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ISE Financial Institutions Management A Risk Management Approach 10th International Edition Anthony Saunders Professor, Marcia Millon Cornett, Otgo Erhemjamts - Solutions
4. If there are diseconomies of scope, do specialized FIs have a relative cost advantage or disadvantage over productdiversified FIs?
3. Does the existence of economies of scale for FIs mean that in the long run, small FIs cannot survive?
2. What is the link between interstate banking restrictions and the retail demand for electronic payment services?
1. What are two risk factors involved in an FI’s investment of resources in innovative technological products?
2. Related to a third-party risk is so called fourth-party risk. Fourth parties are those entities to which FI’s third parties may outsource or use for certain tasks. How do you address this issue and keep it from becoming a rabbit hole?
1. Just as banks paid out billions in settlements over LIBOR manipulation, they also paid billions in fines to the Department of Justice for creating and selling toxic mortgage-backed securities. Describe the sources of operational risks that can lead to mortgage fraud, negligent underwriting
29. Go to the FDIC website at www.fdic.gov and find the total amount of unused commitments and letters of credit and the notional value of interest rate swaps of FDIC-insured commercial banks for the most recent quarter available using the following steps. Click on“Analysts.” From there click
28. Defend the statement that although off-balance-sheet activities expose FIs to several forms of risks, they also can alleviate the risks of FIs.
27. Discuss how the failure of an affiliate can affect the holding company or its affiliates even if the affiliates are structured separately.
26. What is the difference between a one-bank holding company and a multibank holding company? How does the principle of corporate separateness ensure that a bank is safe from the failure of its affiliates?
25. Explain how settlement risk is incurred in the interbank payment mechanism and how it is another form of off-balance-sheet risk.
24. The manager of Shakey Bank sends a $2 million funds transfer payment message via CHIPS to Trust Bank at 10 AM. Trust Bank sends a $2 million funds transfer message via CHIPS to Hope Bank later that same day. What type of risk is inherent in this transaction?How will the risk become reality?
23. Distinguish between loan sales with and without recourse. Why would FIs want to sell loans with recourse? Explain how loan sales can leave FIs exposed to contingent interest rate risks.
22. What is meant by when-issued trading? Explain how forward purchases of when-issued government T-bills can expose FIs to contingent interest rate risk.
21. Explain how the use of derivative contracts such as forwards, futures, swaps, and options creates contingent credit risk for an FI.Why do OTC contracts carry more contingent credit risk than do exchange-traded contracts? How is the default risk of OTC contracts related to the time to maturity
20. A corporation is planning to issue $1 million of 270-day commercial paper for an effective annual yield of 5 percent. The corporation expects to save 30 basis points on the interest rate by using either an SLC or a loan commitment as collateral for the issue.a. What are the net savings to the
19. How do standby letters of credit differ from commercial letters of credit? With what other types of FI products do SLCs compete? What types of FIs can issue SLCs?
18. A German bank issues a three-month letter of credit on behalf of its German customer who is planning to import $100,000 worth of goods from the United States. The bank charges an upfront fee of 100 basis points.a. What upfront fee does the bank earn? How is this fee recorded on the bank’s
17. What is a letter of credit? How is a letter of credit like an insurance contract?
16. Do the contingent risks of interest rate, takedown, credit, and aggregate funding tend to increase the insolvency risk of an FI?Why or why not?
15. How is an FI exposed to takedown risk and aggregate funding risk?How are these two contingent risks related?
14. How is an FI exposed to credit risk when it makes loan commitments? How is credit risk related to interest rate risk? What control measure is available to an FI for the purpose of protecting against credit risk? What is the realistic opportunity to implement this control feature?
13. How is an FI exposed to interest rate risk when it makes loan commitments? In what way can an FI control for this risk? How does basis risk affect the implementation of the control for interest rate risk?
12. Suburb Bank has issued a one-year loan commitment of $10 million for an upfront fee of 50 basis points. The back-end fee on the unused portion of the commitment is 20 basis points. The bank’s base rate on loans is 7 percent and loans to this customer carry a risk premium of 2 percent. The
11. An FI has issued a one-year loan commitment of $2 million for an upfront fee of 25 basis points. The back-end fee on the unused portion of the commitment is 10 basis points. The FI’s base rate on loans is 7.5 percent and loans to this customer carry a risk premium of 2.5 percent. The FI
10. Use the following information on a one-year loan commitment to calculate the return on the loan commitment.BR = FI’s base interest rate on the loans = 8%φ = Risk premium on loan commitment = 2.5%f1 = Upfront fee on the whole commitment = 25 basis points f2 = Back-end fee on the average
9. An FI makes a loan commitment of $2.5 million with an upfront fee of 50 basis points and a back-end fee of 25 basis points on the unused portion of the loan. The takedown on the loan is 50 percent and takedown occurs at the beginning of the year.a. What total fees does the FI earn when the loan
8. What are the characteristics of a loan commitment that an FI may make to a customer? In what manner and to whom is the commitment an option? What are the various possible pieces of the option premium? When does the option or commitment become an on-balance-sheet item for the FI and the borrower?
7. What role does Schedule L play in reporting off-balance-sheet activities? Refer to Table 16–4. What was the annual growth rate over the 23-year period 1992–2015 in the notional value of offbalance-sheet items compared with on-balance-sheet items? Which contingencies have exhibited the most
6. What factors explain the growth of off-balance-sheet activities in the 1980s through the 2000s among U.S. FIs? What factors explain the decrease in off-balance-sheet activities in the 2010s?
5. An FI has purchased options on bonds with a notional value of$500 million and has sold options on bonds with a notional value of $400 million. The purchased options have a delta of 0.25 and the sold options have a delta of 0.30. What is (a) the contingent asset value of this position, (b) the
4. Why are contingent assets and liabilities like options? What is meant by the delta of an option? What is meant by the term notional value?
3. Contingent Bank has the following balance sheet in market value terms (in millions of dollars).In addition, the bank has contingent assets with $100 million market value and contingent liabilities with $80 million market value. What is the true stockholder net worth? What does the term
2. How does one distinguish between an off-balance-sheet asset and an off-balance-sheet liability?
1. Classify the following items as (1) on-balance-sheet assets, (2) onbalance-sheet liabilities, (3) off-balance-sheet assets, (4) offbalance-sheet liabilities, (5) capital accounts, or (6) none of the above.a. Loan commitments.b. Written option contract on interest rates.c. Letter of credit.d.
2. Other than hedging and speculation, what reasons do FIs have for engaging in OBS activities?
1. While recognizing that OBS instruments may add to the risk of an FI’s activities, explain how they also work to reduce the overall insolvency risk of FIs.
2. What are two major sources of affiliate risk?
1. What is the source of settlement risk on the CHIPS payments system?
4. Which is more risky for an FI, loan sales with recourse or loan sales without recourse?
3. What is meant by counterparty risk in a forward contract?
2. What is the major difference between a commercial letter of credit and a standby letter of credit?
1. What are the four risks related to loan commitments?
2. How can option pricing theory be used to price OBS assets and liabilities?
1. Define a contingent asset and a contingent liability.
33. 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 percent worst case (or 99th percentile). Calculate the minimum capital charge for market risk for this FI.
32. In its trading portfolio, an FI holds 5,000 shares of HSBC at a share price of $43.50, 4,000 shares of China Construction Bank at a price of $16.40, and 2,500 shares of Whirlpool at $170.00. The FI also has sold 3,000 McDonald’s shares at $96.75 and 1,500 of China Construction Bank. Calculate
31. In its trading portfolio, an FI holds 2,000 shares of Under Armour at a share price of $84.50,3,000 shares of BT Group (British telecommunication firm) at a price of $68.50, and 4,500 shares of AT&T at $34.40. The FI also has sold 5,000 Swatch Group (a Swiss watchmaker) at $19.00 and 2,500 of
30. Despite the fact that market risk capital requirements have been imposed on FIs since the 1990s, huge losses in value were recorded during the financial crisis from losses incurred in FIs’ trading portfolios. Why did this happen? What changes to capital requirements did regulators propose to
29. Bank of Hawaii’s stock portfolio has a market value of $250 million. The beta of the portfolio approximates the market portfolio, whose standard deviation (σm) has been estimated at 2.25 percent. What are the five-day VAR and ES of this portfolio using adverse rate changes in the 99th
27. An FI has £5 million in its trading portfolio on the close of business on a particular day. The current exchange rate of pounds for dollars is £0.6400/$, or dollars for pounds is $1.5625 at the daily close.The volatility, or standard deviation (σ), of daily percentage changes in the spot
25. 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? Probability A Probability B 50.00%
24. What is the difference between VAR and expected shortfall (ES) as measure of market risk?
23. How is Monte Carlo simulation useful in addressing the disadvantages of back simulation? What is the primary statistical assumption underlying its use?
22. 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?
21. Export Bank has a trading position in euros and Australian dollars.At the close of business on October 20, the bank had €22 million and A$40 million. The exchange rates for the most recent six days are given below:a. What is the foreign exchange (FX) position in dollar equivalents using the
20. Export Bank has a trading position in Japanese yen (¥) and Swiss francs (SFr). At the close of business on February 4, the bank had¥450 million and SFr10 million. The exchange rates for the most recent six days are given below.a. What is the foreign exchange (FX) position in dollar
19. What are the advantages of using the back simulation approach to estimate market risk? Explain how this approach would be implemented.
18. Calculate the DEAR for the following portfolio with the correlation coefficients and then with perfect positive correlation between various asset groups.What is the amount of risk reduction resulting from the lack of perfect positive correlation among the various asset groups? Assets Estimated
17. Jeff Resnick, vice president of operations at Choice Bank, is estimating the aggregate DEAR of the bank’s portfolio of assets consisting of loans (L), foreign currencies (FX), and common stock(EQ). The individual DEARs are $300,700, $274,000, and$126,700, respectively. If the correlation
16. Bank of Alaska’s stock portfolio has a market value of $10 million.The beta of the portfolio approximates the market portfolio whose standard deviation (σm) has been estimated at 1.5 percent. What is the five-day VAR of this portfolio using adverse rate changes in the 99th percentile?
15. Suppose that an FI holds a $15 million trading position in stocks that reflect the U.S. stock market index (e.g., the S&P 500). Over the last year, the σm of the daily returns on the stock market index was 156 bp. Calculate the DEAR for this portfolio of stocks using a 99 percent confidence
14. Bank of Bentley has determined that its inventory of yen (¥)- and Swiss franc (SFr)-denominated securities is subject to market risk.The spot exchange rates are ¥120.00/$ and SFr0.9500/$, respectively. The σ’s of the spot exchange rates of the ¥ and SFr,based on the daily changes of spot
13. Bank of Southern Vermont has determined that its inventory of 20 million euros (€) and 25 million British pounds (£) is subject to market risk. The spot exchange rates are $1.20/€ and $1.60/£, respectively. The σ’s of the spot exchange rates of the € and £, based on the daily
12. Suppose that an FI has a €1.6 million long trading position in spot euros at the close of business on a particular day. Looking back at the daily percentage changes in the exchange rate of the €/$ for the past year, the volatility or standard deviation (σ) of daily percentage changes in
11. Bank Two has a portfolio of bonds with a market value of $200 million. The bonds have an estimated price volatility of 0.95 percent. What are the DEAR and the 10-day VAR for these bonds?
10. Bank Beta has an inventory of AAA-rated zero-coupon bonds with a maturity of 13.42 years and a face value of $127,503,041. The modified duration of these bonds is 12.5 years, the DEAR is$2,150,000, and the potential adverse move in yields is 35 basis points. What is the market value of the
9. 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 percent in the over-the-counter market.a. What is the modified duration of these bonds?b. What is the price volatility if the potential adverse move in
8. In what sense is duration a measure of market risk?
7. The mean change in the daily yields of a 15-year, zero-coupon bond has been five 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.a. What is the highest yield change expected if a 99 percent
6. The DEAR for a bank is $8,500. 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?
5. 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?
4. 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 7.0 percent. The historical mean change in daily yields is 0.0 percent and the standard deviation is 12 basis points.a. What is the modified
3. What is meant by daily earnings at risk (DEAR)? What are the three measurable components? What is the price volatility component?
2. Why is the measurement of market risk important to the manager of a financial institution?
1. What is meant by market risk?
2. What is the effect of using the 99th percentile (1 percent worst case) rather than the 95th percentile (5 percent worst case) on the measured size of an FI’s market risk exposures?
1. What is the BIS standardized framework for measuring market risk?
2. Why is ES superior to VAR as a measure of market risk?
1. What is the difference between VAR and ES?
3. What is the Monte Carlo simulation approach to measuring market risk?
2. 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 Risk-Metrics to measure market risk?
3. Refer to Example 15–4. What is the DEAR of the portfolio if the returns on the three assets are independent of each other?
2. Refer to Example 15–1. What is the DEAR for this bond if σis 15 bp?
1. What is the ultimate objective of market risk measurement models?
29. Go to the World Bank website at http://databank.worldbank.org and find the amount of bank loans currently outstanding in Brazil using the following steps. In “Explore Databases” search window, type “external debt” and click search. From the resulting databases, click on “Quarterly
28. Go to the Heritage Foundation website at www.heritage.org/index and find the most recent Economic Freedom Index for the United States using the following steps. Click on “Explore the data.” This will bring the file onto your computer that contains the relevant data. What factors led to this
27. What are the major costs and benefits of converting loans to bonds for an FI?
26. What are the major benefits and costs of loan sales to an FI?
25. A bank was expecting to receive $100,000 from a loan issued to the Spanish government. Since Spain has problems repaying the loan immediately, the bank extends the loan for another year at the same interest rate of 10 percent. However, in the rescheduling agreement, the bank reserves the right
24. A $20 million loan outstanding to the Nigerian government is currently in arrears with City Bank. After extensive negotiations,City Bank agrees to reduce the interest rate from 10 percent to 6 percent and to lengthen the maturity of the loan to 10 years from the present 5 years remaining to
23. A bank is in the process of renegotiating a three-year nonamortizing loan to Greece. The principal outstanding is $20 million and the interest rate is 8 percent. The new terms will extend the loan to 10 years at a new interest rate of 6 percent. The cost of funds for the bank is 7 percent for
22. A bank is in the process of renegotiating a sovereign loan. The principal outstanding is $50 million and is to be paid back in two installments of $25 million each, plus interest of 8 percent. The new terms will stretch the loan out to five years with only interest payments of 6 percent, no
21. How would the restructuring, such as rescheduling, of sovereign bonds affect the interest rate risk of the bonds? Is it possible that such restructuring would cause the FI’s cost of capital not to change? Explain.
20. Which variables typically are negotiation points in a multiyear restructuring agreement (MYRA)? How do changes in these variables provide benefits to the borrower and to the lender?
19. What is concessionality in the process of rescheduling a loan?
18. Zlick Company plans to invest $20 million in Chile to expand its subsidiary’s manufacturing output. Zlick has two options. It can convert the $20 million at the current exchange rate of 410 pesos to a dollar (i.e., P410/$1), or it can engage in a debt-forequity swap with its bank, City Bank,
17. Chase Bank holds a $200 million loan to Argentina. The loans are being traded at bid–offer prices of 91–93 per 100 in the London secondary market.a. If Chase has an opportunity to sell this loan to an investment bank at a 7 percent discount, what are the savings after taxes compared with
16. What are the risks to an investing company participating in a debtfor-equity swap?
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