FINA 465 Exam 2 Review

If interest rates decrease 40 basis points (0.40 percent) for an FI that has a cumulative gap of -$25 million, the expected change in net interest income is... A. +$100,000. B. -$100,000. C. -$625,000. D. -$250,000. E. +$250,000.

A. +$100,000.

If interest rates increase 75 basis points for an FI that has a gap of -$15 million, the expected change in net interest income is... A. -$112,500. B. +$112,500. C. +$1,125,0000. D. -$1,125,0000. E. -$150,000.

A. -$112,500

Which of the following situations pose a refinancing risk for an FI? A. An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-year maturity. B. An FI issues $10 million of liabilities of two-year maturity to finance the purchase of $10 million of assets with a two-year maturity. C. An FI issues $10 million of liabilities of three-year maturity to finance the purchase of $10 million of assets with a two-year maturity. D. An FI matches the maturity of its assets and liabilities. E. All of the options.

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

This risk of default is associated with general economy-wide or macro conditions affecting all borrowers. A. Systematic credit risk. B. Firm-specific credit risk. C. Refinancing risk. D. Liquidity risk. E. Sovereign risk.

A. Systematic credit risk.

If the loans in the bank's portfolio are all negatively correlated, what will be the impact on the bank's credit risk exposure? A. The loans' negative correlations will decrease the bank's credit risk exposure because lower than expected returns on some loans will be offset by higher than expected returns on other loans. B. The loans' negative correlations will increase the bank's credit risk exposure because lower than expected returns on some loans will be offset by higher than expected returns on other loans. C. The loans' negative correlations will increase the bank's credit risk exposure because higher returns on less risky loans will be offset by lower returns on riskier loans. D. The loans' negative correlations will decrease the bank's credit risk exposure because higher returns on less risky loans will be offset by lower returns on riskier loans. E. There is no impact on the bank's credit risk exposure.

A. The loans' negative correlations will decrease the bank's credit risk exposure because lower than expected returns on some loans will be offset by higher than expected returns on other loans.

Which theory of term structure posits that long-term rates are a geometric average of current and expected short-term interest rates? A. The unbiased expectations theory. B. The liquidity premium theory. C. The loanable funds theory. D. The market segmentation theory. E. None of the options.

A. The unbiased expectations theory.

The liquidity premium theory of the term structure of interest rates... A. assumes that investors will hold long-term maturity assets if there is a sufficient premium to compensate for the uncertainty of the long-term. B. assumes that long-term interest rates are an arithmetic average of short-term rates plus a liquidity premium. C. recognizes that forward rates are perfect predictors of future interest rates. D. assumes that risk premiums increase uniformly with maturity. E. None of the options.

A. assumes that investors will hold long-term maturity assets if there is a sufficient premium to compensate for the uncertainty of the long-term.

The risk that borrowers are unable to repay their loans on time is... A. credit risk. B. sovereign risk. C. currency risk. D. liquidity risk. E. interest rate risk.

A. credit risk.

An advantage FIs have over individual household investors is that they are able to diversify away credit risk by holding a large portfolio of loans to different entities. This reduces... A. firm-specific credit risk. B. systematic credit risk. C. interest rate risk. D. market risk. E. political risk.

A. firm-specific credit risk.

Matching the foreign currency book of assets and liability maturity does not protect the FI from ... A. sovereign country risk. B. interest rate risk. C. liquidity risk. D. foreign exchange risk. E. off-balance-sheet risk.

A. sovereign country risk.

Politically motivated limitations on payments of foreign currency may expose an FI to ... A. sovereign country risk. B. interest rate risk. C. credit risk. D. foreign exchange risk. E. off-balance-sheet risk.

A. sovereign country risk.

Which of the following indicates a positive gap according to the repricing model? A. the book value of rate-sensitive liabilities is less than the book value of rate-sensitive assets. B. the book value of rate-sensitive assets is less than the book value of rate-sensitive liabilities. C. the market value of rate-sensitive assets is less than the market value of rate-sensitive liabilities. D. the book value of rate-sensitive liabilities is greater than the book value of rate-sensitive assets. E. the market value of rate sensitive assets is greater than the market value rate sensitive liabilities.

A. the book value of rate-sensitive liabilities is less than the book value of rate-sensitive assets.

When repricing all interest-sensitive assets and all interest-sensitive liabilities in a balance sheet, the cumulative gap will be... A. zero. B. one. C. greater than one. D. a negative value.

A. zero.

Bank of the Atlantic has liabilities of $4 million with an average maturity of two years paying interest rates of 4.0 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6.0 percent annually. What is the bank's net interest income for the current year? A. $300,000. B. $140,000. C. $160,000. D. $280,000. E. $80,000.

B. $140,000.

An FI finances a $250,000 2-year fixed-rate loan with a $200,000 1-year fixed-rate CD. Use the repricing model to determine (a) the FI's repricing (or funding) gap using a 1-year maturity bucket, and (b) the impact of a 100 basis point (0.01) decrease in interest rates on the FI's annual net interest income? A. $0; $0. B. -$200,000; +$2,000. C. -$200,000; -$2,000. D. +$50,000; -$500. E. -$200,000; -$1,000.

B. -$200,000; +$2,000.

What type of risk focuses upon mismatched asset and liability maturities and durations? A. Liquidity risk. B. Interest rate risk. C. Credit risk. D. Foreign exchange rate risk. E. Off-balance sheet risk.

B. Interest rate risk.

Which of the following observations is true of a spot loan? A. It involves a maximum size and a maximum period of time over which the borrower can withdraw funds. B. It involves immediate withdrawal of the entire loan amount by the borrower. C. It is an unsecured short-term debt instrument issued by corporations. D. It is a nonbank loan substitute. E. It is a line of credit.

B. It involves immediate withdrawal of the entire loan amount by the borrower.

The increased opportunity for a bank to securitize loans into liquid and tradable assets is likely to affect which type of risk? A. Sovereign risk. B. Market risk. C. Insolvency risk. D. Technological risk. E. Interest rate risk.

B. Market risk.

The BIS definition: "the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events," encompasses which of the following risks? A. Credit risk and liquidity risk B. Operational risk and technology risk C. Credit risk and market risk D. Technology risk and liquidity risk E. Sovereign risk and credit risk

B. Operational risk and technology risk

Which theory of term structure states that long-term rates are equal to the geometric average of current and expected short-term rates plus a risk premium that increases with the maturity of the security? A. The unbiased expectations theory. B. The liquidity premium theory. C. The loanable funds theory. D. The market segmentation theory.

B. The liquidity premium theory.

The unbiased expectations theory of the term structure of interest rates... A. assumes that long-term interest rates are an arithmetic average of short-term rates. B. assumes that the yield curve reflects the market's current expectations of future short-term interest rates. C. recognizes that forward rates are perfect predictors of future interest rates. D. assumes that risk premiums increase uniformly with maturity. E. None of the options.

B. assumes that the yield curve reflects the market's current expectations of future short-term interest rates.

"Matching the book" or trying to match the maturities of assets and liabilities is intended to protect the FI from... A. liquidity risk. B. interest rate risk. C. credit risk. D. foreign exchange risk. E. off-balance-sheet risk.

B. interest rate risk.

As commercial banks move from their traditional banking activities of deposit taking and lending and shift more of their activities to trading, they are more subject to... A. credit risk. B. market risk. C. political risk. D. sovereign risk. E. liquidity risk.

B. market risk

The risk that a debt security's price will fall, subjecting the investor to a potential capital loss is... A. credit risk. B. market risk. C. currency risk. D. liquidity risk. E. political risk.

B. market risk

The net worth of a bank is the difference between the... A. value of retained earnings and the provision for loan losses. B. market value of assets and the market value of liabilities. C. book value of assets and book value of liabilities. D. rate-sensitive assets and rate-sensitive liabilities. E. None of the options.

B. market value of assets and the market value of liabilities.

The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as.. A. liquidity risk. B. reinvestment risk. C. credit risk. D. foreign exchange risk. E. off-balance-sheet risk.

B. reinvestment risk.

The risk that many borrowers in a particular country fail to repay their loans as a result of a recession in that country relates to A. credit risk. B. sovereign risk. C. currency risk. D. liquidity risk. E. interest rate risk.

B. sovereign risk.

Unanticipated diseconomies of scale or scope are a result of... A. interest rate risk. B. technology risk. C. credit risk. D. foreign exchange risk. E. off-balance-sheet risk.

B. technology risk.

The duration of a soon to be approved loan of $10 million is four years. The 99 th percentile increase in risk premium for bonds belonging to the same risk category of the loan has been estimated to be 5.5 percent. If the fee income on this loan is 0.4 percent and the spread over the cost of funds to the bank is 1 percent, what is the expected income on this loan for the current year? A. $40,000. B. $100,000. C. $140,000. D. $180,000.

C. $140,000.

The duration of a soon to be approved loan of $10 million is four years. The 99 th percentile increase in risk premium for bonds belonging to the same risk category of the loan has been estimated to be 5.5 percent. What is the estimated risk-adjusted return on capital (RAROC) of this loan? A. 6.36 percent. B. 7.00 percent. C. 7.13 percent. D. 10.55 percent. E. 25.45 percent.

C. 7.13 percent.

What is the essential idea behind Risk-adjusted return on capital (RAROC) models? A. Evaluating the actual or contractually promised annual ROA on a loan. B. Analyzing historic or past default risk experience. C. Balancing expected interest and fee income less the cost of funds against the loan's expected risk. D. Extracting expected default rates from the current term structure of interest rates. E. Dividing net interest and fees by the amount lent.

C. Balancing expected interest and fee income less the cost of funds against the loan's expected risk.

Regulation limits FI investment in non-investment grade bonds (rated below Baa or non-rated). What kind of risk is this designed to limit? A. Liquidity risk. B. Interest rate risk. C. Credit risk. D. Foreign exchange rate risk. E. Off-balance sheet risk.

C. Credit risk.

A mortgage loan officer is found to have provided false documentation that resulted in a lower interest rate on a loan approved for one of her friends. The loan was subsequently added to a loan pool, securitized and sold. Which of the following risks applies to the false documentation by the employee? A. Market risk. B. Credit risk. C. Operational risk. D. Technological risk. E. Sovereign risk.

C. Operational risk.

Which term refers to the risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset investments? A. Reinvestment risk. B. Credit risk. C. Refinancing risk. D. Liquidity risk. E. Sovereign risk.

C. Refinancing risk.

Which term refers to the risk that interest income will decrease as maturing assets are replaced with new, more current assets? A. Credit risk. B. Refinancing risk. C. Reinvestment risk. D. Liquidity risk. E. Sovereign risk.

C. Reinvestment risk.

Which of the following is NOT a valid conceptual or application problem of the mortality rate approach to estimate default risk? A. Implied future probabilities are sensitive to the period over which MMRs are calculated. B. The estimates are sensitive to the number of issues in each investment grade. C. Syndicated loans seem to have higher mortality rates than corporate bonds. D. The estimated probability values are historic or backward-looking measures. E. The estimates are sensitive to the relative size of issues in each investment grade.

C. Syndicated loans seem to have higher mortality rates than corporate bonds.

The asymmetric return distribution (relatively high probability of anticipated return; lower probability of default) on risky debt exposes the FI to... A. technology risk. B. interest rate risk. C. credit risk. D. foreign exchange risk. E. off-balance-sheet risk.

C. credit risk.

An FI that finances long-term fixed rate mortgages with short-term deposits is exposed to... A. increases in net interest income and decreases in the market value of equity when interest rates fall. B. decreases in net interest income and decreases in the market value of equity when interest rates fall. C. decreases in net interest income and decreases in the market value of equity when interest rates rise. D. increases in net interest income and decreases in the market value of equity when interest rates rise. E. increases in net interest income and increases in the market value of equity when interest rates rise.

C. decreases in net interest income and decreases in the market value of equity when interest rates rise.

The risk that a foreign government may devalue the currency relates to ... A. credit risk. B. sovereign risk. C. foreign exchange risk. D. liquidity risk. E. interest rate risk.

C. foreign exchange risk.

When the assets and liabilities of an FI are not equal in size, efficient hedging of interest rate risk can be achieved by A. increasing the duration of assets and increasing the duration of equity. B. issuing more equity and reducing the amount of borrowed funds. C. not exactly matching the maturities of assets and liabilities. D. issuing more equity and investing the funds in higher-yielding assets. E. efficient hedging cannot be achieved without the use of derivative securities.

C. not exactly matching the maturities of assets and liabilities.

What type of risk focuses upon mismatched currency positions? A. Liquidity risk. B. Interest rate risk. C. Credit risk. D. Foreign exchange rate risk. E. Off-balance sheet risk.

D. Foreign exchange rate risk.

What type of risk focuses upon mismatched currency positions? A. Liquidity risk. B. Interest rate risk. C. Credit risk. D. Foreign exchange rate risk. E. Off-balance sheet risk.

D. Foreign exchange rate risk.

Which of the following refers to the term "mortality rate"? A. The success rate of new investments. B. A one-period rate of interest expected on a bond issued at some date in the future. C. The probability that a borrower will default in any given year. D. Historic default rate experience of a bond or loan. E. The probability that a borrower will default over a specified multi-year period.

D. Historic default rate experience of a bond or loan.

Bank of the Atlantic has liabilities of $4 million with an average maturity of two years paying interest rates of 4.0 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6.0 percent annually. To what risk is the bank exposed? A. Reinvestment risk. B. Refinancing risk. C. Interest rate risk. D. Reinvestment risk and interest rate risk. E. Refinancing risk and interest rate risk.

D. Refinancing risk and interest rate risk.

With regard to market value risk, rising interest rates... A. increase the value of fixed rate liabilities. B. increase the value of fixed rate assets. C. increase the value of variable-rate assets. D. decrease the value of fixed rate liabilities E. decrease the value of variable-rate assets.

D. decrease the value of fixed rate liabilities

Holding corporate bonds with fixed interest rates involves... A. default risk only. B. interest rate risk only. C. liquidity risk and interest rate risk only. D. default risk and interest rate risk. E. default and liquidity risk only.

D. default risk and interest rate risk.

Holding corporate bonds with fixed interest rates involves... A. default risk only. B. interest rate risk only. C. liquidity risk and interest rate risk only. D. default risk and interest rate risk.

D. default risk and interest rate risk.

The risk that a German investor who purchases British bonds will lose money when trying to convert bond interest payments made in pounds sterling into euros is called ... A. liquidity risk. B. interest rate risk. C. credit risk. D. foreign exchange rate risk. E. off-balance-sheet risk.

D. foreign exchange rate risk.

An FI that finances a euro (€) loan with U.S. dollar ($) deposits is exposed to ... A. technology risk. B. interest rate risk. C. credit risk. D. foreign exchange risk. E. off-balance-sheet risk.

D. foreign exchange risk.

The risk that interest income will increase at a slower rate than interest expense is ... A. credit risk. B. political risk. C. currency risk. D. interest rate risk. E. liquidity risk.

D. interest rate risk.

Interest rate risk management for financial intermediaries deals primarily with... A. controlling the overall size of the institution. B. controlling the scope of the institution's activities. C. limiting the geographic spread of the institution's offices. D. limiting the mismatches on the institution's balance sheet. E. continuously and carefully complying with all government regulations.

D. limiting the mismatches on the institution's balance sheet.

The risk that many depositors withdraw their funds from an FI at once is ... A. credit risk. B. sovereign risk. C. currency risk. D. liquidity risk. E. interest rate risk.

D. liquidity risk.

The repricing gap approach calculates the gaps in each maturity bucket by subtracting the... A. current assets from the current liabilities. B. long term liabilities from the fixed assets. C. rate-sensitive assets from the total assets. D. rate-sensitive liabilities from the rate-sensitive assets. E. current liabilities from tangible assets.

D. rate-sensitive liabilities from the rate-sensitive assets.

The gap ratio expresses the reprice gap for a given time period as a percentage of... A. equity. B. total liabilities. C. current liabilities. D. total assets. E. current assets.

D. total assets.

Suppose that interest rates rise by 2 percent on both RSAs and RSLs. The expected annual change in net interest income of the bank is... A. -$300,000. B. $500,000. C. -$2,800,000. D. -$3,000,000. E. $300,000.

E. $300,000.

If interest rates decrease 50 basis points for an FI that has a gap of +$5 million, the expected change in net interest income is... A. +$2,500. B. +$25,000. C. +$250,000. D. -$250,000. E. -$25,000.

E. -$25,000.

Which of the following is a weakness of the repricing model to measure interest rate risk? A. Potential for overaggregation of assets and liabilities within each maturity bucket. B. It ignores how changes in interest rates affect the market value of assets and liabilities. C. It ignores the reinvestment of loan interest and principal payments that are reinvested at current market rates. D. It fails to recognize off-balance-sheet activities that may be rate-sensitive. E. All of the options.

E. All of the options.

According to Altman's credit scoring model, which of the following Z scores would indicate a low default risk firm? A. Less than 1. B. 1. C. Between 1 and 1.81. D. Between 1.81 and 2.99. E. Greater than 2.99.

E. Greater than 2.99.

The asset transformation function potentially exposes the FI to... A. foreign exchange risk. B. technology risk. C. operational risk. D. trading risk. E. interest rate risk.

E. interest rate risk.

The major source of risk exposure resulting from issuance of standby letters of credit is... A. technology risk. B. interest rate risk. C. credit risk. D. foreign exchange risk. E. off-balance-sheet risk.

E. off-balance-sheet risk.

The potential exercise of unanticipated contingencies can result in... A. technology risk. B. interest rate risk. C. credit risk. D. foreign exchange risk. E. off-balance-sheet risk.

E. off-balance-sheet risk.

Marginal default probability refers to the... A. probability that a borrower will default over a specified multi-year period. B. marginal increase in the default probability due to a change in credit premium. C. historic default rate experience of a bond or loan. D. expected maximum change in the loan rate due to a change in the credit premium. E. probability that a borrower will default in any given year.

E. probability that a borrower will default in any given year.

True or False: A positive repricing gap implies that a decrease in interest rates will cause interest expense to decrease more than the decrease in interest income.

False

True or False: Credit risk and interest rate risk cannot affect insolvency risk.

False

True or False: Credit risk only exposes the lender to the uncertainty that interest payments may not be received.

False

True or False: Diversification in the loan portfolio of an FI is intended to reduce systematic risk of each of the loans in the portfolio.

False

True or False: Exactly matching the maturities of assets and liabilities will provide a perfect hedge against interest rate risk for an FI.

False

True or False: FIs that make loans or buy bonds with long maturity liabilities are more exposed to interest rate risk than FIs that make loans or buy bonds with short maturity liabilities.

False

True or False: FIs that make long-term loans are less exposed to credit risk than if they make short-term loans.

False

True or False: For an FI to exactly hedge the foreign investment risk, the foreign currency assets must equal the foreign currency liabilities.

False

True or False: Foreign exchange risk includes interest rate risk and credit risk as well as changes in the foreign exchange rate between two countries.

False

True or False: Foreign exchange risk is that the value of assets and liabilities may change because of changes in the level of interest rates.

False

True or False: Historically credit card loans have very low rates of default or credit risk when compared to other assets that an FI may hold.

False

True or False: Off-balance sheet activities never have an effect on the value of equity the FI holds.

False

True or False: One cause of liquidity risk occurs when customers of an FI pay down their lines of credit.

False

True or False: Systematic credit risk can be reduced significantly by diversification.

False

True or False: An off-balance-sheet activity does not appear on the current balance sheet because it does not involve holding a current primary claim or the issuance of a current secondary claim.

True

True or False: Credit risk stems from non-repayment or delays in repayment of either principal or interest on FI assets.

True

True or False: Employee fraud is a type of operational risk to a financial institution.

True

True or False: FIs that actively trade assets and liabilities are exposed to market risk.

True

True or False: Firm specific credit risk can be reduced by diversification.

True

True or False: Foreign exchange rate risk occurs because foreign exchange rates are volatile and can impact banks with exposed foreign assets and/or liabilities.

True

True or False: Foreign exchange risk is that the value of assets and liabilities may change because of changes in the foreign exchange rate between two countries.

True

True or False: Loss of reputation is a type of operational risk to a financial institution.

True

True or False: Market risk is present whenever an FI takes an open position in an asset and prices change in a direction opposite to that expected.

True

True or False: Off-balance-sheet risk occurs because of activities that do not appear on the balance sheet.

True

True or False: One method of guarding against credit risk is to assess a risk premium based on the estimate of default risk exposure that a borrower carries.

True

True or False: Sovereign risk involves the inability of a foreign corporation to repay the principal or interest on a loan because of stipulations by the foreign government that is out of the control of the foreign corporation.

True

True or False: Sovereign risk is a different type of credit risk that affects an FI that purchases bonds of foreign corporations and governments.

True

True or False: Technology risk is the uncertainty that economies of scale or scope will be realized from the investment in new technologies.

True

True or False: The more volatile asset prices, the more market risks an FI has when they have an open, or unhedged, position.

True

True or False: The relationship of a limited or fixed upside return with a high probability and the potential large downside loss with a small probability is an example of an asset's credit risk to an FI.

True

True or False: The repricing gap model is a book value accounting based model.

True

True or False: The risk that a computer system may malfunction during the processing of data is an example of operational risk.

True

True or False: To be immunized against foreign currency and foreign interest rate risk, an FI should match both the size and maturities of its foreign assets and foreign liabilities.

True

True or False: Unanticipated withdrawals by liability holders are a major part of liquidity risk.

True

True or False: When a bank's repricing gap is positive, net interest income is positively related to changes in interest rates.

True