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ISE Financial Institutions Management A Risk Management Approach 10th International Edition Anthony Saunders Professor, Marcia Millon Cornett, Otgo Erhemjamts - Solutions
34. A U.S. FI has a long position in £75,500,000 assets funded with U.S. dollar-denominated liabilities. The FI manager is concerned about the £ appreciating relative to the dollar and is considering a hedge of this FX risk using pound futures contracts. The manager has regressed recent changes
33. An FI is planning to hedge its one-year, 100 million Swiss francs(SFr)–denominated loan against exchange rate risk. The current spot rate is $1.10/SFr. A one-year SFr futures contract is currently trading at $1.08/SFr. SFr futures are sold in standardized units of SFr125,000.a. Should the FI
32. An FI has assets denominated in British pounds of $125 million and pound liabilities of $100 million. The exchange rate of pounds for dollars is currently $1.20/£.a. What is the FI’s net FX exposure?b. Is the FI exposed to a dollar appreciation or depreciation?c. How can the FI use futures
31. What technique is commonly used to estimate the hedge ratio?What statistical measure is an indicator of the confidence that should be placed in the estimated hedge ratio? What is the interpretation if the estimated hedge ratio is greater than 1? Less than 1?
30. What does the hedge ratio measure? Under what conditions is this ratio valuable in determining the number of futures contracts necessary to fully hedge an investment in another currency?
29. What is meant by tail the hedge? What factors allow an FI manager to tail the hedge effectively?
28. An FI has an asset investment in euros. The FI expects the exchange rate of dollars/euro to increase by the maturity of the asset.a. Is the dollar appreciating or depreciating against the euro?b. To fully hedge the investment, should the FI buy or sell euro futures contracts?c. If there is
27. Dudley Hill Bank has the following balance sheet:Further, DA = 6 years DL = 2 years The interest rate on both the assets and the liabilities is 8 percent.The bank manager receives information from an economic forecasting unit that interest rates are expected to rise from 8 to 9 percent over the
26. Suppose an FI purchases a $1 million 91-day (360-day year)Eurodollar futures contract trading at 98.50.a. If the contract is reversed two days later by selling the contract at 98.60, what is the net profit?b. What is the loss or gain if the price at reversal is 98.40?
25. Assume that 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.a. What number of futures contracts is needed to
24. Village Bank has $240 million worth of assets with a duration of 14 years and liabilities worth $210 million with a duration of 4 years.In the interest of hedging interest rate risk, Village Bank is contemplating a macrohedge with interest rate T-bond futures contracts now selling for 102–21
23. An FI is planning to hedge its $100 million bond instruments with a hedge using Eurodollar interest rate futures. How would the FI estimate to determine the exact number of Eurodollar futures contracts to hedge?
22. Refer again to problem 21. How does consideration of basis risk change your answers to problem 21?a. Compute the number of futures contracts required to construct a macrohedge ifb. Explain what is meant by br = 0.90.c. If br = 0.90, what information does this provide on the number of futures
21. Consider the following balance sheet (in millions) for an FI:Assets Liabilities Duration = 10 years$950 Duration = 2 years $860 Equity 90a. What is the FI’s duration gap?b. What is the FI’s interest rate risk exposure?c. How can the FI use futures and forward contracts to put on a
20. A mutual fund plans to purchase $500,000 of 30-year Treasury bonds in four months. These bonds have a duration of 12 years and are priced at 96.25 (percent of face value). The mutual fund is concerned about interest rates changing over the next four months and is considering a hedge with T-bond
19. Reconsider Tree Row Bank in problem 16, but assume that the cost rate on the liabilities is 6 percent. On-balance-sheet rates are expected to increase by 100 basis points. Further, assume there is basis risk such that rates on three-month Eurodollar CDs are expected to change by 0.10 times the
18. How would your answer for part (b) in problem 16 change if the relationship of the price sensitivity of futures contracts to the price sensitivity of underlying bonds were br = 0.92?
17. What is basis risk? What are the sources of basis risk?
16. 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 percent. Tree Row Bank wishes to hedge the balance sheet with Eurodollar futures
15. What is meant by fully hedging the balance sheet of an FI?
14. What is the meaning of the Treasury bond futures price quote 101–130?
13. For a given change in interest rates, why is the sensitivity of the price of a Treasury bond futures contract greater than the sensitivity of the price of a Treasury bill futures contract?
12. Hedge Row Bank has the following balance sheet (in millions):Assets $150 Liabilities $135 Equity 15 Total $150 Total $150 The duration of the assets is six years and the duration of the liabilities is four years. The interest rate on both the assets and the liabilities is 10 percent. The bank
11. What are the reasons why an FI may choose to hedge selectively its portfolio?
10. 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?
9. The duration of a 20-year, 8 percent coupon Treasury bond selling at par is 10.292 years. The bond’s interest is paid semiannually and the bond qualifies for delivery against the Treasury bond futures contract.a. What is the impact on the Treasury bond price if market interest rates increase
8. In each of the following cases, indicate whether it would be appropriate for an FI to buy or sell a forward contract to hedge the appropriate risk.a. A commercial bank holds three-month CDs in its liability portfolio.b. An insurance company plans to buy bonds in two months.c. A savings bank is
7. Long Bank has assets that consist mostly of 30-year mortgages and liabilities that are short-term demand and time deposits. Will an interest rate futures contract the bank buys add to or subtract from the bank’s risk?
6. Suppose an FI purchases a 20-year Treasury bond futures contract at 95.a. What is the FI’s obligation at the time the futures contract is purchased?b. If an FI purchases this contract, in what kind of hedge is it engaged?c. Assume that the Treasury bond futures price falls to 94. What is the
5. Contrast the position of being short with that of being long in futures contracts.
4. An FI holds a 15-year, $10 million par value bond that is priced at 104 with a yield to maturity of 7 percent. The bond has a duration of eight years and the FI plans to sell it after two months. The FI’s market analyst predicts that interest rates will be 8 percent at the time of the desired
3. What is a naive hedge? How does a naive hedge protect an FI from risk?
2. What are some of the major differences between futures and forward contracts? How do these contracts differ from spot contracts?
1. What are derivative contracts? What is the value of derivative contracts to the managers of FIs? Which type of derivative contracts had the highest notional value outstanding among all U.S.banks as of 2018?
2. What are some of the practical problems an FI manager may face when using catastrophe futures to hedge losses on insurance lines?
1. Why are credit forwards useful for hedging the credit risk of an FI’s portfolio?
3. In running a regression of ΔSt on ΔFt, the regression equation is ΔSt = 0.51 + 0.95 ΔFt and R2 = 72 percent. What is the hedge ratio? What is the measure of hedging effectiveness?
2. Suppose that R2 = 0 in a regression of ΔSt on ΔFt. Would you still use futures contracts to hedge? Explain your answer.
1. Circle an observation in Figure 23–6 that shows futures price changes exceeding spot price changes.
3. In Example 23–3, how many futures contracts should have been sold using the 20-year bond futures contracts if the basis risk measure br = 0.8?
2. In Example 23–2, suppose the FI had the reverse duration gap;that is, the duration of its assets was shorter (DA = 3) than the duration of its liabilities (DA = 5). (This might be the case of a bank that borrows with long-term notes or time deposits to finance floating-rate loans.) How should
1. What is the difference between microhedging and macrohedging and between routine hedging and selective hedging?
40. Go to the FDIC website at www.fdic.gov. Find the most recent breakdown of bank holding company deposit share for the State of New York using the following steps. Click on “Industry Analysis”from the drop-down menu in the top-right corner. From there click on “Bank Data & Statistics” and
39. What are the difficulties of expanding globally? How can each of these difficulties create negative effects on the operating performance of FIs?
38. What are the major advantages of international expansion to FIs?Explain how each advantage can affect the operating performance of FIs.
37. What were the main features of FBSEA? How did FBSEA encourage cooperation with the home country regulator? What was the effect of the FBSEA on the Federal Reserve and on foreign banks?
36. What events led to the passage of the Foreign Bank Supervision Enhancement Act (FBSEA) of 1991? What was the main objective of this legislation?
35. What was the fundamental philosophical focus of the International Banking Act (IBA) of 1978?
34. What factors affected the proportion of U.S. banking assets that were controlled by foreign banks during the 1990s through 2018?
33. What is the European Community (EC) Second Banking Directive?What impact has the Second Banking Directive had on the competitive banking environment in Europe?
32. What effect have the problems of emerging market economies in the late 1990s and 2000s had on the global expansion of traditional banking activities by U.S. banks?
31. What is the expected impact of the implementation of the Basel III risk-based capital requirements on the international activities of some major U.S. banks?
30. Identify and explain the impact of at least four factors that have encouraged global U.S. bank expansion.
29. How did the Overseas Direct Investment Control Act of 1964 assist in the growth of global banking activities? How much growth in foreign assets occurred from 1980 to 2018?
28. What are some of the benefits for banks engaging in domestic geographic expansion?
27. What are some plausible reasons for the percentage of assets of small and intermediate-sized banks decreasing and the percentage of assets of large banks increasing since 1984?
26. What factors other than market concentration does the Justice Department consider in determining the acceptability of a merger?
25. The Justice Department has been asked to review a merger request for a market with the following four FIs:a. What is the HHI for the existing market?b. If Bank A acquires Bank D, what will be the impact on the market’s level of concentration?c. If bank C acquires Bank D, what will be the
24. City Bank currently has a 60 percent market share in banking services, followed by NationsBank with 20 percent and State Bank with 20 percent.a. What is the concentration ratio as measured by the Herfindahl-Hirschman Index (HHI)?b. If City Bank acquires State Bank, what will be the new HHI?c.
23. What is the Herfindahl-Hirschman Index? How is it calculated and interpreted?
22. What are the three revenue synergies that may be obtained by an FI from domestic geographic expansion?
21. What cost synergies may be obtained by an FI from domestic geographic expansion?
20. How did the provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allow for full interstate banking?What are the expected profit performance effects of interstate banking? What has been the impact on the structure of the banking and financial services industry?
19. What is an interstate banking pact?
18. In what way did the Garn-St. Germain Act and FIRREA provide incentives for the expansion of interstate branching?
17. How are insurance companies able to offer services in states beyond their state of incorporation?
16. How do limitations on domestic geographic diversification affect an FI’s profitability?
15. In what ways does the current regulatory structure argue against providing additional securities powers to the banking industry?Does this issue just concern banks?
14. Under what circumstances could the existence of deposit insurance provide an advantage to banks in competing with other traditional securities firms?
13. What six conflicts of interest have been identified as potential roadblocks to the expansion of banking powers into the financial services area?
12. What role does bank activity diversification play in the ability of a bank to exploit economies of scale and scope? What remains as the limitation to creating potentially greater benefits?
11. What are three ways that the failure of a securities affiliate in a holding company organizational form could negatively affect a bank affiliate? How has the Fed attempted to prevent a breakdown of the ring-fences or firewalls between bank and nonbank affiliates in these situations?
10. An Investment bank subsidiary of a financial services holding company agrees to underwrite a debt issue for one of its clients. It has suggested a firm commitment offering for issuing 100,000 shares of stock. The FI quotes a bid–ask spread of $97–$97.50 to its customer on the issue date.a.
9. An FI is underwriting the sale of 1 million shares of Ultrasonics, Inc., and is quoting a bid–ask price of $6.00–$6.50.a. What are the fees earned by the FI if a firm commitment method is used to underwrite the securities?b. What are the fees if the FI uses the best-efforts method and a
8. What are the differences in the risk implications of a firm commitment securities offering versus a best-efforts offering?
7. What is shadow banking? How does the shadow banking system differ from the traditional banking system?
6. The Financial Services Modernization Act of 1999 allows banks to own controlling interests in nonfinancial companies. What are the two restrictions on such ownership?
5. What types of insurance products were commercial banks permitted to offer before 1999? How did the Financial Services Modernization Act of 1999 change this? How have nonbanks managed to exploit the loophole in the Bank Holding Company Act of 1956 and engage in banking activities? What law closed
4. Explain in general terms what impact the Financial Services Modernization Act of 1999 should have on the strategic implementation of Section 20 activities.
3. What restrictions were placed on Section 20 subsidiaries of U.S.commercial banks that made investment banking activities other than those permitted by the Glass-Steagall Act less attractive? How did this differ from banking activities in other countries?
2. What general prohibition regarding the activities of commercial banking and investment banking did the Glass-Steagall Act impose?
1. How do restrictions on product diversification reduce the profitability and risk of FIs?
3. Comparing the advantages and disadvantages discussed above, why do you think so few U.S. banks have established branches in the Ukraine?
2. What are the major disadvantages of international expansion to an FI?
1. What are the major advantages of international expansion to an FI?
3. How did the IBA of 1978 and the FBSEA of 1991 affect foreign banks operating in the United States?
2. What were the major policy changes pertaining to bank expansion introduced by NAFTA?
1. What regulatory and economic factors have encouraged the growth of U.S. offshore banking? What factors have deterred U.S. offshore banking?
2. Given the same scenario as in question 1, what three characteristics would most discourage you?
1. Suppose you are a manager of an FI looking at another FI as a target for acquisition. What three characteristics of the target FI would most attract you?
3. Suppose each of five firms in a banking market has a 20 percent share. What is the HHI?
2. What are the three dimensions of revenue synergy gains?
1. What recent bank mergers have been motivated by cost synergies?
2. What were the main features of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994?
1. What are some of the ways in which interstate banking barriers have been eroded?
4. What are three potential procompetitive effects cited in support of banks’ expansion into securities activities? What reason is given to support the opposite claim (i.e., that bank expansion would not enhance competition)?
3. In addition to the six potential conflicts of interest discussed in this section, can you think of any additional possible conflicts that might arise if commercial banks were allowed to expand their investment banking activities?
2. Describe three ways in which the losses of a securities affiliate in a holding company structure could be transmitted to a bank.
1. What are some of the issues that tend to arise in response to bank expansion into securities, insurance, and commercial activities?
2. How are the product activities of U.S. commercial banks likely to change in the future?
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