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principles of risk management
Questions and Answers of
Principles Of Risk Management
An FI has a loan portfolio of 10,000 loans of $10,000 each. The loans have a historical average default rate of 4 percent and the severity of loss is 40 cents per dollar.a. Over the next year, what
A five-year fixed-rate loan of $100 million carries a 7 percent annual interest rate. The borrower is rated BB. Based on hypothetical historical data, the probability distribution given below has
From Table 12A–1 , what is the probability of a loan upgrade? A loan downgrade?What is the impact of a rating upgrade or downgrade?How is the discount rate determined after a credit event has
Refer to Appendix 12B for problem 25. Probability New Loan Value plus Forward Rate Spreads at Time t Rating Distribution Coupon $ t 1+% 5,% AAA 0.01% $114.82 1 3.00% 0.72% AA 0.31 114.60 A 1.45
An FI is limited to holding no more than 8 percent of its assets in securities of a single issuer. What is the minimum number of securities it should hold to meet this requirement? What if the
What rules on credit concentrations has the National Association of Insurance Commissioners enacted? How are they related to modern portfolio theory?LO.1
What reasons did the Federal Reserve Board offer for recommending the use of subjective evaluations of credit concentration risk instead of quantitative models? How did this change in 2006?LO.1
Over the last ten years, a bank has experienced the following loan losses on its C&I loans, consumer loans, and total loan portfolio.Year C&I Loans Consumer Loans Total Loans 2012 0.0080 0.0165
Assume that, on average, national banks engaged primarily in mortgage lending have their assets diversified in the following proportions: 60 percent residential, 15 percent commercial, 5 percent
Information concerning the allocation of loan portfolios to different market sectors is given below. Allocation of Loan Portfolios in Different Sectors (%) Sectors Commercial Consumer Real Estate
What databases are available that contain loan information at the national and regional levels? How can they be used to analyze credit concentration risk?LO.1
Suppose that an FI holds two loans with the following characteristics.Spread Between Loan Rate and FI's Loan X Cost of Funds 1 ? 4.0% 2 ? 2.5 Loss to Fl Expected Annual Given Default Fees Default
Suppose that an FI holds two loans with the following characteristics. Annual Spread Between Loss to Fl Expected Loan Rate and FI's Annual Given Loan X Cost of Funds Fees Default Default Frequency 1
CountrySide Bank uses Moody's KMV Portfolio Manager to evaluate the risk- return characteristics of the loans in its portfolio. A specific $10 million loan earns 2 percent per year in fees and the
A bank vice president is attempting to rank, in terms of the risk-reward trade- off, the loan portfolios of three loan officers. Information on the portfolios is noted below. How would you rank the
The obvious benefit to holding a diversified portfolio of loans is to spread risk exposures so that a single event does not result in a great loss to an FI. Are there any benefits to not being
What is the minimum risk portfolio? Why is this portfolio usually not the portfolio chosen by Fls to optimize the return-risk trade-off?LO.1
Why is it difficult for small banks and thrifts to measure credit risk using mod- ern portfolio theory?LO.1
The Bank of Tinytown has two $20,000 loans with the following characteris- tics: Loan A has an expected return of 10 percent and a standard deviation of returns of 10 percent. The expected return and
Explain how modern portfolio theory can be applied to lower the credit risk of an FI's portfolio.LO.1
An FI has set a maximum loss of 2 percent of total capital as a basis for setting concentration limits on loans to individual firms. If it has set a concentration limit of 25 percent of capital to a
A manager decides not to lend to any firm in sectors that generate losses in excess of 5 percent of capital.a. If the average historical losses in the automobile sector total 8 percent, what is the
What does loan concentration risk mean?LO.1
What is migration analysis? How do Fls use it to measure credit risk concen- tration? What are its shortcomings?LO.1
How do loan portfolio risks differ from individual loan risks?LO.1
Go to the Investment Company Institute Web site and look up the most recent data on the asset values and number of short-term and long-term mutual funds using the following steps. The Web site is
Go to the Fidelity Investments Web site and look up the annual 1-, 5-, and 10-year returns on Fidelity Select Biotechnology Fund using the following steps. The Web site is www.fidelity.com. Click on
What is the difference between domestic hedge funds and offshore hedge funds? Describe the advantages of offshore hedge funds over domestic hedge funds.LO.1
What types of fees do mutual funds charge?LO.1
What are the different categories of hedge funds?LO.1
What is a hedge fund and how is it different from a mutual fund?LO.1
Who are the primary regulators of the mutual fund industry? How do their regulatory goals differ from those of other types of financial institutions?LO.1
Suppose an individual invests $10,000 in a load mutual fund for two years. The load fee entails an up-front commission charge of 4 percent of the amount invested and is deducted from the original
What is a 12b-1 fee? Suppose you have a choice between a load fund with no annual 12b-1 fee and a no-load fund with a maximum 12b-1 fee. How would the length of your expected investment horizon, or
What is the difference between a load fund and a no-load fund? Is the argu- ment that load funds are more closely managed and therefore have higher returns supported by the evidence presented in
Open-end fund A owns 165 shares of AT&T valued at $25 each and 50 shares of Toro valued at $45 each. Closed-end fund B owns 75 shares of AT&T and 100 shares of Toro. Each fund has 1,000 shares of
What is the difference between open-end and closed-end mutual funds? Which type of fund tends to be more specialized in asset selection? How does a closed-end fund provide another source of return
A mutual fund owns 400 shares of General Electric, currently trading at $16, and 400 shares of Microsoft, Inc., currently trading at $28. The fund has 1,000 shares outstanding.a. What is the net
How is the net asset value (NAV) of a mutual fund determined? What is meant by the term marked-to-market daily?LO.1
What are the three possible components reflected in the return an investor receives from a mutual fund?LO.1
What change in regulatory guidelines occurred in 2009 that had the primary purpose of giving investors a better understanding of the risks and objectives of a fund?LO.1
What are the principal demographics of household owners who own mutual funds? What are the primary reasons why household owners invest in mutual funds?LO.1
What are the economic reasons for the existence of mutual funds; that is, what benefits do mutual funds provide for investors? Why do individuals rather than corporations hold most mutual funds
How does the risk of short-term funds differ from the risk of long-term funds?LO.1
Why did the proportion of equities in long-term funds increase from 38.3 percent in 1990 to over 70 percent by 2000 and then decrease to 63 percent in 2009? How might an investor's preference for a
Using the data in Table 5-3, discuss the growth and ownership holdings over the last 29 years of long-term funds versus short-term funds.LO.1
What are long-term mutual funds? In what assets do these funds usually invest? What factors caused the strong growth in this type of fund from 1992 through 2007?LO.1
What are money market mutual funds? In what assets do these funds typi- cally invest? What factors have caused the strong growth in this type of fund since the late 1970s?LO.1
What is a mutual fund? In what sense is it a financial institution?LO.1
Go to the U.S. Treasury Web site at www.ustreas.gov and find the most recent data on foreign transactions in U.S. securities and U.S. transactions in foreign securities using the following steps.
Go to the Securities Industry and Financial Markets Association Web site at www.sifma.org and find the most recent data on U.S. corporate underwrit- ing activity using the following steps. Click on
What are the three requirements of the USA Patriot Act that financial service firms must implement after October 1, 2003?LO.1
Identify the major regulatory organizations that are involved in the daily operations of the investment securities industry, and explain their role in pro- viding smoothly operating markets.LO.1
How did the National Securities Markets Improvement Act of 1996 (NSMIA) change the regulatory structure of the securities industry?LO.1
Based on the data in Table 4-7, what were the second-largest single asset and the largest single liability of securities firms in 2009? Are these asset and liabil- ity categories related? Exactly how
How do the operating activities, and thus the balance sheet structures, of secu- rities firms differ from the operating activities of depository institutions and insurance firms? How are the balance
How did the financial crisis affect the performance of securities firms and investment banks?LO.1
Using Table 4-6, which type of security accounts for most underwriting in the United States? Which is likely to be more costly to underwrite: corporate debt or equity? Why?LO.1
What factors are given credit for the resurgence of profitability in the securi- ties industry beginning in 1991? Are firms that trade in fixed-income securities more or less likely to have volatile
What three factors are given credit for the steady decline in brokerage com- missions as a percentage of total revenues over the period beginning in 1977 and ending in 1991?LO.1
An investor notices that an ounce of gold is priced at $818 in London and $825 in New York.a. What action could the investor take to try to profit from the price discrepancy?b. Under which of the
If an investor observes that the price of a stock trading in one exchange is different from the price in another exchange, what form of arbitrage is appli- cable, and how can the investor participate
One of the major activity areas of securities firms is trading.a. What is the difference between pure arbitrage and risk arbitrage?b. What is the difference between position trading and program
XYZ, Inc., has issued 10 million new shares of stock. An investment bank agrees to underwrite these shares on a best-efforts basis. The investment bank is able to sell 8.4 million shares for $27 per
An investment bank pays $23.50 per share for 4 million shares of JCN Com- pany. It then sells those shares to the public for $25 per share. How much money does JCN receive? What is the profit to the
An investment bank agrees to underwrite a $500 million, 10-year, 8 percent semiannual bond issue for KDO Corporation on a firm commitment basis. The investment bank pays KDO on Thursday and plans to
How do agency transactions differ from principal transactions for market makers?LO.1
What are the risk implications to an investment bank from underwriting on a best-efforts basis versus a firm commitment basis? If you operated a company issuing stock for the first time, which type
What is the difference between a private placement and a public offering?LO.1
What is the difference between an IPO and a secondary issue?LO.1
What are the key activity areas for securities firms? How does each activity area assist in the generation of profits and what are the major risks for each area?LO.1
What are the different types of firms in the securities industry and how does each type differ from the others?LO.1
In what ways have changes in the investment banking industry mirrored changes in the commercial banking industry?LO.1
Explain how securities firms differ from investment banks. In what ways are they financial intermediaries?LO.1
Estimate the convexity for each of the following three bonds, all of which trade at a yield to maturity of 8 percent and have face values of $1,000.A 7-year, zero-coupon bond. A 7-year, 10 percent
Consider a $1,000 bond with a fixed-rate 10 percent annual coupon rate and a maturity (N) of 10 years. The bond currently is trading at a yield to maturity (YTM) of 10 percent.a. Complete the
Consider a five-year, 15 percent annual coupon bond with a face value of $1,000. The bond is trading at a yield to maturity of 12 percent.a. What is the price of the bond?b. If the yield to maturity
A financial institution has an investment horizon of two years 9.33 months (or 2.777 years). The institution has converted all assets into a portfolio of 8 percent, $1,000 three-year bonds that are
In general, what changes have occurred in the financial markets that would allow financial institutions to restructure their balance sheets more rapidly and efficiently to meet desired goals? Why is
Identify and discuss three criticisms of using the duration model to immunize the portfolio of a financial institution.
Assume that a goal of the regulatory agencies of financial institutions is to immunize the ratio of equity to total assets, that is, A(E/A) = 0. Explain how this goal changes the desired duration gap
The following balance sheet information is available (amounts in thousands of dollars and duration in years) for a financial institution:Amount Duration T-bills $ 90 0.50 T-notes 55 0.90 T-bonds 176
The balance sheet for Gotbucks Bank, Inc. (GBI) is presented below ($ millions).Assets Liabilities and Equity Cash Federal funds Loans (floating)Loans (fixed)$ 30 20 105 65 Core deposits Federal
Financial Institution XY has assets of $1 million invested in a 30-year, 10 percent semiannual coupon Treasury bond selling at par. The duration of this bond has been estimated at 9.94 years. The
If you use only duration to immunize your portfolio, what three factors affect changes in the net worth of a financial institution when interest rates change?
Calculate the duration of a two-year, $1,000 bond that pays an annual cou- pon of 10 percent and trades at a yield of 14 percent. What is the expected change in the price of the bond if interest
Maximum Pension Fund is attempting to balance one of the bond portfolios under its management. The fund has identified three bonds that have five year maturities and trade at a yield to maturity of 9
Two bonds are available for purchase in the financial markets. The first bond is a two-year, $1,000 bond that pays an annual coupon of 10 percent. The sec- ond bond is a two-year, $1,000 zero-coupon
A one-year, $100,000 loan carries a coupon rate and a market interest rate of 12 percent. The loan requires payment of accrued interest and one-half of the principal at the end of six months. The
You note the following yield curve in The Wall Street Journal. According to the unbiased expectations hypothesis, what is the one-year forward rate for the period beginning two years from today, 2f1?
The Wall Street Journal reports that the rate on three-year Treasury securities is 5.25 percent and the rate on four-year Treasury securities is 5.50 percent. The one-year interest rate expected in
Based on economists' forecasts and analysis, one-year Treasury bill rates and liquidity premiums for the next four years are expected to be as follows: R = 5.65% E(21) = 6.75% L 0.05% = E(3%) = 6.85%
How does the liquidity premium theory of the term structure of interest rates differ from the unbiased expectations theory? In a normal economic envi- ronment, that is, an upward-sloping yield curve,
The Wall Street Journal reports that the rate on three-year Treasury securities is 5.60 percent and the rate on four-year Treasury securities is 5.65 percent. According to the unbiased expectations
The Wall Street Journal reported interest rates of 6 percent, 6.35 percent, 6.65 percent, and 6.75 percent for three-year, four-year, five-year, and six-year Treasury notes, respectively. According
Suppose that the current one-year rate (one-year spot rate) and expected one- year T-bill rates over the following three years (i.e., years 2, 3, and 4, respec- tively) are as follows: R = 6% E(2) =
The current one-year Treasury bill rate is 5.2 percent, and the expected one- year rate 12 months from now is 5.8 percent. According to the unbiased expectations theory, what should be the current
What are the weaknesses of the maturity model? The following questions and problems are based on material in Appendix 8B to the chapter.LO.1
EDF Bank has a very simple balance sheet. Assets consist of a two-year, $1 million loan that pays an interest rate of LIBOR plus 4 percent annually. The loan is funded with a two-year deposit on
Scandia Bank has issued a one-year, $1 million CD paying 5.75 percent to fund a one-year loan paying an interest rate of 6 percent. The principal of the loan will be paid in two installments:
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