Consider a financialinstitution with a bond portfolio comprised of sovereign country debt that hasboth interest rate and exchange rate risk exposure. The duration of assets is3.4 years and the duration of liabilities is 5.2 years. The portfolio hasassets of US$18 billion (including 2.5 billion euro) and liabilities of US$16billion (including 4.15 billion euro) with no other currencies bought or soldforward.

1.Whatis the interest rate risk of the bond portfolio?

a.Theduration gap of +1.8 years implies anexposure to interest rate increases.

b.Theduration gap of +1.8 years implies anexposure to interest rate decreases.

c.Theduration gap of +1.8 years implies an exposure to interest rate increases.

d.Theduration gap of ?1.8 years implies an exposure to interest rate decreases.

2.Whatis the foreign exchange rate risk of the bond portfolio?

a.Beinglong 2.5 billion euro, it is exposed to euro/US dollar exchange rate declines.

b.Beingshort 1.65 billion euro, it is exposed to euro/US dollar exchange ratedeclines.

c.Beingshort 1.65 billion euro, it is exposed to euro/US dollar exchange rateincreases.

d.Beingshort 2.5 billion euro, it is exposed to euro/US dollar exchange rateincreases.

e .Being short 4.15billion euro, it is exposed to euro/US dollar exchange rate increases

Page 1 of 6 UNIVERSITY OF STIRLING DIVISION OF ECONOMICS SPRING SEMESTER 2016 BFIPL01 -Banking and Financial Institutions 23 March 2016 Module Examiner: Dr T. Diasakos Assignment for the first part of the course. Deadline for submission: March 30, 2016 at 12 noon Answer ALL questions and problems from ALL sections. For the questions of Section B, you should write out not only your answers but also the calculations for your answer. If you wish you may do these calculations, as well as those for the problems of Section C, on an excel file which you may submit along with the word file of your answers. SECTION A: Answer ALL questions (5 points for each question) 1. What is the general interpretation of the concept of duration, and what is the technical definition of this term? How does duration differ from maturity? 2. Syndicated loans a. What are syndicated loans? b. Why do banks syndicate loans? c. From the perspective of borrowers, what are pros and cons of loan syndication? 3. How does using options differ from using forward contracts? 4. A call option on a bond allows the owner of the option to buy a bond at a specific price. What must happen to interest rates for the purchaser of a call option on a bond to make money? How does the writer of the call option make money? 5. What is foreign exchange risk? What does it mean for a financial institution to be net long in foreign assets? What must happen to the foreign exchange rate to cause an FI that is net long to suffer losses? (Please turn over for Section B) Page 2 of 6 SECTION B. MULITPLE CHOICE QUESTIONS (3 points for each question) Use the following information to answer questions 1-2. Consider a financial institution with a bond portfolio comprised of sovereign country debt that has both interest rate and exchange rate risk exposure. The duration of assets is 3.4 years and the duration of liabilities is 5.2 years. The portfolio has assets of US$18 billion (including 2.5 billion euro) and liabilities of US$16 billion (including 4.15 billion euro) with no other currencies bought or sold forward. 1. What is the interest rate risk of the bond portfolio? a. The duration gap of +1.8 years implies an exposure to interest rate increases. b. The duration gap of +1.8 years implies an exposure to interest rate decreases. c. The duration gap of +1.8 years implies an exposure to interest rate increases. d. The duration gap of -1.8 years implies an exposure to interest rate decreases. 2. What is the foreign exchange rate risk of the bond portfolio? a. Being long 2.5 billion euro, it is exposed to euro/US dollar exchange rate declines. b. Being short 1.65 billion euro, it is exposed to euro/US dollar exchange rate declines. c. Being short 1.65 billion euro, it is exposed to euro/US dollar exchange rate increases. d. Being short 2.5 billion euro, it is exposed to euro/US dollar exchange rate increases. e. Being short 4.15 billion euro, it is exposed to euro/US dollar exchange rate increases. For questions 3-7 consider the following currency portfolio held by a US financial intermediary. Assets Denominated in Foreign currency Japanese yen Euro Pound sterling Liabilities Denominated in Foreign currency 755m yen 25m euro 10m pound 525m yen 100m euro 5m pound Currency Bought Forward 135m yen 15m euro 50m pound Currency Sold Forward 440m yen 325m euro 0 Notes: The current spot rates are: $1.13/euro; $1.61/pound sterling; $0.0084/yen. The current forward rates are: $1.15/euro; $1.57/pound sterling; $0.0089/yen. All $ are US dollars. (Please turn over for questions 3-10) Page 3 of 6 3. What is the portfolio's exposure to the euro? a. -$385 million b. +$385 million c. -385 million euro d. +385 million euro e. -75 million euro 4. Using the difference between the spot and the forward rate as the measure of the exchange rate shock, what is the US dollar impact on the portfolio of the change in pound sterling? (Measure the exchange rate change using the forward rate minus the spot rate.) a. - $37,500 b. -$6.5 million c. -$2.2 million d. -$10.5 million e. -$22.2 million 5. Using the difference between the spot and the forward rate as the measure of the exchange rate shock, what is the US dollar impact on the portfolio of the change in pound sterling? (Measure the exchange rate change using the forward rate minus the spot rate.) a. - $37,500 b. -$6.5 million c. -$2.2 million d. -$10.5 million e. -$22.2 million 6. Use currency forwards to construct a perfect (nave) hedge for the portfolio's exposure to the Japanese yen. a. Buy 75 million yen forward. b. Sell 75 million yen forward. c. Buy 755 million yen forward. d. Sell 755 million yen forward. e. Buy 525 million yen forward. 7. Use currency forwards to construct a perfect (nave) hedge for the portfolio's exposure to the pound sterling. a. Buy 55 million pounds forward. b. Sell 55 million pounds forward. c. Buy 10 million pounds forward. d. Sell 10 million pounds forward. e. Sell 5 million pounds forward. (Please turn over for questions 8-10) Page 4 of 6 8. Comparing options hedges to futures/forward hedges: a. Options hedges mark to market more frequently than futures/ forward hedges. b. Options hedges have higher transactions costs than futures/forward hedges. c. Options hedges have asymmetric cash flows, whereas futures/forward hedges have symmetric cash flows. d. Only Choice b is correct. e. Choices a, b and c are correct. 9. Is a financial institution immunized itself against interest rate risk exposure if its maturity gap is set to zero? a. Yes, because with a maturity gap of zero the change in the market value of assets exactly offsets the change in the market value of liabilities. b. No, because with a maturity gap of zero the change in the market value of assets exactly offsets the change in the market value of liabilities. c. Yes, because the maturity model reaches an equilibrium at zero. d. No, because the timing of cash flows is relevant to immunization against interest rate risk exposure. e. No, because a representative bank will always have a positive maturity gap. 10. The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as: a. liquidity risk b. interest rate risk c. credit risk d. foreign exchange risk e. off balance sheet risk (Please turn over for section C) Page 5 of 6 SECTION C: Answer BOTH problems Problem 1 (20 points) Two banks are being examined by the regulators to determine the interest rate sensitivity of their balance sheets. Bank A has assets composed solely of a 10year, 12 percent, $1 million loan. The loan is financed with a 10year, 10 percent, $1 million Certificate of Deposit (CD). Bank B has assets composed solely of a 7year, 12 percent zerocoupon bond with a current (market) value of $894,006.20 and a maturity (principal/face) value of $1,976,362.88. The bond is financed with a 10year, 8.275 percent coupon, $1,000,000 face value CD with a YTM of 10 percent. The loan and the CDs pay interest annually, with principal due at maturity. a. If all interest rates above increase by 1 percent (100 basis points), how do the market values of the assets and liabilities of each bank change? That is, what will be the net effect on the market value of the equity for each bank? (5 points) b. What accounts for the differences in the changes of the market value of equity between the two banks? (5 points) c. Verify your results above by calculating the duration for the assets and liabilities of each bank, and estimate the changes in value for the expected change in interest rates using the duration formula. (10 points) Problem 2 (25 points) CBank is considering offering its customers a 5year, 4.25% p.a., fullyamortized, 3000 consumption loan. The loan payments are to be made annually at yearend, and the interest rate will be fixed throughout the life of the loan. At the moment the market interest rate is 4% p.a. and the risk management division of C Bank forecasts that for the next five years it will follow a binomial model in which each year it will rise or fall by 10 basis points (i.e., during the first year it will move either up to 4.1% or down to 3.9%). The riskneutral probabilities of ups and down are 0.5 throughout the binomial tree. d. Find the annual loan payment, and its annual breakdown between payment of interest and payment of principal. (7 points) e. Draw the interestrate, and the market value of the loan trees. (5 points) f. Describe the interest rate risk that this loan carries for CBank. (3 points) The loan officer of Cbank is considering offering also the following prepayment option: at yearend of years 2 or 3, the remainder of the principal can be paid off in one lumpsum payment, with a penalty though of 0.5% of the amount that is paid off. g. Should the loan officer include the prepayment option or not? (10 points) Page 6 of 6 THE END