Sample Examination Paper FINANCIAL INSTITUTIONS MANAGEMENT Official reading and writing 

time : 180 minutes Instructions to Candidate: 

1. Answer ALL questions in Sections A, B and C 2. This is a Closed Book examination. 3. You must write your answers to section A, B and C in the answer book. You should begin each answer on a new page in the answer book. 4. Please allocate your time according to the percentage contribution of the questions. 5. Examination materials must NOT be removed from the examination room. Materials: • 1 Blue book • A calculator (scientific, financial or graphics ) is permitted • A copy of formula sheet is provided. PLEASE DO NOT COMMENCE WRITING UNTIL INSTRUCTED TO DO SO PLEASE SEE NEXT PAGE FIM - Sample Examination SECTION A: Multiple Choice Each question is worth 1 mark- select the answer you believe most correct. A1.Losses in asset values due to adverse changes in interest rates are borne initially by the (a) equity holders of an FI. (b) liability holders of an FI. (c) regulatory authorities. (d) taxpayers. A2.In the KMV portfolio model, the risk of a loan measures (a) annual all-in-spread minus the loss given default. (b) annual all-in-spread minus the expected default frequency. (c) the product of the expected default frequency and the estimated loss given default. A3.Assume a $500,000 loan has a duration of 2.5 years. The current interest rate level is 10% and a sudden change in the credit premium of 1% is expected. Further assume that the one- year income on the loan is $2,500. What is the loan’s RAROC (round to two decimals)? (a) 10.00%. (b) 11.00%. (c) 22.00%. (d) 50.00%. A4.An Australian bank issues a three-year Australian Certificate of Deposit at 3.5 percent annual interest to finance a C$1.5 million (Canadian dollar) investment in two-year, fixed rate Canadian bonds selling at par and paying 7 percent annually. The bank is exposed to : (d) the volatility of the loan's default rate around its expected value times the amount lost given default. (a) (b) (c) (d) Reinvestment and foreign exchange risks. Refinancing, liquidity and credit risks . Refinancing, foreign exchange and credit risks. Reinvestment, foreign exchange and credit risks. A5.Assume the interest rate in the market for one-year zero-coupon government bonds is i = 8% and the rate for one-year zero-coupon grade BBB bonds is k = 10.2%. What is the implied probability of repayment on the corporate bond (round to two decimals)? (a) (b) (c) (d) 2.00%. 2.04%. 97.96%. 98.00% Page 2 of 16 FIM - Sample Examination A6.The following are the net currency positions of a U.S. bank (stated in U.S. dollars). Currency Euro Yen Canadian Dollar Assets Liabilities FX Bought FX Sold 30,000 70,000 175,000 325,000 30,000 50,000 200,000 250,000 36,000 7,500 9,000 11,000 (a) The bank is net long in the euro and therefore faces the risk that euro will fall in value against the US dollar (b) The bank is net short in the euro and therefore faces the risk that the euro will fall in value (c) The bank is net short in the euro and therefore faces the risk that the euro will rise in value against the US dollar against the US dollar (d) The bank is net long in the euro and therefore faces the risk that euro will rise in value against the US dollar A7. ABC Bank is charging a 10 percent interest rate on a $10,000,000 loan. The bank has a cost of funds of 7 percent. The borrower has a ten percent chance of default, and if default occurs, the bank expects to recover 85 percent of the principal and interest. What is the expected return on the loan using the KMV model? (a) 6.5 percent. (b) 0.5 percent. (c) 3.5 percent. (d) 1.5 percent A8. What does a high ratio of loans to deposits of a depository institution indicate? (b) The depository institution has high degree of loan commitments, therefore it is exposed to lower liquidity risk. (c) Liquidity concerns are at a bare minimum for the depository institution. (d) The depository institution relies heavily on core deposits to fund loans, therefore it is exposed to lower liquidity risk. (a) The depository institution relies heavily on borrowed funds to fund loans, therefore it is exposed to higher liquidity risk. Page 3 of 16 FIM - Sample Examination A9. Which of the following statements best describes the treatment of adjusting for credit risk of off-balance-sheet activities under Basel risk based capital ratio ? (a) All OBS activities are treated equally in making credit-risk adjustments. (b) Standby letter of credit guarantees issued by banks to back commercial paper have a 0 percent conversion factor. (c) The credit or default risk of over-the-counter contracts is approximately zero. (d) A10. A decline in an FI’s asset quality due to, for instance, increasing loan defaults: (a) exposes the FI to increasing credit risk. (b) can have an impact on the FI’s funding cost. (c) might threaten the FI’s solvency. (d) All of the given answers. The treatment of forward, option, and swap contracts differs from the treatment of contingent or guarantee contracts. Page 4 of 16 FIM - Sample Examination Section B (3 questions) (Answer all questions, each question is worth 15 marks) B1. FIM Bank has the following balance sheet (in millions), with the risk weights in parentheses. The bank has no off balance sheet activities. Assets Cash (0%) $20 OECD interbank deposits (20%) 25 Mortgage loans (50%) 70 Consumer loans (100%) 70 Total Assets $185 Liabilities and Equity Deposits $175 Subordinated debts (5 years) 3 Non cumulative (perpetual) preference shares 5 Equity 2 Total liabilities and equity $185 (a) Assuming that operational risk and market risk are zero, does the bank have enough capital to meet the Basel III Common Equity Tier 1, Total Tier 1, Total capital requirements? (3 marks) Risk adjusted assets : (0x20)+(20%x25)+(50%x70)+(100%x70) = $110 Common Equity Tier1 = $2 Total Tier 1 capital = $2+$5 =$ 7 Tier II capital = $3 Total Capital = $2+$5+$3=$10 Capital Adequacy Ratios : Common Equity Tier 1 ratio = 2/110 = 1.8% (less than the requirement of 4.5%) Total tier I capital ratio = 7/110 = 6.4% ( more than the requirement of 6%) Total Capital ratio : 10/110 = 9.1% (more than the requirement of 8%) The bank does not meet Common Equity Tier I ratio requirement but it meets Total Tier I and Total Capital ratios requirements. Page 5 of 16 FIM - Sample Examination (b) What are the weaknesses of Basel I Risk Based Capital Requirements? (6 marks) - The risk weights may not be true representations of the correct or necessary weights (or actual risks), or they may not be in the correct proportion to each other. For example, does a weight of 100 per cent imply twice as much risk as a weight of 50 per cent? - Basel I uses broad category of borrowers risk : All commercial loans are given equal weight, even for two borrowers with significantly different credit ratings. Therefore it does not differentiate the different risk of borrowers in the same risk categories. - Basel I only includes credit risk and market risk, does not include factors to measure interest rate risk, foreign exchange risk, liquidity risk, operational risk, etc. Therefore fully comply with this requirement does not minimise the solvency risk exposure because it doesn’t incorporate the other major risks. For example, a capital-deficient bank can improve its capital adequacy ratio by replacing shorter-term, higher credit risk assets such as commercial loans with low credit risk assets such as long-term Treasury bonds. Replacing the commercial loans with Treasury bonds reduces credit risk, hence improving the capital adequacy ratio, but this process actually increases interest rate risk. The corporate loans are less interest rate sensitive because of the short term maturity, on the other hand Treasury bonds are actually more interest rate sensitive since they are long term even though their credit risk is low. - Due to the additive nature of the formula, Basel I does not incorporate the correlations of the assets. Therefore it does not incorporate potential capital savings from loan portfolio diversification, in effect, Basel I capital requirements assume the correlation between assets is one. (c) What is the major feature in Basel II Capital Requirements? (6 marks) Basel II represents a substantial improvement on Basel I by improving the measurement of the risks. BASEL II risk weights are considered to be more closely related to the major risks by introducing wider differentiation of credit risk weights, using the reference of credit ratings provided by external credit rating agencies and including more types of risk (not only credit and market risks, but also operational risk). Page 6 of 16 FIM - Sample Examination B2. FIM Bank is a US bank, issues a six-month, $1 million Eurodollar deposit at an annual interest rate of 6.5 per cent. It invests the funds in a six-month Singaporean dollar (S$) bond paying 7.5 per cent per year. The current spot rate is $0.74/S$. (a) The six-month forward rate on the Singaporean dollar is being quoted at $0.745/S$. What is the net spread earned on this investment if the bank covers its foreign exchange exposure using the forward market? (5 marks) Interest plus principal expense on six-month CD = $1m x (1 + 0.065/2) = $1 032 500 Principal of Singaporean bond (in S$) = $1 000 000/0.74 = S$ 1,351,351.35 Interest and principal (in S$) = S$ 1,351,351.35 x (1 + 0.075/2) = S$ 1,402,207.03 Interest and principal in dollars if hedged: S$ 1,402,027.03 x 0.745 = $ 1,044,510.14 Net spread = ($1,044,510.14 -1 032 500) /$ 1 million = 1.20% per semi annual, or 2.4 % p.a. (b) Explain how forward and spot rates will both change in response to the spread calculated in part (a)? (5 marks) If FIs are able to earn higher spreads in other countries and guarantee these returns by using the forward markets, these are equivalent to risk-free investments (except for default risk). As a result, in part (a) there will be an increase in demand for the Singaporean Dollar in the spot market and an increase in sale of the forward Singaporean Dollar as more banks engage in this kind of lending. This results in an appreciation of the spot Singaporean Dollar and a depreciation of the forward Singaporean Dollar until the spread is zero for securities of equal risk. (c) If the bank decides to hedge foreign exchange risk using on-balance sheet techniques, what conditions are necessary to achieve a perfect hedge ? Explain how the conditions are effective in hedging the foreign exchange risk exposure (5 marks) On-balance-sheet hedging requires matching currency positions and durations of assets and liabilities. Matching currency positions means that assets and liabilities must be in the same currency (i.e if the bank invests in Singaporean Dollar, the bank must fully fund its investment by borrowing in Singaporean Dollar as well). By matching the currency of the assets and liabilities, the loss in asset value (in domestic currency term) due to depreciation of the foreign currency against the domestic currency can be offset with the decrease in liability value (in domestic currency). Matching durations of the assets and liabilities is required because if the duration of foreign- currency-denominated fixed-rate assets is greater than similar currency denominated fixed-rate liabilities, the market value of the assets could decline more than the liabilities when market rates rise (and vice versa) and therefore the hedge will not be perfect. Page 7 of 16 FIM - Sample Examination B3. One of the important choices facing a financial institution manager is the relative scale of a bank’s on and off-balance-sheet activities. (a) How does one distinguish between an off-balance-sheet asset and an off-balance-sheet liability? Provide examples in explaining your answer. (5 marks) Off-balance-sheet activities are contingent claim contracts. An item is classified as an off- balance-sheet asset when the occurrence of the contingent event results in the creation of an on- balance-sheet asset. An example is a loan commitment. If the borrower decides to exercise the right to draw down on the loan, the FI will incur a new asset on its portfolio. Similarly, an item is an off-balance-sheet liability when the contingent event creates an on- balance-sheet liability. An example is a standby letter of credit (SLC). In the event that the original payer of the SLC defaults, then the FI is liable to pay the amount to the payee, incurring a liability on the right-hand-side of its balance sheet. (b) How is a financial institution exposed to draw down and aggregate funding risks when it makes loan commitments? How are these two contingent risks related? (5 marks) An FI is exposed to draw down risk because not all loan commitments are fully taken down. As a result, an FI has to forecast its funding requirements in order not to keep funds at levels that are too high or too low. Maintaining low levels of funds may result in paying more to obtain funds on short notice. Maintaining high levels of funds may result in lower earnings. Additionally, FIs are exposed to aggregate funding risk, that is, all customers may choose to take down their loan commitments during a similar period, such as when interest rates are rising or credit availability is low. This could cause a severe liquidity problem for the FI. These two risks are related because draw downs usually occur when interest rates are rising or when credit availability is low. If all customers decide to increase their draw downs, it could put a severe strain on the FI. Similarly, when interest rates are falling or when credit availability is high, customers are likely to find cheaper financing elsewhere. Thus, FIs should take into account the interdependence of these two events when forecasting future funding need. (c) Why do over-the- counter (OTC) contracts carry more contingent credit risk than do exchange-traded contracts? (5 marks) Credit risk occurs because of the potential for the counterparty to default on payment obligations. OTC contracts (forward contracts and swaps) typically are non-standardised or unique contracts that do not have external guarantees from an organised exchange. Defaults on these contracts usually will occur when the FI stands to gain and the counterparty stands to lose, that is, when the contract is hedging the risk exactly as the FI hoped. The default risk is higher when the volatility of the underlying asset is higher. Page 8 of 16 FIM - Sample Examination Exchange traded contracts (futures contracts and options) are traded in organised markets. Margin requirement and marking to market requirement reduce the default risk of exchange traded contracts. Section C (2 questions) Answer all questions, each question is worth 22.5 marks C1. FIM Bank is an Australian bank, it wants to obtain the daily earnings at risk (DEAR) on its trading portfolio. The portfolio consists of the following assets. (a)Fixed-income securities (Bonds): The bank holds a 20-year zero coupon bond with a face value of AU$1,000,000. The bond is trading at a yield to maturity of 5 percent. The potential adverse move in yields is 0.0065. Calculate DEAR for the bond if a 90% confidence limit is required. (3.5 marks) Market value of position = $1M/(1 + 0.05)20 = $ 376, 889.5 The modified duration of these bonds is: MD = D/(1 + R) = 20/(1.05) = 19.0476 Price volatility = (MD) x (potential adverse move in yield) = (19.0476 ) x (.0065) = 0.12381 DEAR = $ 376,889.5 x 0.12381 = $46,662.51 (b) Equities: The bank holds AU$5 million trading position in stocks that reflect the stock market index (the β = 1). Over the last year, the historical mean change in the stock market index was 0.0 per cent and the standard deviation of the stock market index was 0.018. Calculate DEAR for equities if a 90% confidence limit is required. (3 marks) Stock market return volatility = 1.65x σm = 1.65 x 0.018 = 0.0297 or 2.97% DEAR = Dollar market value of position x Stock market return volatility = $5,000,000 x 2.97 % = $ 148,500.00 Page 9 of 16 FIM - Sample Examination (c) Foreign exchange: Dollar equivalent value of € position = €6.5 million x 1.35 = $ 8,775,000.00 FX volatility = 1.65 x 0.0065 = 0.0107 DEAR = Dollar value of position x FX volatility = $ 8,775,000.00 x 0.0107 = $ 94,111.88 (d) Assume correlations matrix among assets are as follows ____________________________________________________________________________ The bank has a 6.5 million long trading position in spot euros at the close of business on a particular day. The exchange rate is AU$1.35/€1 at the daily close. Looking back at the daily changes in the exchange rate of the euro to AUD for the past year, the bank finds that the historical mean change in daily exchange rates was 0.0 per cent and the volatility or standard deviation (σ) of the spot exchange rate was 0.0065. Calculate DEAR for foreign exchange if a 90% confidence limit is required. (3 marks) Foreign Exchange Bond -0.3 Foreign Exchange Stocks 0.6 0.4 Calculate 5-day value at risk (VAR) of AFIM bank’s trading portfolio, using a 90% confidence level and explain how the VAR position would be interpreted. (3 marks) Using the correlation matrix along with the individual asset DEARs, the aggregate portfolio DEAR of the whole (3-asset) trading portfolio is: DEAR portfolio=[(DEARbond)2 + (DEARstocks)2 + (DEARforex)2 + (2 x ρzB,FX x DEARB x DEARFOREX) + (2 x ρBond,Stocks x DEARBond x DEARStocks) + (2 x ρForexstocks x DEARforex x DEARStocks)]1/2 = [((46,662.51 )2 + (148,500.00)2 + (94,111.88)2 + 2(-0.3)( 46,662.51)( 94,111.88) + 2(0.6)( 46,662.51)( 148,500.00) + 2(0.4)( 94,111.88)( 148,500.00)]1/2 = $ 223,489.46 5-day VAR = $ 223,489.46 x √5 = $ 499,737.61 Page 10 of 16 FIM - Sample Examination Interpretation of the results : The portfolio VAR shows the estimated potential loss of the portfolio's value over a five-day unwind period as a result of adverse moves in market conditions, with 5% probability that the actual loss would be greater than the VAR because there is 5% probability that the adverse moves in market conditions would be worse than expected. (e) Explain the weaknesses or practical issues of Risk Metrics model (5 marks) The appropriateness of the Risk Metrics procedures depends on the assumption that yield changes are normally distributed. As we use market yields to calculate returns of assets and portfolios, returns of assets and portfolios then can be described by a normal distribution. Many empirical evidence on this issue shows that the assumption of normality is not too unreasonable, at least as an approximation. However, there are several important departures from normality : Many asset return distributions have fat tails (there are more occurrences of the extreme values that is inconsistent with a normal distribution). This is particularly worrying because this implies that extraordinary losses will occur more frequently and be larger than what they are expected using normal distribution assumptions. Estimated VAR based on normal distribution assumption could therefore underestimate the true DEAR quite considerably. In addition, asset return distributions are often positively skewed (i.e. there are more observations in the left hand side tail than the right hand side one) . Positive skewness is unfortunate, because it means that we have more bad events (low returns) than the good ones, which means the estimated VAR based on normal distribution could underestimate the true VAR. (f) Explain the implementation of Historic or Back Simulation approach in measuring market risk and how the approach compensates the limitations of Risk Metrics model (5 marks) Historic or Back Simulation approach uses the past prices (up to 500 days) and revalue the current return of the portfolio using those past prices, and estimate portfolio’s VAR. Using 500 days period, we rank the portfolio returns from the worst (lowest) to the best (highest). The value of the 25th lowest return (or 5% of the total value) is the maximum of the 5% worst returns. Using the principle of VAR, if we believe that there is 5% probability of the adverse change in market yield, this is the lowest portfolio return with 5% probability the actual return would be lower than this. Page 11 of 16 FIM - Sample Examination Historic or Black simulation improves the Risk Metrics model by relaxing the normal distribution assumptions. It is also easier to use because unlike Risk Metrics calculation of VAR portfolio, it doesn’t require to calculate correlations and standard deviations of the returns C2. (a) Explain the impacts on a depository institution's balance sheet when it uses stored liquidity management to offset : 1. the liquidity effects of a net deposit drain of funds and 2. the exercise of loan commitments. What are the operational benefits and costs of the method ? (7.5 marks) Impacts on Balance sheet : The use of stored liquidity to fund net deposit drains Withdrawals of deposits will decrease the bank’s liabilities and the use of stored liquidity to fund the withdrawals will also decrease the bank’s assets. As a result, the balance sheet size is contracting. The use of stored liquidity to fund exercise of Loan Commitments On the other hand, if the stored liquidity is used to fund the exercise of Loan Commitments, the balance sheet size will not be affected. That is because the exercise of loan commitments will create new loans therefore increasing the amount of loans on the asset side of the balance sheet. If the bank uses its cash and liquid assets (stored liquidity) to fund the new loans then the stored liquidity will decrease by the same amount. As a result, the size of balance sheet will not be affected, because the increase in the loans will be offset by the decrease in cash and liquid assets (stored liquidity). Operational benefits (advantages) : - Storing liquid assets reduces borrowing costs as banks with strong liquid asset position are considered to be safe, therefore they can borrow at lower borrowing costs. - With strong liquid asset position, the bank has enough buffer to minimise its liquidity risk. Costs (disadvantages) : - A negative aspect of using stored liquidity is the risk that the size of balance sheet is reduced if the stored liquidity is used to fund the withdrawals of deposits. - Storing liquidity requires the bank to hold excess cash reserves and other liquid assets. Holding excess cash reserves forgoes investment opportunities. By holding excess cash reserves the bank loses the opportunity to invest the funds in more productive assets. Liquid assets carry Page 12 of 16 FIM - Sample Examination low yields, as they have low default risk. Therefore storing liquid assets may reduce the bank’s return. (b) Suppose the manager of a bank’s liquid assets portfolio anticipates that interest rates will rise over the next few years. How might the manager structure the liquid asset portfolio using “playing the yield curve strategy” to take advantage of this situation? (7.5 marks) If interest rates are expected to increase (i.e the yield curve is upward sloping), in order to take advantage of rising interest rates using the playing the yield curve strategy, the bank manager restructures the portfolio in favour of short-term securities. When interest rates increase, market values of ST securities will decrease by less than the market values of LT securities, therefore the bank can minimise its capital losses. In addition, as rates rise, the maturing short term securities can be reinvested at higher yields, resulting in an overall higher return on the liquid assets portfolio. (c)Suppose the bank manager forecasts interest rates to decrease. Carefully explain the “barbell approach” used to take advantage of the interest rate forecast (7.5 marks). With barbell strategy, the bank invests funds in either end of the maturity, but none in the middle, i.e place some of the funds in short term highly liquid securities at one extreme and place the remaining funds in long term bonds at the other extreme. If the interest rates are expected to decrease, more will be invested in the long term bonds and less in the short term bonds. That is because the long term bonds’ prices will increase more than shot term bonds’ prices when interest rates decrease. By holding more LT bonds, the bank can maximise the capital gains as the LT bonds can be sold at higher prices. END OF EXAMINATION PAPER Page 13 of 16 ROE Decomposition Model : ROE = ROA x EM ROA = PM x AU Bond Valuation n C FV P=t+ FIM - Sample Examination Formula Sheet or 0 (1+ R)t (1+ R)n t=1 ��=��(1− 1 )+ ���� 0 �� (1+��)�� (1+��)�� Share Valuation 12 P= D + D +...+ D 0 (1+k) (1+k)2 (1+k) P =D0(1+g) 0 (k−g) Maturity Model with a portfolio of assets and liabilities Mi =Wi1Mi1 +Wi2Mi2 +...+WinMin Duration NN CFDFt PVt t D= t=1 N  PV t=1 tt N D = t =1 CF DF t t=1 tt Duration for a portfolio of assets and liabilities Di =Wi1Di1 +Wi2Di2 +...+WinDin Measuring price sensitivity with duration : P  R  P =−D1+R E=−D A R −−D L R   A ( 1 + R )   L ( 1 + R )  Page 14 of 16 FIM - Sample Examination If the level of interest and expected shock to interest rates are the same for both assets and liabilities, then: E=−(DA−DLk)A R (1+R) Repricing Model on interest rate risk : ∆NIIi = (GAPi)∆Ri = (RSAi-RSLi) ∆Ri Simple promised return on loan : Loan rate = Base Rate + Credit risk premium or margin Contractually Promised return on loan : 1+k = 1 + [f + (BR+m)] / [1- b(1-R)] Expected return on loan : E(r) = p(1+k). Term Structure Derivation of Credit Risk: p (1+ k) = 1+ i or [(1 - p) γ(1 + k)] + [p(1 + k)] = 1 + i (1+��) −�� ��= (1+��) 1−�� K – I = Φ = (1 + i) / (γ + p – pγ) – (1 + i) RAROC = one year net income on a loan / loan (asset) at risk or capital at risk Loan (asset) at risk or capital at risk = ΔLN = -DLN x LN x (ΔR/(1+R)) Loan Portfolio Diversification and Modern Portfolio Theory (MPT) Expected return (R ) on a portfolio of loans (assets): p �� ���� =∑�������� ��=1 Variance of returns (or risk of two asset portfolio) 2 =X22 +X22 +2X X  p 11 22 1212 =X22 +X22 +2X X   11 22 121212 Page 15 of 16 FIM - Sample Examination KMV Portfolio Manager Model : Expected return on a loan to borrower i R = AIS - E(L )= AIS - (EDF  LGD ) iiiiii Risk of a loan to borrower i (σi): =UL= LGD= EDF(1−EDF)LGD i i Di i i i i Net FX exposure of an FI:= (FX assetsi – FX liabilitiesi) + (FX boughti – FX soldi) = Net foreign assetsi + Net FX boughti Daily earnings at risk (DEAR) = Dollar market value of the position × Price sensitivity x Potential adverse move in yield , or Daily earnings at risk (DEAR) = Dollar market value of the position × Price volatility Market value at risk (VAR) = DEAR × N DEAR for Foreign Exchange : DEAR = dollar value of position × FX volatility Dollar equivalent value of position = FX position × spot exchange rate DEAR for Equities DEAR = dollar value of position × stock market return volatility market return volatility = 1.65 std devM. DEAR portfolio =[DEARa2 + DEARb2 + DEARc2 + 2rab × DEARa *× DEARb + 2rac × DEARa × DEARc + 2rbc × DEARb × DEARc]1/2 Liquidity Index : N P I=(Wi) i   P*  i=1 i Page 16 of 16