian cities revealed very little consumer interest. This is an example of:

A) credit risk.

B) liquidity risk.

C) stupidity risk.

D) technological risk.

E) operational risk.

4

21) Rank order the net charge-off rates from high to low for the following loan types: 1.I. C&I loans 2.II. Credit card loans 3.III. Real estate loans

A) I, II, III B) I, III, II C) II, I, III D) II, III, I E) III, I, II

22) Repurchase agreements (repos) are used extensively to finance security holdings. In 2007, many investment banks and other financial institutions were unable to roll over their maturing repurchase agreements during the subprime mortgage crisis. This inability to get new repo financing is an example of:

A) credit risk.

B) liquidity risk.

C) sovereign risk.

D) technological risk.

E) operational risk.

23) A thrift makes long-term fixed-rate mortgages funded with short-term deposits and then interest rates rise. Which of the following is true?

A) Profitability would decline B) Profitability would increase C) The market value of equity increases D) Interest income would fall E) Profitability and market value of equity increase

5

24) In year one, a bank facing reinvestment risk earns 11 percent on its assets and pays 10 percent on its liabilities. In year two, the bank had a negative profit spread of 100 basis points.

Which of the following is true? In year two,

A) rates rose 100 basis points.

B) rates rose 200 basis points.

C) rates fell 100 basis points.

D) rates fell 200 basis points.

E) None of these options are correct.

25)

For most financial institutions, present value uncertainty is the risk that:

A) the market value of an asset (liability) will decline if interest rates increase.

B) interest income will rise by more than interest expense when rates increase.

C) assets will be insufficient to cover loan losses.

D) bank capital will be insufficient to cover loan losses.

E) real interest rates will exceed nominal rates.

26)

In October 2005, the Bankruptcy Reform Act was signed into law. This law primarily:

A) made it easier for many debtors to receive bankruptcy protection.

B) made it more difficult for many debtors to receive bankruptcy protection.

C) applied only to corporations.

D) applied only to corporations and financial institutions.

E) made it easier for foreign debtors to seek debt relief under U.S. law.

27) A bank has book value of $5 million in liquid assets and $95 million in nonliquid assets.

Large depositors unexpectedly withdraw $9.5 million in deposits. To cover the withdrawals the bank sells all of its liquid assets at book value. To raise the additional funds needed the bank sells the necessary amount of nonliquid assets at 80 cents per dollar of book value. As a result, the bank's equity will .

6

A) remain unchanged B) fall $4.5 million C) fall $3.6 million D) fall $1.4 million E) fall $5.0 million

28) Which of the following would normally be banking book assets rather than trading book assets?

A) Long position in Gold B) Short position in bonds C) FX forward contracts D) Long-term loans E) Options on interest rates

29) A bank has on-balance-sheet assets with a book value of $940 million and a market value of $985 million and on-balance-sheet liabilities with a book value of $900 million and a market value of $930 million. The bank also has off-balance-sheet assets currently valued at $150 million and off-balance-sheet liabilities worth $160 million. Stockholders’ net worth should be valued at million.

A) $30 B) $40 C) $45 D) $50 E) $55

7

30) The £ is worth 1.2569 euros and the euro is worth $1.5568. Statistical analysis indicates that when the euro rises 1 percent against the dollar, the pound rises 0.5 percent against the euro and vice versa. A U.S. bank has assets of £40 million that mature in one year funded with liabilities of €55 million due in six months. The bank would be hurt by: 1.I. an increase in the value of the euro against the dollar.

2.II. a decrease in the value of the euro against the dollar.

3.III. an increase in euro interest rates relative to pound interest rates.

4.IV. an increase in pound interest rates relative to euro interest rates.

A) I only B) I and II only C) I and III only D) II and IV only E) II and III only

31) Argentina has refused to pay loans made to it by foreign institutions three times. This is an example of:

A) operational risk.

B) liquidity risk.

C) foreign exchange risk.

D) sovereign risk.

E) insolvency risk.

32) A bank invests $250 million to add the ability to provide online bill paying for its customers. Usage of the new service is at about 50 percent of expected usage. This is an example of:

A) technological risk.

B) operational risk.

C) market risk.

D) credit risk.

E) derivative risk.

8

33)

CHIPS and ACH are:

A) potato products of Frito-Lay. B) check clearing systems run by the Federal Reserve.

C) retail payment systems used in Europe.

D) international bank regulators.

E) wholesale electronic payment systems.

34)

The terrorist attacks on the World Trade Center in 2001 are an example of .

A) regulatory risk B) liquidity risk C) credit risk D) insolvency risk E) event risk

35) Having longer-maturity assets than liabilities causes banks to bear which of the following risks? 1.I. Interest rate risk 2.II. Liquidity risk 3.III. Credit risk

A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III

36) the

Regulators’ overall evaluation of the riskiness of a depository institution is measured by .

9

A) Basel Accord B) CRA rating C) CAMELS rating D) Exposure scale E) FFIEC score

37) The Fed allowed nonbank financial institutions to borrow money from the discount window during the mortgage crisis and even allowed nonbanks to swap mortgages for Treasury securities. This was an attempt by the Fed to reduce at institutions.

A) operational risk B) technological risk C) liquidity risk D) foreign exchange risk E) diversifiable risk

38) A bank has invested in U.S. Treasury investments that mature in two years. They will be held until maturity. The investments are funded with three-year maturity time deposits. The primary risk this bank faces is:

A) refinancing risk.

B) reinvestment risk.

C) liquidity risk.

D) credit risk.

E) off-balance-sheet risk.

39)

If a bank is exposed to refinancing risk, its profitability is reduced if interest rates and if it is exposed to reinvestment risk, its profitability is reduced if interest rates .

10

A) rise; fall B) rise; rise C) fall; rise D) fall; fall E) rise; stay the same

40) Which one of the following intermediaries is likely to engage in more asset liability maturity matching?

A) Banks B) Savings associations C) Savings banks D) Life insurers

41) A guarantee issued by an FI that obligates the FI to pay if the purchaser of the letter defaults on a debt is called a

A) loan commitment.

B) forward rate agreement.

C) credit swap agreement.

D) collar.

E) None of these options are correct.

42) In May 2007, the largest known credit card theft was discovered when it was revealed that 200 million card numbers were stolen from TJX Company. This is an example of:

A) credit risk.

B) operational risk.

C) liquidity risk.

D) technological risk.

E) regulatory risk.

11

43) If a bank invested $75 million in a two-year asset paying 12 percent interest per year and simultaneously issued a $75 million one-year liability paying 10 percent interest per year, what would be the net interest income in two years if, at the end of the first year, all interest rates increased by 1.5 percentage points?

A) Decrease by $0.725 million B) Decrease by $1.125 million C) Increase by $1.875 million D) Increase by $0.725 million E) Decrease by $0.385 million

44) Suppose you purchase a 10-year AAA-rated British bond for par that is paying an annual coupon of 9 percent and has a face value of 1,000 British Pounds (£). The spot rate is US$1.105 for £. At the end of the year, the bond is downgraded to AA and the yield increases to 11 percent.

In addition, the new spot rate becomes US$0.985 for £.

What is the loss or gain to a British investor who holds this bond for a year?

A) 11.07% loss B) 7.14% loss C) 5.32% loss D) 2.07% loss E) 1.08% loss

45) Suppose you purchase a 10-year AAA-rated British bond for par that is paying an annual coupon of 9 percent and has a face value of 1,000 British Pounds (£). The spot rate is US$1.105 for £. At the end of the year, the bond is downgraded to AA and the yield increases to 11 percent.

In addition, the new spot rate becomes US$0.985 for £.

What is the loss or gain to a U.S. investor who holds this bond for a year?

12

A) −11.28% loss B) −10.14% loss C) −15.32% loss D) −8.71% loss E) −12.71% loss

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

46) Why do banks continue to make credit card loans even though credit card default rates are often at least twice as high as other loan types?

47) A bank has $150 million in one-year loans earning a fixed rate equal to 4.75 percent. The assets are funded by $150 million in liabilities that have a cost of 4.25 percent and a maturity of three years. If all interest rates are projected to fall 100 basis points by next year, by how much will the bank's profits and loan NIM change in year 2? Does this bank face refinancing risk or reinvestment risk? Explain.

48) In general terms explain why certain types of derivatives such as options, futures, swaps, and other exotic contracts can generate such catastrophically large losses and even insolvency for users at times. Does this mean that corporate or institutional use of derivatives should be limited or otherwise regulated? Explain.

49)

Should regulators of FIs be concerned about the increased trading activity of FIs?

13

50) Why would an FI be willing to issue a letter of credit guarantee to a municipal bond issuer?

51)

How does foreign exchange risk arise for an FI?

52) What is sovereign risk? How is this different from credit risk on a domestic loan? How can sovereign risk be limited?

53) What are the three major objectives of technological investments at FIs? What are the major risks involved with these investments?

54) What is insolvency risk? How can liquidity risk and credit risk cause insolvency? What are the two best protections against insolvency at an FI?

14

55) Characterize each of the following according to the type of risk it primarily represents: 1.I. Loan default 2.II. Unexpected deposit withdrawals 3.III. Losses on foreign currency holdings 4.IV. Losses on standby letters of credit 5.V. Reduction in earnings after an interest rate increase 6.

Indicate which of the risks could cause insolvency of the FI.

15

Answer Key Test name: Chap 20_8e 1) FALSE 2) TRUE 3) FALSE 4) FALSE 5) TRUE 6) TRUE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) FALSE 12) FALSE 13) TRUE 14) TRUE 15) FALSE 16) D ($68.2 million − $18.6 million)/($620 million − $18.6 million) = 0.0825, or 8.25% 17) B 18) B 19) E 20) D 21) C 22) B 23) A

16

24) D 25) A 26) B 27) C ($9.5 million − $5 million) × 80% = $3.6 million 28) D 29) C ($985 million + $150 million) − ($930 million + $160 million) = $45 million 30) C The euro value of the assets = £40 × 1.2569 = €50.276 million, so the bank has a net euro liability exposure that puts it at risk from an increase in the value of the euro against the dollar. Because the pound assets mature in one year and the euro liabilities mature in six months, the bank is at risk from rising euro interest rates relative to pound interest rates.

31) D 32) A 33) E 34) E 35) B 36) C 37) C 38) B 39) A 40) D 41) E 42) B 43) B Year 1 interest income = $75 million × 0.12 =

$ 9.0 million

17

Year 1 interest expense = $75 million × 0.10 = Net interest income

$ 7.5 million $ 1.5 million

Year 2 interest income = $75 million × 0.12 = Year 2 interest expense = $75 million × 0.115 =

$ 9.0 million $ 8.625 million

Net interest income

$ 0.375 million

$1.5 million − $0.375 million = $1.125 million decrease.

44) D The initial bond value is 1,000 £. In one year, find the value of the bond using a financial calculator: N = 9, PMT = −90, I = 11, FV = −1,000 and solve for PV to get 889.26 £.

The loss for the British investor is (889.26 £ − 1,000 £ + 90 £)/1,000 £ = −0.0207, or −2.07% 45) E The initial value of the bond to the U.S. investor is 1,000 £ × $1.105/£ = $1,105 The price of the bond in 1-year will be: In one year, find the value of the bond using a financial calculator: N = 9, PMT = −90, I = 11, FV = −1,000 and solve for PV to get 889.26 £.

In U.S. dollars the value will be 889.26 £ × 0.985 = $875.92 The value of the coupon payment received at the end of the year is 90 £ × $0.985/£ = $88.65 The loss to the U.S. investor is ($875.92 − $1,105 + $88.65)/$1,105 = −0.1271, or −12.71% 46) Credit card loss rates are higher than many other loan types, but FIs charge high enough interest rates (and fees) to make them worthwhile.

FIs also extend credit card loans to large numbers of borrowers and the ensuing diversification reduces the risk.

18

47) Year 1 profits = (4.75% − 4.25%) × $150 million = $750,000; NIMyear1 = $750,000/$150 million = 0.50% Year 2 profits = (3.75% − 4.25%) × $150 million = −$750,000 Change in profits = −$1,500,000 NIMyear2 = −$1,500,000/$150 million = −1.00%, so NIM decreases by 100 basis points.

This bank faces reinvestment risk. When interest rates fall, the NIM and profits fall because the asset return decreases and the liability cost stays the same due to the shorter maturity of the assets.

48) Derivatives are complex instruments that can be difficult to price and difficult to estimate the payouts that can occur if market conditions change. The user has the responsibility to understand the risks involved.

They also involve large amounts of leverage. This means that a small investment can give the user the gains or losses of a much larger investment. It is debatable whether derivatives usage should be limited to certain parties. One could make a case for limiting derivatives usage to those who have demonstrated the knowledge, skill, and financial resources needed to be able to take on the risks associated with these contracts. In fact, we already do this for individual investors. More disclosure of the risks involved in certain OTC derivatives is probably needed because in many cases the bank sellers know more about the risks than the buyers of these contracts. Former Fed Chairman Alan Greenspan has argued that derivatives help complete the market (i.e., allow better hedging) and that their usage should not be burdened with excessive regulations.

19

49) Yes. Trading is generally a riskier activity than normal lines of business of FIs. Regulators of depository institutions should be especially concerned because deposit insurance subsidizes the risktaking activities of these institutions as insured depositors do not require a risk premium commensurate with the riskiness of the bank's risk.

50) Most guarantees are not used and the FI charges a fee for the service.

The fee is commensurate with the risk the FI faces. Granting the letter may also lead to additional business with the bond issuer.

51) Trading in foreign currencies; making foreign currency loans; buying foreign currency securities; and borrowing foreign currencies.

52) Sovereign risk is the risk that loan repayments from foreign borrowers may be interrupted by the foreign government. This differs from credit risk on a domestic loan in that legal recourse in the event of nonrepayment of principal or interest is generally less in many developing countries. Even in more developed countries collection will normally be more complex and expensive with longer delays than would be experienced in the United States. Moreover, the borrower may wish to repay, but may be prevented from repaying the loan by the local government.

Sovereign risk is difficult to eliminate but it can be limited by not lending to foreign governments, only to foreign private interests, and by threatening to not make any new loans to entities in that country, including the foreign government.

20

53) 1.Lower operating costs via exploiting economies of scale and scope 2. Increase profits 3. Capture new markets/customers The major risks include failures in technology, increased opportunities for fraud using the technology, and failure to generate additional business that utilizes the technology.

54) Insolvency occurs when equity becomes zero or negative. Hence, one of the best protections against insolvency is equity capital. The more equity an FI has, the lower the insolvency risk. The second-best protection is prudent management. The job of an FI manager is to decide how much risk is appropriate. Too much risk can cause an institution to fail. Liquidity risk can cause insolvency when a bank's creditors refuse to renew deposits or other borrowings; this may force the bank to have to liquidate assets at fire-sale prices. The loss in value of the assets sold would reduce equity and could cause insolvency. Credit risk occurs when money invested in loans or securities is not paid back to the lending institution. These losses reduce equity capital and can lead to insolvency.

55) 1.I. Credit risk 2.II. Liquidity risk 3.III. Market risk 4.IV. Off-balance-sheet risk 5.V. Interest rate risk All five could cause insolvency.

21

Chapter 21: Managing Credit Risk on the Balance Sheet TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Provision for loan losses, net charge-offs, and the percentage of nonperforming loans all increased dramatically in 2007. ⊚ ⊚

true false

2) Gross debt service usually must be greater than 30 percent before a residential mortgage will be approved. ⊚ ⊚

true false

3) Individuals with higher levels of income must have higher GDS and TDS ratios to qualify for a loan. ⊚ ⊚

true false

4) Collateral on a mortgage is normally only considered if the applicant has enough income to service the loan. ⊚ ⊚

true false

5) The five C's of credit are financial capacity, collateral, conditions, connections with the bank, and capital. ⊚ ⊚

true false

6) Credit analysis of a mid-market corporate borrower differs from the analysis of a small business in that the analysis of the mid-market borrower is more focused on the business itself and less on the business owners.

1

⊚ ⊚

true false

7) As long as overall cash flow growth is positive, a bank loan officer would not be concerned if cash flow from operations was projected to be negative over the term of the loan. ⊚ ⊚

true false

8) A rising sales to working capital ratio may indicate a potential borrower is using its net current assets more efficiently. ⊚ ⊚

true false

9) The more variable a borrower's cash flows are, the lower the fixed charge coverage ratio should be to limit risk. ⊚ ⊚

true false

10) Issuance of short-term debt would result in an increase in cash flow from operations on the statement of cash flows. ⊚ ⊚

true false

11) If you were a loan officer evaluating a small business credit application for a loan secured by working capital, you would generally want to see a higher (rather than lower) number of days in inventory and number of days' sales in receivables. ⊚ ⊚

true false

2

12) If you are a lender evaluating a loan application and you calculate the following ratio: (EBIT + Lease Payments)/[Interest + Lease Payments + (Sinking Fund/(1 − T))], then you are calculating a debt service ratio and it should be less than one in order to approve the loan. ⊚ ⊚

true false

13) A firm's cash account grew by $300 over the year when the firm had cash flow from financing of −$150 and cash flow from investing of $100. The firm's operating cash flow must have been +$250. ⊚ ⊚

true false

14) Asset management ratios are used in credit analysis to help understand the borrower's ability to generate sales from the amount invested in some asset category. ⊚ ⊚

true false

15) The risk-adjusted return on capital (RAROC) model calculates the actual or promised annual cash flow on a loan as a percentage of the amount lent. ⊚ ⊚

true false

16) Junk bonds usually yield lower returns than investment-grade bonds due to their speculative feature. ⊚ ⊚

true false

17) Management of credit risk is achieved through the diversification effect by combining numerous loans in a portfolio. ⊚ ⊚

true false

3

18) Residential mortgage loan applications have the most diverse application processes that differ from one institution to the other. ⊚ ⊚

true false

19) Credit scoring models are probabilistic models based on economic and financial borrower characteristics aimed at determining the likelihood of default of a borrower. ⊚ ⊚

true false

20) Analysis of the statement of cash flows involves assessment of operating, financing and investing cash flows and analysis of the resulting net income. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) Nonperforming loans are loans that are past due that are not accruing interest.

A) 30 days B) 60 days C) 90 days D) 120 days E) 180 days

22) is the process of taking possession of the mortgaged property to satisfy the debt in the event of failure to repay the mortgage and foregoing claim to any deficiency.

4

A) Perfecting collateral B) Foreclosure C) Power of sale D) Conditions precedent E) Lien enforcement

23)

Which one of the following is usually the better predictor of default?

A) Standard & Poor's credit rating B) Moody's credit rating C) Altman Z-score D) Moody’s Analytics EDF E) All of these choices are correct.

24) The base loan rate accounts for: 1.I. the FI’s weighted average cost of capital.

2.II. the FI’s marginal cost of funds.

3.III. the credit risk of the loan.

A) I only B) I and II only C) II and III only D) I and III only E) I, II, and III

25)

Which one of the following five C's of credit is not correctly defined?

5

A) Capacity—Whether the borrower has enough other credit available to pay off the loan in the event of cash flow problems.

B) Capital—The borrower's equity.

C) Character—A measure of the borrower's intention/willingness to repay the loan.

D) Conditions—Assessing how economic conditions could affect the borrower's ability to repay the loan.

E) Collateral—An asset of the borrower that the lender may seize in the event of default on the loan.

26) A corporate customer obtains a $1.5 million loan from a bank. The customer agrees to pay a 6.25 percent interest rate and agrees to maintain a compensating balance of 4 percent of the loan amount that will be held in noninterest-bearing transactions deposits at the bank for one year. The bank charges a 1 percent loan origination fee on the amount borrowed. Reserve requirements are 10 percent. What is the expected rate of return to the bank (to the nearest basis point)?

A) 6.95% B) 7.52% C) 7.99% D) 8.01% E) 8.45%

27) Mortgage Applicant

Annual Gross Income

Joe Bill

$ 100,000 $ 45,000

Projected Monthly Mortgage Payment $ 2,100 $ 1,000

Annual Property Taxes

Other Monthly Debt Payments

$ 3,000 $ 1,400

$ 600 $ 150

GDS cutoff: 30 percent TDS cutoff: 35 percent Using only the GDS criteria, which one of the following statements is true?

6

A) Joe gets the loan, but Bill does not.

B) Bill gets the loan, but Joe does not.

C) Both get the loan.

D) Neither gets the loan.

E) The bank does not have money to make the loan.

28) Mortgage Applicant

Annual Gross Income

Joe Bill

$ 100,000 $ 45,000

Projected Monthly Mortgage Payment $ 2,100 $ 1,000

Annual Property Taxes

Other Monthly Debt Payments

$ 3,000 $ 1,400

$ 600 $ 150

GDS cutoff: 30 percent TDS cutoff: 35 percent Using only the TDS criteria, which one of the following statements is true?

A) Joe gets the loan, but Bill does not.

B) Bill gets the loan, but Joe does not.

C) Both get the loan.

D) Neither gets the loan.

E) The bank does not have money to make the loan.

29) Individual credit-scoring models typically include all of the following information except:

A) income.

B) length of time in residence.

C) credit history.

D) age.

E) ethnic background.

7

30) A corporate loan applicant has cash of $40, receivables of $50, and inventory of $20. The applicant also has current debts of $65. If the bank's policy requires a current ratio of 1.75 or better and an acid test ratio of 1.25 or better, would the applicant receive the loan?

A) Yes, because the applicant's current ratio and acid test ratios are acceptable.

B) No, because the applicant's current ratio and acid test ratios are both unacceptable.

C) No, because although the applicant's current ratio is acceptable, its acid test ratio is not.

D) No, because although the applicant's acid test ratio is acceptable, its current ratio is not.

E) Yes, because the bank will make the loan regardless of the results.

31) Assets Cash

BALANCE SHEET BIG VALLEY ENTERPRISES Income Statement Liabilities and Equity $ 10 Current $ Cash Sales Liabilities 160

$ 275

Accounts receivable Inventory

80

Long-Term Debt

230

Credit sales

500

115

Common Stock

75

560

Fixed Assets

400

Retained Earnings

140

Operating Expenses Depreciation

Total

$ 605

Total

$ 605

Interest

55

Taxes

30

Net Income

?

100

Interest is Big Valley's only fixed cash charge.

Big Valley's market value of equity to book value of debt ratio = 1.5.

Peer Average Ratios Current Ratio Quick Ratio Days Sales in Receivables

1.35 0.5 50

8

Sales to Working Capital Sales to Fixed Assets Times Interest Earned Debt to Asset Ratio Return on equity

14 1.8 4 50% 15%

Big Valley's current ratio indicates that Big Valley is liquid than the typical firm in the industry, and Big Valley's quick ratio indicates that Big Valley is liquid than the typical firm.

A) more; more B) more; less C) less; less D) less; more E) similar; similar

32) Assets Cash

BALANCE SHEET BIG VALLEY ENTERPRISES Liabilities and Income Statement Equity $ 10

Accounts receivable Inventory

80

Current Liabilities Long-Term Debt

$ 160 230

Cash Sales

$ 275 500

115

Common Stock

75

Operating Expenses

560

Fixed Assets

400

Retained Earnings

140

Depreciation

100

Total

$ 605

Total

$ 605

Interest

55

Taxes

30

Net Income

?

Credit sales

Interest is Big Valley's only fixed cash charge.

Big Valley's market value of equity to book value of debt ratio = 1.5.

9

Peer Average Ratios Current Ratio Quick Ratio Days Sales in Receivables Sales to Working Capital Sales to Fixed Assets Times Interest Earned Debt to Asset Ratio Return on equity

1.35 0.5 50 14 1.8 4 50% 15%

Big Valley's return on equity indicates that the firm generates a shareholders than their peers.

return to their

A) 2.04 percent higher B) 3.02 percent higher C) 15.25 percent higher D) 5.75 percent lower E) 1.05 percent lower

33) Assets Cash

BALANCE SHEET BIG VALLEY ENTERPRISES Liabilities and Income Statement Equity $ 10 Current $ Cash Sales Liabilities 160

$ 275

Accounts receivable Inventory

80

Long-Term Debt

230

Credit sales

500

115

Common Stock

75

Operating Expenses

560

Fixed Assets

400

Retained Earnings

140

Depreciation

100

Total

$ 605

Total

$ 605

Interest

55

Taxes

30

Net Income

?

10

Interest is Big Valley's only fixed cash charge.

Big Valley's market value of equity to book value of debt ratio = 1.5.

Peer Average Ratios Current Ratio Quick Ratio Days Sales in Receivables Sales to Working Capital Sales to Fixed Assets Times Interest Earned Debt to Asset Ratio Return on equity

1.35 0.5 50 14 1.8 4 50% 15%

Big Valley has a times interest earned ratio that is , which indicates that Big Valley has long-term insolvency risk than the typical firm in the industry.

A) 4; the same B) 3.91; less C) 3.91; more D) 4.58; more E) 4.58; less

34) Assets Cash Accounts receivable

BALANCE SHEET BIG VALLEY ENTERPRISES Liabilities and Income Statement Equity $ 10 Current $ Cash Sales Liabilities 160 80 Long-Term Debt 230 Credit sales

Inventory

115

Common Stock

75

Fixed Assets

400

140

Total

$ 605

Retained Earnings Total

$ 605

$ 275 500

Operating Expenses Depreciation

560

Interest

55

100

11

Taxes

30

Net Income

?

Interest is Big Valley's only fixed cash charge.

Big Valley's market value of equity to book value of debt ratio = 1.5.

Peer Average Ratios Current Ratio Quick Ratio Days Sales in Receivables Sales to Working Capital Sales to Fixed Assets Times Interest Earned Debt to Asset Ratio Return on equity

1.35 0.5 50 14 1.8 4 50% 15%

Altman's Z-score model is Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5.

X1 = Working Capital/Total Assets X2 = Retained Earnings/Total Assets X3 = EBIT/Total Assets X4 = Market Value Equity/Book Value Long-Term Debt X5 = Sales/Total Assets Using the Altman's Z model, Big Valley's Z-score is:

A) 3.22.

B) 2.88.

C) 2.65.

D) 2.11.

E) 1.85.

35) Assets Cash

BALANCE SHEET BIG VALLEY ENTERPRISES Income Statement Liabilities and Equity $ 10 Current $ Cash Sales

$ 12

Liabilities

160

275

Accounts receivable Inventory

80

Long-Term Debt

230

Credit sales

500

115

Common Stock

75

Operating Expenses

560

Fixed Assets

400

Retained Earnings

140

Depreciation

100

Total

$ 605

Total

$ 605

Interest

55

Taxes

30

Net Income

?

Interest is Big Valley's only fixed cash charge.

Big Valley's market value of equity to book value of debt ratio = 1.5.

Peer Average Ratios Current Ratio Quick Ratio Days Sales in Receivables Sales to Working Capital Sales to Fixed Assets Times Interest Earned Debt to Asset Ratio Return on equity

Big Valley's fixed asset efficiency score is typical firm in the industry.

1.35 0.5 50 14 1.8 4 50% 15%

which is

that of the

A) 1.8; the same as B) 1.54; lower than C) 1.94; higher than D) 2.15; higher than E) 1.32; lower than

36) BALANCE SHEET BIG VALLEY ENTERPRISES

13

Assets

Income Statement

Accounts receivable Inventory

80

Liabilities and Equity Current Liabilities Long-Term Debt

115

Common Stock

75

Operating Expenses

560

Fixed Assets

400

140

Depreciation

100

Total

$ 605

Retained Earnings Total

$ 605

Interest

55

Taxes

30

Net Income

?

Cash

$ 10

$ 160 230

Cash Sales

$ 275 500

Credit sales

Interest is Big Valley's only fixed cash charge.

Big Valley's market value of equity to book value of debt ratio = 1.5.

Peer Average Ratios Current Ratio Quick Ratio Days Sales in Receivables Sales to Working Capital Sales to Fixed Assets Times Interest Earned Debt to Asset Ratio Return on equity

Big Valley is collecting their receivables about

1.35 0.5 50 14 1.8 4 50% 15%

than the typical firm.

A) 22 percent more quickly B) 12 percent more quickly C) 17 percent more slowly D) 12 percent more slowly E) 16 percent more quickly

37)

14

Assets Cash Accounts receivable

BALANCE SHEET BIG VALLEY ENTERPRISES Liabilities and Income Statement Equity $ 10 Current $ Cash Sales Liabilities 160 80 Long-Term Debt 230 Credit sales

Inventory

115

Common Stock

75

Fixed Assets

400

Retained Earnings

140

Total

$ 605

Total

$ 605

$ 275 500

Operating Expenses Depreciation

560

Interest

55

Taxes

30

Net Income

?

100

Interest is Big Valley's only fixed cash charge.

Big Valley's market value of equity to book value of debt ratio = 1.5.

Peer Average Ratios Current Ratio Quick Ratio Days Sales in Receivables Sales to Working Capital Sales to Fixed Assets Times Interest Earned Debt to Asset Ratio Return on equity

1.35 0.5 50 14 1.8 4 50% 15%

Big Valley's use of debt to finance assets indicates that Big Valley has typical firm in the industry.

the

A) more long-term solvency risk than B) the same long-term solvency risk as C) less interest expense than D) less long-term solvency risk than E) a lower market value of equity to book value of equity ratio than

15

38) Mid-market commercial lending may be typically defined as borrowers: 1.I. with sales revenue between $5 million and $100 million.

2.II. with a recognizable corporate structure.

3.III. with ready access to deep and liquid capital markets.

A) I only B) II only C) III only D) I and II only E) I, II, and III

39) In analyzing credit risk for a loan to a major diversified corporation, the bank typically has which of the following advantages? 1.I. Market-based models to analyze credit risk 2.II. Greater negotiating power due to the size of the loan required 3.III. Ratings agency measures of default risk

A) I only B) I and II only C) II and III only D) I and III only E) I, II, and III

40)

A firm with a low Z-score has high:

A) insolvency risk.

B) interest rate risk.

C) liquidity risk.

D) international risk.

E) None of these options are correct.

16

41) Business credit-scoring models suffer from several weaknesses. These include which of the following? 1.I. Credit-score models are not statistically sound tools to use in making a lending decision.

2.I. The appropriate weights on a credit-score model are likely to change unpredictably over time.

3.II. These models ignore non-quantifiable behavioral factors, such as a relationship with the bank and reputation.

4.IV. Credit-scoring models discriminate against minorities.

A) I and II only B) II and III only C) II, III, and IV only D) I, II, and III only E) I, II, III, and IV

42) The conditions specified in a credit agreement that must be fulfilled before a drawdown is allowed are called

A) collateral perfection.

B) power of sale conditions.

C) conditions precedent.

D) foreclosure agreements.

E) audit review terms.

43)

Based on an option valuation method, the EDF model:

A) determines if the equity is mispriced.

B) calculates the market value of the lender's investment.

C) estimates the probability that a firm will default over a specified period of time.

D) estimates the likelihood that the Z-score model is correct.

E) estimates the probability that the firm’s rating will change over a period of time.

17

44) A bank charges a commercial borrower a 6.55 percent interest rate on a one-year loan.

The bank also charges a 0.5 percent origination fee and requires compensating balances of 7 percent in the form of demand deposits. Reserve requirements are 10 percent. What is the promised gross rate of return on the loan?

A) 8.45 percent B) 7.89 percent C) 9.10 percent D) 7.52 percent E) 6.95 percent

45) If you were a loan officer evaluating a small business credit application for a loan and you wanted to ensure that the applicant had more than sufficient cash flow to pay off its existing debt, the applicant's cash-flow-to-debt ratio would have to be greater than:

A) one.

B) zero.

C) the TIE ratio.

D) the interest rate on the debt.

E) peer average ratio.

46) In concept, the RAROC measure indicates a loan is acceptable if the RAROC is greater than the:

A) borrower's ROE. B) lender's ROA. C) borrower's ROA. D) lender's ROE. E) NCO rate.

47) As a business lender, you would prefer that the borrower have stable or growing cash flows resulting from which part of the statement of cash flows?

18

A) Financing cash flows B) Cash flows from investment C) Operating cash flows D) Dividends E) Common Stock

48) A bank is using the RAROC to evaluate large business loans. The benchmark rate of return is 7.55 percent. The one-year loan interest rate is 8.00 percent and the bank must pay 7.40 percent to raise the funds. The cost to service the loan is 0.3 percent. If the loan defaults, 92 percent of the money lent will be lost. Based on historical default rates, the extreme worst-case loss scenario is about 5 percent. Should the bank make the loan? Why or why not?

A) Yes, because the RAROC is 7.11 percent.

B) No, because the RAROC is 7.11 percent.

C) Yes, because the RAROC is 6.52 percent.

D) No, because the RAROC is 6.52 percent.

E) No, because the RAROC is more than 7.55 percent.

49) the:

The ratio that measures the firm’s efficiency in utilizing its assets to generate revenue is

A) current ratio.

B) debt ratio.

C) time interest earned ratio.

D) total assets turnover ratio.

E) cash-flow-to-debt ratio.

50)

Which ratio measures the firm’s ability to pay current interest and lease payments?

19

A) Current ratio B) Debt ratio C) Time interest earned ratio D) Total assets turnover ratio E) Cash-flow-to-debt ratio

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

51) Before allowing the borrower to actually acquire the funds for a mid-market collateralized loan, what must the lender ensure? What type of monitoring occurs by the lender after the loan is granted?

52)

Explain how the Moody’s Analytics model predicts bankruptcy probability.

53) Explain the purpose/benefits in adding a credit-scoring model to evaluate a loan application.

54) For most business loans, growing earnings are not a sufficient reason to grant a loan.

Why?

20

55) A $40,000 one-year loan with a 1 percent origination fee and a 7.50 percent interest rate is funded with money on which the bank owes 3 percent. What is the expected pretax dollar spread on the loan? If the bank needs to net at least 3.5 percent on the funds lent to make its ROE, how many dollars can the bank spend on credit investigation, loan servicing, and so forth?

Would the bank be able to spend more if the loan amount was greater? What does this example suggest about credit analysis?

56)

Describe the credit analysis process for a mid-market corporate loan applicant.

57)

What are the five C's of credit? Briefly describe each.

58) A corporate loan applicant has had a growing cash account for the last three years, but cash flow from operations has been negative in every year. Would this concern you if you were the loan officer charged with approving the loan? If so, why? If not, why not?

59)

Why won't a loan officer usually approve a loan solely on the basis of collateral?

21

60) Explain what each ratio in the Altman credit model measures and explain why higher values of each of the variables predict lower default probability.

61) A bank has a base loan rate of 4.75 percent and for the loan under consideration it would apply a 2 percent risk premium. The bank also requires compensating balances (noninterestbearing) equal to 5 percent of the loan amount. The bank's reserve requirements are 10 percent.

The bank charges 1 percent of the loan amount as an origination fee. The borrower is asking for a $500,000 loan. Calculate the ROA on the loan.

62) A bank can charge a corporate borrower 6.25 percent on a loan. The borrower is asking for a $600,000 loan. The extreme loss rate on this loan type is 4.0 percent and, when default occurs, about 15 percent of the loan amount is recovered. The interest and noninterest cost of the loan is 5.85 percent. What is the RAROC of the loan? Under what circumstances should the bank make the loan?

63) Why is bank lending to large corporations more difficult than making loans to small or mid-size firms? What additional factors are involved? Do banks have some additional tools to help in assessing credit risk of large firms? What are some examples?

22

Answer Key Test name: Chap 21_8e 1) TRUE 2) FALSE 3) FALSE 4) TRUE 5) FALSE 6) TRUE 7) FALSE 8) TRUE 9) FALSE 10) FALSE 11) FALSE 12) FALSE 13) FALSE 14) TRUE 15) FALSE 16) FALSE 17) TRUE 18) FALSE 19) TRUE 20) FALSE 21) C 22) B 23) D 24) B 25) A 26) B 23

(1% + 6.25%)/[1 − (4%(1 − 10%))] = 7.52% 27) C Joe: GDS = [($2,100 × 12) + $3,000]/$100,000 = 0.2820, or 28.20%; Bill: GDS = [($1,000 × 12) + $1,400]/$45,000 = 0.2978, or 29.78%; both are under the max of 30%.

28) C Joe: TDS = [($2,700 × 12) + $3,000]/$100,000 = 0.3540, or 35.40%; Bill: TDS = [($1,150 × 12) + $1,400]/$45,000 = 0.3378, or 33.78%; The maximum TDS is between 35% and 40% so both loans are acceptable.

29) E 30) D Current ratio = ($40 + $50 + $20)/$65 = 1.69, Not acceptable; Acid Test ($40 + $50)/$65 = 1.38, Acceptable 31) D Current = ($10 + $80 + $115)/$160 = 1.28, Peer = 1.35; Quick = ($10 + $80)/$160 = 0.56, Peer = 0.5 32) E NI/Equity = ($275 + $500 − $560 − $100 − $55 − $30)/($75 + $140) = 0.1395, or 13.95%; Industry = 15% 33) C [($275 + $500 − $560)/$55] = 3.91; Industry = 4 34) A WC/TA = 7.44%; RE/TA = 23.14%; EBIT/TA = 19.01%; MVE/BVLTD = 1.50; S/TA = 1.28 These numbers give a Z-score of 3.22, which indicates low default risk.

35) C

24

S/FA = ($275 + $500)/$400 = 1.9375; Peer S/FA = 1.8 36) C Days’ sales in receivables = ($80 × $365)/$500 = 58.4 days; 58.4/50 − 1 = 0.1680, or 16.8% 37) A Debt/TA = ($160 + $230)/$605 = 0.6446, or 64.46%; Peer Debt/TA = 50% 38) D 39) D 40) A 41) B 42) C 43) C 44) D (0.005 + 0.0655)/[1 − (0.07 × (1 − 0.10))] = 0.0752, or 7.52% 45) D 46) D 47) C 48) D (0.080 − 0.074 − 0.003)/(0.05 × 0.92) = 0.0652, or 6.52%, but this is below the benchmark of 7.55%.

49) D 50) C

25

51) The lender must perfect the security interest in the collateral. This process includes confirming that the collateral does not have a preexisting lien that would prevent foreclosure and sale, ensuring that back taxes are not owed, and in certain cases, obtaining an independent assessment of the collateral value. Following the draw down, the lender must monitor the condition of the collateral periodically and reassess the borrower's ability to continue to service the loan. This review normally takes place annually.

52) The Moody’s Analytics model calculates the expected default frequency (EDF). The database contains 30 years of information for 6,000 public and 220,000 private corporate default events. This represents 60,000 public and 2.8 million private companies, healthy and distressed, from across the globe. The data are used to generate a score that reflects the probability of default and has been shown to be a better predictor of financial distress or failure than accounting-based models and S&P rating changes.

53) Credit-scoring models allow the loan officer to quickly make a decision about a loan. The idea behind a credit-scoring model is to identify how characteristics of past borrowers that repaid their loans on time differ from borrowers that defaulted. The differences are then weighted with a point system and new loan applicants are then scored to see if they fall into the sound or default category.

26

54) Collateral is still important because economic conditions can change over the life of the loan and the bank would like to be able to limit its losses in the event the borrower's earnings are not sufficient to repay the loan. The lender must also evaluate how sensitive the borrower's earnings are to economic conditions and how much the economy might change over the period of the loan. Finally, earnings are not cash; cash is required to repay the loan and the lender will be more concerned about sources and uses of cash than about earnings.

55) Gross Revenue = (7.50% − 3.00% + 1.00%) × $40,000 = $2,200 Minimum Revenue = 7.50% − 3.00% + 1.00% − 3.50% = 2.00% of $40,000 = $800 The bank would be able to spend more money for a larger loan amount.

This indicates the need for the lender to employ credit scoring and other quick, low-cost methods of evaluating small loan amounts to maintain profitability on these transactions.

56) The account officer gathers information about the loan applicant's business. This may include meeting the client's existing customers, checking referrals, and cold calling new business prospects. The account officer analyzes the risk of the applicant by applying the five C's of credit. If the account officer decides to pursue the loan application, the loan is submitted for review and approval by senior lending officials and/or a loan review committee.

27

57) Character: Character of applicant; applicant's willingness to work hard to repay the loan.

Capacity: Borrower's ability to generate enough cash to repay the loan.

Condition: How changing economic and other conditions will affect the borrower's ability to repay.

Capital: How much capital (protection from insolvency) the borrower has.

Collateral: The value of assets pledged against the loan.

58) This would be a concern because it indicates cash growth is being generated by borrowing, issuing new equity, or by selling assets. None of these are sustainable sources of financing. Moreover, the applicant is not generating cash flow from its operations. This may be acceptable if the firm is in a growth period and has good collateral, but the loan officer would normally desire to have positive cash flow from operations.

59) There are two reasons why a loan officer will not typically grant a loan if the borrower has insufficient cash flow but good collateral. First, the lender's rate of return is usually reduced if the lender has to seize collateral and incur storage and sale costs, because seizing and disposing of collateral is very costly. Borrowers also may not maintain collateral in the best condition if they believe it will be seized and the borrower's future business will also probably be lost for good. Second, it is unethical to grant a loan that the loan officer knows or strongly believes cannot be repaid. Old western TV shows notwithstanding, making a loan to seize the collateral at a good price is bad business.

60) The variables and their explanations are: X1 = Working capital/Total assets

The higher the ratio, the more liquid assets (%) the firm has.

Greater liquidity implies a stronger ability to pay off debts

28

X2 = Retained earnings/Total assets

X3 = EBIT/Total assets

X4 = Market value of equity/Book value of long-term debt

X5 = Sales/Total assets

in the short run.

The higher retained earnings are to total assets, the greater the firm’s ability to generate and keep profits. This should indicate a greater ability to pay off debt.

A higher value for this ratio indicates a greater ability to generate profits off the given assets and should indicate a stronger ability to pay off debt.

When this ratio is higher, it signals that the market believes that the firm’s ability to generate cash through time is strong relative to the principal owed on the debt, thus indicating that the equity investors believe the firm’s prospects are good.

This ratio measures the firm’s ability to turn dollars invested in assets into sales revenue. The higher the ratio, the more efficiently managers are using assets to generate sales. Sales are a cornerstone of profitability and the ability to pay off debts.

61) Loan ROA = (0.01 + 0.0475 + 0.02)/[1 − (0.05 × (1 − 0.10))] = 0.08115, or 8.115% 62) RAROC = Net first-year $ income on the Loan/Value of loan at risk Net first-year $ income on the loan = (0.0625 − 0.0585) × $600,000 = $2,400 Value of loan at risk = Dollar value of loan × Unexpected (extreme) default rate × Loss given default = $600,000 × 0.040 × (1 − 0.15) = $20,400 RAROC = $2,400/$20,400 = 0.1176, or 11.76% The bank should make the loan if the bank's ROE is less than the RAROC of 11.76%.

29

63) ● Banks have reduced bargaining power on terms with large corporations. This means they may not be able to set profitable terms, and it implies that banks may have to consider what would happen to other aspects of the business relationship, such as consulting, if a loan is refused. These other relationships represent a conflict of interest with the lending function. ● Large corporate borrowers tend to be involved in many different lines of business, making industry comparisons and risk assessment difficult. ● If the borrower is a holding company that has no assets other than the separate firms, the bank's loan to the holding company will be subordinated to direct claims of the subsidiaries.

Banks have some additional tools to help with loans to large corporations. The Altman Z-score model, the ratings from Moody's and Standard & Poor's, and the Moody’s Analytics model are examples.

These tools can help the bank assess the risk of loan default.

30

Chapter 22: Managing Liquidity Risk on the Balance Sheet TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) If a bank meets a net deposit drain by borrowing money in the Fed funds market, it is using purchased liquidity. ⊚ ⊚

true false

2) A corporation informs the bank that it will immediately draw down the maximum amount on its credit line. This is an example of liability side risk. ⊚ ⊚

true false

3) If a bank's brokered deposits increase by $3 million and their savings accounts decrease by $1 million, then core deposits decreased. ⊚ ⊚

true false

4) A bank's financing gap is calculated as average loans minus average deposits plus liquid assets. ⊚ ⊚

5)

true false

Repos and Fed funds borrowed are examples of stored liquidity. ⊚ ⊚

true false

6) When money market interest rates are higher than deposit rates, using purchased liquidity to replace deposit drains can reduce a bank's profit margin. ⊚ ⊚

true false

1

7) Using stored liquidity to offset a deposit drain will reduce the size of the bank but using purchased liquidity to offset the drain will not. ⊚ ⊚

8)

Property and casualty insurers have a greater need for liquidity than life insurers. ⊚ ⊚

9)

true false

true false

Relying on purchased liquidity is more risky than relying on stored liquidity. ⊚ ⊚

true false

10) Closed-end mutual funds have less need to maintain liquid asset holdings than open-end mutual funds. ⊚ ⊚

11)

true false

The financing gap is defined as average core deposits minus average borrowed funds. ⊚ ⊚

true false

12) The greater the discount required to sell assets quickly, the higher the value of the bank's liquidity index. ⊚ ⊚

true false

2

13) The fear that liquidity problems at one bank may cause depositors to worry about the solvency of other banks is called the disease effect. ⊚ ⊚

true false

14) Stored liquidity management occurs when a DI uses its reserves held at the Federal Reserve to meet the net deposit drain. ⊚ ⊚

true false

15) A DI has highly liquid assets if there is a large price difference between immediate firesale asset prices and fair market prices of assets. ⊚ ⊚

true false

16) A widely accepted method measuring liquidity risk exposure of a DI is core deposits over total assets ratio. ⊚ ⊚

true false

17) Liquidity planning is the only viable method that eliminates liquidity risk from DIs that currently exists. ⊚ ⊚

true false

18) Contagion effect occurs when a failure of one DI leads to concerns among depositors about the solvency risk of the other DIs. ⊚ ⊚

true false

3

19) Life insurers and property and casualty insurers have federal guarantee programs similar to DIs' deposit insurance. ⊚ ⊚

true false

20) When investment funds experience dramatic liquidity needs, the liquidated assets are distributed to fund’s shareholders on a first-come, first-served basis. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) First National Bank of North America (FNBNA) Assets Liabilities and Equity

Cash

Amount (million $)

Rate of Return

$ 10

0.00%

30 60

5.50% 9.00%

Securities Loans Total

$ 100

Amount (million $)

Cost Rate

Core deposits Borrowings Equity

$ 80

4.00%

10 10

7.00%

Total

$ 100

If FNBNA is expecting a $10 million net deposit drain and the securities liquidity index is 0.97, by how much will pretax net income change if the drain is funded entirely through securities sales?

A) −$306,122 B) −$150,000 C) −$375,339 D) −$476,289 E) −$474,490

4

22) First National Bank of North America (FNBNA) Assets Liabilities and Equity

Cash Securities Loans Total

Amount (million $)

Rate of Return

$ 10

0.00%

30 60

5.50% 9.00%

$ 100

Amount (million $)

Cost Rate

Core deposits Borrowings Equity

$ 80

4.00%

10 10

7.00%

Total

$ 100

If FNBNA is expecting a $15 million net deposit drain and the securities liquidity index is 0.98, how many securities would have to be liquidated if the bank used only its securities to fund the expected deposit drain?

A) $15,000,000 B) $16,444,331 C) $15,600,000 D) $15,306,122 E) $16,772,345

23) First National Bank of North America (FNBNA) Assets Liabilities and Equity

Cash Securities Loans Total

Amount (million $) $ 10

Rate of Return

30 60

5.50% 9.00%

$ 100

0.00%

Core deposits Borrowings Equity Total

Amount (million $) $ 80

Cost Rate

10 10

7.00%

4.00%

$ 100

5

If FNBNA is expecting a $20 million net deposit drain and the bank wishes to fund the drain by borrowing more money, how much will pretax net income change if the borrowing cost is the same as on its existing borrowed funds?

A) $600,000 B) −$312,000 C) −$2,000,000 D) −$600,000 E) $312,000

24)

Which one of the following situations creates the most liquidity risk?

A) Long-term assets funded by long-term liabilities B) Short-term assets funded by short-term liabilities C) Long-term assets funded by short-term liabilities D) Short-term assets funded by long-term liabilities E) Long-term liabilities funded by short-term assets

25)

Which of the following results in a net liquidity drain?

A) Demand deposits increase $100; loans increase $50.

B) Demand deposits decrease $100; loan repayments are $150.

C) Repurchase agreements increase $100; demand deposits decrease $50.

D) Reverse repurchase agreements increase $50; demand deposits decrease $50.

E) None of these choices are correct.

26) A bank meets a deposit withdrawal with one of the following alternatives. Which one of the following is an example of using stored liquidity to meet a deposit withdrawal?

6

A) Increasing Eurodollar deposits B) Contacting an investment banker to find new corporate deposits C) Increasing Fed funds borrowed D) Issuance of a negotiable CD E) Selling the bank's holdings of T-bills

27) Second National Bank (SNB) (million $) Funds borrowed Maximum amount SNB can still borrow Cash-type assets Excess cash reserves Federal Reserve borrowings

$ 6,500 $ 8,500 $ 3,700 80 20

What are Second National Bank's total sources of liquidity?

A) $6,520 B) $13,500 C) $14,200 D) $12,280 E) $5,760

28) Second National Bank (SNB) (million $) Funds borrowed Maximum amount SNB can still borrow Cash-type assets Excess cash reserves Federal Reserve borrowings

$ 6,500 $ 8,500 $ 3,700 80 20

What are Second National Bank's total uses of liquidity?

7

A) $6,520 B) $13,500 C) $14,200 D) $12,280 E) $5,760

29) Second National Bank (SNB) (million $) Funds borrowed Maximum amount SNB can still borrow Cash-type assets Excess cash reserves Federal Reserve borrowings

$ 6,500 $ 8,500 $ 3,700 80 20

What is Second National Bank's total net liquidity?

A) $6,520 B) $13,500 C) $14,200 D) $12,280 E) $5,760

30)

If a bank relies solely on purchased liquidity, the bank will likely:

A) maintain large amounts of liquid assets.

B) fund its loan commitments with asset sales.

C) be required to borrow money at short notice.

D) be required to raise equity capital quickly.

E) be forced to liquidate liabilities at fire-sale prices.

31)

Which one of the following is a source of liquidity risk for a bank?

8

A) Predicted increase in net deposit drain before Christmas B) Maturation of notes payable C) Corporation calling in a bond the bank is holding D) A natural disaster in the bank's community E) None of these choices are correct.

32) Bank A has a loan-to-deposit ratio of 110 percent, core deposits equal 55 percent of total assets, and borrowed funds are 25 percent of assets. Bank B has a loan-to-deposit ratio of 80 percent. Core deposits are 65 percent of assets and borrowed funds are 5 percent of assets. Which bank has more liquidity risk? All else held constant, which bank will probably be more profitable when interest rates are low?

A) Bank A; Bank A B) Bank A; Bank B C) Bank B; Bank A D) Bank B; Bank B E) You can't tell.

33)

Core deposits include all but which of the following?

A) Retail demand deposits B) NOW accounts C) MMDAs D) Savings accounts E) Negotiable CDs

34) BIS’ Basel Committee on Banking Supervision provides regulatory standards for liquidity risk supervision. Which of the following are among the new ratios required to be maintained by large DIs? 1.I. Liquidity coverage ratio 2.II. Net stable funds ratio 3.III. Financing gap over total asset ratio 4.IV. Core deposits over financing gap ratio

9

A) I only B) II and III C) I and II only D) II and III only E) I, II, III, and IV

35) A financial intermediary has two assets in its investment portfolio. It has 35 percent of its security portfolio invested in one-month Treasury bills and 65 percent in real estate loans. If it liquidated the bills today, the bank would receive $98 per hundred of face value. If the real estate loans were sold today, they would be worth $85 per $100 of face value. In one month, the real estate loans could be liquidated at $94 per $100 of face value. What is the intermediary's onemonth liquidity index?

A) 0.93 B) 0.92 C) 0.91 D) 0.90 E) 0.89

36)

When calculating the liquidity index, the larger the discount from fair value, the the liquidity index; and the the liquidity risk the FI faces.

A) larger; greater B) smaller; greater C) larger; lower D) smaller; lower

37) An increasingly positive financing gap can indicate liquidity risk because it may indicate deposits and/or rising loan commitments.

10

A) increasing; increasing B) decreasing; decreasing C) increasing; decreasing D) decreasing; increasing

38) Insurance industry guarantee funds do not eliminate runs on insurers because: 1.I. the funds are not backed by the federal government.

2.II. the funds lack permanent reserves to back policies.

3.III. the size of the required contributions differs widely from state to state.

A) I only B) II only C) III only D) I and III only E) I, II, and III

39) A married couple each has an IRA and deposits at a bank. The couple also has one child.

If they had the money, what is the total amount of their accounts that could be insured at one bank?

A) $250,000 B) $750,000 C) $1,250,000 D) $1,500,000 E) $2,000,000

40) Which of the following can create liquidity risk for a life insurer? 1.I. Unexpectedly high number of policy surrenders 2.II. Unexpectedly low number of new policies sold 3.III. Unexpectedly high insurance claims filed by policyholders

11

A) I only B) II only C) I and II only D) II and III only E) I, II, and III

41) Runs on insurance firms are more likely to occur than runs on banks even in states with guaranty funds for insurers because these funds generally:

A) lack a permanent reserve fund.

B) do not repay insurance policyholders immediately.

C) lack federal government backing.

D) All of these choices are correct.

E) None of these choices are correct.

42)

The two main reasons why runs on U.S. banks no longer occur are:

A) reserve requirements and higher bank liquidity ratios.

B) a required positive financing gap and bank use of purchased liquidity.

C) the FDIC and the discount window.

D) insurance funds operated by individual states and tighter bank regulations.

E) None of these choices are correct.

43)

In the absence of deposit insurance, a deposit is a

to the bank's assets.

A) pro rata claim B) first-come/first-serve claim C) full pay or no pay claim D) pro rata claim and first come/first serve claim E) first come/first serve claim and full pay or no pay claim

12

44) How does reliance on purchased liquidity rather than core deposits affect a bank? 1.I. Increases the risk of a liquidity crisis 2.II. Allows the bank to adjust to deposit drains without affecting bank size 3.III. Increases overall interest sensitivity of the bank's profits to interest rates

A) I only B) II only C) I and II only D) II and III only E) I, II, and III

45) Which of the following statements, if any, is (are) true? 1.I. Mutual funds never have runs.

2.II. Funds invested with insurers are as safe as deposits at a bank.

3.III. Pension funds generally have less liquidity risk than banks.

A) All three are true.

B) Only I is true.

C) Only II and III are true.

D) Only III is true.

E) None of these choices are correct.

46) Discount window borrowing is available to: 1.I. banks.

2.II. thrifts.

3.III. investment banks.

4.IV. nonfinancial corporations.

13

A) I and II only B) I and III only C) I, II, and III only D) II, III, and IV only E) I, II, III, and IV

47) The amount that a policyholder receives when he or she cashes in an insurance policy is called the:

A) cash value.

B) surrender value.

C) face value.

D) policy value.

E) fair market value.

48) The greater the constant.

ratio, the more liquid is the institution, all else held

A) borrowed funds to total assets B) core deposits to total assets C) loans to deposits D) unused commitments to lend to total assets E) unused commitments to lend to liquid assets

49) The BIS guidelines for monitoring intraday liquid-ity risk at internationally active banks include which of the following: 1.I. Measure expected daily gross liquidity inflows and outflows, anticipate the intraday timing of these flows where possible, and forecast the range of potential net funding shortfalls that might arise at different points during the day.

2.II. Monitor intraday liquidity positions against expected activities and available resources.

3.III. Arrange to acquire sufficient intraday funding to meet intraday objectives.

4.IV. Have the ability to maintain a collateral-to-asset ratio above the minimum required by BIS.

14

A) I and II only B) II and III only C) I, II, and IV only D) I, II, and III only E) I, II, III, and IV

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

50) You have the following data for a bank (million $): Liabilities due Assets maturing Saleable assets Unused loan commitments Access to brokered deposits Expected net deposit drains

1 day

1 month

$ 23 $ 19 $ 14 $ 8 $ 11 $ 22

$ 60 $ 35 $ 54 $ 100 $ 55 $ 98

Calculate the net funding requirement for each period and the cumulative net funding requirement over the month. What does the plan reveal?

51)

Explain how liquidity risk can lead to insolvency risk.

52)

What are the major sources of liquidity risk for a bank? For a life insurer?

15

53) A bank has $6 million in Treasury bills, $3 million in excess reserves at the Fed, $1 million in vault cash, and an $8 million line of credit on the repo market. The bank has borrowed $6 million in Fed funds and $12 million in short-term notes borrowed to finance loans. What is the net liquidity position of the bank and what can you conclude from it?

54) Explain the relationship between each of the following ratios and liquidity risk. 1.(a) Loan-to-deposit ratio 2.(b) Borrowed funds to total assets 3.(c) Loan commitments to total assets

55)

Does a positive or a negative financing gap indicate greater liquidity risk? Explain.

56)

Describe the major components of a liquidity plan.

57) We rarely see bank runs since the advent of Federal Deposit Insurance, but runs on life insurers and mutual funds do occur even though claimants have pro rata claims in the event of default. Why do these runs still occur?

16

58) What are the trade-offs involved between storing liquidity and purchasing liquidity as needed for a bank?

59)

Why might a bank face abnormal deposit drains?

60) The Fed now operates the discount window differently than it used to. What are the major changes?

17

Answer Key Test name: Chap 22_8e 1) TRUE 2) FALSE 3) TRUE 4) FALSE 5) FALSE 6) TRUE 7) TRUE 8) TRUE 9) TRUE 10) TRUE 11) FALSE 12) FALSE 13) FALSE 14) TRUE 15) FALSE 16) FALSE 17) FALSE 18) TRUE 19) FALSE 20) FALSE 21) D Liquidate securities totaling $10,000,000/0.97 = $10,309,278 lose interest income = 5.5% × $10,309,278 = $567,010 and lose $309,278 on the fire sale. This is offset by the decrease in interest expense of 4% × $10,000,000 core deposits = $400,000. The total net loss is $476,289.

18

22) D $15,000,000/0.98 = $15,306,122 23) D $20,000,000 × (4% − 7%) = −$600,000 24) C 25) D 26) E 27) D Cash assets + Max can borrow + Excess cash = $3,700 + $8,500 + $80 = $12,280 28) A Funds borrowed + Fed borrowing = $6,500 + $20 = $6,520 29) E Sources − Uses = $3,700 + $8,500 + $80 − ($6,500 + $20) = $5,760 30) C 31) D 32) A 33) E 34) C 35) A [(0.35 × 0.98) + (0.65 × 0.85)]/[(0.35 × 1.00) + (0.65 × 0.94)] = 0.93 36) B 37) C 38) E 39) D

19

$750,000 for a couple (two separate accounts and one joint account), $250,000 child's account held in trust by parents, and $250,000 for each IRA for a total of $1,500,000.

40) E 41) D 42) C 43) E 44) E 45) D 46) C 47) B 48) B 49) D 50) 1 day

1 month

Assets maturing Saleable assets Access to brokered deposits Total Cash Outflows

$ 19 $ 14 $ 11 $ 44

$ 35 $ 54 $ 55 $ 144

Liabilities due Unused loan commitments Expected net deposit drains Total Net funding requirement Cumulative net funding requirement

$ 23 $ 8 $ 22 $ 53 ($ 9) ($ 9)

$ 60 $ 100 $ 98 $ 258 ($ 114) ($ 123)

Cash Inflows

The liquidity plan indicates that the bank will need to obtain an additional $9 million in funding immediately and should plan on an additional $114 million over the next month.

20

51) If an FI has to sell illiquid assets to meet cash requirements, it may have to sell them at less than face value (indeed at less than market value) as a result of the need for a speedy sale. If the asset write-downs are large enough, equity value is reduced. Once equity is reduced to zero, the institution is insolvent.

52) For a bank: Unanticipated net deposit drains; unanticipated loan demand; unanticipated exercise of loan commitments.

For an insurer: Unanticipated policy surrenders; unanticipated poor investment returns; and fewer new policies than expected.

53) Sources of liquidity T-Bills Excess reserves at Fed Vault cash Credit line Total sources Uses of liquidity

$ 6 $ 3 $ 1 $ 8 $ 18

Fed Funds ST Notes Total Uses Net Liquidity Position

$ 6 $ 12 $ 18 $ 0

The net liquidity position reveals it is zero. While the bank has all expected liquidity needs covered, it has no contingency funds and it should have a plan prepared detailing how additional funds can be raised at short notice if needed.

21

54) (a) Loan-to-deposit ratio: The higher the ratio, the lower the amount of liquid assets to cover possible deposit withdrawals, and hence, liquidity risk is higher. (b) Borrowed funds to total assets: The higher the ratio, the more the bank is relying on the ability to purchase funds to raise money for loans, a relatively illiquid asset, and hence, liquidity risk is higher. (c) Loan commitments to total assets: The higher the ratio, the greater the possibility the bank will need additional liquidity in the near future, and this would require either additional liquid assets or borrowing capacity.

55) A positive financing gap indicates that average loans are greater than average core deposits. This implies that stable deposit funds have been used to fund relatively illiquid asset loans resulting in greater liquidity risk. If the gap is negative, then some deposits have been used to fund liquid assets and there is less likelihood that the bank will need to purchase liquidity i.e., less liquidity risk.

56) 1. Assign responsibility to manage liquidity to key personnel. 2.

Construct a list of withdrawal patterns and fund providers that are most likely to withdraw funds. 3. Identify potential size of fund withdrawals over given time intervals and identify sources of funds. 4. Set internal limits on borrowing and bounds on rates paid in each market. 5. Design a plan for disposal of assets in a specified sequence if necessary to meet liquidity needs.

22

57) Life insurers: State guarantee funds, if they exist, do not guarantee timely payment to policyholders. Rational policyholders would seek to cash out first (while they can still receive the full surrender value of the policy) rather than face an uncertain payout received at an uncertain time in the future.

Mutual funds: Runs on mutual funds do not occur because of fear of default. Runs occur in periods of falling asset values when mutual fund investors seek to cash out prior to facing large losses on the value of their fund holdings. Redemptions can deplete the fund's cash reserves and force the fund to sell assets at depressed prices.

58) Storing liquidity is the conservative approach. It requires maintaining substantial stocks of cash and near-cash assets that earn zero or low rates of return. Carrying costs will be high and are likely to constitute a drag on profitability and ROE. If the bank relies on its ability to purchase liquidity as needed, it may improve profitability since fewer low-earning assets need to be held, but the bank will probably face greater variability in funds costs. Purchased funds tend to be interestsensitive and the bank that uses them will face greater costs in higher interest rate environments. Moreover, a bank relying on purchased funds faces higher risk in abnormal conditions when the bank's ability to acquire reasonable cost borrowings at short notice may be impaired due to poor bank or market conditions.

23

59) If depositors believe the bank is facing insolvency, large depositors with amounts over the insurance limits are likely to withdraw their funds from the bank. Similarly, the failure of a related bank, perhaps another bank in the holding company or another bank with related business, may cause fears of a bank failure resulting in deposit withdrawals. Changes in rates of return between bank deposits and competing nonbank accounts can cause interest-sensitive bank customers to withdraw their funds from banks.

60) The Fed used to keep the discount rate below the target Fed funds rate and give limited access to the discount window for emergency lending to institutions that could not find private credit sources. The Fed changed this policy several years ago. All sound member institutions can borrow from the discount window through its primary credit program.

The discount rate is normally kept above the FOMC target Fed funds rate. Secondary credit is available for troubled institutions at a rate of 50 basis points above the primary credit rate. A longer-term seasonal lending program is also available for banks that can demonstrate seasonal funding needs.

24

Chapter 23: Managing Interest Rate Risk and Insolvency Risk on theBalance Sheet TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Insolvency occurs when an institution's duration gap becomes negative. ⊚ ⊚

true false

2) The duration gap model is a more complete measure of interest rate risk than the repricing model. ⊚ ⊚

true false

3) In a bank's three-month maturity bucket, a 30-year ARM with a rate reset in six months would be considered a fixed-rate asset, but in its one-year maturity bucket, this ARM would be considered a rate-sensitive asset. ⊚ ⊚

true false

4) A rate-sensitive asset is one that either matures within the maturity bucket or one that will have a payment change within the maturity bucket if interest rates change. ⊚ ⊚

5)

true false

If a bank has a negative repricing gap, falling interest rates increase profitability. ⊚ ⊚

true false

6) If a bank wishes to have a positive balance sheet repricing gap and a negative balance sheet duration gap, then the bank should predominantly have short-term rate-sensitive assets funded by long-term fixed-rate liabilities. ⊚ ⊚

true false

1

7) The repricing gap fails to consider how the value of fixed-income accounts will change when rates change. ⊚ ⊚

8)

true false

The "runoff" of fixed-income contracts is itself rate-sensitive. ⊚ ⊚

true false

9) For a one-year maturity bucket, the repricing model assumes that a nine-month loan is as equally rate-sensitive as a three-month loan. ⊚ ⊚

true false

10) The cash flow from the interest a bank receives on a long-term loan that is normally reinvested is called the runoff from the loan. ⊚ ⊚

11)

true false

If DA > kDL, then falling interest rates will cause the market value of equity to rise. ⊚ ⊚

true false

12) The repricing gap is the most comprehensive measure of interest rate risk used by financial intermediaries. ⊚ ⊚

true false

2

13) Due to convexity problems, banks are actually better off using the simpler repricing model to manage interest rate risk rather than the duration model. ⊚ ⊚

true false

14) A bond's price changes 2 percent when interest rates drop. The duration model would predict a price increase of more than 2 percent. ⊚ ⊚

true false

15) Convexity arises because a fixed-income security's price is a nonlinear function of interest rates. ⊚ ⊚

true false

16) The maturity bucket is the time window over which the dollar amounts of assets and liabilities are measured. ⊚ ⊚

true false

17) According to the CGAP effect, when CGAP is positive the change in NII is negatively related to the change in interest rates. ⊚ ⊚

true false

18) A bank manager would want to set the repricing gap greater than zero when interest rates are expected to rise. ⊚ ⊚

true false

3

19) A bank manager would want to set the duration gap greater than zero when interest rates are expected to rise. ⊚ ⊚

true false

20) The loss in value caused by credit risk is borne first by the liability holders, and then by the equity holders. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) A bank has a negative repricing gap using a six-month maturity bucket. Which one of the following statements is most correct if MMDAs are rate-sensitive liabilities?

A) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could encourage its retail deposit customers to switch from two-year CDs at current rates to three-month CDs. B) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank could encourage its retail deposit customers to switch from MMDAs to twoyear CDs at current rates.

C) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank could encourage its retail deposit customers to switch from three-month CDs to two-year CDs at current rates.

D) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could encourage its retail deposit customers to switch from two-year CDs at current rates to MMDAs. E) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could encourage its retail deposit customers to switch from MMDAs to two-year CDs at current rates.

22) A bank has a positive repricing gap using a six-month maturity bucket. Which one of the following statements is most correct?

4

A) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could encourage its retail loan customers to switch from one-year adjustable rate loans to Fed funds loans.

B) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank could encourage its retail loan customers to switch from one-month reset floating rate loans to three-year fixed-rate loans at current rates.

C) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank could encourage its retail loan customers to switch from fixed-rate mortgages to adjustable rate mortgages.

D) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could encourage its retail loan customers to switch from three-year to five-year auto loans.

E) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank could encourage its retail loan customers to switch from their bank to another bank.

23) The structure of a bank's balance sheet as evidenced by its repricing gap and its duration gap affects a bank's sensitivity to interest rate changes. Which one of the following statements about the two types of gaps is true?

A) The repricing gap immunizes the present value of all future cash flows, whereas managing the duration gap can stabilize future cash flows, but not their present value.

B) The duration gap considers all cash flows up to and including maturity, whereas the repricing gap really only considers how cash flows will change within the maturity bucket.

C) If a bank could only manage one type of gap, the bank would limit its interest rate risk the most by managing its repricing gap instead of its duration gap.

D) The repricing gap is superior to the duration gap since the repricing gap has a welldefined maturity bucket.

E) It is virtually impossible for an institution to have both a positive duration gap and a negative repricing gap at the same time.

24) A bank has a negative duration gap. Which one of the following statements is most correct?

5

A) If all interest rates are projected to increase, to limit a net value decline before rates rise, the bank should increase the amount of short-term loans on the balance sheet.

B) If all interest rates are projected to increase, to limit a net value decline before rates rise, the bank should increase the amount of short-term bonds issued by the bank.

C) If all interest rates are projected to decrease, to limit a net value decline before rates fall, the bank should increase the amount of long-term loans on the balance sheet.

D) If all interest rates are projected to decrease, to limit a net value decline before rates fall, the bank should increase the amount of long-term bonds issued by the bank.

E) None of the options are correct.

25) A bank is facing a forecast of rising interest rates. How should it set the repricing and duration gaps?

A) Positive repricing gap and negative duration gap B) Negative repricing gap and positive duration gap C) Positive repricing gap and positive duration gap D) Negative repricing gap and negative duration gap E) None of the options are correct.

26) A bank has a negative duration gap. Interest rates decline. Which one of the following best describes the effects of the interest rate change?

A) The bank's market value of equity is unchanged since the market value of its assets and liabilities moves in the same direction.

B) The bank's market value of equity goes up because the market value of its assets goes up by more than the market value of its liabilities goes down.

C) The bank's market value of equity goes down because the market value of its assets goes up by more than the market value of its liabilities goes down.

D) The bank's market value of equity goes down because the market value of its assets goes down by more than the market value of its liabilities goes down.

E) The bank's market value of equity goes down because the market value of its liabilities increases by more than the market value of its assets increases.

6

27)

With a six-month maturity bucket, a nine-month fixed-rate loan would be considered a asset and a 30-year mortgage with a rate adjustment in three months would be classified as a asset.

A) rate-sensitive; fixed-rate B) rate-sensitive; rate-sensitive C) fixed-rate; fixed-rate D) fixed-rate; rate-sensitive E) fixed-rate; nonearning

28)

A bank has the following balance sheet:

Assets

Return

Cash

0.00%

Investments (< 1 year) Short-term loans (< 1 year) Long-term fixed-rate loans (maturity> 1 year)

4.00%

$ 200

Liabilities and Equity Fixed-rate deposits Rate-sensitive deposits

6.00%

$ 225

6.75%

$ 250

Total

Million $ $ 35

$ 710

3.50%

Millions $ $ 240

2.00%

$ 260

Fed fund borrowings

2.50%

$ 25

Long-term borrowings at fixed rate (maturity> 1 year) Equity

5.50%

$ 119

Total

Cost

$ 66 $ 710

The bank's one-year repricing gap is (million):

A) $425.

B) $285.

C) $74.

D) $140.

E) $66.

7

29)

A bank has the following balance sheet:

Assets

Return

Cash

0.00%

Investments (< 1 year) Short-term loans (< 1 year)

4.00%

Long-term fixed-rate loans (maturity> 1 year)

6.75%

6.00%

Total

Million $ $ 35

Liabilities and Equity Fixed-rate deposits

$ 200 $ 225 $ 250

$ 710

Cost 3.50%

Millions $ $ 240

Rate-sensitive deposits Fed fund borrowings

2.00%

$ 260

2.50%

$ 25

Long-term borrowings at fixed rate (maturity> 1 year) Equity

5.50%

$ 119

$ 66

Total

$ 710

If the spread effect is zero and all interest rates decline 50 basis points, the bank's NII will change by over the year.

A) $0 B) $400,000 C) −$400,000 D) $700,000 E) −$700,000

30)

A bank has the following balance sheet:

Assets

Return

Million $ $ 35

Liabilities and Equity Fixed-rate deposits

Cash

0.00%

Investments (< 1 year)

4.00%

$ 200

Short-term loans (< 1

6.00%

$ 225

Cost 3.50%

Millions $ $ 240

Rate-sensitive deposits

2.00%

$ 260

Fed fund borrowings

2.50%

$ 25

8

year) Long-term fixed-rate loans (maturity> 1 year)

6.75%

Total

$ 250

$ 710

Long-term borrowings at fixed rate (maturity> 1 year) Equity Total

For a nine-month maturity bucket, the bank has and million in fixed-rate liabilities.

5.50%

$ 119

$ 66 $ 710

million in fixed-rate assets

A) $425; $285 B) $285; $425 C) $285; $359 D) $359; $285 E) $250; $66

31) A bank has a positive repricing gap and estimates that the spread between RSAs and RSLs will move directly with interest rates. If interest rates fall, the bank's overall NII will:

A) B) C) D)

rise. fall. be unchanged. rise or fall depending on the size of the spread effect relative to the size of the CGAP

effect.

E) None of the options are correct.

32) A bank has a negative repricing gap and estimates that the spread between RSAs and RSLs will move inversely with interest rates. If interest rates increase, NII will:

9

A) B) C) D)

rise. fall. be unchanged. rise or fall depending on the size of the spread effect relative to the size of the CGAP

effect.

E) None of the options are correct.

33) Weaknesses of the repricing model include the fact that: 1.I. it ignores changes in present values caused by changes in interest rates.

2.II. it ignores different cash flow sensitivities within a maturity bucket.

3.III. it fails to account for runoffs and prepayments.

A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III

34) A bank has three assets. It has $75 million invested in consumer loans with a three-year duration, $39 million invested in T-bonds with a 16-year duration, and $18 million in six-month maturity T-bills. What is the duration of the bank's asset portfolio in years?

A) 3.95 B) 4.83 C) 6.50 D) 7.38 E) 11.51

A bank has DA = 2.4 years and DL= 0.9 years. The bank has total equity of $82 million 35) and total assets of $850 million. Interest rates are at 6 percent.

What is the bank's duration gap in years?

10

A) 1.5325 B) 1.5868 C) 1.2685 D) 1.4563 E) 1.6222

A bank has DA = 2.4 years and DL = 0.9 years. The bank has total equity of $82 million 36) and total assets of $850 million. Interest rates are at 6 percent.

If interest rates increase 100 basis points, the predicted dollar change in equity value will equal:

A) $10,171,698.

B) −$10,171,698.

C) $12,724,528.

D) −$12,724,528.

E) $4,928,756.

A bank has DA = 2.4 years and DL = 0.9 years. The bank has total equity of $82 million 37) and total assets of $850 million. Interest rates are at 6 percent.

To get DE to equal zero to protect the equity value in the event of an interest rate change, the bank could:

A) reduce DA to 1.21 years.

B) increase DL to 2.44 years.

C) increase DL to 3.10 years.

D) reduce DA to zero.

E) increase DL to 2.77 years.

38) For large interest rate declines, duration and for large interest rate decreases, it

the increases in the bond's price, the decline in the bond's price.

11

A) underpredicts; overpredicts B) overpredicts; underpredicts C) underpredicts; underpredicts D) overpredicts; overpredicts E) None of the options are correct.

39)

For a bank with a positive duration gap, an increase in interest rates will:

A) increase the likelihood of insolvency.

B) decrease the likelihood of insolvency.

C) not affect the likelihood of insolvency.

D) result in increased loan trading.

E) None of the options are correct.

40) After interest rate and yield curve changes, a bank's market value of assets increased $4 million and the market value of its liabilities fell $6 million. The book value of equity and the market value of equity .

A) increased $2 million; was unchanged B) fell $2 million; was unchanged C) was unchanged; fell $2 million D) was unchanged; fell $10 million E) was unchanged; increased $10 million

41) A bank has a positive duration gap. Which one of the following statements is most correct?

12

A) If all interest rates are projected to increase, to limit a net value decline before rates rise, the bank should increase long-term loans and decrease short-term loans.

B) If all interest rates are projected to decrease, to limit a net value decline before rates fall, the bank should increase long-term loans and decrease short-term loans.

C) If all interest rates are projected to increase, to limit a net value decline before rates rise, the bank should increase short-term loans and decrease long-term loans.

D) If all interest rates are projected to decrease, to limit a net value decline before rates fall, the bank should increase long-term bonds issued by the bank and decrease short-term bonds.

E) None of the options are correct.

42)

A bank has a positive repricing gap. This implies that:

A) some RSAs are financed by fixed-rate liabilities.

B) some RSLs are financing fixed-rate assets.

C) some RSAs are financing equity.

D) the bank has no fixed-rate assets.

E) None of the options are correct.

43)

A bank has a negative repricing gap. This implies that:

A) some RSAs are financed by fixed-rate liabilities.

B) some RSLs are financing fixed-rate assets.

C) some RSAs are financing equity.

D) the bank has no fixed-rate assets.

E) None of the options are correct.

44) An FI's balance sheet is characterized by long-term fixed-rate assets funded by short-term variable-rate securities. Most likely the bank has a:

13

A) positive repricing gap and a positive duration gap.

B) positive repricing gap and a negative duration gap.

C) negative repricing gap and a positive duration gap.

D) negative repricing gap and a negative duration gap.

E) None of the options are correct.

45) Weaknesses of the duration gap immunization model include all but which of the following?

A) Continuously matching the duration of assets and liabilities can be time-consuming and costly.

B) Duration-based predictions are always incorrect due to convexity.

C) Duration measurement and management are more complex than the repricing model.

D) Duration-based immunization strategies require continuous rebalancing of asset and liability durations.

E) Duration measures only how cash flows change, not the present value of those changes.

46)

Convexity in bond prices is caused by the:

A) coupon changes on a bond.

B) change in default probability associated with a yield change.

C) CGAP effect.

D) curvature around the bond price yield relationship.

E) mismatch between the duration of the assets and liabilities.

47) A bank has book value of assets equal to $800 million and market value of assets equal to $1,100 million. The bank has book value of liabilities of $700 million and market value of liabilities equal to $850 million. The bank's market-to-book ratio is:

14

A) 2.5.

B) 2.0.

C) 1.5.

D) 1.0.

E) 0.67.

48) A bank has an average asset duration of 2.25 years, the average duration of the liabilities is 1.25 years, and the bank has total assets of $2 billion and $200 million in equity. The bank has an ROE of 9.00 percent. If all interest rates decrease 50 basis points, the predicted change in the bank's market value of equity is .

A) −2.85 percent B) −3.55 percent C) 3.55 percent D) 2.85 percent E) 5.16 percent

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

49) A thrift has an annual CGAP of −$25 million. A credit union has an annual CGAP of +$5 million. The thrift has total assets of $500 million and net income of $7.5 million, and the credit union has total assets of $40 million and net income of $0.7 million.

Assuming a zero spread effect, if all interest rates decrease 50 basis points, what is the change in NII for the thrift? For the credit union?

15

50) A thrift has an annual CGAP of −$25 million. A credit union has an annual CGAP of +$5 million. The thrift has total assets of $500 million and net income of $7.5 million, and the credit union has total assets of $40 million and net income of $0.7 million.

Calculate each institution's CGAP as a percent of assets. Based on the gap, which institution's NII is more sensitive to interest rates? Explain.

51) A thrift has an annual CGAP of −$25 million. A credit union has an annual CGAP of +$5 million. The thrift has total assets of $500 million and net income of $7.5 million, and the credit union has total assets of $40 million and net income of $0.7 million.

In each of the following cases indicate whether the change in profits due to the spread effect was (i) greater than (ii) less than, or (iii) equal to the change in profitability due to the repricing gap.

In some cases you may not be able to tell; indicate when this is the case.

A) B) C) D)

52)

Gap

Change in Rates

Change in NII

+ + − −

+ − − +

+ + − −

What are four major weaknesses of the repricing model?

53) The effect of an interest rate change on the market value of an FI's equity is a function of three things. What are they and how do they affect the equity value change?

16

A bank has DA = 2.5 years, DL = 0.80 years, and k = 92%. Assets are equal to $1,200 54) million. According to the duration gap model, what size interest rate change would make the institution insolvent if rates are currently 5 percent?

55)

Explain how an FI's capital protects against credit risk and interest rate risk.

56) Explain how interest rate risk could change at banks, thrifts, and other institutions that originate and sell fixed-rate mortgages but are funded with deposits if these institutions lose the ability to securitize and sell mortgages. What could be the effect on the economy?

57) What factors can cause a bank's book value of equity to differ from its market value?

What widely available ratio is typically used to measure the difference between the two?

58) What are arguments for and against requiring banks to mark all assets and liabilities to market continuously? Relate your arguments to managing credit risk and interest rate risk.

17

18

Answer Key Test name: Chap 23_8e 1) FALSE 2) TRUE 3) TRUE 4) TRUE 5) TRUE 6) TRUE 7) TRUE 8) TRUE 9) TRUE 10) TRUE 11) TRUE 12) FALSE 13) FALSE 14) FALSE 15) TRUE 16) TRUE 17) FALSE 18) TRUE 19) FALSE 20) FALSE 21) E 22) B 23) B 24) C 25) A 26) E 19

27) D 28) D RSAs − RSLs = [$200 + $225] − [$260 + $25] = $140 29) E $140 million × −0.0050 = −$700,000 30) C FRA = Cash + LT loans = $35 + $250 = $285; FRL = Fixed-rate deposits + LT borrow = $240 + $119 = $359 31) B 32) B 33) E 34) C [($75 million/($75 million + $39 million + $18 million) × 3] + [($39 million/($75 million + $39 million + $18 million) × 16] + [($18 million/($75 million + $39 million + $18 million) × 0.5] = 6.50 35) B 2.4 − ([($850 million − $82 million)/$850 million] × 0.9) = 1.5868 36) D − [2.4 − (($850,000,000 − $82,000,000)/$850,000,000) × 0.9] × [0.01/1.06] × $850,000,000 = −$12,724,528 37) E 2.5 × $850 million/$768 million = 2.77 38) A 39) A 40) E 41) C 42) A 20

43) B 44) C 45) E 46) D 47) A ($1,100 million − $850 million)/($800 million − $700 million) = 2.5 48) E DGap = DurA − kDurL = 2.25 − (0.90 × 1.25) = 1.125; %∆E = −1.125 × (−0.005/1.09) × $2 billion/$200 million = 0.0516, or 5.16% 49) Thrift: ∆NII = −$25 million × −0.0050 = $125,000 Credit Union: ∆NII = +$5 million × −0.0050 = −$25,000 50) Although a given interest rate change will lead to a larger dollar profit change for the thrift, the credit union actually has the larger percentage gap, $5,000,000/$40,000,000 = 0.1250, or 12.50 percent for the CU versus −$25,000,000/$500,000,000 = −0.05, or −5 percent for the thrift.

Thrift: ∆NII = −$25 million × −0.0050 = $125,000 Credit Union: ∆NII = +$5 million × −0.0050 = −$25,000 The interest rate change results in a $125,000 profit change for the thrift and a −$25,000 profit change for the CU. The thrift's profit change is only $125,000/$7,500,000 = 0.0167, or 1.67 percent of net income while the CU's profit change is −$25,000/$700,000 = −3.57 percent of net income.

The CU's profitability is more sensitive to interest rates.

51) ∆ spread 1.(A) Cannot tell 2.(B) Greater than change in gap 3.(C) Greater than change in gap 4.(D) Cannot tell

21

52) ● It ignores the market value effects of a change in interest rates. ● It ignores different cash flow patterns within a maturity bucket. ● It ignores cash flows from off-balance-sheet activities.

[The latter two are implementation problems as used in practice more than they are problems with the model.]

53) ● The Duration gap (DA − kDL).The larger the gap, the greater the value change. If rates rise and the gap is positive, the value of equity falls. ● The size of the FI. The greater the size, the greater the dollar value change for a given rate change. ● The size of the interest rate change. The greater the rate change, the greater the value change.

54) − (1 − 0.92) × $1,200 million = − [2.5 − (0.92 × 0.8)] × [$1,200 million × (∆R/1.05)]; ∆R = 0.0476 = +476 BP 55) ● Credit risk: Equity is written down when loans go bad. If too many loans default and the equity is reduced to zero, then the FI is insolvent. Thus, the more equity the FI has, the lower the likelihood that loan defaults will cause insolvency. ● Interest rate risk: Changes in interest rates can reduce the market value of equity of a bank if there is an unfavorable rate change based on the duration gap. The bigger the amount of equity, the more rates have to change before the insolvency occurs.

22

56) Banks, thrifts, and other institutions that create mortgages funded by deposits and other short-term liabilities have negative repricing gaps and positive duration gaps, and they are thus at risk from rising interest rates.

One way they limit this interest rate risk is to quickly sell the mortgages after origination. In that case, the long-term fixed-rate asset is typically removed from the balance sheet and the gap is reduced. If they can no longer sell the mortgages, they will have to either create fewer mortgages or engage in extensive hedging to limit interest rate risk exposure. The first alternative would reduce the availability of mortgage credit in the markets and could result in further drops in home prices.

This could seriously hurt our economy because our growth is so driven by consumer spending, which is not likely to grow when home values are dropping. The second alternative (hedging) will add to the cost of creating mortgage credit, and this cost would have to be passed on to the customer in the form of either higher fees or higher interest rates. This could also hurt the housing market.

57) The factors that can cause a bank’s book value of equity to differ from its market value are: ● Interest rate volatility: The more volatile rates are, the greater the discrepancy. ● Management timing of recognizing bad loans and writing them off.

More frequent and thorough examinations usually improve the timeliness of these write-downs. ● Selective sales of assets can increase the discrepancy (e.g., selling assets that have increased in value, keeping those that have losses). ● In general, loan sales decrease the difference between the book value and market value of equity as the sale reflects the current market value.

The market-to-book ratio is used to ascertain how far apart the two measures are.

23

58) Arguments for: When banks mark to market, book values of equity will conform to market values much more closely. This allows stakeholders such as stockholders, depositors, and regulators to better analyze the bank's condition and set a better market value of equity as conditions change.

When banks use book values for some or all assets and liabilities, the book equity measure is not automatically updated until management engages in transactions, such as selling depreciated value assets or recognizing actual loan losses. This delay can allow a suffering institution to generate greater losses that eventually the insurer and, ultimately, the taxpayer must pay for.

Arguments against: The banking industry counters with several arguments: First, banks and thrifts maintain that implementing market value accounting is difficult and burdensome, particularly for smaller institutions that have many nontraded assets for which it would be difficult to obtain a market value.

Second, managers do not want unrealized (paper) gains and losses to be reflected in income, claiming this would excessively destabilize earnings and equity; they argue that they usually hold assets to maturity and do not realize current market values. Finally, bank managers also claim that they would engage in less long-term lending and investing if these accounts were regularly marked to market.

24

Chapter 24: Managing Risk off the Balance Sheet with Derivative Securities TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) A spot contract is for immediate delivery whereas a forward contract is for future delivery. ⊚ ⊚

true false

2) The lack of perfect correlation between spot and futures prices implies that most hedges will have some basis risk. ⊚ ⊚

3)

Gains and losses on a futures contract must be recognized daily. ⊚ ⊚

4)

true false

true false

Buying a cap is similar to buying a call option on bond prices. ⊚ ⊚

true false

5) A macrohedge is a hedge of a particular asset or liability exposure to a change in a macroeconomic variable. ⊚ ⊚

true false

6) Basis risk is the risk that the prices or value of the underlying spot and the derivatives instrument used to hedge do not move predictably relative to one another. ⊚ ⊚

true false

1

7)

Writing a call option on a bond pays off if interest rates rise. ⊚ ⊚

true false

8) Forward contracts are not subject to default risk because the exchanges honor the contract in case the counterparty defaults, but future contracts are subject to default risk because they are nonstandardized contracts. ⊚ ⊚

true false

9) Swaps are usually the best hedging tool to use to hedge long-term risks of four or five years or more. ⊚ ⊚

true false

10) A U.S. corporation has a yen-denominated loan it must repay in six months. A long position in yen futures could help offset the corporation's foreign exchange risk. ⊚ ⊚

11)

A purchaser of a bond call option gains if interest rates fall. ⊚ ⊚

12)

true false

true false

As interest rates fall, bond prices and call option potential profits increase. ⊚ ⊚

true false

13) Swaps and forwards are subject to contingent risk; exchange-traded futures and options are not.

2

⊚ ⊚

true false

14) The buyer of an American-style bond call option has the right, but not the obligation, to sell the bond at a set price until the option expires. ⊚ ⊚

true false

15) The writer of an American-style bond call option has the right, but not the obligation, to buy the bond at a preset price until the option expires. ⊚ ⊚

true false

16) The maximum gain (ignoring commissions and taxes) from buying an at-the-money bond put option is the bond price at time of option purchase less the put premium. The maximum loss is the put premium. ⊚ ⊚

17)

true false

A fixed-floating interest rate swap is called a plain vanilla swap. ⊚ ⊚

true false

An FI with DA < kDL may choose to enter into a long-term swap in which it pays a fixed 18) rate of interest and receives a variable rate in order to effectively reduce the duration gap. ⊚ ⊚

true false

19) A bank with a negative repricing gap could enter into a swap to pay a fixed rate of interest and receive a variable rate of interest to effectively reduce its repricing gap.

3

⊚ ⊚

true false

20) A bank has a positive repricing gap and wishes to protect its profits from an unfavorable interest rate move. Purchasing a cap will help limit this bank's interest rate risk. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) Which of the following requires daily cash flow settlements between the parties?

A) Forward contract B) Futures contract C) Purchased options contract D) Swap contract E) Collars

22)

A macrohedge is a:

A) hedge of a particular asset or liability.

B) hedge of an entire balance sheet.

C) hedge using options.

D) hedge without basis risk.

E) hedge using futures on macroeconomic variables.

23)

A microhedge is a:

4

A) hedge of a particular asset or liability.

B) hedge against a change in a particular macro variable.

C) hedge of an entire balance sheet.

D) hedge using options.

E) hedge without basis risk.

24)

Basis risk occurs because it is generally impossible to:

A) hedge unanticipated rate changes.

B) exactly predict interest rate changes.

C) exactly match the terms of the hedging instrument with the terms of the asset or liability at risk.

D) find negatively correlated asset prices.

E) All of these choices are correct.

25) A bond portfolio manager has a $25 million market value bond portfolio with a six-year duration. The manager believes interest rates may increase 50 basis points. Which of the following could be used to help limit his risk? 1.I. Sell the bonds forward.

2.II. Buy bond futures contracts.

3.III. Buy call options on the bonds.

4.IV. Buy put options on the bonds.

A) I only B) II only C) I and III only D) I and IV only E) II and III only

26)

Which of the following are potentially subject to risk-based capital requirements?

5

A) Swaps and futures B) Swaps and forwards C) Forwards and futures D) Purchased option positions and futures E) Purchased option positions and swaps

27)

A forward contract:

A) is marked to market.

B) has significant default risk.

C) is standardized.

D) is traded over the counter.

E) is highly liquid.

28) The price of a bond rises from 98 to par. Even if you do nothing, this would still result in an immediately recognized loss on a on a bond, and a paper gain on a bond .

A) long forward contract; call option B) short futures contract; call option C) call option; put option D) short futures contract; put option E) short forward contract; call option

29)

A position in T-bond futures should be used to hedge falling interest rates and a position in T-bond futures should be used to hedge falling bond prices.

A) long; short B) long; long C) short; long D) short; short E) None of the options are correct.

6

30) Which of the following bond option positions increase in value when interest rates increase?

A) Long call and written put B) Long put and written call C) Long putand long call D) Written putand written call E) None of the options are correct.

31) For a bond put option, the the exercise price, the greater the cost of the put, and for a bond call option, the the exercise price, the higher the cost of the call option.

A) higher; higher B) lower; lower C) higher; lower D) lower; higher E) None of the options are correct.

32)

The safest way to hedge a bond asset with options is to:

A) purchase a call option on the bond.

B) write a call option on the bond.

C) purchase a put option on the bond.

D) write a put option on the bond.

E) None of the options are correct.

33)

The safest way to hedge a bond liability with options is to:

7

A) purchase a call option on the bond.

B) write a call option on the bond.

C) purchase a put option on the bond.

D) write a put option on the bond.

E) None of the options are correct.

34)

An FI with DA > kDL could do which of the following to reduce the duration gap?

A) Engage in a swap and pay a variable rate and receive a fixed rate of interest B) Sell bond futures contracts C) Buy bonds forward D) Buy bond call options E) None of the options are correct.

35)

The largest two categories of swaps are

A) credit risk and interest rate swaps.

B) currency and commodity swaps.

C) interest rate and currency swaps.

D) equity and interest rate swaps.

E) None of the options are correct.

36) A bondholder owns 15-year government bonds with a $5 million face value and a 6 percent coupon that is paid annually. The bonds are currently priced at $550,018.73 with a yield of 5.034 percent. The bonds have a duration of 10.53 years. If interest rates are projected to increase by 50 basis points, how much will the bondholder gain or lose?

A) $27,571 B) $25,063 C) −$27,571 D) −$25,063 E) $5,313

8

37) An FI has long-term fixed-rate assets funded by short-term variable-rate liabilities. To protect the equity value, the FI may engage in a swap to pay a rate and receive a interest.

A) fixed; variable B) variable; variable C) variable; fixed D) fixed; fixed E) None of the options are correct.

38) The profits on a derivatives position are fixed when a bond's price falls below a certain point, but above that point the profits fall when the bond price rises. This profit profile fits which of the following positions?

A) Purchased call option B) Written call option C) Purchased put option D) Written put option E) None of the options are correct.

39)

Plain vanilla interest rate swaps are exchanges of:

A) principal only.

B) interest only.

C) principal and interest.

D) principal and currency.

E) interest rate and currency.

40) After conducting a rate-sensitive analysis, a bank finds itself with the following amounts of rate-sensitive assets and liabilities (RSAs and RSLs) and fixed-rate assets and liabilities (FRAs and FRLs). The rate of return and cost rates on the accounts are also given in the following table:

9

Assets RSAs @ 4.25% FRAs @ 5.15% NEA Total

Amount (million $) $ 322 $ 700 $ 120 $ 1,142

Liabilities & Equity RSLs @ 3.11% FRLs @ 4.95% Equity Total

Amount (million $) $ 200 $ 800 $ 142 $ 1,142

If we were to design a macrohedge, which of the following positions would help reduce the bank's interest rate risk?

1.I. Establishing a long position in bond futures contracts 2.II. Buying put options on bonds 3.III. Purchasing an interest rate cap

A) I only B) II only C) III only D) I and III only E) II and III only

41) After conducting a rate-sensitive analysis, a bank finds itself with the following amounts of rate-sensitive assets and liabilities (RSAs and RSLs) and fixed-rate assets and liabilities (FRAs and FRLs). The rate of return and cost rates on the accounts are also given in the following table: Assets RSAs @ 4.25% FRAs @ 5.15% NEA Total

Amount (million $) $ 322 $ 700 $ 120 $ 1,142

Liabilities & Equity RSLs @ 3.11% FRLs @ 4.95% Equity Total

Amount (million $) $ 200 $ 800 $ 142 $ 1,142

If the bank wishes to set up a swap to totally hedge the interest rate risk, the bank should: A) pay a variable rate of interest and receive a fixed rate of interest.

B) pay a fixed rate of interest and receive a variable rate of interest.

C) pay a variable rate of interest and receive a variable rate of interest.

D) pay a fixed rate of interest and receive a fixed rate of interest.

E) None of the options are correct.

10

42) After conducting a rate-sensitive analysis, a bank finds itself with the following amounts of rate-sensitive assets and liabilities (RSAs and RSLs) and fixed-rate assets and liabilities (FRAs and FRLs). The rate of return and cost rates on the accounts are also given in the following table: Assets RSAs @ 4.25% FRAs @ 5.15% NEA Total

Amount (million $) $ 322 $ 700 $ 120 $ 1,142

Liabilities & Equity RSLs @ 3.11% FRLs @ 4.95% Equity Total

Amount (million $) $ 200 $ 800 $ 142 $ 1,142

Suppose the institution wishes to fully hedge the interest rate risk with a swap. A swap is available with whatever notional principal is needed that pays fixed at 4.95 percent and pays variable at LIBOR. LIBOR is currently 5.11 percent. By how much would profits change right now if the bank engages in the swap?

A) $202,600 B) −$202,600 C) $300,000 D) −$195,200 E) $195,200

43) A thrift purchases a one-year interest rate floor with a floor rate of 4.23 percent from a large bank. The option has a notional principal of $1 million and costs $2,000. If in one year, interest rates are 3.15 percent, the thrift's net profit, ignoring commissions and taxes, was ; and if in one year, interest rates were 5.2 percent, the thrift's net profit was .

A) $0; $7,500 B) $8,800; −$2,000 C) $8,800; $0 D) $29,500; −$2,000 E) $29,500; $0

11

44) A regional bank negotiates the purchase of a one-year interest rate cap with a cap rate of 5.45 percent with a large bank. The option has a notional principle of $2 million and costs $3,400. In one year, interest rates are 6.33 percent. The regional bank's net profit, ignoring commissions and taxes, was:

A) $105,600.

B) $18,400.

C) $17,600.

D) $14,200.

E) $11,500.

45) Your firm has sold long-term government bonds short on a when-issued basis; your firm must purchase the bonds and deliver them when they are issued in six months. To hedge this risk, you could: 1.I. buy at-the-money put options on bonds.

2.II. sell bond futures contracts.

3.III. write at-the-money call options on bonds.

A) I only B) II only C) I and III only D) II and III only E) None of these choices are correct.

46)

In 2019, only about

of the largest banks actively used derivatives.

A) 742 B) 832 C) 942 D) 992 E) 1,334

47)

A naïve hedge is one:

12

A) in which the hedger is not fully informed.

B) in which the hedger attempts to eliminate all of the risk of the underlying spot position.

C) in which the hedger uses microhedges rather than macrohedges to limit risk.

D) in which the hedger unwittingly increases the risk of the FI's position.

E) that does not have to be reported on the FI's financial statements.

48) An FI buys a $500 million cap of 7 percent at a premium of 0.75 percent of face value. In addition, it sells a $500 million floor of 3 percent at a premium of 0.70 percent of face value.

If interest rates rise to 7.25 percent what is the net profit of the FI?

A) −$1,250,000 B) −$250,000 C) $0 D) $1,000,000 E) $1,250,000

49) An FI buys a $500 million cap of 7 percent at a premium of 0.75 percent of face value. In addition, it sells a $500 million floor of 3 percent at a premium of 0.70 percent of face value.

If interest rates fall to 2.5 percent what is the net profit of the FI?

A) −$2,750,000 B) −$250,000 C) $0 D) $2,000,000 E) $2,750,000

13

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

50) A U.S. firm is earning British pounds from its foreign subsidiary. A UK firm is earning dollars from its U.S. subsidiary. Neither firm can borrow at a cost-effective rate outside of its home country/currency. What kind of swap could be used to limit the FX risk of both firms and explain the payment flows involved? (Be specific.)

51) Why is the credit risk on a plain vanilla interest rate swap generally less than the credit risk of a loan with an equivalent (notional) principal amount?

52) Is it safer to hedge a contingent liability with options, futures, forwards, or swaps?

Explain.

53) Draw a graph of the gains and losses from owning a bond and simultaneously buying a put on the bond.

14

54) A U.S. bank has deposit liabilities denominated in euros that must be repaid in two years.

The deposits pay a fixed interest rate of 4 percent. The bank took the money raised and converted it to dollars, whereupon it lent the dollars to a corporate customer that will repay the bank over the next two years in dollars at a variable rate of interest equal to LIBOR +3 percent. The interest rate earned may change every six months.

Other than credit risk, what are the risks to the bank?

55) A U.S. bank has deposit liabilities denominated in euros that must be repaid in two years.

The deposits pay a fixed interest rate of 4 percent. The bank took the money raised and converted it to dollars, whereupon it lent the dollars to a corporate customer that will repay the bank over the next two years in dollars at a variable rate of interest equal to LIBOR +3 percent. The interest rate earned may change every six months.

Design a swap that the bank could use to reduce its risks.

56) A U.S. corporation is bidding on a revenue-generating contract in England. If the corporation gets the bid, it will be paid in pounds. 1.a. If the managers are risk averse, can hedging increase the likelihood that the U.S. firm gets the bid? Explain.

2.b. In this situation, should the corporation hedge with options, futures, or forwards? Explain.

57)

What are the advantages and disadvantages of forwards versus futures contracts?

15

58) In terms of direct costs, are futures or options likely to be a more expensive form of hedging? Why? In terms of opportunity costs, which is more expensive? Why?

59) A bank wishes to hedge its $30 million face value bond portfolio (currently priced at 99 percent of par). The bond portfolio has a duration of 9.75 years. It will hedge with T-bond futures ($100,000 face) priced at 98 percent of par. The duration of the T-bonds to be delivered is nine years. How many contracts are needed to hedge? Should the contracts be bought or sold?

Ignore basis risk.

An FI has DA = 2.45 years and kDL = 0.97 years. The FI has total assets equal to $375 60) million. The FI wishes to effectively reduce the duration gap to one year by hedging with T-bond futures that have a market value of $115,000 and a DFut = 8 years. How many contracts are needed and should the FI buy or sell them? (D = Duration)

61) A bank wishes to hedge its $25 million face value bond portfolio (currently priced at 106 percent of par). The bond portfolio has a duration of five years. It will hedge with put options that have a delta of 0.67. The bond underlying the option contract has a market value of $112,000 and a duration of eight years. How many put options are needed? Assume that there is no basis risk on the hedge.

16

62) A $995 million bank has a negative repricing gap equal to 6 percent of assets. The bank is currently paying 4.5 percent on its rate-sensitive liabilities. These rates will vary as interest rates move. The managers wish to reduce the effective repricing gap to zero with an interest rate cap or floor. A one-year cap is available with a 5 percent cap rate and a one-year floor is available at a floor rate of 4 percent. 1.a. Suggest a position using either the cap or the floor (but not both) that will limit the bank's interest rate risk. Explain.

2.b. Suppose that interest rates are volatile this year and the cap costs $275,000 and the floor costs $195,000. Suggest a collar that helps limit the bank's cost of hedging. How does the collar affect the bank's risk?

63) A bank wishes to reduce its duration gap from 1.2 years to zero by using put options. The bank has $800 million in assets. The underlying bonds on the puts are valued at $115,000 and have a duration of four years. The put options have a delta of 0.58. How many put options are needed? Assume that there is no basis risk on the hedge.

17

Answer Key Test name: Chap 24_8e 1) TRUE 2) TRUE 3) TRUE 4) FALSE 5) FALSE 6) TRUE 7) TRUE 8) FALSE 9) TRUE 10) TRUE 11) TRUE 12) TRUE 13) TRUE 14) FALSE 15) FALSE 16) TRUE 17) TRUE 18) FALSE 19) TRUE 20) FALSE 21) B 22) B 23) A 24) C 25) D 26) B 18

27) B 28) B 29) B 30) B 31) C 32) C 33) A 34) B 35) C 36) C $ΔP = −Dur × (ΔR/(1 + R)) × P0 = −10.53 × (0.0050/1.05034) × $550,018.73 = −$27,570.58 37) A 38) B 39) B 40) A Risk is from falling interest rates or rising prices with a positive repricing gap.

41) A Risk is from falling interest rates or rising prices with a positive repricing gap.

42) D Pay variable; receive fixed; ($322 − $200) × (4.95% − 5.11%) = −$195,200 43) B Max [(Floor rate − Actual rate) × NP, 0] − $2,000 = [(4.23% − 3.15%) × $1 million] − $2,000 = $8,800; $0 − $2000 = −$2,000 44) D 19

Max [(Actual rate − Cap rate) × NP, 0] − $3,400 = [(6.33% − 5.45%) × $2,000,000] − $3,400 = $14,200 45) E The risk is from rising prices.

46) E 47) B 48) D The cost of the collar is: (−0.0075 × $500,000,000) + (0.0070 × $500,000,000) = −$250,000 If interest rates rises to 7.25 percent, only the cap will be exercised, the profit from the cap will be: $500,000,000 × (0.0725 − 0.07) = $1,250,000 Net profit will be $1,250,000 − $250,000 = $1,000,000 49) A The cost of the collar is: (−0.0075 × $500,000,000) + (0.0070 × $500,000,000) = −$250,000 If interest rates rises to 2.5 percent, only the floor will be exercised by the buyer of the floor, and the loss from the floor will be: −$500,000,000 × (0.03 − 0.025) = −$2,500,000 Net loss will be −$2,500,000 − $250,000 = $2,750,000 50) The U.S. firm would borrow $ in the United States; the UK firm would borrow £ in the UK. The U.S. firm agrees to pay the £ interest and principal on the UK firm's borrowings using its subsidiary's pound earnings, and the British firm agrees to pay the $ interest and principal on the American firm's debt (using its subsidiary's $ proceeds).

20

51) Swap payments are netted against one another so the actual payment due is lower than the payment that would be due on an equivalent principal loan. There is no lending of principal, so no principal is due on a swap, but it is due on a loan. A third party may be hired (for a fee) to guarantee payments on a swap, even if a counterparty defaults, or a standby letter of credit or collateral may be required.

52) A contingent liability should be hedged by buying options. Then, if the liability doesn't occur, the FI is not left with an unlimited loss exposed risk position in a derivative without an offsetting spot position.

53)

54) There are two risks other than credit risk: 1. 1. Interest rates may fall, reducing the income from the corporate loan, while the funding cost of the liabilities would stay the same.

2. 2. The value of the euro could increase against the dollar, raising the dollar cost to repay the euro deposits because the dollars earned would buy fewer euros.

55) The bank could pay dollars at a variable rate of interest based on LIBOR and receive euros at a fixed rate of interest. This would reduce both the foreign exchange and interest rate risk.

21

56) 1.a. Hedging can increase the likelihood the firm gets the bid because if the firm hedges, it can be more certain of the dollar value of the pounds received if it hedges now before the outcome of the bid is known. This should allow the firm to bid more and increase its chances of obtaining the contract even after considering the cost of hedging.

2.b. In this case, an options hedge will be preferred (buy puts on the pound) since the firm is not sure that it will get the bid. Options are preferred in this case because the firm does not have to use them if it does not get the bid. If the firm hedges with futures or forwards before receiving the outcome of the bid, and then it doesn't get the bid, the firm finds that it has engaged in highly risky currency speculation without an offsetting spot position to limit the risk.

57) The advantages of forwards include the participant's ability to negotiate nonstandard terms and the lack of required cash payments before maturity. Advantages of futures include their marketability, the lack of counterparty default risk, and the anonymity of the participants.

58) In terms of direct costs, options are generally a more expensive form of hedging because they are a right and not an obligation. An option writer knows that the buyer will only exercise the option when it is in the buyer's favor and at the writer's expense, so the writer will charge for this right. In terms of opportunity costs, however, futures are probably a more expensive method of hedging because futures hedges limit both gains and losses, but long option hedges truncate losses while allowing large gains. However, in a totally efficient market, the additional flexibility provided by options would increase the price of the option relative to futures until a net advantage no longer existed.

59) NF =9.75 × (0.99 × $30 million)/(9 × (0.98 × $100,000)) =328.32;328contracts should be sold (round down) 22

60) NF = (2.45 − 0.97 − 1) × $375 million/(8 × $115,000) = 195.65; 195 contracts should be sold (round down)

61) Number of puts =5 × (106% × $25 million)/(0.67 × 8 × $112,000) =220.72; 220put options should be bought (round down) 62) 1.a. The bank's risk is from rising interest rates. The required notional principal = 6% × $995 million = $59.7 million, the size of the repricing gap. The bank should purchase the cap with a notional principal amount of $59.7 million. If interest rates rise above the cap rate of 5 percent, driving up the bank's liability costs, payments received on the cap will help offset the rising costs of the rate-sensitive liabilities.

The cap doesn't earn anything until rates move above 5 percent, so the bank will lose profitability equal to $59.7 million × 0.005 = $298,500 before the cap moves into the money.

2.b. The bank could purchase the cap and sell the floor to limit the cost of hedging. The net cost of the collar is then the income from selling the floor, $195,000 minus the cost of the cap, $275,000, or a net cost of $80,000. Selling the floor limits net gains from the declining cost of the rate-sensitive liabilities on the balance sheet if interest rates drop.

In other words, selling the floor adds an opportunity cost from declining interest rates.

63) Number of puts =1.2 × $800 million/(0.58 × 4 × $115,000)=3,598.2;3,598put options should be bought (round down)

23

Chapter 25: Managing Risk off the Balance Sheet with Loan Sales and Securitization TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) A mortgage pass-through security is a bond issue backed by a group of mortgages that pays fixed semiannual coupon payments and the principal is repaid only at maturity. ⊚ ⊚

2)

true false

In 2007 and 2008, loan sales primarily consisted of sales of distressed loans. ⊚ ⊚

true false

3) The buyer of a loan in a participation has a double risk exposure: one to the borrower and one to the selling bank. ⊚ ⊚

4)

A loan sold without recourse generates a contingent liability for the selling bank. ⊚ ⊚

5)

true false

Loans sold to correspondent banks are predominantly sales of distressed HLT loans. ⊚ ⊚

7)

true false

More than 90 percent of loan sales in the U.S. market are via assignments. ⊚ ⊚

6)

true false

true false

Vulture funds specialize in buying distressed loans.

1

⊚ ⊚

8)

true false

Most loan sales are now accomplished in about 10 days. ⊚ ⊚

true false

9) Advantages of Brady bonds over LDC loans include improved liquidity and higher coupon rates. ⊚ ⊚

true false

10) Under current reserve requirements, bank loan sales with recourse are considered a liability and are subject to reserve requirements. ⊚ ⊚

true false

11) The sale or transfer of assets at less than fair value that occurs at a time when the seller is insolvent is termed fraudulent conveyance. ⊚ ⊚

true false

12) When a vulture fund acquires a distressed loan, the fund usually assists the distressed firm's managers in formulating a long-term plan for restoring profitability. ⊚ ⊚

true false

13) An investor in a GNMA mortgage-backed security may be able to earn a return higher than the rate on a comparable maturity Treasury without taking on much, if any, default risk.

2

⊚ ⊚

true false

14) An advantage of securitization and loan sales over interest rate swaps as a riskmanagement tool is that securitization, by removing loans from the balance sheet, reduces the regulatory tax imposed by existing regulations. ⊚ ⊚

true false

15) Because of the government backing, investors in GNMA pass-throughs are guaranteed to earn at least the T-bill rate on their investments. ⊚ ⊚

true false

16) A CMO is a multiclass pass-through that helps investors choose the amount of prepayment risk they will face. ⊚ ⊚

true false

17) Loan sale by assignment provides more control over the contract to the loan buyer than participation loans. ⊚ ⊚

true false

18) HLT loans are long maturity loans backed by the borrower’s assets with floating interest rates tied to the Federal Funds rate. ⊚ ⊚

true false

19) In collateralized mortgage obligations, Class A holders have higher prepayment risk protection than class C holders.

3

⊚ ⊚

true false

20) Increased liquidity of bank loans, enhanced ability to manage the maturity gap and overcollateralization are some of the benefits of securitization. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

21) Advantages of loan sales and securitization typically include all but which one of the following?

A) Reduction in credit risk B) Reduction in interest rate risk C) Increase in liquidity of the balance sheet D) Reduction in regulatory tax burden E) Increase in net interest income

22)

In selling loans, FIs act as an asset

and in creating CMOs, FIs act as an asset

.

A) transformer; broker B) transformer; transformer C) broker; broker D) broker; transformer

23)

A pass-through security is best characterized as:

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A) a multiclass mortgage-backed bond.

B) a security with a pro rata claim to the underlying pool of assets.

C) a bond backed by real estate.

D) a part of a loan assignment.

E) a part of a loan participation.

24)

Which one of the following types of transactions leaves the assets on the balance sheet?

A) Loan sale without recourse B) GNMA pass-throughs backed by mortgages placed in trust C) CMOs issued using mortgage pool as collateral D) Mortgage-backed bonds issued E) None of the options are correct.

25)

For a loan sold with recourse:

A) the loan seller has no further obligation at all to the loan buyer.

B) the loan seller removes the assets from the balance sheet and does not report a contingent liability in the footnotes.

C) the loan buyer cannot collect from the loan seller in the event of borrower default.

D) no reserve requirement is imposed.

E) None of the options are correct.

26) In a loan participation, which of the following is/are true? 1.I. The loan buyer has no part in the original underlying credit agreement, even after purchase of the loan.

2.II. If the selling bank fails, the loan buyer's claim against the selling bank may be treated as unsecured.

3.III. In the event the selling bank fails, the original borrower's deposits may be used to reduce the loan amount without any proceeds going to the loan buyer.

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A) I only B) II only C) II and III only D) I and II only E) I, II, and III

27) Characteristics of loan participations include the following: 1.I. The loan participant is not a primary creditor on the loan.

2.II. The original lender can change some loan terms without the participant's permission.

3.III. Participations are without recourse.

A) I only B) II only C) II and III only D) I and II only E) I, II, and III

28) If a mortgage pass-through experiences smaller prepayments than expected early on in the life of the security, the result will be that pass-through holders will receive than expected cash flows early on and than expected cash flows later on.

A) greater; less B) greater; greater C) less; greater D) less; less E) less; no different

29) You own a mortgage-backed security and you will receive fixed semiannual interest payments and no principal payments as long as prepayments remain within a given range. If prepayments move outside the range, cash flows will vary. You must be holding a .

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A) class C or lower sequential pay CMO B) PAC CMO C) PO security D) pass-through security E) CDO

30)

Important buyers of loans include all but which one of the following?

A) Foreign banks B) Insurance companies C) Closed-end bank loan mutual funds D) Vulture funds E) Credit unions

31) A loan that finances a merger or acquisition that results in a high-leverage ratio for the borrower is called a(n):

A) correspondent loan.

B) CMO. C) HLT loan.

D) low-recourse loan.

E) distressed loan.

32)

Banks were willing to swap LDC loans for Brady bonds because:

A) Brady bonds carried higher interest rates than the loans.

B) the bonds had variable interest rates.

C) the bonds were marketable and the loans were not.

D) the bonds were uncollateralized.

E) None of the options are correct.

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33) Loan sales are likely to continue because: 1.I. they can increase near-term reported earnings.

2.II. they reduce the amount of capital required.

3.III. more corporate borrowers have access to the commercial paper market.

A) I and II only B) II and III only C) I and III only D) II only E) I, II, and III

34)

Fraudulent conveyance proceedings are:

A) charges that a loan was improperly sold according to the conditions of the original loan agreement.

B) charges of improprieties in HLTs. C) evidence of moral hazard on the part of the loan buyer.

D) illegal methods to boost borrower's earnings to increase probability of loan acceptance.

E) the primary cause of the subprime mortgage crisis.

35) The act of buying a share in a loan syndication with limited contractual control and rights over the borrower is called a:

A) correspondent loan.

B) loan assignment.

C) HLT loan.

D) loan participation.

E) distressed loan.

36) A three-class CMO has Class A, Class B, and Class C securities outstanding. Which class has the longest duration?

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A) Class A B) Class B C) Class C D) Class B and Class C have the same duration.

E) All of these choices are correct.

37) A bank originates $150,000,000 worth of 30-year single-family mortgages funded by demand deposits and the required amount of capital. Reserve requirements are 10 percent and the bank pays 32 basis points in deposit insurance premiums. The bank is earning a 6.25 percent coupon on the mortgages. The mortgages are priced at par and total monthly payments on the mortgages are $923,576.

How much capital is required to back the mortgages if the minimum risk-based capital requirement is 8 percent?

A) $75.0 million B) $37.5 million C) $12.0 million D) $3.0 million E) $6.0 million

38) A bank originates $150,000,000 worth of 30-year single-family mortgages funded by demand deposits and the required amount of capital. Reserve requirements are 10 percent and the bank pays 32 basis points in deposit insurance premiums. The bank is earning a 6.25 percent coupon on the mortgages. The mortgages are priced at par and total monthly payments on the mortgages are $923,576.

If the mortgages are securitized and deposits are reduced, how much will the bank save in the first year's reserve requirements and deposit insurance premiums in total?

9

A) $14,912,000 B) $16,512,000 C) $16,000,000 D) $17,332,500 E) $18,249,300

39) A bank originates $150,000,000 worth of 30-year single-family mortgages funded by demand deposits and the required amount of capital. Reserve requirements are 10 percent and the bank pays 32 basis points in deposit insurance premiums. The bank is earning a 6.25 percent coupon on the mortgages. The mortgages are priced at par and total monthly payments on the mortgages are $923,576.

If the bank can originate and securitize this amount of mortgages with the same terms four times over the next year (including the existing mortgages) and the bank earns a servicing fee each month equal to 3.5 percent of the monthly payments, what will be the bank's monthly fee income 12 months from now?

A) $110,456 B) $116,432 C) $122,673 D) $129,301 E) $133,444

40) A form of trust that can issue multiple class debt securities without having to pay taxes on the interest paid is called a:

A) CMO. B) REMIC. C) MBB. D) PIP. E) GNMA.

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41) In a three-class sequential pay CMO, if we consider Class B holders as having average prepayment risk, then Class A holders have prepayment risk and Class C holders have prepayment risk.

A) above average; below average B) below average; below average C) below average; above average D) above average; above average

42) A three-class sequential pay CMO has an initial principal balance of $30 million per class. In the first month, interest payments of $5 million and principal payments of $2 million are received. In the second month, Class A holders receive interest on principal and Class B holders receive interest on principal.

A) $30 million; $30 million B) $28 million; $28 million C) $27 million; $27 million D) $28 million; $30 million E) $30 million; $28 million

43)

Which one of the following forms of securitization is usually "double securitization"?

A) Mortgage-backed bonds B) CMO C) Pass-through D) Loan sale E) Loan purchase

44)

The typical duration of a Class B CMO is:

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A) 1.5 to 3 years.

B) 3 to 5 years.

C) 5 to 7 years.

D) 7 to 10 years.

E) 18 to 20 years.

45) The sum of the market values of all the classes of a CMO is greater than the total value of the GNMA pass-throughs backing the CMO because:

A) the CMO has less credit risk than the pass-through.

B) CMO investors can choose their degree of prepayment protection.

C) the government guarantees CMOs' performance.

D) CMOs have a more favorable tax status than pass-throughs.

E) CMO investors have no prepayment risk.

46)

The FDIC is concerned about issuance of mortgage-backed bonds (MBBs) because:

A) the FDIC is concerned about investors' prepayment risk.

B) MBBs increase deposit insurance premiums.

C) the process takes loans off the balance sheet and replaces them with liabilities.

D) the process reduces the amount of assets available to back insured deposits.

E) None of the options are correct.

47) With a GNMA pass-through, the investor bears of the prepayment risk; with a noncallable mortgage-backed bond, the investor bears of the prepayment risk; and with a CMO, the investor bears of the prepayment risk.

A) some; all; none B) all; some; none C) all; none; some D) none; some; all E) none; some; none

12

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

48) On January 1, a bank had originated 500 30-year fixed-rate mortgages with a 6.25 percent coupon at par. The average mortgage size is $255,000. The bank charges a 1 percent origination fee for each mortgage, but processing costs amount to 0.4 percent. After securitization, the bank will retain 35 basis points in fee income for servicing the mortgage payments. The cost of this processing is 12 basis points.

What is the total amount of net fee revenue generated from the mortgages over the year?

49) On January 1, a bank had originated 500 30-year fixed-rate mortgages with a 6.25 percent coupon at par. The average mortgage size is $255,000. The bank charges a 1 percent origination fee for each mortgage, but processing costs amount to 0.4 percent. After securitization, the bank will retain 35 basis points in fee income for servicing the mortgage payments. The cost of this processing is 12 basis points.

The bank keeps a capital-to-asset ratio of 8 percent. If the bank does not securitize the mortgages, they will be fully funded with demand deposits that have a reserve requirement of 10 percent. The demand deposits also have a deposit insurance premium of 0.20 cents per $100 of deposits. If the bank securitizes the mortgages, how much less capital will the bank require? If the savings from not having the required reserves and the deposit insurance premiums could be invested at 5 percent, what is the dollar opportunity cost of not securitizing?

50)

How does a mortgage pass-through differ from a CMO?

51)

Why are most loan sales on an assignment basis rather than a participation basis?

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52) What are the major differences in the traditional and HLT segments of the loan sale market with respect to the types of loans sold?

53)

Why has securitization progressed most rapidly for home mortgages?

54) How does mortgage securitization reduce the regulatory tax burden of a depository institution?

55) A three-class (Class A, B, and C) sequential pay CMO starts with an $80 million principal amount in each class. The mortgages in the pool have a 7 percent interest rate. The CMO classes receive monthly payments. During the first month, $1 million in interest and $1.5 million in principal is received from mortgage holders. What principal amounts are outstanding for each class during the second month? How will this affect the total payment each class receives? Explain.

56)

Why are MBBs the least used form of mortgage securitization?

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57)

How does a PAC CMO differ from a sequential pay CMO?

58) What are the major factors that are likely to contribute to continued growth in the loan sale market?

59) Explain the payment pattern on a GNMA pass-through and a new Class B CMO when interest rates fall. Which has more predictable payments, and why would an investor care?

60)

What loans, other than mortgages, are currently being securitized?

15

Answer Key Test name: Chap 25_8e 1) FALSE 2) FALSE 3) TRUE 4) FALSE 5) TRUE 6) FALSE 7) TRUE 8) TRUE 9) FALSE 10) TRUE 11) TRUE 12) FALSE 13) TRUE 14) TRUE 15) FALSE 16) TRUE 17) TRUE 18) FALSE 19) FALSE 20) FALSE 21) E 22) D 23) B 24) D 25) E 26) E 16

27) D 28) C 29) B 30) E 31) C 32) C 33) A 34) A 35) D 36) C 37) E $150,000,000 × 0.50 × 0.08 = $6,000,000; mortgages carry a 50 percent risk weight.

38) B $150,000,000 × 0.50 × 0.08 = $6,000,000; so $150,000,000 − $6,000,000 = $144,000,000 in deposits needed to fund the mortgages.

Since the reserve requirement is 10%, this requires [$144,000,000/(1 − 0.1)] = $160,000,000 in deposits Reserve requirements are $160,000,000 × 0.1 = $16,000,000.

Deposit insurance premiums = ($160,000,000 × 0.0032) = $512,000; Total saved in reserve requirements and deposit insurance premiums = $16,512,000 (=$16,000,000 + $512,000) 39) D 4 × $923,576 × 0.035 = $129,301 40) B 41) A 42) D 43) B 44) C 17

45) B 46) D 47) C 48) Net origination fee income = (500 × $255,000) × (1% − 0.4%) = $765,000 Monthly mortgage payments: N = 12 × 30, I = 6.25/12, FV = 0, PV = −255,000, solve for PMT to get 1570.08 per average mortgage.

Total = 500 × $1,570.08 = $785,039.43 for 500 mortgages The bank nets 35 − 12 = 23 basis points on this total per month or 0.0023 × $785,039.43 × 12 months = $21,667.09 per year Total annual net fee income = $765,000 + $21,667 = $786,667 49) Capital requirement from the mortgages = (500 × $255,000) × 0.50 risk weight × 0.08 capital = $5,100,000 Opportunity cost from required reserves and deposit insurance: Total deposits required to fund mortgages = (500 × $255,000 − $5,100,000)/(1 − 0.10) = $136 million Reserve requirement of 10 percent on this amount gives $136 million × 0.10 = reserves of $13,600,000 which earn 0 percent Deposit insurance premiums = $136 million × 0.0020 = $272,000 Total costs = $13,600,000 + $272,000 = $13,872,000 This total could be invested and earn 5 percent so that in one year the bank could have had $13,872,000 × 1.05 = $14,565,600 The opportunity cost is thus the sum of the lost interest income and the deposit insurance premium cost = ($14,565,600 − $13,872,000) + $272,000 = $965,600

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50) A pass-through "passes through" payments made by households to the investors on a pro rata basis. A CMO is a multiclass pass-through in which the issuer transforms or repackages the monthly mortgage payments made by households to provide investors with different risk and return characteristics. The CMO holder has less prepayment risk than a pass-through holder.

51) Assignment provides the loan buyer with clear legal rights in the event of default by the loan seller or borrower. In a participation, the loan buyer is not a direct claimant of the borrower, whereas a loan buyer has a direct claim on the original borrower in an assignment. In a participation, the loan seller also retains broad powers to modify the credit agreement without the consent of the loan buyers. This is not true in an assignment.

52) In the traditional short-term segment, loan sales are generally sales of high-quality loans issued for 90 days or less with rates tied to the commercial paper market. Loans in the HLT segment are longer maturity (three to six years) and have floating rates tied to LIBOR. Some HLT loans are quite large and, because of the high leverage of the borrower, many HLT loans are distressed.

53) Home mortgages have standard maturities and easily appraisable collateral; default insurance is provided by FHA, VA, FMHA, or some private source to alleviate the need for security investors to assess default risk. These features make it easier to create and sell large amounts of marketable securities for mortgages than for other loan types.

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54) Mortgage securitization reduces the regulatory tax burden of a depository institution by: ● reducing the amount of capital an FI is required to back the mortgages. ● reducing reserve requirements on demand deposits used to fund the mortgage loans. ● reducing the amount of FDIC insurance premiums required on deposits used to fund the mortgages.

55) During the second month, Class A holders have total principal amount outstanding of $80 million − $1.5 million = $78.5 million. They will receive interest on the reduced principal amount so the total payment they receive will fall. Class B and C holders are protected from prepayments as long as Class A has principal outstanding, so Class B and C holders will receive interest-only payments on the original $80 million principal amount.

56) The process of creating pass-throughs and CMOs removes mortgages from FI balance sheets; the creation of MBBs does not. The purpose of issuing MBBs instead of debentures is to provide collateral to the bondholder to improve the credit rating and get a lower debt cost.

However, the issuer of the MBB bears all the prepayment risk (just as in a pass-through the investor bears all the prepayment risk), so the bonds issued must be substantially overcollateralized. They also do not eliminate the regulatory tax burden, nor improve diversification. These drawbacks limit their attractiveness to issuers.

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57) A PAC investor receives constant cash flows if prepayments remain within a given range. PACs have a principal repayment schedule absent from sequential pay CMOs that give the investor more certain cash flows. A PAC is another way to limit prepayment risk. In a sequential pay, CMO investors who desire greater prepayment risk choose a class with greater prepayment protection, but at some point their class will become unprotected. With a PAC, the PAC investor always remains in the better-protected class.

58) The major factors are that loan sales: ● help to manage credit risk and achieve better diversification. ● can generate immediately recognized fees that boost current income levels. ● improve the liquidity of the loan portfolio. ● reduce capital and reserve requirements.

59) Prepayments increase as interest rates fall. The GNMA investor will receive his or her pro rata share of all prepayments and the prepaid amounts will reduce the principal of his or her investment and thus reduce all subsequent dollars of interest earned on the security. The holder of the new Class B CMO will initially be protected from any prepayments until all of the principal of the Class A CMO holders is paid off, so the Class B CMO holder will have no principal reduction and will continue to collect the same dollars of interest.

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60) ● Automobile loans ● Credit card receivables ● Small business loans backed by the Small Business Administration ● Commercial and industrial loans ● Student loans ● CDOs/CLOs ● Equipment loans ● Junk bonds ● Adjustable rate mortgages

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