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Exam January 2011

# Exam January 2011

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04/22/2012

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# University of Amsterdam, Business School

Caput Commercial Banking Academic Year 2010/2011 Exam January 2011
Student name …………….. Student ID …………….. Signature ……………..

Instructions
The rules of this exam are as follows: • Please write your full name, student ID and signature. • Please keep all answers brief and to the point. Do not provide irrelevant informa- tion, but show all steps that are necessary to solve a problem. • There are 12 pages in this exam including this page. Questions start on Page 2 and end on Page 9. The last three pages are empty and are to be used for rough work. • Please return all the pages together with the text of the exam. • This is a closed books closed notes exam. • Ordinary calculators are permitted, but no computers or other devices. • Dictionary is not allowed. • Please answer in the space provided as far as possible. • The exam includes four exercises. All exercises are compulsory (no options!) - so attempt all exercises you can. • If a question seems unclear, interpret it as best you can and proceed. Do not contact me or anyone else seeking clarification. • You have 2 hours (!) to complete the exam. Good luck! Score Exercise 1 (max 10 points) Exercise 2 (max 25 points) Exercise 3 (max 25 points) Exercise 4 (max 40 points) Total points: 100

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there will be a reduction in the duration of the bankʼs liabilities. how many Euros of 4-year notes should the bank issue?   2   . Assuming a flat yield curve. If the proceeds from issuing these notes are used to retire 10-year notes. The bankʼs CFO has decided that the bank should target a debt duration of four years instead of five. Assume that it is possible to issue 4-year notes with a duration of three years.Exercise 1 Bank XYZʼs debt obligations have a present value Euros 2b and a duration of 5 years. Half of this is a 10-year note with a duration of six years.

3   . (1) Calculate the NPV of each project. Entrepreneurs only start a project if they end up with a strictly positive expected payoff (taking into account what they have to pay back to the bank). (4) Which interest rate will banks charge in equilibrium if a debt un-collateralized contract is signed between parties? (5) Is there any market imperfection at the equilibrium interest rate found in point (4)? Motivate your answer. to break-even I have to charge an interest rate such that 4/5 ∗ 3/5 ∗ 50(1 + r) + 1/5 ∗ 50(1 + r) = 50(1. The only thing the bank knows is that safe projects occur in 20% of all cases. (7) Choose one of the instruments you have listed above and show analytically how it can be used to solve the problem of asymmetric information. Suppose now that the previous manager is fired and a new smart manager is hired. The risky project generates cash flows 100 with probability 3/5 (and 0 with prob 2/5).e.1). (6) List at least three different instruments the bank can use to mitigate the problem of asymmetric information. credit worthy at that interest rate? (3) Does the bank break-even at that interest rate? Motivate your answer. Are both projects credit worthy? Suppose there is asymmetric information.Exercise 2 Consider an economy with a large number of penniless entrepreneurs. banks break-even in expectation. Each entrepreneur requires external funding equal to 50 to start a new project today. i. The project can be risky or risk-free. Suppose initially that the manager of the bank reasons as follows: ”The project is risky with probability 4/5 and it fails with probability 2/5. With probability 1/5 the project is risk-free. The entrepreneur instead knows the projectʼs riskiness. The bank does not know the riskiness of the project and it can not discover it by screening the project. Assume that everybody is riskneutral and the riskfree interest rate is 10%. The risk-free project always generates cash flows of 60. So. Explain intuitively why they are useful. There is perfect competition in the credit market.” (2) Is a loan applicant that would accept the resulting interest rate.

What is the price at which the bank is able to sell a high quality loan and a low quality loan. from lower regulatory capital costs). The problem is that the bank is perfectly informed about the quality of the loan. What are the total gains from selling each loan for the bank? (b) Now suppose that the bank cannot credibly communicate the quality of the loan. A low quality loan generates income 1000 with probability 1/5 in one year and zero with probability 4/5. Prior to the loan sale. the investor attaches probability ρ to the event that the loan is of high quality. where H ≥ 200.   4   . say. The investor knows that the loan can either be of low or high quality. (a) Suppose that the bank can credibly communicate the quality of the loan with zero cost. while the investor is not. This is true when the loan is high quality but also when is low quality. (e) What happens to the condition found in point (c) if H = 200? Explain your answer. What is the new equilibrium price at which the bank is able to sell the loan? (c) Suppose now that the true quality of the loan is high and the bank cannot credibly communicate the quality of this loan. Under which condition the bank is willing to sell the high quality loan.Exercise 3 Consider a bank that seeks to sell a loan to one of many riskneutral investors. if the equilibrium price is the one found in point (b)? (d) What happens to the condition found in point (c) as ρ −→ 1? Explain your answer. The bank enjoys a benefit equal to 40 when removing a loan from its book (stemming. A high quality loan generates income H for sure.

4. The bank satisfies the capital ratio imposed by Basel 1988. Euro b): Assets cash corporate loans t-bills 25 800 25 Liabilities deposits long-term debt common stock 700 125 25 Using this information say whether the following four sentences are true or false and motive your answer. 1. 2. duration > maturity. The bank can further increase the capital ratio by issuing additional long-term debt?       5   . 6. For a non-zero-coupon bond. 6c.ple. The bankʼs total regulatory capital is 150. an increase in the coupon in. Suppose that a bank has the following balance sheet (market values. Explain your answer using maximum 5 lines. 6d. 5. Capital adequacy regulation (Basel I) induced banks to transfer credit risks to third parties for example through securitization in order to relieve regulatory capital burden. The bank risk-weighted assets are 400. there are different types of entrepreneurs and the type is private information). The collateral is generally used to deal with moral hazard problems (for exam. The effect of market yield changes on the banks equity value does not depend on the mismatch between the duration of the banks assets and liabilities. The deposit insurance and the lender of last resort are two instruments used to avoid bank runs.Exercise 4 For each statement below say if it is true or false. 3. 6a.creases duration. These two instruments are ex-ante efficient. The number of pints you get depends on the answer you give. 6b. the entrepreneur can choose the level of effort which is private information) but not with adverse selection problems (for example.

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