Section A: Short Explanation (30 marks, 5 marks each).

Instruction: Choose six (6) out of eight (8) questions. Your answer should not be more
than a quarter (1/4) of a page.

1. Briefly describe duration, and explain how a bank’s duration gap determined?
Duration is a value- and time-weighted measure of maturity that considers the timing of all
cash inflows from earning assets and all cash outflows associated with liabilities. It measures
the average maturity of a promised stream of future cash payments. It is a direct measure of
price risk.
A bank's duration gap is determined by taking the difference between the dollar-weighted
duration of a bank's assets portfolio and the dollar-weighted duration of its liabilities. The
duration of the bank’s assets can be determined by taking a weighted average of the duration
of all of the assets in the bank’s portfolio. The weight is the dollar amount of a particular type
of asset out of the total dollar amount of the assets of the bank. The duration of the liabilities
can be determined in a similar manner.

2. Explain a long hedge and short hedge in financial futures.

A long hedger offsets risk by buying financial futures contracts before the time new deposits
are expected to flow in and interest rates are expected to decline. This helps institution to
hedge against an opportunity risk when a loan is to be made, or when securities are to be
added to the bank's portfolio. Later, as deposits come flowing in, a like amount of futures
contracts is sold.

A short hedge is structured to create profits from future transactions in order to offset losses
experienced on a financial institution’s balance sheet if the market interest rates rise. The
asset-liability manager will sell futures contracts calling for the future delivery of the
underlying securities, choosing contracts expiring around the time new borrowings will
occur, when a fixed-rate loan is made, or when bonds are added to a financial firm’s
portfolio. Later, as borrowings and loans approach maturity or securities are sold and before
the first futures contract matures, a like amount of futures contracts will be purchased on a
futures exchange.

3. What does securitization of assets mean? What advantages does securitization offer to the
lending banks?
Securitization involves the pooling of groups of earning assets and removing those pooled
assets from the lender’s balance sheet. After that, the pool is usually designated as a special-
purpose entity (vehicle) and turned into collateral for issuing asset-backed securities. This
process refers to as securitization of assets. As the pooled assets generate interest income and
repayments of principal, the cash generated flows through to investors who purchased these
securities.
Securitization gives lending institutions the opportunity to use their assets as sources of funds
and, in particular, to remove lower-yielding assets from the balance sheet to be replaced with
higher-yielding assets.
The lending institution can create liquid assets out of illiquid, expensive-to-sell assets. Also,
this helps diversify the lender’s credit risk exposure.
It permits lenders to hold a more geographically diversified loan portfolio, perhaps
countering local losses with higher returns available from loans from different geographic
areas with more buoyant economies.
Securitization is also a tool for managing interest rate risk and possibly credit risk, depending
on the quality of the packaged loans.
Securitization opens avenues for lending institutions to earn added fee income from servicing
the packaged loans. Lenders can also benefit from the normal positive interest-rate spread
between the average yield on the packaged loans and the coupon (promised) rate on the
securities issued against those loans, capturing residual income.

4. What are standby credit letters? Why have they grown so rapidly in recent years? Who are
the principal parties to a standby credit agreement?

Standby credit letters are promises of the issuer to a lender to pay off an obligation of its
customer, in case that customer cannot pay. It can also be in the form of a guarantee that a
project of the customer will be completed on time.
The standby credit agreements have grown substantially in the recent years. There has been a
tremendous growth in direct financing by companies (issuance of commercial paper) and
with growing concerns about default risk on these direct obligations, increasing number of
borrowers have asked banks to provide a credit guarantee.
The opportunity standbys offer lenders to use their credit evaluation skills to earn additional
fee income without the immediate commitment of funds.
The principal parties to a standby credit agreement are the issuing bank or any other financial
institution known as the “issuer”, the “account party” who requested the letter, and the
“beneficiary” who will receive payment from the issuing institution if the account party
cannot meet its obligation.

5. What are structured notes and stripped securities? What unusual features do they contain?

Structured notes usually are packaged investments, such as pools of federal agency securities,
assembled by security dealers that offer customers flexible yields in order to protect their
customers' investments against losses due to changing interest rates. Interest yield on such
notes could be reset periodically based on a reference interest rate, such as a U.S. Treasury
bond rate.
Stripped securities represent a claim against either the principal or interest payments
associated with a debt security. The expected cash flow from a Treasury note, Treasury bond
or mortgage-backed security is separated into a stream of principal payments and a stream of
interest payments, each of which may be sold as a separate security maturing on the day the
payment is due. In particular, stripped securities offer interest-rate hedging possibilities to
help protect an investment portfolio against loss from interest-rate changes.

6. What are the most significant differences among Basel I, II, and III? Explain the
importance of the concepts of internal risk Assignment, VaR, and market discipline.
Basel I used a “one size fits all” approach to determine a bank’s capital requirements. Basel II
recognizes that different banks have different risk exposures and should be subject to
different capital requirements. It also broadens the types of risk considered for determining
capital requirements, including credit, market, and operational risk. Capital requirements laid
down in Basel I and II apparently were inadequate in the face of the latest credit crash. Also,
Basel II had resulted in less total capital and a weaker mix of capital, worsening what turned
into a global credit catastrophe. Basel III was hence designed to head off future financial
crises. Basel III calls for greater total capitalization (a higher percentage relative to assets)
plus a stronger definition of what belongs and does not belong in a bank’s capital accounts.
Internal risk Assignment refers to an innovation in Basel II which allows banks to measure
their own risk exposure and determine how much capital they needed to meet that exposure.
These measurements are subject to review by the regulators to ensure that they are
reasonable. The VaR model is one of the models used to determine a bank’s risk exposure. It
measures the price or market risk of a portfolio of assets whose value may decline due to
adverse movements in the financial markets or interest rates. Market discipline refers to the
market determining the bank’s risk exposure. The market’s collective actions of buying and
selling a bank's securities (like subordinate debt) in the financial market provide an
independent Assignment of the bank's financial condition. Since such debt is not guaranteed,
the buyers of such securities would be very vigilant about the bank’s financial condition.

7. Explain the following terms: character, capacity, cash, collateral, conditions, and control.
a. Character – Character Assignment involves finding out the purpose of credit request by a
customer and the intention of the borrower to repay the funds.
b. Capacity – Capacity is a customer’s authority to request a loan and the legal standing to
sign a binding loan agreement.
c. Cash – Cash is the ability of a customer to generate sufficient cash flows to service the
principal and interest amount on the loan as and when they become due.
d. Collateral – Collateral refers to an asset pledged by a borrower as a security with the
lending institution against loaned funds.
e. Conditions – Conditions refer to the current economic situations in the borrower’s line of
work. This is important because the ability of the borrower to generate cash flows may be
affected by change in conditions.
f. Control – The control element refers to considerations regarding the impact of changes in
law and regulation that can adversely affect the borrower and whether the loan request meets
the lender’s and the regulatory authorities’ standards for loan quality.

8. What are working capital loans, term loans, and revolving credit lines?
a. Working capital loans are short-run credits to fund the current assets of a business,
such as accounts receivable, inventories, or to replenish cash. Usually a working capital loan
is designed to cover seasonal peaks in a business customer’s production levels. Normally,
working capital loans are secured by accounts receivable or by pledges of inventory and carry
a floating interest rate on the amounts actually borrowed against the approved credit line.
b. Term loans are business credit that have an original maturity of more than one year
and are normally used to fund the purchase of new plant and equipment or to provide for a
permanent increase in working capital. Term loans usually look to the flow of future earnings
of a business firm to amortize and retire the credit. Term loans normally are secured by fixed
assets (e.g., plant or equipment) owned by the borrower and may carry either a fixed or a
floating interest rate.
c. Revolving credit lines are lines of credit that promise the business borrower access to
any amount of borrowed funds up to a specified maximum amount; moreover, the customer
may borrow, repay, and borrow again any number of times until the credit line reaches its
maturity date. It is one of the most flexible of all business loans, and is often granted without
specific collateral and may be short-term or cover a period as long as five years

Section B: Short Calculation Questions (40 marks, 10 marks each).

Instruction: Answer four (4) out of six (6) questions.

1. a. Your bank needs to borrow $500 million by selling time deposits with 180-day
maturities. If interest rates on comparable deposits are currently at 3.5 percent.

(i) What is the cost of issuing these deposits?

 (ii) (ii) Suppose interest rates rise to 4.5 percent. What then will be the cost of these
deposits?

Marginal deposit interest cost = Amount of new deposits to be issued × Annual interest rate ×
Maturity of deposit in days
Annual interest rate ×
360
At a rate of 3.5 percent, the interest cost is:

30
$500 million × 0.035 × = $8,750,000
360 (Should be 180/360)

At a rate of 4.5 percent, the interest cost would be:

30
$500 million × 0.045 × = $11,250,000
360 (Should be 180/360)

b. By what amount will the market value of a Treasury bond futures contract change if
interest rates rise from 5 to 5.25 percent? The underlying Treasury bond has a duration of
10.48 years and the Treasury bond futures contract is currently being quoted at 113-06.
(Remember that Treasury bonds are quoted in 32nds.)

Change in value of a T-bond futures contract=

$113,187.5 × 0.0025
-10.48 × = -2,824.3
1 + 0.005

2. A bank plans to borrow $100 million in the money market at a current interest rate of
4.5 percent. However, the borrowing rate will float with market conditions. To protect itself,
the firm has purchased an interest-rate cap of 5 percent to cover this borrowing. If money
market interest rates on these funds sources suddenly rise to 5.5 percent as the borrowing
begins, how much interest in total will the firm owe and how much of an interest rebate will
it receive, assuming the borrowing is for only one month?

The amount of interest in total that the firm will owe is:

Number of months
Total Interest Owed = Amount Borrowed×Interest Rate Charged×
12
1
=100,000,000×0.055× = $458,333.33
12

The amount of interest rebate that the financial firm will receive for its one month borrowing
is as follows:

Number of months
 Market interest rate - Cap rate  ×Amount borrowed×
12

1
=  0.055 - 0.05  × 100,000,000 × = $41,666.67
12

3. The Lake Bank Corp. has placed $100 million of GNMA-guaranteed securities in a trust
account off the balance sheet. A CMO with four tranches has just been issued by Lake Bank
Corp using the GNMAs as collateral. Each tranche has a face value of $25 million and makes
monthly payments. The annual coupon rates are 4.5 percent for Tranche A, 5 percent for
Tranche B, 5.5 percent for Tranche C, and 6.5 percent for Tranche D.

a. Which tranche has the shortest maturity, and which tranche has the most
prepayment protection?

Answer: Tranche A has the shortest maturity and tranche D has the most prepayment
protection.

b. Every month principal and interest are paid on the outstanding mortgages, and
some mortgages are paid in full. These payments are passed through to Lake Bank
Corp, and the trustee uses the funds to pay coupons to CMO bondholders. What are
the coupon payments owed for each tranche for the first month?

Answer:
Tranche A: 25 million × (.045/12) = $93,750
Tranche B: 25 million × (.050/12) = $104,167
Tranche C: 25 million × (.055/12) = $114,583
Tranche D: 25 million × (.065/12) = $135,417

c. If scheduled mortgage payments and early prepayments bring in $5 million, how

much will be used to retire the principal of CMO bondholders and which tranche will
be affected?

Answer:
Total interest to be paid: $93,750 + $104,167 + $114,583 + $135,417 = $447,917
Amount applied to principal: $5,000,000 - $447,917 = $4,552,083

4. A municipal bond has a $1,000 face (par) value. Its yield to maturity is 5 percent, and the
bond promises its holders $60 per year in interest (paid annually) for the next 10 years before
it matures. Using a Present Value Table provided calculate this bond’s duration.

Annual PV of Time Time

Interest PV Annual Period Weighted
Year Income At 5% Interest Recorded PV
1 $ 60 0.95238 $ 57.14 × 1 = $ 57.14
2 60 0.90703 54.42 × 2 = 108.84
3 60 0.86384 51.83 × 3 = 155.49
4 60 0.82270 49.36 × 4 = 197.45
5 60 0.78353 47.01 × 5 = 235.06
6 60 0.74622 44.77 × 6 = 268.64
7 60 0.71068 42.64 × 7 = 298.49
8 60 0.67684 40.61 × 8 = 324.88
9 60 0.64461 38.68 × 9 = 348.09
10 60 0.61391 36.83 × 10 = 368.35
10 1,000 0.61391 613.91 × 10 = 6,139.13
$1,077.22 $8,501.56

Then, duration of the bond = $ 8,501.56 ÷ $1,077.22 = 7.89 years

5. The management at Ohio National Bank located in Athens, Ohio, is calculating the key
capital adequacy ratios for its third-quarter reports. At quarter-end, the bank’s total assets are
$95 million and its total risk-weighted assets including off-balance-sheet items are $75
million. Tier 1 capital items sum to $4 million, while Tier 2 capital items total $2.5 million.
a. Calculate Ohio National’s leverage ratio, total capital-to-total assets, core capital-to-total
risk-weighted assets, and total capital-to-total risk-weighted assets.

Total assets $95.00 million

Total risk-weighted assets including off- 75.00 million
balance-sheet items

Tier 1 capital 4.00 million

Tier 2 capital 2.50 million
Tier 1 capital
Leverage ratio =
Total asset
$4 million
Leverage ratio = = 0.0421or 4.21percent
$95 million

Total capital-to-total assets ratio =

 Tier 1 capital + Tier 2 capital 
Total assets

Total capital-to-total assets ratio =

 $4 million + $2.5 million  = 0.0684 or 6.84 percent
$95million

Tier 1capital
Core capital-to-total risk-weighted assets =
Risk weighted assets including off-balance-sheet items

$4 million
Core capital-to-total risk-weighted assets = = 0.0533or 5.33percent
$75 million

Total capital-to-total risk-weighted assets =

 Tier 1 capital  Tier 2 capital 
Risk weighted assets including off-balance-sheet items

 $4 million + $2.5 million 

Total capital-to-total risk-weighted assets = = 0.0867 or 8.67 percent .
$75 million

b. Does Ohio National meet the requirement stipulated for a bank to qualify as
adequately capitalized?
Yes, Ohio National Bank meets the requirement of having a minimum ratio of total capital to
risk weighted assets of at least 8 percent, a ratio of Tier 1 capital to risk-weighted assets of at
least 4 percent, and a leverage ratio of at least 4 percent stipulated for a bank to qualify as
adequately capitalized.
6. The table below shows data of Xiamen Corporation. Please construct ratios under the
following dimension of a business firm’s performance:

a. Expense Control Ratios (7 ratios):

b. Operating Efficiency (5 ratios):

Business Assets Annual Revenue and Expense Items

Cash account $60 Net sales $600
Accounts receivable 155 Cost of goods sold 445
Inventories 128 Wages and salaries 52
Fixed assets 286 Interest expense 28
Miscellaneous assets 96 Overhead expenses 29
725 Depreciation expenses 12
Liabilities and Equity Selling, administrative, 28
and other expenses
Short-term debt: 108 Before-tax net income 6
Accounts payable 117* Taxes owed 1
Notes payable 325* After-tax net income 5
Long-term debt (bonds) 15
Equity capital 160
725
*Annual principal payments on bonds and notes payable total $55. The firm’s marginal tax
rate is 35 percent.

a. Expense Control Ratios:

Cost of goods sold $445

= = 74.17 percent
Net sales $600

Wages and salaries $52

= = 8.67 percent
Net sales $600

Interest expense $28

= = 4.67 percent
Net sales $600

Overhead expenses $29

= = 4.83percent
Net sales $600

Depreciation expenses $12

= = 2.00 percent
Net sales $600

Selling, administrative, and other expenses expenses $28

= = 4.67 percent
Net sales $600

Taxes owed $1
= = 0.17 percent
Net sales $600

b. Operating Efficiency: Measure of a Business Firm’s Performance Effectiveness

Annual cost of goods sold $445

= = 3.48x
Average inventory $128
 Net sales $600
= = 2.10x
Net fixed assets $286

Net sales $600

= = 0.83x
Total assets $725

Net sales $600

= = 3.87x
Accounts and notes receivable $155

Accounts receivable $155

Average collection period = = = 93 days
Annual credit sales   $600
 360 360