4th batch

Question no. 01
a. In the absence of financial institutions, direct investment would necessitate both savers and
corporate entities to engage in significant due diligence. This process would likely involve
assessing the financial health, market position, and future prospects of the entity issuing the
securities. Without intermediaries to facilitate these transactions and provide advice, the
complexity, time, and costs involved would increase, potentially reducing the overall efficiency
of the financial markets.

b. The major risks involved in direct security purchases are:

Credit Risk: This occurs when the issuer fails to fulfill their financial obligations. For instance,
a company may default on a bond payment if it runs into financial difficulties.

Market Risk: This risk is associated with the fluctuations in the securities’ prices, which can be
influenced by macroeconomic variables, market sentiment, and changes in interest rates.

Liquidity Risk: This involves the difficulty of selling securities without causing a significant
movement in the price and possibly incurring losses. This risk is heightened in less liquid
markets where finding a buyer can be challenging.

c. Agency costs arise from the conflicts of interest inherent in the principal-agent relationship,
where the goals of corporate managers (agents) might not align with those of shareholders or
bondholders (principals). Financial institutions help mitigate these costs through mechanisms
such as information disclosure, monitoring, and the implementation of governance structures that
align the interests of managers with those of investors.

Question no. 02
a. Commercial banks and other depository institutions are instrumental in the transmission of
monetary policy. When the central bank changes the reserve requirements or adjusts the policy
interest rates, banks respond by altering their lending and deposit rates. This modification
directly impacts the money supply and the broader economic activity. For example, if the central
bank reduces the reserve requirement, banks can lend more, thereby increasing the money supply
and potentially stimulating economic activity.

b. Credit unions often enjoy benefits that commercial banks do not, primarily due to their tax-
exempt status and differing regulatory requirements. This allows them to offer higher interest
rates on deposits and lower rates on loans, which can be seen as an unfair competitive advantage
by their fully taxed and regulated counterparts.

c. The demand and supply dynamics of loanable funds directly influence interest rates. For
example, if the government increases its savings rate, the supply of loanable funds increases,
leading to lower interest rates. Conversely, if consumers decide to save less and spend more, the
demand for loans increases, pushing interest rates up. Monetary policy plays a crucial role by
influencing interest rates, which affects both the demand for and the supply of loanable funds
through mechanisms like central bank rates and open market operations.

Question no. 03
a. Factors Leading to Decrease in Loan Volume:

Increased Regulation: Post-financial crisis, regulations like Basel III required higher capital
reserves, making lending less attractive due to higher capital costs.

Rise of Non-Bank Competition: Entities like fintech companies began offering loans, which
were more convenient and often cheaper than those from traditional banks.

Change in Consumer Behavior: There's been a shift towards more conservative borrowing
post-2008 financial crisis.

Strategic Changes: Banks have diversified into non-interest income sources like fees from
payment processing or wealth management, reducing their reliance on traditional interest from
loans.

b. Sovereign Risk: Yes, banks can still be exposed to sovereign risk when lending to high-
quality foreign corporations. This risk stems from the possibility that political or economic
instability in the borrower’s country could impact their ability to meet their obligations,
irrespective of the corporation's own financial health.
c. Advantages of Finance Companies:

Flexibility in Lending: Often have less stringent lending criteria.

Speed: Typically able to make quicker lending decisions.

Specialization: May offer products specifically tailored to small businesses, like equipment
financing or invoice factoring.

d. Types of Risk Faced by Financial Institutions:

Credit Risk: Risk of loss from a borrower’s failure to repay a loan.

Market Risk: Risk of loss from fluctuations in market prices.

Liquidity Risk: Risk that an institution cannot meet its obligations as they come due without
incurring unacceptable losses.

Operational Risk: Risk of loss from inadequate or failed internal processes, people, and
systems.

Systemic Risk: Risk of breakdown in an entire system, typically triggered by the failure of a
single entity or group of entities.

Question no. 04
a. Repricing Gap Percentage: Expressing the repricing gap as a percentage of assets helps in
assessing how much of a bank’s assets and liabilities are subject to interest rate changes. This
metric can indicate the potential impact of market interest rate changes on the bank's net interest
margin.

b. Maturity Bucket: Maturity buckets are used in asset-liability management to group assets
and liabilities by their maturity (or next repricing date) to assess interest rate risk. The selection
of the time frame for each bucket is crucial as it impacts the institution's ability to manage and
align its interest income and expenses against market rate fluctuations.
c. Loan Pricing: Loan pricing is the process of setting the interest rate and fees charged on a
loan, which is crucial for financial institutions because it directly affects their profitability.
Factors to consider include:

Cost of Funds: The rate at which the financial institution borrows money.

Credit Risk: The risk of default by the borrower, influencing the interest rate charged.

Competitive Market Conditions: Rates offered by competitors.

Regulatory Requirements: Compliance costs that need to be covered.

d.
Question no. 05
a. Risk-Based Capital Adequacy: Defines the minimum capital which must be retained to cover
risks. Basel III, often considered the best framework for this, enhances bank capital requirements
by enforcing stricter regulation on bank liquidity and leverage.

b. Interest Rate Impact Calculation:

c. Explanation: The CGAP being zero implies equal sensitivity of assets and liabilities to rate
changes. The net interest income decreased because the decrease in asset yields was
proportionally greater than the decrease in liabilities costs, worsening the interest spread.

Question no. 06
a. Sources and Uses of Funds vs. Structure of Funds Approach:

Sources and Uses Approach: Focuses on matching the cash flows from sources (like deposits)
to uses (like loans), ensuring that maturities and interest rates are aligned.

Structure of Funds Approach: Focuses on the overall composition of the balance sheet in
managing liquidity, ensuring there are enough liquid assets to meet any short-term obligations.

b. Market Signals of Liquidity Management:

Interest Rate Changes: Rapid changes can indicate liquidity issues.

Changes in Trading Volumes: High volumes can indicate liquidity or panic selling.

Credit Spread Changes: Widening spreads can signal deteriorating credit conditions.

c. Investment Returns Calculation:

 5th batch

Question no. 01
a. Types of Financial Transactions:

i. Borrowing money from a bank: Indirect finance. The bank acts as an intermediary between
savers and borrowers.

ii. One year loan provided to the neighbor: Direct finance. Funds are lent directly without any
intermediary.

iii. Your corporation's contracting with an investment banker to help sell its bonds: Semi-
direct finance. The investment banker acts as an agent rather than a principal, facilitating the sale
of securities.

iv. Withdrawing money from a bank savings deposit account and lending it to a friend:
Disintermediation. You withdraw deposits and lend them directly, bypassing the traditional
banking system.

v. A share of Square stock bought at its initial public offering (IPO): Semi-direct finance.
The investment bank facilitates the IPO, acting as an intermediary but not as a direct lender or
borrower.

b. Lowering Transaction Costs:

Reducing Search Costs: Financial intermediaries have information on both borrowers and
savers, which reduces the time and effort required for them to find each other.

Economies of Scale: Intermediaries can handle large volumes of transactions at a lower average
cost than individual transactions between savers and borrowers.

c. Financial vs. Real Assets:

Financial Assets: Represent claims on future cash flows or income generated by real assets.
Examples include stocks, bonds, and bank deposits.
Real Assets: Physical or tangible assets that have value due to their substance and properties.
Examples include buildings, machinery, or land.

Question no. 02
a. Reinvestment Risk and Interest Rate Risk:

Reinvestment Risk: The risk that cash flows from an investment might be reinvested at a lower
rate than the original investment. It is part of interest rate risk because changes in interest rates
affect the reinvestment rates.

Impact on Earnings: If a financial institution funds short-term assets with long-term liabilities,
a decrease in interest rates will reduce the earnings on newly invested assets, while costs on
long-term liabilities remain high. Conversely, an increase will increase earnings on newly
invested assets, improving overall profitability.

b. Reducing Moral Hazard:

Co-insurance: Requires the insured to bear a portion of the loss, ensuring they have a stake in
preventing losses.

Risk-Based Premiums: Higher risk individuals pay higher premiums, incentivizing better
behavior.

Limits on Insurance Amount: Ensures that the insured does not benefit from a loss,
discouraging behavior that could lead to a claim.

c. Diversification vs. Specialization:

Statement: Uncertain. While diversification reduces risk by spreading exposure, specialization

can enable banks to develop expertise and better risk management strategies in specific areas,
potentially leading to higher returns.

Question no. 03
a. Alleviating Liquidity Risk: Financial Institutions (FIs) mitigate liquidity risk for investors by
transforming less liquid assets into more liquid forms. This process, often referred to as liquidity
transformation, involves creating secondary markets or offering products such as mutual funds
that allow investors to buy and sell shares more freely than the underlying assets.

b. Differences Between Brokers and Depository Institutions:

Brokers: Act as intermediaries that facilitate the buying and selling of securities for clients. They
do not typically hold these assets on their balance sheets.

Depository Institutions: These are banks and similar entities that accept deposits and use these
funds to provide loans and other financial services. They bear the risk associated with these
assets.

c. Calculation of Modified Duration: Modified Duration = Macaulay Duration / (1 + YTM /

number of compounding periods per year) Given:

Macaulay Duration = 6.994 years

Yield to Maturity (YTM) = 8%

Compounding annually (1 period per year)

Modified Duration=6.9941+0.08/1=6.9941.08≈6.47 years\text{Modified Duration} = \

frac{6.994}{1 + 0.08/1} = \frac{6.994}{1.08} \approx 6.47 \
text{ years}Modified Duration=1+0.08/16.994=1.086.994≈6.47 years

Value and Change in Duration: Modified duration is used to measure a bond's price sensitivity
to yield changes, estimating how much the price of a bond would change in response to a 1%
change in interest rates. It is crucial for managing interest rate risk.

Question no. 04
a. Refinancing Risk: Refinancing risk occurs when an institution must refinance its borrowings
under unfavorable conditions, such as higher interest rates, which is a component of broader
interest rate risk.

Impact on Earnings with Interest Rate Changes:

If interest rates increase, the cost of rolling over short-term liabilities will increase, leading to
higher interest expenses and reduced earnings.

Conversely, if rates decrease, the cost of new short-term liabilities will be lower, potentially
increasing earnings.

b. Calculation of Bank’s Net Interest Income after Rate Increase: Initial Interest Income =
$50 million × 10% = $5 million Initial Interest Expense = $50 million × 8% = $4 million Net
Interest Income before rate increase = $5 million - $4 million = $1 million

After a 1% increase: New Interest Expense = $50 million × 9% = $4.5 million Net Interest
Income after rate increase = $5 million - $4.5 million = $0.5 million

Change in Net Interest Income: Change = $0.5 million - $1 million = -$0.5 million

Question no. 05
a. Benefits of an Efficient Technological Base for FIs:

Operational Efficiency: Automating processes reduces costs and increases speed.

Customer Experience: Technologies like mobile banking improve accessibility and

convenience.

Data Management: Enhanced data analytics can lead to better decision-making and risk
management.

b. Detailed Calculation for Interest Rate Changes: Rate-

sensitive assets and liabilities=$575,000\text{Rate-sensitive assets and liabilities} = \
$575,000Rate-sensitive assets and liabilities=$575,000 Rate-sensitive assets new yield=7.75%
−0.15%=7.60%\text{Rate-sensitive assets new yield} = 7.75\% - 0.15\% = 7.60\%Rate-
sensitive assets new yield=7.75%−0.15%=7.60% Rate-sensitive liabilities new yield=8.75%
−0.05%=8.70%\text{Rate-sensitive liabilities new yield} = 8.75\% - 0.05\% = 8.70\%Rate-
sensitive liabilities new yield=8.75%−0.05%=8.70%

New Interest Income=$575,000×7.60%=$43,700\text{New Interest Income} = \$575,000 \times

7.60\% = \$43,700New Interest Income=$575,000×7.60%=$43,700
New Interest Expense=$575,000×8.70%=$50,025\text{New Interest Expense} = \$575,000 \
times 8.70\% = \$50,025New Interest Expense=$575,000×8.70%=$50,025
New Net Interest Income=$43,700−$50,025=−$6,325\text{New Net Interest Income} = \$43,700
- \$50,025 = -\$6,325New Net Interest Income=$43,700−$50,025=−$6,325

Impact Analysis:

The bank's net interest income decreases due to a larger decrease in asset yields compared to
liability costs, exacerbating the negative spread.

Question no. 06
a. Repricing Gap as a Percentage of Assets:

Purpose: Provides insight into how much of the institution's assets are subject to interest rate
changes within a specific time frame.

Benefit: Helps in risk assessment and interest rate exposure management.

b. Maturity Bucket Importance: Maturity buckets help manage the timing of cash flows and
repricing risks by grouping assets and liabilities based on their maturity periods, crucial for
maintaining balance in the financial structure.

c. Duration Calculations and Plotting Relationship:

Duration is a measure of the average time the bondholder has to wait to receive the bond’s cash
flows. It also measures bond price sensitivity to changes in interest rates.