FINA 450 - Exam 2

The risk that borrowers are unable to repay their loans on time is

credit risk.

Holding corporate bonds with fixed interest rates involves

default risk and interest rate risk.

Which of the following is pure life insurance with a savings element built in?

endowment life

Underwriting risk faced by property-casualty insurance companies may result from unexpected

increases in loss rates.

Interest rate risk management for financial intermediaries deals primarily with

limiting the mismatches on the institution's balance sheet.

The risk that many depositors withdraw their funds from an FI at once is

liquidity risk.

For property-casualty insurers, losses are higher for lines that are exposed to

long tails and high inflation.

For property-casualty insurers, loss rates are more predictable for

low-severity high-frequency events.

The risk that a debt security's price will fall, subjecting the investor to a potential capital loss is

market risk.

When the assets and liabilities of an FI are not equal in size, efficient hedging of interest rate risk can be achieved by

not exactly matching the maturities of assets and liabilities.

The largest line of life insurance in terms of total contract value in the U.S. is

ordinary life.

Cumulative default probability refers to

probability that a borrower will default over a specified multi-year period.

Third Duration Investments has the following assets and liabilities on its balance sheet. The two-year Treasury notes are zero coupon assets. Interest payments on all other assets and liabilities occur at maturity. Assume 360 days in a year. Assets: $300 million 30-day Treasury bills $550 million 90-day Treasury bills $700 million 2-year Treasury notes $180 million 180-day municipal bonds Liabilities: $1,150 million 14-day repos $560 million 1-year commercial paper $20 million equity What is the duration of the assets?

0.955 years

If losses on a particular line of medical malpractice insurance were $650 million and premiums earned were $575 million, the loss ratio would be

1.13 implying that this line of insurance is unprofitable.

The following information on the mortality rate of loans as estimated by an FI: A-rated loans: Yearly (1) = 0.5% Yearly (2) = 0.5% Cumulative (1) = 0.5% Cumulative (2) = x B-rated loans: Yearly (1) = 1% Yearly (2) = 1.25% Cumulative (1) = 1% Cumulative (2) = x If the cumulative mortality rate in year 3 is 3.46 percent for the B-rated loan, what is its yearly mortality rate in year 3?

1.25%

Calculate the modified duration of a two-year corporate loan paying 6 percent interest annually. The $40,000,000 loan is 100 percent amortizing, and the current yield is 9 percent annually.

1.36 years

Calculate the duration of a two-year corporate loan paying 6 percent interest annually, selling at par. The $30,000,000 loan is 100 percent amortizing with annual payments.

1.49

Using a modified discriminant function similar to Altman's, Burger Bank estimates the following coefficients for its portfolio of loans: Z = 1.4X1 + 1.09X2 + 1.5X3 where X1 = debt to asset ratio; X2 = net income and X3 = dividend payout ratio. What is the Z-score if the debt to asset ratio is 40 percent, net income is 12 percent, and the dividend payout ratio is 60 percent?

1.59

First Duration Bank has the following assets and liabilities on its balance sheet: (Assets, Par amount, rate) 2-yr commercial loans, annual fixed rate at par, $400m, 10% 1-yr treasury bills, $100m (Rate liabilities, Par amount, Rate) 1-yr Cds annual fixed rate at par, $450m, 7% Net worth, $50m What is the duration of the commercial loans?

1.91

The following represents two yield curves. 1-year Pure Discount treasury Yields = 3% B-rated Corporate Bond Yields (Pure Discount Bonds) = 6% 2-year Pure Discount treasury Yields = 6% B-rated Corporate Bond Yields (Pure Discount Bonds) = 10% 20-year Pure Discount treasury Yields = 12% B-rated Corporate Bond Yields (Pure Discount Bonds) = 17% What interest rate is expected on a one-year B-rated corporate bond in one year? (Hint: Use the implied forward rate.)

14.15%

The following is the balance sheet of Boston Bank. The average maturity of demand deposits is estimated at 2 years. (Face Value, Runoff <1 year) 3-mo. T-Bills = $60m 2-yr bonds = $60m, 5% 5-yr bonds = $80m, 10% Demand Dep. = $180m, 10% Equity = $20m What is the repricing gap if a 3-year maturity gap is used? Ignore runoffs.

3-year maturity GAPGAP(3yr) = RSA(3yr) - RSL(3yr)GAP(3yr) = (3-month T-Bills + 2-year Bonds) - (Demand Deposits)GAP(3yr) = (60 + 60) - 180 = 120 - 180 = −$60 million.

The following are the assets and liabilities of a government security dealer Assets $150 million 30 day Treasury bills $275 million 91 day Treasury bills $90 million 180 day municipal notes $350 million 2 year Treasury notes Liabilities $575 million 14 day repurchase agreements $290 million 1 year commercial paper Use the repricing model to determine the funding gap for a maturity bucket of 30 days.

30-day maturity bucket RSA = 30-day T-Bills; RSL = 14-day repurchase agreement GAP = RSA - RSL = 150 - 575 = -$425.

The following information details the current rate sensitivity report for Gotbucks Bank, Inc. ($ million). (Asset/liability, Overnight, 1-30 days, 31-91 days, 92-181 days) Assets Fed Funds, $20 Loans, $0, $10, $15, $80 Liabilities Fed Funds, $50 Euro CDs, $5, $25, $40, $0 Calculate the funding gap for Gotbucks Bank using (a) a 30 day maturity period and (b) a 91 day maturity period.

30-day maturity bucket and 91-day maturity bucket RSA(30) = Fed Funds + overnight loan bucket + 30-day loan bucket RSL(30) = Fed Funds + overnight Euro CD bucket + 30 day Euro CD bucket RSA(30) = (20 + 0 + 10) = $30 RSL(30) = (50 + 5 + 25) = $80 GAP(30) = 30 - 80 = -$50 RSA(91) = Fed Funds + overnight loan bucket + 30-day loan bucket + 91-day loan bucket RSL(91) = Fed Funds + overnight Euro CD bucket + 30-day Euro CD bucket + 91-day Euro CD bucket RSA(91) = (20 + 0 + 10 + 15) = $45 RSL(91) = (50 + 5 + 25 + 40) = $120 GAP(91) = 45 - 120 = -$75 Answer is -$50 and -$75.

The following is information on current spot and forward term structures (assume the corporate debt pays interest annually): Treasury: Spot 1 year = 3% Spot 2 year = 4.75% Forward 1-year (1 year maturity) = X BBB Corporate Debt: Spot 1 year = 7.5% Spot 2 year = 9.15% Forward 1-year (1 year maturity) = Y Using the term structure of default probabilities, the implied default probability for BBB corporate debt during the current year is

4.19%

What is the duration of a 5-year par value zero coupon bond yielding 10 percent annually?

5.00 years

The numbers provided by Fourth Bank of Duration are in thousands of dollars. Treasury bill = $90 Treasury notes = $55 Treasury bonds = $176 Loans = $4,679 Time deposits = $1,100 Fed funds sold = $230 Demand deposits = $2,500 Equity = $1,170 What is the bank's leverage adjusted duration gap?

6.51 years

The following is information on current spot and forward term structures (assume the corporate debt pays interest annually): Treasury: Spot 1 year = 3% Spot 2 year = 4.75% Forward 1-year (1 year maturity) = X BBB Corporate Debt: Spot 1 year = 7.5% Spot 2 year = 9.15% Forward 1-year (1 year maturity) = Y Calculate the value of x (the implied forward rate on one-year maturity Treasuries to be delivered in one year).

6.53%

The following represents two yield curves. 1-year Pure Discount treasury Yields = 3% B-rated Corporate Bond Yields (Pure Discount Bonds) = 6% 2-year Pure Discount treasury Yields = 6% B-rated Corporate Bond Yields (Pure Discount Bonds) = 10% 20-year Pure Discount treasury Yields = 12% B-rated Corporate Bond Yields (Pure Discount Bonds) = 17% What is the probability that two-year B-rated corporate debt will be fully repaid?

92.9%

The following represents two yield curves. 1-year Pure Discount treasury Yields = 3% B-rated Corporate Bond Yields (Pure Discount Bonds) = 6% 2-year Pure Discount treasury Yields = 6% B-rated Corporate Bond Yields (Pure Discount Bonds) = 10% 20-year Pure Discount treasury Yields = 12% B-rated Corporate Bond Yields (Pure Discount Bonds) = 17% What is the implied probability of repayment on one-year B-rated debt?

97.17%

The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as

reinvestment risk.

An insurance policy that often is the least expensive to the insured because of the policy does not include a savings plan is called

term life.

The surrender value of an insurance policy is

the cash value paid to the policyholder if the policy is terminated before it matures.

Immunizing the balance sheet to protect equity holders from the effects of interest rate risk occurs when

the effect of a change in the level of interest rates on the value of the assets of the FI is exactly offset by the effect of the same change in interest rates on the liabilities of the FI.

A reasonable way to overcome some of the risk of adverse selection in the life insurance business can be accomplished by

variable life.

An insurance policy in which fixed premium payments are invested in mutual funds of stocks, bonds, and money market instruments is called

variable life.

In which of the following situations would an FI be considered net long in foreign assets if it has ¥100 million in loans?

¥80 million in liabilities. **Any FI is considered to be "net long" when the value of the assets is more than the value of liabilities. (asset value - liability value) = net position

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

∆NII = (CGAP) × ∆R∆NII = +$5,000,000 × (-0.005) = -$25,000.

First Duration Bank has the following assets and liabilities on its balance sheet: (Assets, Par amount, rate) 2-yr commercial loans, annual fixed rate at par, $400m, 10% 1-yr treasury bills, $100m (Rate liabilities, Par amount, Rate) 1-yr Cds annual fixed rate at par, $450m, 7% Net worth, $50m What is the FI's interest rate risk exposure?

Exposed to increasing rates.

What type of risk focuses upon future contingencies?

Off-balance sheet risk.

The balance sheet of XYZ Bank appears below. All figures in millions of U.S. dollars. Assets: 1. Short-term consumer loans (1-yr maturity) = $150 2. Long-term consumer loans = $125 3. 3-month treasury bills = $130 4. Six-month treasury notes = $135 5. 3-yr treasury bond = $170 6. 10-year fixed-rate mortgages = $120 7. 30-year floating-rate mortgages (rate adjusted every 9 months) = $140 Total = $970 Liabilities 1. Equity capital (fixed) = $120 2. Demand deposits (2-yr maturity) = $40 3. Passbook savages = $130 4. 3-month CDs = $140 5. 3-month bankers acceptances = $120 6. 6-month commercial paper = $160 7. 1-yr time deposits = $120 8. 2-yr time deposits = $40 Total = $970 Total one-year rate-sensitive assets is

One-year rate-sensitive assetsRSA = (short-term consumer loans + 3-month T-bills + 6-month T-notes + 30-year floating rate mortgages)RSA = (150 + 130 + 135 + 140) = $555.

The balance sheet of XYZ Bank appears below. All figures in millions of U.S. dollars. Assets: 1. Short-term consumer loans (1-yr maturity) = $150 2. Long-term consumer loans = $125 3. 3-month treasury bills = $130 4. Six-month treasury notes = $135 5. 3-yr treasury bond = $170 6. 10-year fixed-rate mortgages = $120 7. 30-year floating-rate mortgages (rate adjusted every 9 months) = $140 Total = $970 Liabilities 1. Equity capital (fixed) = $120 2. Demand deposits (2-yr maturity) = $40 3. Passbook savages = $130 4. 3-month CDs = $140 5. 3-month bankers acceptances = $120 6. 6-month commercial paper = $160 7. 1-yr time deposits = $120 8. 2-yr time deposits = $40 Total = $970 Total one-year rate-sensitive liabilities is

One-year rate-sensitive liabilitiesRSL = (3-month CDs + 3-month bankers acceptances + 6-month commercial paper + 1-year time deposits)RSL = (140 + 120 + 160 + 120) = $540.

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?

Operational risk.

Consider a six-year maturity, $100,000 face value bond that pays a 5 percent fixed coupon annually. What is the price of the bond if market interest rates are 4 percent?

$105,242.14

Hadbucks National Bank current balance sheet appears below. All assets and liabilities are currently priced at par and pay interest annually. (Assets, Amount, Annual Rate) 1-year bonds, $60, 7% 10-year loan, $40, 12% Total = $100 (Liabilities, Amount, Annual Rate) 1-year CD, $50, 5% 2-year CD, $40, 6% Equity, $10 Total = $100 What is the weighted average maturity of assets?

Proportions 1-year bonds = 0.6 10-year loan = 0.4 Maturity of Asset 1-year bonds = 0.6 10-year loan = 4 Total = 4.6

Hadbucks National Bank current balance sheet appears below. All assets and liabilities are currently priced at par and pay interest annually. (Assets, Amount, Annual Rate) 1-year bonds, $60, 7% 10-year loan, $40, 12% Total = $100 (Liabilities, Amount, Annual Rate) 1-year CD, $50, 5% 2-year CD, $40, 6% Equity, $10 Total = $100 What is this FI's maturity gap?

Proportions 1-year bonds = 0.6 10-year loan = 0.4 Maturity of Asset 1-year bonds = 0.6 10-year loan = 4 Total = 4.6 Proportions 1-year CD = 0.5555 2-year CD = 0.4445 Maturity of Liability 1-year CD = 0.5555 2-year CD = 0.8889 Total = 1.44 MGAP = MA - ML = 4.60 - 1.44 = 3.16 years.

Which of the following is an advantage of converting from a mutual insurance company to a stockholder-controlled company?

Publicly held companies have access to equity markets for additional capital for future business expansion.

A $1,000 six-year Eurobond has an 8 percent coupon, is selling at par, and contracts to make annual payments of interest. The duration of this bond is 4.99 years. What will be the new price using the duration model if interest rates increase to 8.5 percent?

$976.90

Suppose that debt-equity ratio (D/E) and the sales-asset ratio (S/A) were two factors influencing the past default behavior of borrowers. Based on past default (repayment) experience, the linear probability model is estimated as: PDi = 0.5(D/Ei) + 0.1(S/Ai). If a prospective borrower has a debt-equity ratio of 0.4 and sales-asset ratio of 1.8, the expected probability of default is

0.38

First Duration Bank has the following assets and liabilities on its balance sheet: (Assets, Par amount, rate) 2-yr commercial loans, annual fixed rate at par, $400m, 10% 1-yr treasury bills, $100m (Rate liabilities, Par amount, Rate) 1-yr Cds annual fixed rate at par, $450m, 7% Net worth, $50m What is the FI's leverage-adjusted duration gap?

0.83 years

Calculate the annual cash flows of a $2 million, 10-year fixed-payment annuity earning a guaranteed 8 percent annually if the payments are to start at the end of this year.

$298,058.98 PV = 2,000,000 FV = 0 I = 8 N = 10 PMT = ?

Calculate the annual cash flows of a $2 million, 10-year fixed-payment deferred annuity earning a guaranteed 8 percent per year if annual payments are to begin at the end of the sixth (6th) year.

$437,946.42 PV = 2,000,000 I = 8 N = 5 PMT = 0 FV = 2,938,656.15 PV = 2,938656.15 FV = 0 I = 8 N = 10 PMT = ?

Hadbucks National Bank current balance sheet appears below. All assets and liabilities are currently priced at par and pay interest annually. (Assets, Amount, Annual Rate) 1-year bonds, $60, 7% 10-year loan, $40, 12% Total = $100 (Liabilities, Amount, Annual Rate) 1-year CD, $50, 5% 2-year CD, $40, 6% Equity, $10 Total = $100 What is market value of the one-year CD if all market interest rates increase by 2 percent?

$49,065,420 FV = 50,000,000 I = 7 N = 1 PMT = 50m x 0.05 = 2,500,000 PV = ?

Hadbucks National Bank current balance sheet appears below. All assets and liabilities are currently priced at par and pay interest annually. (Assets, Amount, Annual Rate) 1-year bonds, $60, 7% 10-year loan, $40, 12% Total = $100 (Liabilities, Amount, Annual Rate) 1-year CD, $50, 5% 2-year CD, $40, 6% Equity, $10 Total = $100 What is market value of the one-year bond if all market interest rates increase by 2 percent?

$58.899 million FV = 60,000,000 I = 9 N = 1 PMT = 60 x 0.07 = 4,2000,000 PV = ?

The duration of a soon to be approved loan of $10 million is four years. The 99thpercentile 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 minimum RAROC acceptable to the bank is 8 percent, what should be its expected percentage fee income in order for it to approve the loan?

.571%

First Duration, a securities dealer, has a leverage-adjusted duration gap of 1.21 years, $60 million in assets, 7 percent equity to assets ratio, and market rates are 8 percent. What is the impact on the dealer's market value of equity per $100 of assets if the change in all interest rates is an increase of 0.5 percent? [i.e., ∆R = 0.5 percent]

-$336,111

Which of the following situations pose a refinancing risk for an FI?

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.

Which function of an FI involves buying primary securities and issuing secondary securities?

Asset transformation.

What is the essential idea behind Risk-adjusted return on capital (RAROC) models?

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

Why does immunization against interest rate shocks using duration for fixed-income securities work?

Because the gains or losses on reinvested cash flows that result from an interest rate change are exactly offset by losses or gains from the security when it is sold.

The balance sheet of XYZ Bank appears below. All figures in millions of U.S. dollars. Assets: 1. Short-term consumer loans (1-yr maturity) = $150 2. Long-term consumer loans = $125 3. 3-month treasury bills = $130 4. Six-month treasury notes = $135 5. 3-yr treasury bond = $170 6. 10-year fixed-rate mortgages = $120 7. 30-year floating-rate mortgages (rate adjusted every 9 months) = $140 Total = $970 Liabilities 1. Equity capital (fixed) = $120 2. Demand deposits (2-yr maturity) = $40 3. Passbook savages = $130 4. 3-month CDs = $140 5. 3-month bankers acceptances = $120 6. 6-month commercial paper = $160 7. 1-yr time deposits = $120 8. 2-yr time deposits = $40 Total = $970 The cumulative one-year repricing gap (CGAP) for the bank is

Cumulative one-year repricing gap (CGAP)CGAP = one-year RSA - one-year RSLCGAP = 555 - 540 = $15 millionCGAP is positive. The bank faces reinvestment risk.

The balance sheet of XYZ Bank appears below. All figures in millions of U.S. dollars. Assets: 1. Short-term consumer loans (1-yr maturity) = $150 2. Long-term consumer loans = $125 3. 3-month treasury bills = $130 4. Six-month treasury notes = $135 5. 3-yr treasury bond = $170 6. 10-year fixed-rate mortgages = $120 7. 30-year floating-rate mortgages (rate adjusted every 9 months) = $140 Total = $970 Liabilities 1. Equity capital (fixed) = $120 2. Demand deposits (2-yr maturity) = $40 3. Passbook savages = $130 4. 3-month CDs = $140 5. 3-month bankers acceptances = $120 6. 6-month commercial paper = $160 7. 1-yr time deposits = $120 8. 2-yr time deposits = $40 Total = $970 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

Effect of 2 percent increase in rates∆NII = (CGAP) × ∆R∆NII = $15,000,000 × 0.02 = +$300,000.

Hadbucks National Bank current balance sheet appears below. All assets and liabilities are currently priced at par and pay interest annually. (Assets, Amount, Annual Rate) 1-year bonds, $60, 7% 10-year loan, $40, 12% Total = $100 (Liabilities, Amount, Annual Rate) 1-year CD, $50, 5% 2-year CD, $40, 6% Equity, $10 Total = $100 What is the impact on the FI's equity of a 2 percent overall increase in market interest rates on all fixed-rate instruments?

Equity declines by $2.912 million. Change in equity due to a 2 percent increase in market rates:∆E = ∆A - ∆L ∆A = (58,899,082 - 60,000,000) + (35,827,107 - 40,000,000) = -1,100,918 - 4,172,893 = -$5,273,811 ∆L = (49,065,420 - 50,000,000) + (38,573,388 - 40,000,000) = -934,580 - 1,426,612 = -$2,361,192 ∆E = -$5,273,811 - (-2,361,192) = -$2,912,619 The value of equity will fall $2.912 million.

Which of the following statements about leverage-adjusted duration gap is true

Larger the gap in absolute terms, the more exposed the FI is to interest rate shocks.

The balance sheet of XYZ Bank appears below. All figures in millions of U.S. dollars. Assets: 1. Short-term consumer loans (1-yr maturity) = $150 2. Long-term consumer loans = $125 3. 3-month treasury bills = $130 4. Six-month treasury notes = $135 5. 3-yr treasury bond = $170 6. 10-year fixed-rate mortgages = $120 7. 30-year floating-rate mortgages (rate adjusted every 9 months) = $140 Total = $970 Liabilities 1. Equity capital (fixed) = $120 2. Demand deposits (2-yr maturity) = $40 3. Passbook savages = $130 4. 3-month CDs = $140 5. 3-month bankers acceptances = $120 6. 6-month commercial paper = $160 7. 1-yr time deposits = $120 8. 2-yr time deposits = $40 Total = $970 The gap ratio is

Gap ratio = CGAP ÷ Total Assets = $15 million ÷ $970 million = 0.015 or 1.546%.

According to Altman's credit scoring model, which of the following Z scores would indicate a low default risk firm?

Greater than 2.99

What type of risk focuses upon mismatched asset and liability maturities and durations?

Interest rate risk.

Which of the following refers to the term "mortality rate"?

Historic default rate experience of a bond or loan.

Suppose that the financial ratios of a potential borrowing firm took the following values: X1 = 0.30 X2 = 0 X3 = -0.30 X4 = 0.15 X5 = 2.1 Altman's discriminant function takes the form: Z = 1.2 X1+ 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5 According to Altman's credit scoring model, this firm should be considered

a high default risk firm.

What does the Moody's Analytics model use as equivalent to holding a call option on the assets of the firm?

The value of equity in a firm.

Can an FI immunize itself against interest rate risk exposure even though its maturity gap is not zero?

Yes, because the maturity model does not consider the timing of cash flows.

If the loss ratio on a line of insurance is 70 percent and loss adjustment expenses are 33 percent, then the line is profitable before dividends if the ratio of

commissions and other expenses are 16 percent and investment yields are 20 percent.

Variable universal life insurance policies

allow both the premium and benefit payout to vary with investment returns.

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

firm-specific credit 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

foreign exchange rate risk.

All else equal, as compared to an annual payment fixed income security, a semi-annual payment security has a

higher duration and more cash flows.