AFIN8003 – FINAL EXAM PART A – Applied questions (60%) Answer all 3 questions in Part A

AFIN8003 – FINAL EXAM

PART A – Applied questions (60%)

Answer all 3 questions in Part A. Each question is worth 20 marks. 

Write your name and MQ ID on the first page of Part A.

Handwrite your answers on your own plain A4 paper using a dark pen (typed answers or Apple iPad-style digital writing tools are not acceptable). Organise your answers part by part, in the same order as the questions, clearly labelling each part ‘(a)’, ‘(b)’, etc. Do not write the questions again on your answer sheet. Show all working. Present your answers clearly and concisely. Underline the key final answer in each part. Explain what you are doing, stressing the meaning of the various steps. The way you organise your answers will be a factor in your overall mark.

A1. Interest rate risk (20 marks)

HRB 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.

1. What is the leverage-adjusted duration gap for HRB Bank? (4 marks)
2. What is the expected change in net worth (in $m) for HRB Bank if the interest rate forecast is accurate? (4 marks)
3. What will be the effect on net worth (in $m) if interest rates increase 200 basis points? (4 marks)
4. In each of the following cases, identify what direction of interest rate risk the manager of

HRB Bank faces (ie rising or falling interest rates). (4 marks)

4. 1. HRB bank plans to issue CDs in three months.
   2. HRB plans to buy bonds in two months.
   3. The bank plans to sell Treasury securities next month.
   4. HRB has assets with duration of 4 years and liabilities with duration of 6 years.
5. Assume that options are used to hedge HRB’s interest rate risk. For each of the cases in Part

(d), state whether the risk should be hedged by buying a put or a call option. Explain. (4 marks)

1. 1. HRB bank plans to issue CDs in three months.
   2. HRB plans to buy bonds in two months.
   3. HRB plans to sell Treasury securities next month.
   4. HRB has assets with duration of 4 years and liabilities with duration of 6 years.

A2. Liquidity risk (20 marks)

1. COG Bank has acquired Retire Well Pension Fund. To help finance the takeover, COG will liquidate the overfunded portion of Retire Well’s pension fund. The face values and current and one-year future liquidation values of the assets that will be liquidated are given below. 

Calculate the one-year liquidity index for these securities. (6 marks)

2. COG Bank has the following balance sheet (in millions):

One of COG Bank’s customers decides to exercise a $30 million loan commitment. 

1. How will the new balance sheet appear if COG uses stored liquidity management to meet the loan drawdown? (4 marks)
2. How will the new balance sheet appear if COG uses purchased liquidity management to meet the loan drawdown? (4 marks)
3. Are the two methods of liquidity management equivalent in their effect on the size of COG bank? Explain. (2 marks)

3. “The financing gap can be defined as average loans minus average deposits or, alternatively, as negative liquid assets plus borrowed funds. A negative financing gap implies that the bank must borrow funds or rely on liquid assets to fund the bank. Thus, the financing requirement can be expressed as financing gap plus liquid assets. This relationship implies that some level of loans and core deposits as well as some amount of liquid assets determine the need for the bank to borrow or purchase funds.” Is this statement True or False? ((2 marks)
4. How is the liquidity problem faced by managed funds different from that faced by banks? (2 marks)

A3. Capital adequacy (20 marks)

New Bank has the following balance sheet (in millions of dollars) and has no off-balance-sheet or securitisation activities.

1. What is the dollar value of the three regulatory capital amounts held by New Bank  (i.e. common equity Tier 1, total Tier 1, total capital) (3 marks)
2. What is the value of total credit-risk-weighted assets? (Note: risk weights are Cash 0%, Commonwealth bonds 0%, mortgages 50%, Business loans 100%) (3 marks)
3. Assuming that operational risk, market risk and other types of risk are zero, calculate the three capital adequacy ratios. (3 marks)
4. Identify and briefly explain three functions of a bank’s capital. (3 marks)
5. Why do exchange-traded derivative security contracts have no capital requirements, whereas over-the-counter derivative contracts do? (2 marks)
6. What reason explains why the regulatory credit conversion factors for the risk exposure of some contracts (eg. foreign exchange) are greater than for others (eg interest rate)? (2 marks)
7. Why do regulators not want banks to act as option writers? (2 marks)
8. Why are regulators more concerned with the levels of capital held by an FI compared to a non-financial institution? (2 marks)

PART B – Long answer question (40%)

Answer the question below. Handwrite your answer on plain writing paper, using dark pen (typed answers or Apple iPad-style digital writing tools are not acceptable).

B1. (40 marks) “Loan syndication and loan securitisation offer banks flexibility, but also involve financial risks for the particular players concerned, and can lead to broader problems for the financial system as a whole”.  Critically discuss this statement.