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Financial Institutions Management A Risk Management 4th Edition Helen Lange, Anthony Saunders, Marcia Millon Cornett - Solutions
1.Calculate the promised return (k ) on a loan if the base rate is 13 per cent, the risk premium is 2 per cent, the compensating balance requirement is 5 per cent, fees are 12 per cent and reserve requirements are 10 per cent.
1.Explain why credit card loan rates are generally much higher than car loan rates.
1.Would you expect that more floating-rate mortgages are originated in high or low interest rate environments? Explain your answer.
1.What are the four major types of loans made by Australian banks? What are the basic distinguishing characteristics of each type of loan?
1.Go to the websites of each of the four largest Australian banks. From their latest annual reports, find their approaches to market risk measurement and management. Compare the methodologies. LO 9.2 , 9.3
Suppose an FI’s portfolio VaR for the previous 60 days was $3 million and stressed VaR for the previous 60 days was $8 million using the 1 per cent worst case (or 99th percentile). Calculate the minimum capital charge for market risk for this FI. LO 9.3
In its trading portfolio, an FI holds 10 000 BHP Billiton (BHP) shares at a share price of $86.50 and has sold 5000 Woolworths (WOW) shares under a forward contract that matures in one year. The current share price for WOW is $20.50. The shift risk factor (standard deviation) for level I risk
Despite the fact that market risk capital requirements have been imposed on FIs since the 1990s, huge losses in value were recorded from losses incurred in FIs’ trading portfolios internationally. Why did this happen? What changes to capital requirements did regulators propose to prevent such
The Bank of Canberra’s stock portfolio has a market value of $250 million. The beta of the portfolio approximates the market portfolio, whose standard deviation (σm ) has been estimated at 2.25 per cent. What are the five-day VaR and ES of this portfolio using adverse rate changes in the 99th
An FI has ¥500 million in its trading portfolio on the close of business on a particular day. The current exchange rate of yen for dollars is ¥80.00/$, or dollars for yen is $0.0125, at the daily close. The volatility, or standard deviation (σ), of daily percentage changes in the spot ¥/$
An FI has £5 million in its trading portfolio on the close of business on a particular day. The current exchange rate of pounds for dollars is £0.6400/$, or dollars for pounds is $1.5625, at the daily close. The volatility, or standard deviation (σ), of daily percentage changes in the spot £/$
1.Consider the following discrete probability distribution of payoffs for two securities, A and B, held in the trading portfolio of an FI:Which of the two securities will add more market risk to the FI’s trading portfolio according to the VaR and ES measures? LO 9.7 Probability (%) A($m)
1.Consider the following discrete probability distribution of payoffs for two securities, A and B, held in the trading portfolio of an FI:Which of the two securities will add more market risk to the FI’s trading portfolio according to the VaR and ES measures? LO 9.7 Probability (%) A($m)
1.What is the difference between VaR and ES as a measure of market risk? LO 9.7
1.How is Monte Carlo simulation useful in addressing the disadvantages of back simulation? What is the primary statistical assumption underlying its use? LO 9.6
1.What is the primary disadvantage of the back simulation approach in measuring market risk? What effect does the inclusion of more observation days have as a remedy for this disadvantage? What other remedies can be used to deal with the disadvantage? LO 9.5
1.Export Bank has a trading position in Japanese yen and Swiss francs. At the close of business on 4 February the bank had ¥300 000 000 and SF10 000 000. The exchange rates for the most recent six days are given below:What is the foreign exchange (FX) position in dollar equivalents using the FX
1.What are the advantages of using the back simulation approach to estimate market risk? Explain how this approach would be implemented. LO 9.5
1.Calculate the DEAR for the following portfolio with and without the correlation coefficients.What is the amount of risk reduction resulting from the lack of perfect positive correlation between the various asset groups? LO 9.4 Shares (S) Foreign exchange (FX) Bonds (B) Assets Estimated DEAR
1.David Small, risk manager for Choice Bank, is estimating the aggregate DEAR of the bank’s portfolio of assets consisting of loans (L), foreign currencies (FX) and ordinary shares (EQ). The individual DEARs are $300 700, $274 000, and $126 700, respectively. If the correlation coefficients (ρ
1.Bank of Ayers Rock’s stock portfolio has a market value of $10 000 000. The beta of the portfolio approximates the market portfolio, whose standard deviation (σm ) has been estimated at 1.5 per cent. What is the five-day VaR of this portfolio using adverse rate changes in the 99th percentile?
1.Bank of Southern Tasmania has determined that its inventory of 20 million euros (€) and 25 million UK pounds (£) is subject to market risk. The spot exchange rates are $1.25/€ and $1.60/£, respectively. The σ’s of the spot exchange rates of the euro and the pound, based on the daily
1.Bank Two has a portfolio of bonds with a market value of $200 million. The bonds have an estimated price volatility of 0.95 per cent. What are the DEAR and the 10-day VaR for these bonds? LO 9.4
1.Bank Alpha has an inventory of AAA-rated, 15-year, zero-coupon bonds with a face value of $400 million. The bonds currently are yielding 9.5 per cent in the over-the-counter market.What is the modified duration of these bonds?What is the price volatility if the potential adverse move in yields is
1.In what sense is duration a measure of market risk? LO 9.3
1.The mean change in the daily yields of a 15-year, zero-coupon bond has been 5 basis points (bp) over the past year with a standard deviation of 15 bp.Use these data and assume that the yield changes are normally distributed.What is the highest yield change expected if a 99 per cent confidence
1.The DEAR for a bank is $8500. What is the VaR for a 10-day period? A 20-day period? Why is the VaR for a 20-day period not twice as much as that for a 10-day period? LO 9.3
1.How can DEAR be adjusted to account for potential losses over multiple days? What would be the VaR for the bond in problem 4 for a 10-day period?What statistical assumption is needed for this calculation? Could this treatment be critical? LO 9.3
1.Follow Bank has a $1 million position in a five-year, zero-coupon bond with a face value of $1 402 552. The bond is trading at a yield to maturity of 7 per cent. The historical mean change in daily yields is 0.0 per cent, and the standard deviation is 12 basis points.What is the modified duration
1.What is meant by ‘daily earnings at risk (DEAR)’? What are the three measurable components? What is the price volatility component? LO 9.2 , 9.3
1.Why is the measurement of market risk important to the manager of a financial institution? LO 9.1
1.What is meant by ‘market risk’? LO 9.1 , 9.2
2 What is the effect of using the 99th percentile (1 per cent worst case) rather than the 95th percentile (5 per cent worst case) on the measured size of an FI’s market risk exposures?
1 What is the BIS standardised framework for measuring market risk?
1.Why is ES superior to VaR as a measure of market risk?
1.What is the difference between VaR and ES?
1.What is the Monte Carlo simulation approach to measuring market risk?
1.What are the steps involved with the historic or back simulation approach to measuring market risk?
1.What are the advantages of the historic or back simulation approach over RiskMetrics to measure market risk?
1.Referring to Example 9.4 , what is the DEAR of the portfolio if the returns on the three assets are independent of each other?
1.Referring to Example 9.1 , what is the DEAR for this bond if σ is 15 bp (i.e. basis points)?
1.What is the ultimate objective of market risk measurement models?
1.Go to the website of the Reserve Bank of Australia and find the speech by Chris Aylmer, head of the domestic markets department, to the Australian Securitisation Forum on 11 November 2013, titled ‘Developments in Secured Issuance and RBA Reporting Initiatives’. From this, determine the total
1.Go to the website of the Australian Treasury Department, and find information about the government’s ‘Stream Two: Support smaller lenders to compete with the big banks’ and describe how this scheme also assisted the Australian securitisation market. LO 8.4
1.How does the FI use securitisation to manage its risk exposure? (Be sure to consider interest rate, currency, liquidity and credit risks.) LO 8.5
1.How does securitisation impact the FI’s role as a delegated monitor? LO 8.6
1.Consider $200 million of 30-year mortgages with a coupon of 10 per cent per annum, paid quarterly.What is the quarterly mortgage payment?What are the interest repayments over the first year of life of the mortgages? What are the principal repayments?Construct a 30-year CMO using this mortgage
1.What factors affect prepayment probability? LO 8.7
1.What would be the impact on mortgage-backed security pricing if the pass-through security was not fully amortised? What is the present value of a$10 million pool of 15-year mortgages with an 8.5 per cent monthly mortgage coupon per annum if market rates are 5 per cent? (The mortgage-backed
1.If 150 $200 000 mortgages are expected to be prepaid in three years, and the remaining 150 $200 000 mortgages in a $60 million 15-year mortgage pool are to be prepaid in four years, what is the weighted average life of the mortgage pool? Mortgages are fully amortised with mortgage coupon rates
1.A bank originates a pool of 500 30-year mortgages, each averaging $150 000, with an annual mortgage coupon rate of 8 per cent. If the mortgagebacked security insurance fee is 60 basis points and the bank’s servicing fee is 19 basis points:What is the present value of the mortgage pool?What is
1.Calculate the value of (a) the mortgage pool and (b) the pass-through security in Question 9 if interest rates increased 100 basis points. (Assume no prepayments.) LO 8.6
1.Consider a mortgage pool with principal of $20 million. The maturity is 30 years with a monthly mortgage payment of 10 per cent per annum.(Assume no prepayments.)What is the monthly mortgage payment (100 per cent amortising) on the pool of mortgages?If the mortgage-backed security insurance fee
1.Outline the costs and benefits of securitising car loans. LO 8.4
1.In addition to assisting the management of interest rate risk, what are four factors that are expected to encourage loan sales in the future? Discuss the impact of each factor. LO 8.3
1.An FI is planning the purchase of a $5 million loan to raise the existing average duration of its assets from 3.5 years to 5 years. It currently has total assets worth $20 million, $5 million in cash (0 duration) and $15 million in loans. All the loans are fairly priced.Assuming it uses the cash
1.In addition to managing interest rate risk, what are some other reasons for the sale of loans by FIs? LO 8.3
1.Why are yields higher on loan sales than on commercial paper issues with similar maturity and issue size? LO 8.1 , 8.3
1.What is the difference between loans sold with recourse and loans sold without recourse, from the perspective of both sellers and buyers? LO 8.1
1.Can all assets and loans be securitised? Explain your answer.
1.Would a AAA-rated FI ever issue mortgage-backed bonds? Explain your answer.
1.Is acting as a fee-reliant asset broker a risk-free strategy for an FI? If not, why not?
1.What are some of the factors that are likely to encourage loan sales growth in the future?
1.How can an FI use its loans to mitigate a liquidity problem?
1.What are some of the economic and regulatory reasons why FIs choose to sell loans?
1.Explain how an FI uses loan syndication to manage interest rate risk.
1.Which types of loans are most likely to be the subject of syndication in Australia? Why?
1.Describe the two basic types of loan sale contracts by which loans can be transferred between seller and buyer.
1.Read the CNBC article by K Holliday, ‘Rising Interest Rates Next Big Risk for Asia: World Bank’, bat www.cnbc.com/id/100811757 . If you were the risk manager of an Asian bank, what strategies could you use to counter the potential risk associated with the predicted changes in interest rates
1.Go to the website of the Australian Securities Exchange (www.asx.com.au ) and find the latest quotes for the 90-day bank accepted bill futures and options contracts. LO 7.2, 7.3, 7.4, 7.5
1.An FI has $500 million of assets with a duration of nine years and $450 million of liabilities with a duration of three years. The FI wants to hedge its duration gap with a swap that has fixed-rate payments with a duration of six years and floating-rate payments with a duration of two years. What
1.Two multinational corporations enter their respective debt markets to issue $100 million of two-year notes. Firm A can borrow at a fixed annual rate of 11 per cent or a floating rate of LIBOR plus 50 basis points, repriced at the end of the year. Firm B can borrow at a fixed annual rate of 10 per
1.First Bank can issue one-year, floating-rate CDs at BBR plus 1 per cent or fixed-rate CDs at 12.5 per cent. Second Bank can issue one-year, floatingrate CDs at BBR plus 0.5 per cent or fixed-rate at 11 per cent.What is a feasible swap with all of the benefits going to First Bank?What is a
1.Bank 1 can issue five-year CDs at an annual rate of 11 per cent fixed or at a variable rate of BBR plus 2 per cent. Bank 2 can issue five-year CDs at an annual rate of 13 per cent fixed or at a variable rate of BBR plus 3 per cent.Is a mutually beneficial swap possible between the two banks?Where
1.A regional bank has $200 million of floating-rate loans yielding the BBR rate plus 2 per cent. These loans are financed by $200 million of fixed-rate deposits costing 9 per cent. A savings bank has $200 million of mortgages with a fixed rate of 13 per cent. They are financed by $200 million of
1.In a swap arrangement, the variable-rate swap cash flow streams often do not fully hedge the variable-rate cash flow streams from the balance sheet due to basis risk.What are the possible sources of basis risk in an interest rate swap?How could the failure to achieve a perfect hedge be realised
1.An insurance company owns $50 million of floating-rate bonds yielding bank accepted bill rate (BBR) plus 1 per cent. These loans are financed by$50 million of fixed-rate guaranteed investment contracts (GICs) costing 10 per cent. A finance company has $50 million of car loans with a fixed rate of
1.Distinguish between a swap buyer and a swap seller. In which markets do each have the comparative advantage? LO 7.7
1.Forwards, futures and option contracts had been used by FIs to hedge risk for many years before swaps were invented. If FIs already had these hedging instruments, why did they need swaps? LO 7.7
1.Explain the similarity between a swap and a forward contract. LO 7.7
1.An FI has a $200 million asset portfolio that has an average duration of 6.5 years. The average duration of its $160 million in liabilities is 4.5 years.The FI uses put options on T-bonds to hedge against unexpected interest rate increases. The average delta (δ) of the put options has been
1.Corporate Bank has $840 million of assets with a duration of 12 years and liabilities worth $720 million with a duration of seven years. The bank is concerned about preserving the value of its equity in the event of an increase in interest rates and is contemplating a macrohedge with interest
1.A pension fund manager anticipates the purchase of a 20-year, 8 per cent coupon T-bond at the end of two years. Interest rates are assumed to change only once every year at year-end with an equal probability of a 1 per cent increase or a 1 per cent decrease. The T-bond, when purchased in two
1.Consider an FI that wishes to use bond options to hedge the interest rate risk in the bond portfolio.How does writing call options hedge the risk when interest rates decrease?Will writing call options fully hedge the risk when interest rates increase? Explain.How does buying a put option reduce
1.Consider the following:What are the two ways to use call and put options on T-bonds to generate positive cash flows when interest rates decline? Verify your answer with a diagram.Under what balance sheet conditions can an FI use options on T-bonds to hedge its assets and/or liabilities against
1.What is a put option? What must happen to interest rates for the purchaser of a put option on a bond to make money? How does the writer of the put option make money? LO 7.5
1.What is a call option? What must happen to interest rates for the purchaser of a call option on a bond to make money? How does the writer of the call option make money? LO 7.5
1.How does using options differ from using forward or futures contracts? LO 7.5
1.Assume an FI has assets of $250 million and liabilities of $200 million. The duration of the assets is six years and the duration of the liabilities is three years. The price of the futures contract is $115 000 and its duration is 5.5 years.What number of futures contracts is needed to construct
1.Refer to problem 18. How does consideration of basis risk change your answers to problem 18?Compute the number of futures contracts required to construct a macrohedge if [ΔRf /(1 + Rf )/ΔR /(1 + R )] = br = 0.90.Explain what is meant by br = 0.90.If br = 0.90, what information does this provide
1.Consider the following balance sheet (in millions) for an FI:What is the FI’s duration gap?What is the FI’s interest rate risk exposure?How can the FI use futures and forward contracts to put on a macrohedge?What is the impact on the FI’s equity value if the relative change in interest
1.How would your answer for part (b) in problem 15 change if the relationship of the price sensitivity of futures contracts to the price sensitivity of underlying bonds were br = 0.92? LO 7.3, 7.4
1.What is basis risk? What are the sources of basis risk? LO 7.4
1.Tree Row Bank has assets of $150 million, liabilities of $135 million, and equity of $15 million. The asset duration is six years and the duration of the liabilities is four years. Market interest rates are 10 per cent. Tree Row Bank wishes to hedge the balance sheet with 20-year T-bond futures
1.What is meant by fully hedging the balance sheet of an FI using futures contracts? LO 7.3
1.What is the meaning of the T-bond futures price bid of 95.75? LO 7.2
1.For a given change in interest rates, why is the sensitivity of the price of a T-bond futures contract greater than the sensitivity of the price of a bank accepted bill futures contract? LO 7.3
1.Hedge Row Bank has the following balance sheet (in millions):The duration of the assets is six years and the duration of the liabilities is four years. The bank is expecting interest rates to fall from 10 per cent to 9 per cent over the next year.What is the duration gap for Hedge Row Bank?What
1.What are the reasons why an FI may choose to hedge selectively its portfolio? LO 7.3
1.What are the differences between a microhedge and a macrohedge for an FI? Why is it generally more efficient for FIs to employ a macrohedge than a series of microhedges? LO 7.3
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