445 QUIZ QUESTIONS

Following is a migration matrix. We observe that for loans that began the year at rating CCC-C, historically on average, less have been upgraded to BBB-B than have defaulted by the end of the year.

FALSE

Suppose a U.S. bank is raising its $162.5 million liabilities in dollars (one-year CD, 8%), but investing 50% in U.S. dollar assets (one-year maturity loans, 9%) and 50% in U.K. pound assets (one-year maturity loans, 15%). Suppose the exchange rate changes from $1.30/£1 at the beginning of the year to $1.42/£1 at the end of the year when the bank needs to repatriate the principal and interest on the loan. The weighted retune on the bank's portfolio of investments is 12%.

FALSE Step 1: What are the dollar proceeds from the U.K. investment?• Pound invest at the beginning of the year: (1/2) × ($162.5)/($1.30/£1) = $81.25/($1.30/£1) = £62.5 Pound revenue from these loans at the end of the year: £62.5 × (1+15%) = £71.875 Translate to U.S. dollar: £71.875 × ($1.42/£1) = $102.0625 Step 2: What is the return on the original dollar investment in the U.K. pound assets? ($102.0625 -$81.25)/$81.25 = 25.615% (>15%) Step 3: What is the weighted return on the bank's portfolio of investments?(1/2) × (9%)+(1/2) × (25.615%) = 17.308% The bank has a profit or a positive net return of 17.308%-8%=9.308% on its portfolio of investments

(1) Commercial and industrial loans, (2) real estate loans, (3) individual loans, and (4) all other loans are four types of bank loans that have similar and time invariant default risks.

False

A bank controls its credit risks by credit rationing rather than by using a range of interest rates for both retail and wholesale credit decision.

False

A significant proportion of depository institutions' (DIs) funding comes from DIs' investments.

False

Decimalization is a price quoting system where security prices are represented using decimals instead of fractions. E.g., $10.25 (decimal quoting system) vs. $10 1⁄4 (fractional quoting system). The U.S. switched from the fractional quoting system to the decimal quoting system for 2 reasons (among others): (1) to be different from international trading standards and establish a unique domestic practice (2) to make it easier for traders to interpret prices and place trades.

False

Loan sale refers to the sale of a loan originated by a bank to another bank with or without recourse. Theoretically, there are a number of economic and regulatory reasons that encourage banks to sell loans, such as (among others) (1) decrease credit risk and liquidity risk, (2) meet the reserve and capital requirements, and (3) generate higher fees. However, in practice, the loan sale market has been restricted from growing since early 1990s, and thus leaving loan sale no more than an un-applicable idea.

False

Mobile wallets, peer-to-peer payments, and ATMs are examples of Fintech innovation in bank retail businesses in recent years.

False

Operational risk is a newly recognized risk in the banking sector, and thus is not important.

False

Operational risk refers to losses resulting from inadequate or failed internal processes, people, and systems or from external events. The frequency of operational loss events is high, yet the severity of the majority of operational loss events is low. Therefore, operational risk does not pose systemic risk.

False

Shadow banking has been growing fast, yet its overall size is still smaller than the traditional banks. Due to its limited potential impact to the financial system, shadow banks are not currently supervised either by the Fed, FDIC, or OCC.

False

Sovereign risk was the root cause of the financial crisis.

False

Suppose a bank has a total loan loss rate of 10%. We have the following regression specification using the bank's loan loss data over the past 10 year. Based on the regression estimation, the bank should limit its loans to the commercial loan sector because the loss rates are higher than the loss rate for the total loan portfolio.

False

Suppose a trading portfolio has zero-coupon bonds, foreign exchange, and U.S. equity. The Daily Earnings at Risk (DEAR) of the portfolio is a value-weighted average of DEAR of each holding asset.

False

The Fed's most frequently used monetary policy tool is the open market operations. The Board of Governors sets the federal funds rate and conducts the Fed's open market operations through its trading desk via buying and selling U.S. government securities.

False

The money traded via CDOs, CDO^2, and synthetic CDOs is limited by the value of the underlying securities.

False

Three federal regulators are principally responsible for regulating FinTech entities and products FDIC, SEC, and the Fed Reserve

False

Traditional banks are hand-to-hand combating with fintech firms to maintain their market share

False

U.S. has high sovereign risk score according all three monitoring agencies: (1) Euromoney Country Risk (2) the Institutional Investor (3) the Organization for Economic Co-operation and Development (OECD).

False

The Variance of Export Revenue (VAREX) captures the volatility of a country's export earnings, and can be used as a measure of sovereign risk. The lower the VAREX, the higher the sovereign risk.

False The more volatile a country's export earning, the less certain creditors can be that at any time in the future it will be able to meet its repayment commitments Thus, there should be a positive relationship between and the probability of rescheduling

Total Loans = 9,142.9 Total Assets = 16, 480.4 The (total loans)/(total assets) ratio is about 26%.

False 9,142.9/16,480.4 = 55.5%

Commercial banks accept deposits and make only commercial loans.

False Can distribute 4 types of loans: Commercial and industrial (C&I) Real estate Individual (e.g., consumer loans for auto purchases and credit card debt) All other loans

Suppose we have the following information of a FI: 𝐴=$100 million; 𝐷𝐴 =5; 𝐷𝐿 =3; 𝑘=0.9• Interest rates are expected to rise from 10% to 11% over the next 6 months• 𝐷=9 for the bonds underlying the put option contract. The long-term treasury bond underlying the option contract has a face value of $100,000 and a market value (B) of $97,000. The put option on these long-term treasury bonds has a delta (δ) of 0.5, which indicates that the option is close to being in the money. The price (premium) of each put option contract is $2,500 (remember: each contract has 1,000options. The price of each put option is $2.5) The bank will pay $1,342,500 for the options.

False Cost = 𝑁𝑝 × premium per contract = 526 × $2,500 = $1,315,000

Demand deposits have high funding (withdraw) risk and high costs.

False Demand deposits = relatively low funding cost, can be withdrawn without notice, i.e., high funding (withdrawal) risk

Bank runs only happen when the bank's core depositors really need to withdraw deposits for consumption needs.

False Deposit drains may occur due to concerns about a bank's solvency or sudden changes in investor preferences regarding holding nonbank financial assets (e.g. mutual funds) relative to deposits

If a direct quote on the foreign exchange rate is US$0.7668 per Canadian dollar, then the indirect quote is C$1.0342 per U.S. dollar.

False Direct quote = 1/indirect quote Indirect quote = 1/direct quote US $0.7668/1 C$→1/(US$0.7668/C$1) = C$1/US$0.7668 = C$1.3041/US$

Forward exchange rate is a price that will be fixed on a particular date in the future for trading a particular currency with another currency on that date.

False Forward exchange rate is a price that is fixed now for trading a particular currency with another currency on a particular date in the future

Liquidity risk is the risk to bank's earnings and capital arising from its ability to timely meet obligations when they come due without incurring unacceptable losses.

False Liquidity risk is the risk to bank's earnings and capital arising from its inability to timely meet obligations when they come due without incurring unacceptable losses. Bank management must ensure that sufficient funds that available at a reasonable cost to meet potential demands from both funds providers (e.g., depositors) and borrowers

Four sources of operational risk are managers, employees, customers, and regulators.

False Operational risk refers to losses resulting from inadequate or failed internal processes, people, and systems or from external events

Only large banks have operational risk. Small banks are not yet exposed to operational risk.

False Operational risk refers to losses resulting from inadequate or failed internal processes, people, and systems or from external events

Suppose there were 2 factors influencing the past default behavior of borrowers: the debt- equity ratio (D/E) and the sales-asset ratio (S/A). Using past default payment data, the linear probability model is estimated as: PD = 0.5(D/E) - 0.05(S/A). Assume a prospective borrower has a D/E=0.5 and an S/A=2.0. This borrower's expected probability of default is 4.5%.

False PD = 0.5(D/E) - 0.05(S/A) = (0.5)(0.5)-(0.05)(2.0)= 0.25-0.1 = 0.15=15%

The Fed operates in 3 major areas: (1) inflation; (2) supervision and regulation; and (3)monetary policy.

False Payments, Supervision & Regulation, Monetary Policy

The Federal Deposit Insurance Corporation (FDIC) was created in 1933. The deposit insurance coverage has been increasing since its established and thus has been successfully deterring bank failure till present.

False Prevents, but does not completely eliminate bank failures

Wells Fargo Scandal is an example of Fintech Risk.

False Process Related Operational Risk

Long futures contract would hedge interest rate risk like buying put options.

False Short futures would also hedge interest rate risk like buying put options

The Fed's most frequently used monetary policy tool is the open market operations. The FOMC sets the federal funds rate and 12 reserve banks conduct the Fed's open market operations through their trading desk via buying and selling U.S. government securities.

False The Federal Reserve Bank of New York conducts the Fed's open market operations through its trading desk via buying and selling U.S. government securities

The 1933 Glass-Steagall Act allowed for the creation of bank holding companies (BHC) that could engage in banking activities, insurance activities, and securities activities

False The Financial Services Modernization Act (1999)

One primary function of the Federal Reserve System is to charter and close national banks.

False The Office of the Comptroller of the Currency (OCC) Established in 1863; the oldest bank regulatory agency • Primary function: charter and close national banks, examine national banks, approve or disapproval national banks' merger application

The Volcker Rule is a federal regulation that generally prohibits banks from investing in the derivatives market.

False The Volcker Rule is a federal regulation that generally prohibits banks from conducting certain investment activities (e.g., short-term proprietary trading of options and futures) with their accounts and limits their dealings with hedge funds and private equity fund

The discount window could be a full substitute for deposit insurance as a liquidity stabilizing mechanism

False The discount window is a partial but not full substitute for deposit insurance as a liquidity stabilizing mechanism

Suppose a bank has a $1 million market value position in zero-coupon bonds of five years to maturity. Today's yield on these bonds is 8% per year. The standard deviation of historical daily yield changes is 10bp. Assuming historical daily yield changes are normally distributed. These bonds are held as part of the trading portfolio. The potential loss in earnings on the $1 million position is $15,210 if the 1 bad day in 100 occurs tomorrow.

False The potential daily loss in earnings on the $1 million position is $10,648 if the 1 bad day in 100 occurs tomorrow

The primary intention of deposit insurance is to protect depositors.

False The primary intention of deposit insurance is to deter bank runs and panics A secondary and related objective has been to protect the smaller, less-informed saver against the reduction in wealth that would occur if that person were last in line when a bank fails

Suppose a bank is long in a bond in its portfolio, the bank can either buy a bond call option or buy a bond put option to hedge the interest rate risk on the bond holding.

False Two ways to hedge the interest rate risk on the long bond position: 1. Writing a bond call option 2. Buying a bond put option

The Fed uses the reserve requirement as a tool to increase or decrease the money supply in the economy and influence interest rates. The Fed is exercising an expansionary monetary policy when it raises the reserve requirement.

False expansionary monetary policy = reducing the reserve requirement contractionary monetary policy = raises the reserve requirement

Suppose on 8/28/2018, the exchange rate of the U.S. dollar for the British pound was $1.3303/£. It is now 9/28/2018, the exchange rate of the U.S. dollar for the British pound was $1.3077/£. A U.S. bank has a net exposure to British pounds of £2,500,000. The bank's dollar gain is $56,000.

False £2,500,000 × (1.3077-1.3303) = -$56,500 The bank's dollar loss is $56,500.

𝐴=$100 million; 𝐷𝐴 =5; 𝐷𝐿 =3; 𝑘=0.9 Interest rates are expected to rise from 10% to 11% over the next 6 months 𝐷=9 for the bonds underlying the put option contract. The long-term treasury bond underlying the option contract has a face value of $100,000 and a market value (B) of $97,000. The put option on these long-term treasury bonds has a delta (δ) of 0.5, which indicates that the option is close to being in the money. The price (premium) of each put option contract is $2,500 (remember: each contract has 1,000 options. The price of each put option is $2.5) The bank should buy 537 contracts to hedge the interest rate increase

False 𝑁𝑝 = 𝐷𝐴−𝑘𝐷𝐿 ×𝐴[ δ×𝐷×𝐵] = 5−(0.9)(3) ×$100𝑚[ 0.5×9×$97,000] = 526.92 contracts → 526 contracts

A liquid asset can be turned into cash quickly and at a low transaction cost with little or no loss in principal value. Holding relatively small amounts of liquid assets exposes a bank to enhanced illiquidity risk and, ultimately, risk of a run.

True

A swap is an agreement between two parties (called counter parties) to exchange a series of cash flows for a specified period of time at a specified interval.

True

Based on the information in the following table and loan volume-based model, Bank B has higher loan concentration.

True

Basel III requires banks to calculate and disclose their market risk capital requirements.

True

Bernie Madoff 's was sentenced to 150 years in prison due to his fraud, a giant Ponzi scheme.

True

Commercial banks offer loans on the asset side of their balance sheet, and offer deposits on the liability side of their balance sheet.

True

Contractually promised return of a loan is the return that a bank realizes if the loan does not default. However, loans may default. Therefore, loan expected return would be lower than the contractually promised return considering the loan's default risk.

True

Credit risk is the potential loss arising from a bank borrower failing to meet its obligations in accordance with the agreed term.

True

Examples of fintech evolution in the financial sector in early 2000s are: marketdecimalization, algorithmic trading, and high-frequency trading.

True

Futures contracts are standardized contracts and are traded on an exchange. Forward contracts are private and customizable contracts and are traded over the counter.

True

If interest rates are expected to fall, then both buying call options and selling put options on bonds could be profitable.

True

Market risk is the risk related to the uncertainty of earnings on a bank's trading portfolio.

True

One primary function of the Federal Deposit Insurance Corporation (FDIC) is to insure the deposits of member banks.

True

Purchased liquidity management and stored liquidity management are 2 ways to manage liquidity risk.

True

Supervision of financial institutions is tailored based on the size and complexity of the institution.Large financial institutions include (1) U.S. FIs with assets of $100 billion or more; and (2) Foreign banking organizations with combined U.S. assets of $100 billion or more. Regional banking organizations refer to FIs with total assets between $10 billion and $100 billion. Community banking organizations refer to FIs with less than $10 billion in assets.

True

Suppose a bank wants to evaluate the credit risk of a $1 million loan with a duration of 2.7 years, a spread of 0.2%, and fees of 0.1% to a AAA borrower. The changes in the credit risk premium (CRP) is estimated as 1.1% and the current average loan rates (R) on AAA bonds is 5%. The RAROC is about 11%.

True

Suppose we have the following information of a bank: 𝑨=$100 million; 𝑫𝑨 =5; 𝑫𝑳 =3; 𝒌=0.9. Interest rates are expected to rise from 10% to 11% over the next 6 months. 𝑫𝒇𝒊𝒙𝒆𝒅=7; 𝑫𝒇𝒍𝒐𝒂𝒕=1. Each interest rate swap contract is $100,000 in size. The bank should buy 383 interest rate swap contracts to hedge the interest rate increase.

True

The Fed is currently exercising an expansionary monetary policy by reducing the reserve requirement to be 0%. The aim of this reduction is to jump-start the economy by allowing banks to use additional liquidity to lend to individual and businesses.

True

The Federal Act mandates that the Federal Reserve conduct monetary policy so as to promote effectively the goals of (1) maximum employment; (2) stable price; and (3) moderate long-term interest rate.

True

The Federal Reserve System has three parts: (1) Board ofGovernors; (2) 12 Reserve banks; and (3) Federal Open MarketCommittee.

True

The Federal Reserve System is the central bank of the United States

True

There are two major ways that banks control the scale of their FX exposure: (1) on-balance- sheet hedging; and (2) off-balance-sheet hedging.

True

This figure shows how SPV works. Specifically, a bank selects a pool of loans and sells them to an off-balance-sheet SPV. The SPV packages the loans together, creates asset-backed securities (ABS), sell ABS to investors, and uses the proceeds to pay the loan-originating bank for the loans. The ultimate investors of ABS receive the cash flows from the loans.

True

This table shows that (1) demand deposits, (2) passbook savings, and (3) MMDAs account for the majority of the total liabilities of the Bank of America. However, these 3 major liability categories have different withdraw risks and different costs.

True

Two primary functions of the Federal Reserve System (FRS) are (1) conduct the nation's monetary policy; and (2) Supervise and regulate member banks.

True

Value at Risk (VAR) is applied under the assumption of normal distribution. ExpectedShortfall (ES) is applied under the assumption of Studentt distribution.

True

When I buy a put option, my loss is capped. However, when I sell a put, my profit is capped.

True

When you buy an option (either call option or put option), your maximum loss is your initial investment. However, when you sell an option (either call option or put option), you maximum loss could be much higher than your initial income from selling the options.

True

With the deposit insurance, the deposit holder's place in line no longer affects his or her ability to obtain the funds from the commercial bank within the insured amount.

True

Sovereign risk is a country risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments.

True Common causing factors for the interference from foreign government - Foreign currency shortages -Adverse political reason -Rapidly deteriorated macroeconomic conditions

The indicator Z score is an overall measure of the default risk classification of a commercial borrower. According to Altman's model (Z=1.2X1+ 1.4X2 + 3.3X3 + 0.6X4 + 1.0X), a firm with a Z score of 3.5 is a low default risk firm.

True < 1.81 is HIGH [1.81, 2.99] is indeterminant default risk > 2.99 is LOW

Assuming that a bank has the total RWA $1,000,000 and total exposure of $2,000,000, CET 1 capital = $80,000, Tier 1 capital = $90,000, and Total capital = $110,000, then the bank has enough capital to meet the Basel requirement, including the capital conservation buffer.

True CET1 = 1M x 70% --> 70k < 80k T1 = 1M x 8.5% --> 85k < 90k T2 = 1M x 10.5% --> 10.5k < 11k

Suppose that a bank has 2 assets: 50% in one-month Treasury bills and 50% in real estate loans. If the bank must liquidate its T-bill today, it receives $99 per $100 of face value. If it can wait to liquidate them on maturity in one month, it will receive $100 per $100 of face value. If the bank has to liquidate its real estate loans today, it receives $80 per $100 of face value. Liquidation at the end of the one month (closer to maturity) will produce $90 per $100 of face value. The one-month liquidity index value for this bank's asset portfolio is 0.939.

True I = [(1/2)(99/100)]+[(1/2)(80/90)] = 0.939 The larger the discount from fair value, the smaller the liquidity index, the higher the liquidity risk the bank faces

Operational risk refers to losses resulting from inadequate or failed internal processes, people, and systems or external events.

True Operational risk refers to losses resulting from inadequate or failed internal processes, people, and systems or from external events

Suppose a bank had a €800,000 trading position in spot euros at the close of business on aparticular day. The exchange rate is $1.25/1€ at the daily close. The standard deviation (σ) of$/€ exchange rate over the past year was 40 bp. Assuming historical $/€ exchange rates arenormally distributed. The potential loss in earnings on the $1 million position is $9,320 if the 1bad day in 100 occurs tomorrow.

True The potential daily earrings exposure to adverse euro to dollar exchange rate changes for the bank from the€800,000 spot currency holdings is $9,320.

Total Assets = 16,480.4 Total Liabilities = 14,611.3 The leverage ratio is about 89%

True Leverage ratio= total liabilities/total assets 14,611.3/16,480.4= 88.66%