Chapter 21 25

True/False Questions

1. Larger banks are more likely to accept riskier loans than smaller banks.

Answer: True Page: 547-548 Level: Easy

2. Non-performing loans are loans that are past due 60 days that are not accruing interest.

Answer: False Page: 547-548 Level: Medium

3. Gross debt service usually must be greater than 30% before a residential mortgage will be approved.

Answer: False Page: 550 Level: Medium

4. The gross debt service ratio is equal to annual accommodation expenses divided by annual gross income.

Answer: True Page: 550 Level: Easy

5. Individuals with higher levels of income must have higher GDS and TDS ratios to qualify for a loan.


6. Collateral on a mortgage is normally only considered if the applicant has enough income to service the loan.


7. The five Cs of credit are character, mental capacity, collateral, conditions, and capital.


Saunders, Financial Markets and Institutions, 2/e 231

Chapter 21 Managing Risk on the Balance Sheet 1: Credit Risk

8. Credit analysis of a mid–market corporate borrower differs from the analysis of a small business in that the analysis of the mid–market borrower is more focused on the business itself and less on the business owners.

Answer: True Page: 554 Level: Medium

9. Perfecting collateral is the process of taking the proceeds of the forced sale of a mortgage property to satisfy the debt in the event of failure to repay the mortgage.


10. Approving a loan for a customer with negative cash flow from operations is not a concern to a bank loan officer as long as cash flow from financing is positive.


11. Liquidity ratios include the current ratio, the quick ratio and the sales to working capital ratio.

Answer: False Page: 557-558 Level: Easy

12. A rising sales to working capital ratio may indicate a potential borrower is using its net current assets more efficiently.


13. The more variable are a borrower's cash flows, the greater the fixed charge coverage ratio should be to limit risk.


14. Corporate credit agreements are usually reviewed at least annually.


15. A borrower's EDF is a better prediction of default than either its Z score or S&P rating.


Saunders, Financial Markets and Institutions, 2/e232

16. Compensating balances are a cost to the borrower and generate income to the lender.


17. RAROC is the expected default frequency of a particular borrower.

Answer: False Page: 562 Level: Easy

18. Compensating balances usually earn interest.


19. Asset management ratios are used in credit analysis to help understand the borrower's ability to generate sales from the amount invested in some asset category.


20. The base loan rate accounts for the credit risk on the loan.


Multiple Choice Questions

21. Which one of the following 5 C's of credit is NOT correctly defined? A) Capacity – Whether the borrower has enough other credit available to pay off the loan in the event

of cash flow problems. B) Capital – The borrower's equity. C) Character – A measure of the borrower's intention/willingness to repay the loan. D) Conditions – Assessing how economic conditions could affect the borrower's ability to repay the

loan. E) Collateral – An asset of the borrower which the lender may seize in the event of default on the loan.

Answer: A Page: 554 Level: Medium



Use the following to answer questions 22-23:

A corporate customer obtains a $5 million line of credit from a bank. The customer agrees to pay a 6% interest rate and agrees to make compensating balances of 5% of the total credit line and 2% of the amount actually borrowed. These will be held in non-interest bearing transactions deposits at the bank for one year. The bank charges a 1% loan origination fee on the amount borrowed and a 0.30% commitment fee on the unused line of credit. The expected draw down (loan amount) is 70% of the line for one year. Reserve requirements are 10%.

22. What is the expected rate of return to the bank (to the nearest basis point)? A) 8.13% B) 8.86% C) 9.51% D) 8.95% E) 9.50%

Answer: B Page: 567 Level: Difficult Response: [(700,000*0.07) + (700,000*0.01) + (300,000*0.0030)] / [700,000 – (0.90* ((0.05*1,000,000) + (0.02*700,000))]

23. What is the expected cost rate to the corporate customer (to the nearest basis point)? A) 8.13% B) 8.86% C) 9.51% D) 8.95% E) 9.50%

Answer: D Page: 567 Level: Difficult Response: [(700,000*0.07) + (700,000*0.01) + (300,000*0.0030)] / [700,000 – (0.05*1,000,000) – (0.02*700,000)]

24. Most loan policies specify a maximum loan to value (LTV) ratio on real estate loans. The LTV is a ratio of A) Book/market value of the loan B) Loan amount/borrower's personal equity C) Unused credit line/total line of credit D) Loan/collateral value E) Loan/maximum amount of consumer debt

Answer: D Page: None Level: Medium



M o r t g a g e G r o s s A n n u a l P r o j e c t e d M o n t h l y A n n u a l O t h e r M o n t h l y A p p l i c a n t I n c o m e M o r t g a g e P y m t . P r o p e r t y T a x e s D e b t P y m t s . B i l l $ 9 0 , 0 0 0 $ 2 , 1 0 0 $ 3 , 0 0 0 $ 5 0 0 J o e $ 5 0 , 0 0 0 $ 1 , 0 0 0 $ 2 , 0 0 0 $ 4 0 0 G D S c u t o f f : 3 0 % T D S c u t o f f : 3 5 %

25. Using only the GDS criteria, which one of the following statements is true? A) Joe gets the loan but not Bill B) Bill gets the loan but not Joe C) Both get the loan D) Neither get the loan


26. Using only the TDS criteria, which one of the following statements is true? A) Joe gets the loan but not Bill B) Bill gets the loan but not Joe C) Both get the loan D) Neither get the loan

Answer: D Page: 551 Level: Medium

27. Individual credit scoring models typically include all of the following information except: A) Income B) Length of time in residence C) Credit history D) Age E) Ethnic background

Answer: E Page: 551 Level: Medium



28. A corporate loan applicant has cash of $30, receivables of $20 and inventory of $50. The applicant also has current debts of $50. If the bank's policy requires a current ratio of 2 or better and an acid test ratio of 1.5 or better would the applicant receive the loan? A) Yes because the applicant's current ratio and acid test ratios are acceptable. B) No because the applicant's current ratio and acid test ratios are both unacceptable. C) No because although the applicant's current ratio is acceptable, its acid test ratio is not. D) No because although the applicant's acid test ratio is acceptable, its current ratio is not.

Answer: C Page: 551 Level: Medium


BALANCE SHEET BIG VALLEY ENTERPRISES

Assets Liabilities and Equity Income StatementAccounts receivable 75 Current Liabilities 15

0 Cash Sales 20

0Inventory 12

5 Long Term Debt 20

0 Credit sales 50

0Fixed Assets 40

0 Common Stock 10

0 Operating Expenses 50

0 Retained Earnings 15

0 Depreciation 10

0Total 60

0 Total 60

0 Interest 25

Taxes 30Interest is Big Valley’s only fixed charge NIBig Valley’s market to book ratio = 1.5

Peer Average RatiosCurrent Ratio 1.5Days Sales in Receivables 45Sales to Working Capital 14Sales to Fixed Assets 1.9Fixed Charge Coverage Ratio 7Debt to Asset Ratio 50%Return on equity 15%


29. Big Valley's fixed charge ratio and debt to asset ratio indicate that Big Valley has a ______ percentage of debt than their peers and Big Valley has a _______ ability to cover their fixed charges than their peers. A) higher ; greater B) higher ; lower C) lower ; greater D) lower ; lower E) similar ; similar

Answer: B Page: 557-559 Level: Medium

30. Big Valley's return on equity indicates that the firm generates a _____ return to their shareholders than their peers. A) 3% higher B) 15% higher C) 5% lower D) 2% lower E) 20% higher

Answer: A Page: 557-559 Level: Medium

31. Big Valley covers their fixed charges _____ times less than the industry average. A) 7 B) 4 C) 1.5 D) 1.75 E) 2.25

Answer: D Page: 557-559 Level: Difficult Response: 7 / [(200 + 500 – 500 – 100) / 25)]



32. Altman's Z-score model is Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5X1 = Working Capital/Total Assets

X2 = Retained Earnings/Total Assets

X3 = EBIT/Total Assets

X4 = Market Value Equity/Book Value Long Term Debt

X5 = Sales/Total Assets

Using the Altman's Z model, Big Valley's Z-score indicates that Big Valley is A) a high default risk B) a low default risk C) an indeterminate default risk D) none of the above

Answer: B Page: 563 Level: Difficult

33. From the data given it appears that Big ValleyI. Has greater short term insolvency risk than the industry averageII. Has less long term insolvency risk than the industry averageIII. Generates fewer sales per dollar invested in fixed assets A) I only B) I and II only C) II only D) I and III only E) I, II and III

Answer: D Page: 555-556 Level: Medium

34. Mid–market commercial lending may be typically defined as borrowers I. With sales revenue between $5 and $100 million.II. With a recognizable corporate structure.III. With ready access to deep and liquid capital markets. A) I only B) II only C) III only D) I and II only E) I, II and III



35. In analyzing credit risk for a loan to a major diversified corporation the bank typically has which of the following advantages?I. Market based models to analyze credit riskII. Greater negotiating power due to the size of the loan required.III. Ratings agency measures of default risk A) I only B) I and II only C) II and III only D) I and III only E) I, II and III


36. A firm with a low Z-score has high A) Insolvency risk B) Interest rate risk C) Liquidity risk D) International risk E) None of the above

Answer: A Page: 562 Level: Easy

37. Business credit scoring models suffer from several weaknesses. These include all but which one of the following? A) Credit score models classify borrowers as either default or non-default with no classification in

between. B) The appropriate weights on a credit score model are likely to change over time. C) These model ignore non-quantifiable behavioral factors such as a relationship with the bank and

reputation. D) Credit scoring models do not fully use all publicly available information. E) All of the above are weaknesses of business credit scoring models.




38. The conditions specified in a credit agreement that must be fulfilled before a drawdown is allowed are called A) collateral perfection B) power of sale conditions C) conditions precedent D) foreclosure agreements E) audit review terms

Answer: C Page: 558 Level: Easy

39. The EDF model uses the borrower's current market value of equity and assets and the option pricing model to A) Determine if the equity is mispriced B) Assess the implied riskiness of the firm's investments C) Calculate the market value of the lender's investment D) Estimate the likelihood that the Z-score model is correct

Answer: B Page: 564 Level: Medium

40. A bank charges a commercial borrower an 11% interest rate on a one year loan. The bank also charges a 0.5% origination fee and requires compensating balances of 8% in the form of demand deposits. What is the promised gross rate of return on the loan? A) 11.45% B) 12.39% C) 12.10% D) 11.67% E) 11.05%

Answer: B Page: 568-569 Level: Medium Response: (0.005 + 0.11) / [1 – (0.08 * (1 – 0.10))]

41. A bank is using the RAROC to evaluate large business loans. The benchmark rate of return is 12%. The one year loan earns 9% and the bank must pay 8.1% to raise the funds. Expected losses are 0.4% If the loan defaults, 90% of the money lent will be lost. Based on historical default rates, the extreme worst loss case scenario is about 5%. Should the bank make the loan? Why or why not. A) Yes because the RAROC is 11.11% B) No because the RAROC is 11.11% C) Yes because the RAROC is 12.45% D) No because the RAROC is 12.45% E) No because the RAROC is less than 8.5%

Answer: B Page: 568-569 Level: Difficult Response: (0.09 – 0.081 – 0.004) / (0.05* 0.90)


Chapter 22


1. Pension funds generally have greater liquidity risk than banks.


2. When a customer executes a draw down on a bank line of credit, that portion of the off balance sheet loan commitment becomes an on balance sheet asset.


3. Demand deposit holders have a put option on the bank.


4. Even though core deposits can be withdrawn with little notice they provide a long term source of funds for a bank.


5. A bank has a one month liquidity index of 0.95. This means that if the bank had to liquidate its assets in one month it would receive only 95 cents per $1.00 of liquid assets.


6. A bank's financing gap is calculated as average loans minus average deposits plus liquid assets.


7. Repos and fed funds are examples of stored liquidity.




8. When open market interest rates are higher, using purchased liquidity to replace deposit drains can reduce a bank's profit margin.


9. Using stored liquidity to offset a deposit drain will reduce the size of the bank, but using purchased liquidity to offset the drain will not.

Answer: True Page: 576-577 Level: Medium

10. Property and casualty insurers have a greater need for liquidity than life insurers.




First National Bank of North America (FNBNA)

A s s e t s L i a b i l i t i e s a n d E q u i t y A m o u n t

( m i l l $ ) R a t e o f R e t u r n

A m o u n t

( m i l l $ ) C o s t R a t e C a s h $ 1 0 0 % C o r e d e p o s i t s $ 8 0 5 % S e c u r i t i e s 3 0 6 % B o r r o w i n g s 1 0 7 % L o a n s 6 0 9 % E q u i t y 1 0 T o t a l $ 1 0 0 T o t a l $ 1 0 0

11. If FNBNA is expecting a $15 million deposit drain, and the securities liquidity index is 0.98 by how much will pre–tax net income change if the drain is funded entirely through securities sales? A) –$306,122 B) –$150,000 C) –$375,339 D) –$456,122 E) –$474,490

Answer: E Page: 578 Level: Difficult Response: Liquidate securities totaling $15,306,122.45, losing 6% interest and $306,122.45 and gain 5% on $15 million core deposits.


12. If FNBNA is expecting a $20 million deposit drain, and the securities liquidity index is 0.97 how many securities would have to be liquidated if the bank used only its securities to fund the expected deposit drain? A) $20,000,000 B) $19,400,000 C) $20,600,000 D) $20,618,557 E) $20,442,345

Answer: D Page: 578 Level: Medium Response: $20 million / 0.97

13. If FNBNA is expecting an $18 million deposit drain, and the bank wishes to fund the drain by borrowing more money, how much will pre–tax net income change if the borrowing cost is the same as on its existing borrowed funds? A) –$360,000 B) –$18,000,000 C) –$2,000,000 D) –$445,000 E) –$312,000

Answer: A Page: 578 Level: Medium Response: $18 million * (7%-5%)

14. Which of the following situations create more liquidity risk? A) Long term assets funded by long term liabilities B) Short term assets funded by short term liabilities C) Long term assets funded by short term liabilities D) Short term assets funded by long term liabilities E) Long term liabilities funded by short term assets

Answer: C Page: 574-575 Level: Medium

15. Which of the following results in a net liquidity drain? A) Demand deposits increase $100; loans increase $50 B) Demand deposits decrease $100; loan repayments are $150 C) Repurchase agreements increase $100; Demand deposit decrease $50 D) Reverse repurchase agreements increase $50; demand deposit decrease $50 E) None of the above




16. Which one of the following is not an example of purchased liquidity management? A) Reduction in vault cash B) Increase in Euro dollar deposits C) Repurchase agreement D) Fed funds borrowed E) Issuance of a negotiable CD



Second National Bank (mill$)Funds borrowed $2,600Maximum borrowed funds limit $5,000Cash–type assets $2,300Excess cash reserves $900Federal Reserve borrowings $300

17. What are Second National Bank's total sources of liquidity? A) $10,800 B) $8,200 C) $11,700 D) $2,900 E) $2,600

Answer: B Page: 579-580 Level: Medium Response: $2,300 + $5,000 + $900

18. What are Second National Bank's total uses of liquidity? A) $10,800 B) $8,200 C) $11,700 D) $2,900 E) $2,600

Answer: D Page: 579-580 Level: Medium Response: $2,600 + $300


19. What is Second National Bank's total net liquidity? A) $5,300 B) $3,500 C) $11,700 D) $7,300 E) $8,600

Answer: A Page: 579-580 Level: Medium Response: $2,300 + $5,000 + $900 – $2,600 – $300

20. If a bank relies solely on purchased liquidity the bank will likely A) Maintain large amounts of liquid assets B) Fund its loan commitments with asset sales C) Be forced to borrow money at short notice D) Be required to raise equity capital quickly E) Be forced to liquidate liabilities at fire sale prices

Answer: C Page: 576-577 Level: Medium

21. Which one of the following is a source of liquidity risk for a bank? A) Predicted increase in net deposit drain before Christmas B) Maturation of notes payable C) Corporation calls in a bond the bank is holding D) A natural disaster in the bank's community E) None of the above

Answer: D Page: 581,585 Level: Medium

22. Bank A has a loan to deposit ratio of 110%, core deposits equal 55% of total assets and borrowed funds are 25% of assets. Bank B has a loan to deposit ratio of 80%. Core deposits are 65% of assets and borrowed funds are 5% of assets. Which bank has more liquidity risk? Ceteris paribus, which bank will probably be more profitable when interest rates are low? A) Bank A; Bank A B) Bank A; Bank B C) Bank B; Bank A D) Bank B; Bank B E) You can't tell




23. Core deposits include all but which one of the following? A) Retail demand deposits B) NOW accounts C) MMDAs D) Savings accounts E) Negotiable CDs


24. The BIS recommends that DIs do which of the following to realistically measure liquidity risk?I. Construct a maturity ladder of funding requirements over both the short and long run.II. Conduct scenario analyses of the bank's implied liquidity position under different bank and economic conditions.III. Always keep the loan to deposit ratio less than one. A) I only B) II only C) I and II only D) II and III only E) I, II and III


25. A FI has two assets. It has 40% of its security portfolio invested in 1 month Treasury bills and 60% in real estate loans. If it liquidated the bills today, the bank would receive $98 per hundred of face value. If the real estate loans were sold today they would be worth $80 per $100 of face value. In one month they could be liquidated at $93 per 100 of face value. What is the FI's one month liquidity index? A) 0.92 B) 0.91 C) 0.90 D) 0.89 E) 0.88

Answer: B Page: 582-583 Level: Medium Response: [(0.40*98) + (0.60*80) / [(0.40*100) + (0.60*93)]


26. When calculating the liquidity index, the larger the discount from fair value, the _____ the liquidity index and the _____ the liquidity risk the FI faces. A) Larger; greater B) Smaller; greater C) Larger; lower D) Smaller; lower

Answer: B Page: 582-583 Level: Easy

27. If a bank's average loan to average deposit ratio is greater than 1 then A) The financing gap is negative B) The bank has no liquidity risk C) Borrowed funds are greater than liquid assets D) Loan commitments must be quite low E) Liquid assets must be zero


28. An increasingly positive financing gap can indicate _____ liquidity risk because it may indicate _____ deposits and/or rising loan commitments A) Increasing; increasing B) Decreasing; decreasing C) Increasing; decreasing D) Decreasing; increasing

Answer: C Page: 583-584 Level: Easy

29. Insurance industry guarantee funds do not eliminate runs on insurers becauseI. The funds are not backed by the federal governmentII. The funds lack permanent reserves to back policiesIII. The funds have low maximum annual contribution amounts which limit insurer's liability A) I only B) II only C) III only D) I and III only E) I, II and III




30. A married couple each have an IRA. The couple also has two children. What is the total amount of deposits that could be insured at one bank? A) $100,000 B) $500,000 C) $600,000 D) $700,000 E) $800,000


31. Which of the following can create liquidity risk for a life insurer? A) Unexpectedly high number of policy surrenders B) Unexpectedly low number of new policies sold C) Unexpected losses on its investments D) All of the above E) None of the above

Answer: D Page: 589 Level: Easy

32. Runs on insurance firms are more likely to occur than runs on banks even in states with guaranty funds for insurers because these funds generally A) Lack a permanent reserve fund B) Do not repay insurance policyholders immediately C) Lack federal government backing D) All of the above


33. The two main reasons why runs on U.S. banks no longer occur are A) Reserve requirements and higher bank liquidity ratios B) Required positive financing gap and bank use of purchased liquidity C) The FDIC and the discount window D) Insurance funds operated by individual states and tighter bank regulations E) None of the above



34. In the absence of deposit insurance, a deposit is a _______________ to the bank's assets. A) Pro rata claim B) First come/first serve claim C) Full pay or no pay claim D) Both A and B E) Both B and C


Chapter 23


1. Insolvency occurs when an institution's loan to deposit ratio drops below 1.


2. The duration gap model is a more complete measure of interest rate risk than the repricing model.


3. In a bank's one year maturity bucket, a 30 year ARM with a rate reset in 9 months would be considered a fixed rate asset.


4. A rate sensitive asset is one that either matures within the maturity bucket or one that can have a payment change within the maturity bucket.


5. If a bank has a negative repricing gap, falling interest rates increase profitability.


6. The effect that a change in interest rates can have on the spread between RSAs financed by RSLs is called the CGAP effect.




7. The repricing gap fails to consider how the value of fixed income accounts will change when rates change.



8. The "runoff" of fixed income contracts is itself rate sensitive.


9. For a one year maturity bucket, the repricing model assumes that a 9 month loan is as equally rate sensitive as a 3 month loan.


10. The cash flow from the interest a bank receives on a long term loan that is normally reinvested is called the runoff from the loan.


11. If DA > kDL then rising interest rates will cause the market value of equity to rise.


12. Bank regulators prefer that banks maintain low levels of capital to ensure high returns to shareholders.


13. Due to convexity problems banks are actually better off using the simpler repricing model than the duration model.


14. A bond's price changes 2% when interest rates drop. The duration model would predict a price increase of more than 2%.


15. Convexity arises because a bond's price is a nonlinear function of interest rates.





16. A bank has a negative repricing gap using a 6 month maturity bucket. Which one of the following statements is most correct if MMDAs are rate sensitive liabilities? A) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could

encourage its retail deposit customers to switch from 2 year CDs at current rates to 3 month CDs. B) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank

could encourage its retail deposit customers to switch from MMDAs to 2 year CDs at current rates. C) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank

could encourage its retail deposit customers to switch from MMDAs to 2 year CDs at current rates. D) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could

encourage its retail deposit customers to switch from 2 year CDs at current rates to MMDAs. E) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could

encourage its retail deposit customers to switch from MMDAs to 2 year CDs at current rates.

Answer: E Page: 598-602 Level: Difficult

17. A bank has a positive repricing gap using a 6 month maturity bucket. Which one of the following statements is most correct? A) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could

encourage its retail loan customers to switch from 1 year adjustable rate loans to Fed Funds loans. B) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank

could encourage its retail loan customers to switch from 1 month reset floating rate loans to 3 year fixed rate loans at current rates.

C) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank could encourage its retail loan customers to switch from fixed rate mortgages to adjustable rate mortgages.

D) If all interest rates are projected to increase, to limit a profit decline when this occurs, the bank could encourage its retail loan customers to switch from three year to five year auto loans.

E) If all interest rates are projected to decrease, to limit a profit decline when this occurs, the bank could encourage its retail loan customers to switch from their bank to another bank.

Answer: B Page: 598-602 Level: Difficult


18. The structure of a bank's balance sheet as evidenced by its repricing gap and its duration gap affects a bank's sensitivity to interest rate changes. Which one of the following statements about the two types of gaps is true? A) The repricing gap immunizes the present value of all future cash flows, whereas managing the

duration gap can stabilize future cash flows, but not their present value. B) The duration gap considers all cash flows up to and including maturity, whereas the repricing gap

really only considers how cash flows will change within the maturity bucket. C) If a bank could only manage one type of gap, the bank would limit its interest rate risk the most by

managing its repricing gap instead of its duration gap. D) The repricing gap is superior to the duration gap since the repricing gap has a well-defined maturity

bucket. E) It is virtually impossible for an institution to have both a positive duration gap and a negative

repricing gap at the same time.

Answer: B Page: 603-605,608-610 Level: Medium

19. A bank has a negative duration gap. Which one of the following statements is most correct? A) If all interest rates are projected to increase, to limit a net value decline when rates rise the bank

should set up a swap to pay variable and receive fixed. B) If all interest rates are projected to decrease, to limit a net value decline when rates fall the bank

should set up a swap to pay variable and receive fixed. C) If all interest rates are projected to increase, to limit a net value decline when rates rise the bank

should set up a swap to pay fixed and receive variable. D) If all interest rates are projected to decrease, to limit a net value decline when rates fall the bank

should set up a swap to pay fixed and receive variable.

Answer: B Page: 603 Level: Difficult

20. A bank is facing a forecast of rising interest rates. How should they set the repricing and duration gap? A) Positive repricing gap and negative duration gap B) Negative repricing gap and positive duration gap C) Positive repricing gap and positive duration gap D) Negative repricing gap and negative duration gap

Answer: A Page: 600,603 Level: Difficult



21. A bank has a negative duration gap. Interest rates decline. Which one of the following best describes the effects of the interest rate change? A) The bank's market value of equity is unchanged since the market value of its assets and liabilities

move in the same direction. B) The bank's market value of equity goes up because the market value of its assets goes up by more

than the market value of its liabilities goes down. C) The bank's market value of equity goes down because the market value of its assets goes up by more

than the market value of its liabilities goes down. D) The bank's market value of equity goes down because the market value of its assets goes down by

more than the market value of its liabilities goes down. E) The bank's market value of equity goes down because the market value of its liabilities increases by

more than the market value of its assets increases.

Answer: E Page: 603 Level: Difficult

22. With a 9 month maturity bucket, a 3 month loan would be considered a _____ asset and a 30 year mortgage with a rate adjustment in 6 months would be classified as a ____ asset. A) Rate sensitive asset; fixed rate asset B) Rate sensitive asset; rate sensitive asset C) Fixed rate asset; fixed rate asset D) Fixed rate asset; rate sensitive asset

Answer: B Page: 597-598 Level: Easy

23. A bank has the following balance sheet:

A s s e t s M i l l $ L i a b i l i t i e s a n d E q u i t y M i l l $ C a s h $ 5 0 F i x e d r a t e d e p o s i t s $ 2 2 0 S i x m o n t h m a t u r i t y i n v e s t m e n t s $ 1 0 0 R a t e s e n s i t i v e d e p o s i t s $ 2 5 0 S h o r t t e r m l o a n s ( < 1 y e a r ) $ 2 2 5 F e d f u n d b o r r o w i n g s $ 3 5 L o n g t e r m f i x e d r a t e l o a n s ( m a t u r i t y > 1 y e a r ) $ 2 5 0

L o n g t e r m b o r r o w i n g s a t f i x e d r a t e ( m a t u r i t y > 1 y e a r ) $ 1 1 4

T o t a l $ 6 2 5 E q u i t y $ 6 T o t a l $ 6 2 5

The bank's one year repricing gap is (Mill $) A) $75 B) $90 C) $34 D) $69 E) $40

Answer: E Page: 599-600 Level: Medium


24. A bank has a positive repricing gap. This implies that A) Some RSAs are financed by fixed rate liabilities B) Some RSLs are financing fixed rate assets C) Some RSAs are financing equity D) The bank has no fixed rate assets


25. A bank has a negative repricing gap. This implies that A) Some RSAs are financed by fixed rate liabilities B) Some RSLs are financing fixed rate assets C) Some RSAs are financing equity D) The bank has no fixed rate assets


26. A bank has a positive repricing gap and estimates that the spread between RSAs and RSLs will move inversely with interest rates. If interest rates fall the bank's overall NII will A) Rise B) Fall C) Necessarily be unchanged D) Rise or fall depending on the size of the spread affect relative to the size of the CGAP effect


27. A bank has a negative repricing gap and estimates that the spread between RSAs and RSLs will move inversely with interest rates. If interest rates fall NII will A) Rise B) Fall C) Necessarily be unchanged D) Rise or fall depending on the size of the spread affect relative to the size of the CGAP effect




28. Weaknesses of the repricing model include: I. It ignores changes in present values caused by changes in interest ratesII. It ignores different cash flow sensitivities within a maturity bucket. III. It fails to account for runoffs and prepayments. A) I only B) I and II only C) I and III only D) II and III only E) I, II and III


29. A bank has three assets. It has $65 million invested in consumer loans with a 6 month duration, $26 million invested in T-Bonds with a 12 year duration and $39 million in one 1 year maturity T-Bills. What is the duration of the bank's asset portfolio in years? A) 2.95 years B) 3.83 years C) 2.65 years D) 3.50 years E) 11.5 years

Answer: A Page: 604 Level: Medium Response: (0.50*0.5) + (0.20*12) + (0.30*1)


A bank has DA = 2.5 years and DL = 1.2 years. The bank has total equity of $80 million and total assets of $820 million. Interest rates are at 10%.

30. If interest rates rise 100 basis points the predicted dollar change in equity value will equal (to the nearest dollar) A) $10,563,636 B) -$10,563,636 C) -$9,690,909 D) $9,690,909 E) $3,526,000

Answer: C Page: 606 Level: Medium Response: –[2.5 – ((740/820)*1.2)]*0.01/1.10 * $820,000,000


31. If interest rates fall 50 basis points the predicted dollar change in equity value will equal A) $4,845,454 B) –$4,845,454 C) $5,281,818 D) –$5,281,818 E) $5,330,000

Answer: C Page: 606 Level: Medium Response: –[2.5 – ((740/820)*1.2)]*–0.0050/1.10*$820,000,000

32. To get DE to equal zero to protect the equity value in the event of an interest rate change, the bank could A) Reduce DA to 1.2 years B) Increase DL to 2.5 years C) Increase DL to 3.10 years D) Reduce DA to zero E) Increase DL to 2.77 years

Answer: E Page: 627 Level: Difficult Response: 2.5 * 820 / 740

33. For large interest rate declines duration _____ the increases in the bond's price, and for large interest rate decreases it _____ the decline in the bond's price A) Underpredicts, overpredicts B) Overpredicts, underpredicts C) Underpredicts, underpredicts D) Overpredicts, overpredicts


34. For a bank with a positive duration gap an increase in interest rates will A) Increase the likelihood of insolvency B) Decrease the likelihood of insolvency C) Not affect the likelihood of insolvency D) Result in increased loan trading




35. After an interest rate increase, a bank's market value of assets fell $8 million and the market value of its liabilities fell $6 million dollars. The book value of equity _____________ and the market value of equity ____________. A) Rose $2 million; was unchanged B) Fell $2 million; was unchanged C) Was unchanged; rose $2 million D) Was unchanged; fell $2 million


Chapter 24


1. A spot contract is an immediate delivery versus payment contract.


2. In March 2002, commercial banks held more than $7 trillion in forward contracts on the their balance sheets.


3. Gains and losses on a futures contract must be recognized daily.


4. A forward hedge can be used to reduce the risk associated with an expected change in rates, but the forward hedge cannot be used to hedge the risk associated with an unexpected change in rates.


5. A macro hedge is a hedge of a particular asset or liability exposure to a change in a macroeconomic variable.


6. Basis risk is the risk that remains in a fully hedged position.

Answer: True Page: 624 Level: Easy Saunders, Financial Markets and Institutions, 2/e258

7. Writing a call option on a bond pays off if interest rates rise.




8. Futures contracts are not subject to capital requirements for banks but many forward contracts are.


9. Swaps are usually the bets hedging tool to use to hedge long term risks of four or five years or more.


10. A U.S. corporation has a Euro bank account denominated in yen. The money cannot be repatriated for six months. A short position in yen futures could help offset the corporation's foreign exchange risk.


11. A put writer gains if interest rates fall.


12. As interest rates fall a long put option position on a bond increases in value.


13. Swaps and forwards are subject to counterparty risk, exchange traded futures and options are not.

Answer: True Page: 642 Level: Difficult

14. The buyer of an American style bond put option has the right, not the obligation, to buy the bond at a set price until the option expires.


15. The writer of an American bond call option has the right, but not the obligation, to buy the bond at a preset price until the option expires.



16. The maximum gain (ignoring commissions and taxes) from buying an at the money bond put option is the bond price at time of option purchase less the put premium. The maximum loss is the put premium.


17. A fixed-floating interest rate swap is called a plain vanilla swap.


18. A FI with DA < kDL may choose to enter into a long term swap where it pays a fixed rate of interest and receives a variable rate in order to effectively reduce the duration gap.


19. A bank with a negative repricing gap could enter into a swap to pay a fixed rate of interest and receive a variable rate of interest to effectively reduce its repricing gap.

Answer: True Page: 627, 634 Level: Medium

20. The BIS requires banks engaging in swaps to hold additional capital to offset the risk of the swap.



21. Which of the following requires daily cash flow settlements between the parties? A) Forward contract B) Futures contract C) Purchased options contract D) Swap contract E) None of the above

Answer: B Page: 641 Level: Easy



22. A macro hedge is a A) Hedge of a particular asset or liability B) Hedge of an entire balance sheet C) Hedge using options D) Hedge without basis risk E) None of the above


23. A micro hedge is a A) Hedge of a particular asset or liability B) Hedge against a change in a particular macro variable C) Hedge of an entire balance sheet D) Hedge using options E) Hedge without basis risk


24. Basis risk occurs because it is generally impossible to A) Hedge unanticipated rate changes B) Exactly predict interest rate changes C) Exactly match the terms of the hedging instrument with the terms of the asset or liability at risk D) Find negatively correlated asset prices E) All of the above


25. A bond portfolio manager has a $25 million market value bond portfolio with a 6 year duration. The manager believes interest rates may increase 50 basis points. Which of the following could be used to help limit his risk?I. Sell the bonds forward.II. Buy bond futures contracts.III. Buy call options on the bonds.IV. Buy put options on the bonds. A) I only B) II only C) I and III only D) I and IV only E) II and III only

Answer: D Page: Various Level: Easy


26. Federal Bank regulators require banks to do all but which one of the following when banks take a position in forwards and futures for their own account? A) Establish internal guidelines regarding hedging activity B) Establish trading limits C) Disclose large position that materially affect risk to shareholders and investors D) Obtain shareholder and regulatory approval prior to implementation of a hedging program E) All of the above are required

Answer: D Page: 625 Level: Difficult

27. Which two of the following are potentially subject to risk based capital requirements? A) Swaps and futures B) Swaps and forwards C) Forwards and futures D) Purchased option positions and futures E) Purchased option positions and swaps


28. A forward contract A) Is marked to market. B) Has significant default risk. C) Is standardized. D) Is traded over the counter. E) Is highly liquid.


29. The price of a bond rises from 98 to par. Even if you do nothing this would still result in an immediately recognized loss on a _____________ on a bond, and a paper gain on a bond ______________. A) Long forward contract; call option B) Short futures contract; call option C) Call option; put option D) Short futures contract; put option E) Short forward contract; call option

Answer: B Page: Various Level: Difficult



30. A _____ position in T-bond futures should be used to hedge rising interest rates and a _____ position in T-bond futures should be used to hedge falling bond prices. A) Long; short B) Long; long C) Short; long D) Short; short


31. Which two bond option positions increase in value when interest rates fall? A) Long call, Written put B) Long put; Written call C) Long put; Long call D) Written put; Written call

Answer: A Page: 629-631 Level: Difficult

32. For a bond put option the _____ the exercise price the greater the cost of the put, and for a bond call option the _____ the exercise price, the lower the cost of the call option. A) Higher; higher B) Lower; lower C) Higher; lower D) Lower; higher

Answer: A Page: 628 Level: Difficult

33. The safest way to hedge a bond asset with options is to A) Purchase a call option on the bond B) Write a call option on the bond C) Purchase a put option on the bond D) Write a put option on the bond


34. The safest way to hedge a bond liability with options is to A) Purchase a call option on the bond B) Write a call option on the bond C) Purchase a put option on the bond D) Write a put option on the bond



35. A FI with DA > kDL could do which of the following to reduce the duration gap? A) Engage in a swap and pay a variable rate and receive a fixed rate of interest B) Sell bond futures contracts C) Buy bonds forward D) Buy bond call options E) None of the above

Answer: B Page: Various Level: Medium

36. The largest two categories of swaps are A) Credit risk and interest rate swaps B) Currency and commodity swaps C) Interest rate and currency swaps D) Equity and interest rate swaps E) None of the above


37. The swap buyer agrees to make a number of _____ interest rate payments on periodic settlements dates to the swap seller. The swap seller agrees to make a number of _____ interest rate payments on periodic settlement dates to the swap buyer A) Variable; fixed B) Variable; variable C) Fixed; variable D) Fixed; fixed


38. A FI has variable rate assets funded by long term fixed rate liabilities. To protect the equity value the FI may engage in a swap to pay a _____ rate and receive a _____ of interest. A) Fixed; variable B) Variable; variable C) Variable; fixed D) Fixed; fixed

Answer: C Page: 635 Level: Difficult



39. If the profits on an option position are fixed when a bond's price rises above a certain point and if profits rise when the bond price falls then you could have which of the following positions?I. Purchased call optionII. Written call optionIII. Purchased put optionIV. Short position in futures A) III only B) III and IV only C) I and IV only D) I, II and III only E) I, III and IV only

Answer: A Page: 630 Level: Difficult

40. Plain vanilla interest rate swaps are exchanges of A) Principle only B) Interest only C) Principle and interest D) Principle and currency E) Interest rate and currency


Chapter 25


1. Growth and decline in HLTs has fostered similar growth and decline in loan sales.


2. A mortgage pass-through security is a bond issue backed by a group of mortgages that pays fixed semi-annual coupon payments where the principle is repaid only at maturity.


3. A CMO is created when an FI originates a loan and sells participations to correspondent banks.



4. The buyer of a loan in a participation has a double risk exposure, one to the borrower and one to the selling bank.


5. A loan sold with recourse generates a contingent liability for the selling bank.


6. More than 90% of loan sales are via assignments.


7. Loan sales usually have yields that are 1 to 10 basis points above those of similarly rated commercial paper.




8. Vulture funds specialize in buying distressed HLT loans.


9. Financial distress occurs when a borrower fails to meet its obligation to pay interest or principle on time and in full.


10. The possibility that a bank will make excessively risky loans knowing that they can then sell the loans to others is called the adverse selection problem


11. Advantages of Brady bonds over LDC loans include improved liquidity and higher coupon rates.


12. Under current reserve requirements, bank loan sales with recourse are considered a liability and are subject to reserve requirements.


13. The sale or transfer of assets at less than fair value that occurs at a time when the seller is insolvent is termed fraudulent conveyance.


14. Life insurers may not engage in asset securitization.


15. GNMA purchases mortgages and creates pass-throughs.



16. FNMA and FHLMC may participate in securitizing conventional mortgages.


17. A thrift with long term fixed rate mortgages funded by 6 month CDs would be hurt if rates rose.


18. An advantage of securitization over interest rate swaps as a risk management tool is that securitization reduces the regulatory tax imposed by existing regulation.


19. GNMA pass-throughs face significant default risk.


20. A CMO is a multi-class pass-through that helps investors manage prepayment risk.



21. Advantages of loan sales and securitization typically include all but which one of the following? A) Reduction in credit risk B) Reduction in interest rate risk C) Reduction in diversification of the loan portfolio D) Reduction in adverse effect of regulatory taxes E) Increase in overall fee income




22. In selling loans, FIs act as an asset _____ and in creating CMOs FIs act as an asset _____. A) Transformer, broker B) Transformer, transformer C) Broker; broker D) Broker, transformer

Answer: D Page: Various Level: Difficult

23. A pass-through security is best characterized as A) A security with a prorata claim to the underlying pool of assets B) A multi-class mortgage backed bond C) A bond backed by real estate D) A part of a loan sale E) None of the above


24. Which one of the following types of transactions leaves the assets on the balance sheet? A) Loan sale without recourse B) GNMA pass throughs issued backed by mortgages placed in trust C) CMOs issued using mortgage pool as collateral D) Mortgage backed bonds issued E) None of the above


25. For a loan sold with recourse A) The loan seller has no further obligation at all to the buyer B) The loan seller removes the assets from the balance sheet and does not report a contingent liability

in the footnotes C) The loan buyer cannot collect from the loan seller in the event of borrower default D) No reserve requirement is imposed E) None of the above



26. In a loan participation which of the following is/are true?I. The buyer has no part in the original underlying credit agreement, even after purchase of the loan.II. If the selling bank fails, the loan buyer's claim against the selling bank may be treated as unsecured.III. In the event the selling bank fails, the original borrower's deposits may be used to reduce the loan amount without any proceeds going to the loan buyer. A) I only B) II only C) II and III only D) I and II only E) I, II and III


27. Characteristics of loan participation include:I. The loan participant is not a primary creditor on the loan.II. The original lender can change some loan terms without the participants permission.III. Participations are without recourse. A) I only B) II only C) II and III only D) I and II only E) I, II and III


28. HLT loans generally have which one of the following characteristics? A) They are unsecured. B) They mature in less than one year. C) They have floating rates. D) They do not have strong covenant protections. E) They are considered distressed loans.




29. The primary mortgage agency involved with thrifts that buys mortgages, operates a swap program and sponsors conventional and government insured mortgage pools is A) GNMA B) FNMA C) FHLMC D) VA E) FHA


30. The traditional interbank loan sale market has diminished because ofI. Reduced importance of correspondent bankingII. Increase in moral hazard concernsIII. Increase in barriers to nationwide banking A) I only B) II only C) III only D) I and II only E) I, II and III


31. Important buyers of loans include all but which one of the following? A) Foreign banks B) Insurance companies C) Closed-end bank loan mutual funds D) Vulture funds E) Credit unions

Answer: E Page: 649-650 Level: Easy

32. The largest loan seller by type is A) Small regional or community banks seeking diversification B) Foreign banks C) Investment banks D) Credit unions E) None of the above



33. Banks were willing to swap LDC loans for Brady bonds because: A) Brady bonds carried higher interest rates than the loans B) The bonds had variable interest rates C) The bonds were marketable and the loans were not D) The bonds were uncollateralized E) None of the above


34. Loan sales are likely to continue because A) They can increase near term reported earnings B) They reduce the amount of capital required C) The commercial paper market continues to grow D) A and B only E) A, B and C


35. Fraudulent conveyance proceedings are A) Charges that a loan was improperly sold according to the conditions of the original loan agreement B) Charge of impropriety in HLTs C) Evidence of moral hazard on the part of the loan buyer D) Illegal methods to boost borrower's earnings to increase probability of loan acceptance E) None of the above


36. One of the reasons insurance firms are now securitizing mortgages is to A) Get out of the mortgage market B) Place more funds in the money market C) Reduce the rate sensitivity of their assets D) Improve the liquidity of their assets E) None of the above




37. Which of the following is a government owned agency? A) FNMA B) FHLMC C) PMC D) CMO E) GNMA

Answer: E Page: 654 Level: Easy


A bank originates $55,000,000 worth of single family mortgages funded by demand deposits and the required amount of capital. Reserve requirements are 10% and the bank pays 25 basis points in deposit insurance premiums. The bank is earning an 8.75% coupon on the mortgage.

38. How much capital is required to back the mortgages. A) $55.0 million B) $5.5 million C) $2.2 million D) $3.5 million E) $1.2 million

Answer: C Page: 655 Level: Medium Response: 55,000,000 *0.50*0.08

39. If the mortgages are securitized how much will the bank save in the first year's reserve requirements and deposit insurance premiums respectively? A) $5.5 million; $187,500 B) $5.87 million; $146,667 C) $5.5 million; $146,667 D) $8 million; $187,500 E) $5.87 million; $200,000

Answer: B Page: 655 Level: Difficult Response: [(55,000,000 – 2,200,000) / (1 – 0.1)] *0.1; (58,666,667 * 0.0025)


40. If the bank does not securitize and there are no other costs or fees the opportunity cost is A) $0.95 million B) $1.72 million C) $0.70 million D) $0.66 million E) None of the above

Answer: D Page: 655 Level: Difficult Response: (5,866,667 extra cash*0.0875 lost) + 146,667 deposit insurance premium

41. Securitizing can help an FI do all but which one of the following? A) Reduce its regulatory tax burden B) Reduce its exposure to one geographic area C) Reduce its interest rate of exposure D) Reduce its liquidity risk exposure E) Increase its interest income


42. If mortgage interest rates fall and prepayments occur the holder of a GNMA pass-through selling at a _____ will have a _____. A) Discount; capital gain B) Premium; capital loss C) Discount; capital loss D) Premium; capital gain E) Both A and B are correctF) Both C and D are correct


43. In a 3 class CMO, Class A holders have _____ prepayment risk, Class B holders have average prepayment risk and Class C holders have _____ prepayment risk. A) Above average; below average B) Below average; below average C) Below average; above average D) Above average; above average




44. A 3 class CMO has an initial principle balance of $30 million per class. In the first month, interest payments of $2 million and principle payments of $1 million are received. In the second month, Class A holders receive interest on _____ principle and Class B holders receive interest on _____ principle. A) $30 million; $30 million B) $29 million; $29 million C) $29.5 million; $29.5 million D) $28 million; $29 million E) $29 million; $30 million


45. Which of the following forms of securitization is usually "double securitization?" A) Mortgage backed bonds B) CMO C) Pass-through D) Loan sale


46. The typical duration of a Class B CMOs is A) 1.5-3 years B) 3-5 years C) 5-7 years D) 7-10 years E) 18-20 years


47. The sum of the market values of all the classes of a CMO is greater than the total value of the GNMA pass-throughs backing the CMO because: A) The CMO has less credit risk than the pass-through. B) CMO investors can choose their degree of prepayment protection. C) The government guarantees CMOs' performance. D) CMOs have more favorable tax status than pass-throughs. E) CMOs investors have no prepayment risk.



48. The FDIC is concerned about issuance of mortgage backed bonds (MBBs) because A) The FDIC is concerned about investors' prepayment risk. B) MBBs increase deposit insurance premiums. C) The process takes loans off the balance sheet and replaces them with liabilities. D) The process reduces assets which may be used to back insured deposits. E) None of the above



Chapter 21 25

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