You are on page 1of 25

Examiners commentaries 2016

Examiners commentaries 2016


FN1024 Principles of banking and finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 201516. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading


references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.

General remarks

Learning outcomes

At the end of the course and having completed the Essential reading and activities you should:

discuss why financial systems exist, and how they are structured
explain why the relative importance of financial intermediaries and financial markets is
different around the world, and how bank-based systems differ from market-based systems
understand why financial intermediaries exist, and discuss the role of transaction costs and
information asymmetry theories in providing an economic justification
explain why banks need regulation, and illustrate the key reasons for and against the
regulation of banking systems
discuss the main types of risks faced by banks, and use the main techniques employed by
banks to manage their risks
explain how to value real assets and financial assets, and use the key capital budgeting
techniques (Net Present Value and Internal Rate of Return)
explain how to value financial assets (bonds and stocks)
understand how risk affects the return of a risky asset, and hence how risk affects the value
of the asset in equilibrium under the fundamental asset pricing paradigms (Capital Asset
Pricing Model and Asset Pricing Theory)
discuss whether stock prices reflect all available information, and evaluate the empirical
evidence on informational efficiency in financial markets.

1
FN1024 Principles of banking and finance

Planning your time in the examination

From the allocation of marks, you should be able to identify the importance and weighting of each
part of the question. Therefore, you should devote an appropriate amount of time to each part
related to the marks awarded.

What are the topics under examination?

The FN1024 Principles of banking and finance examination paper tests your understanding of
a wide range of concepts and techniques in the banking and finance areas. Therefore, you are
expected to demonstrate numerical competence as well as a thoughtful and clear writing style in the
discursive parts of each question.

All the questions asked in the examination are designed to test topics covered in the syllabus as
presented in the Regulations; the subject guide provides a framework for covering the syllabus and
directs you to the Essential reading. You are reminded that the examination for this course may test
any aspect of the syllabus.

What are the examiners looking for?

This is a foundation course and you are expected to demonstrate your knowledge and understanding
of key concepts/terms in banking and finance.

Moreover, you are expected to demonstrate your knowledge of the relevant technical terminology.
Finally, you are encouraged to demonstrate your ability to identify links between concepts presented
in different chapters of the syllabus/subject guide. In essay questions, in addition to depth of
knowledge of the subject matter, the examiners are looking for your ability to discuss and evaluate
arguments and to relate knowledge to the question asked, as opposed to simple repetition of factual
information on a particular topic. One way of helping to ensure that you have a clear,
well-structured and relevant argument is to spend a few minutes organising your answer before you
begin writing, and by trying not to fit a standard answer to the question.

Please note that since 2010 examination marks have not generally been allocated to individual
points made in the answer. This is particularly relevant to Section A questions but also to the parts
of Section B questions where you have to explain a concept. Instead, the examiners will be looking
at the answer as a whole when allocating a mark. The examiners will be looking for evidence of an
overall understanding of the concept/issue being examined. Demonstrating your understanding can
come from providing relevant factual information, relevant examples and showing how the concept
relates to other concepts in the syllabus. This change in the approach to marking will reinforce the
point made in the paragraph above that simple repetition of material from the subject guide is
unlikely to be rewarded with a high mark.

Key steps to improvement

While some of the questions might appear to be technical, most of the marks are awarded for
providing the economic reasoning and explanations. The examiners therefore recommend focusing
on both the economic reasoning and some of the techniques/tools as you work with the subject
guide. Note that in numerical questions alternative hypotheses are equally acceptable if you have
been consistent in the different parts of the question: in these cases the examiners are flexible in the
allocation of marks.

2
Examiners commentaries 2016

Examination revision strategy

Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons. The Examiners commentaries suggest ways of
addressing common problems and improving your performance. One particular failing is question
spotting, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.

We recognise that candidates may not cover all topics in the syllabus in the same depth, but you
need to be aware that the examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.

The syllabus can be found in the Course information sheet in the section of the VLE dedicated to
each course. You should read the syllabus carefully and ensure that you cover sufficient material in
preparation for the examination. Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers. Examination papers may legitimately
include questions on any topic in the syllabus. So, although past papers can be helpful during your
revision, you cannot assume that topics or specific questions that have come up in past examinations
will occur again.

If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.

3
FN1024 Principles of banking and finance

Examiners commentaries 2016


FN1024 Principles of banking and finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 201516. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading


references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions Zone A

Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.

Section A

Answer one question and no more than two further questions from this section.

Question 1

(a) Examine the respective roles of transaction costs and asymmetric information in
accounting for intermediation through financial institutions.
(15 marks)

Reading for this question


See subject guide, Chapter 4, section headed Why do financial intermediaries exist.
Approaching the question
Financial intermediation occurs when a surplus unit lends to an intermediary, rather than
lending directly to a deficit unit. The financial intermediary then lends to deficit units. In
developed economies, most funds flow through intermediaries than directly from surplus to
deficit units.
Two of the main explanations for this dominance of intermediation include:
1. Transaction costs these are significant in direct lending. They include:
i. search costs
ii. verification costs

4
Examiners commentaries 2016

iii. monitoring costs


iv. enforcement costs.
These costs are mainly borne by the lender and the last two occur after the loan has
been made. Intermediaries can reduce these costs (compared to the costs facing an
individual) through specialisation, economies of scale etc.
2. Asymmetric information in lending / borrowing this gives rise to adverse selection and
moral hazard. Adverse selection is solved by information production. Constraining the
actions of borrowers reduces moral hazard. As a result of the free-rider problem, this is
inefficiently solved in direct lending. As banks mainly make non-traded loans, they do
not face the free-rider problem so can more effectively reduce adverse selection and moral
hazard.
Transaction costs help to explain why intermediaries act as agents. Asymmetric
information helps to explain why they act as principals and are better able to allocate
resources.

(b) Explain how transaction costs and asymmetric information in credit markets
has changed in the last 20 years and assess the impact of these changes on
financial disintermediation.
(10 marks)

Reading for this question


See subject guide, Chapter 4, section headed The future for financial intermediaries.
Approaching the question
The reduction in transaction costs brought about by the growth of the internet has
encouraged disintermediation at the retail end of banking. Peer-to-peer lending services help
to reduce search and verification costs in particular.
Also, peer-to-peer lenders may produce information (credit reports etc.) and therefore help
to reduce the adverse selection problem that results from asymmetric information.
These developments have reduced the cost and information asymmetry problems associated
with direct lending at the retail end. The growth in direct lending has been modest so far
but, in the medium term, may result in significant loss of business for banks. At the
wholesale end of banking, disintermediation is better established with companies raising
funds directly from markets (generally with the support of a bank operating off the balance
sheet). This can be partly explained by a reduction in asymmetric information (increase in
information) through the growth in credit ratings published by credit rating agencies.

Question 2

(a) Distinguish between weak-form, semi-strong form and strong-form levels of


market efficiency. Discuss the implications of weak, semi-strong and strong form
efficient equity markets for investors in equity securities.
(6 marks)

Reading for this question


See subject guide, Chapter 9, section headed Levels of informational market efficiency.
Approaching the question
Weak form prices fully reflect all historical information.
Semi-strong prices reflect all public information.
Strong prices reflect all public and private information.

5
FN1024 Principles of banking and finance

Better answers would define what each of these information sets are and explain that the
wider information sets nest the less wide sets (for example, the semi-strong information set
nests the weak).
The implications of weak-form efficiency for investors are that investors cannot use
models/technical analysis based on past data to predict future prices.
The implications of semi-strong efficiency are that investors cannot use fundamental analysis
to try to pick undervalued securities.
The implications of strong form efficiency is that excess returns cannot be obtained by using
private information, for example superior forecasting ability.

(b) Explain what an excess return is in a financial market. Explain why, in an


informationally efficient market, investors are not able to obtain consistent
excess returns.
(6 marks)

Reading for this question


See subject guide, Chapter 9, section headed Concept of excess return.
Approaching the question
The excess return is equal to the difference between the actual return on a security and the
equilibrium expected return. In a forward-looking perspective the expected equilibrium
return can be replaced by the optimal forecast return. Where a market is informationally
efficient investors will not be able to make excess returns consistently. Investors may make
excess returns occasionally (as price changes are a fair game and investors may guess the
change sometimes) but they will not predict price changes correctly consistently.

(c) Discuss the evidence relating to semi-strong efficiency of equity markets.


(13 marks)

Reading for this question


See subject guide, Chapter 9, section headed Empirical evidence on efficient markets.
Approaching the question
Answers should consider the evidence both in favour and against semi-strong market
efficiency. The evidence in favour is mainly connected to studies of the speed at which the
information in earnings/dividend announcements is impounded into the price of a stock.
The evidence against is mainly concerned with under- and over-reaction to announcements.
Answers that refer to the findings of key research studies would be rewarded with higher
marks.

Question 3

(a) Distinguish between liquidity and solvency in relation to a bank. Explain how a
bank could become insolvent and explain the role of capital and liquidity in
preventing insolvency.
(10 marks)

Reading for this question


See subject guide, Chapter 5, sections headed Bank capital requirements and Monitoring
of liquidity.

6
Examiners commentaries 2016

Approaching the question


Liquidity refers to having sufficient access to cash or cash equivalents that enable it to meet
its ongoing cash commitments (deposit repayments, new loans, staff salaries etc.).
Solvency refers to the prospective ability of a bank to meet its debts as they fall due.
Liquidity is a short-term concept and solvency is a long-term concept.
A bank can become insolvent (assets < deposit liabilities) as a result of reductions in the
value of assets (for example large loan defaults or write-downs of the value of market traded
assets), or losses from activities.
Capital refers to total assets deposit liabilities (essentially = equity in the bank). Capital
can absorb losses from asset write-downs and therefore keep the bank solvent. The regulator
places emphasis on banks holding sufficient capital to cover expected and unexpected losses.
Liquidity will also increase confidence among depositors a run less likely. A run could lead
the bank into liquidating assets to meet liquidity needs which, if done quickly, could lead to
insolvency.
Hence both adequate capital and liquidity play an important role in maintaining the
solvency of a bank.

(b) Critically evaluate the methods a bank can use to manage the credit risk it faces.
(15 marks)

Reading for this question


See subject guide, Chapter 6, section headed Credit risk management.
Approaching the question
The main techniques to manage credit risk include:
i. pooling and diversification of loans (the examiners would expect to see an explanation of
both pooling and diversification and their effects) has a portfolio risk reduction effect
ii. screening selection of good risks (reduces adverse selection)
iii. asking for security (collateral) impacts on both adverse selection and moral hazard
(adverse selection those borrowers willing to put up security are more likely to be good
risks; moral hazard borrowers less likely to take risks faced with the loss of the
collateral)
iv. use of restrictive covenants restrictions on borrowers actions after the loan is made
(reduces moral hazard).

Question 4

(a) Discuss the main reasons for regulating banks and examine the safety net
arrangements put in place in most banking systems.
(15 marks)

Reading for this question


See subject guide, Chapter 5, sections headed Why do banks need regulations, Arguments
against regulation and Government safety net.
Approaching the question
Prudential regulation refers to regulation designed to reduce excessive risk-taking. The main
arguments in favour include:
i. to reduce systemic risk by protecting individual banks from failure, the risk of
contagion where one bank failing leads to another bank failing is reduced
ii. to protect consumers
iii. to maintain the safety and soundness of the system.

7
FN1024 Principles of banking and finance

The main problems with regulation include:


i. cost of compliance and complexity
ii. restrictions on competition and innovation
iii. increased moral hazard.

The main justification for regulation is to reduce systemic risk. However, this increases
costs, reduces competition and increases moral hazard. These problems can be minimised by
appropriately implemented regulations but they will always exist and therefore can be seen
as the price worth paying for low systemic risk.
Safety net arrangements are:
i. lender of last resort liquidity provision
ii. deposit insurance
iii. capital injections in times of crisis.

These arrangements increase moral hazard reduced by penal rates on liquidity support,
coinsurance arrangements (no longer) and supervision by the regulator.

(b) Distinguish between micro- and macro-prudential regulation and give examples
of how macro-prudential regulation might work in practice.
(10 marks)

Reading for this question


See subject guide, Chapter 5, section headed Macro-prudential policy.
Approaching the question
Micro-prudential regulation refers to ensuring the soundness of an individual institution, for
example by ensuring they maintain sufficient capital and good management of liquidity. It
used to be believed that by ensuring that an individual bank did not fail, the contagion
effects of bank failure are reduced and so there is less risk of systemic failure.
Macro-prudential regulation is aimed at preventing failure of the system by identifying and
reducing risks at the system level. In this approach, risks are seen to be partly endogenous.
The greater interconnections between banks through the interbank market or securitisation
create greater risk of systemic failure.
Regulators place greater emphasis on macro-prudential regulation as the lessons of the
banking crisis of 2007/08 have shown that the systemic risk that emerged was due more to
macro-prudential type risks than to imprudent behaviour of individual institutions. Both
types of regulation matter but there is now a greater awareness of the contribution to
systemic risk from interconnections between banks and macro-risks. This has led in the UK
to the formation of the Financial Policy Committee with a specific remit to assess and
recommend policy actions to address macro-prudential risk.
Examples of implementation include introducing limits on mortgage lending to prevent a
housing market bubble, or the counter-cyclical capital buffer introduced through Basel 3.

Section B

Answer one question and no more than two further questions from this section.

Question 5

Freeline is a manufacturing company considering two investment projects (A and


B). Project A will cost $200,000 whilst project B costs $140,000. The following
cashflows are predicted for each project:

8
Examiners commentaries 2016

Cash flows ($)


Project C1 C2 C3 C4 C5
A 40,000 60,000 70,000 60,000 40,000
B 90,000 50,000 15,000 10,000 10,000

where Cn refers to cash flow at end of year n.

(a) Assuming a discount rate of 8 per cent, what is the NPV of the two projects?
Based on the NPV criteria identify which projects you would accept and
explain why.
(5 marks)

Reading for this question


See subject guide, Chapter 7, section headed NPV and the valuation of real assets.
Approaching the question
Project A: NPV = $15,370.74.
Project B: NPV = $12,263.89.
Accept both projects as they are not mutually exclusive and both have positive NPVs.

(b) Examine the factors that a firm might consider in determining the discount rate
to use in the NPV calculation.
(4 marks)

Reading for this question


See subject guide, Chapter 7, section headed NPV and the valuation of real assets.
Approaching the question
Opportunity cost of capital, i.e. next best use of funds (what is being given up if the project
is invested in).
Firms cost of capital WACC.
Risk of project if the project is riskier than projects normally invested in then may need to
increase discount rate.

(c) Calculate the IRR of each project. Using a hurdle rate equal to 8%, identify
which projects you would accept and explain why.
(5 marks)

Reading for this question


See subject guide, Chapter 7, section headed Internal rate of return.
Approaching the question
Project A: IRR approximatively 11%.
Project B: IRR approximatively 13%.
Both have an IRR > hurdle rate therefore both projects should be accepted.

(d) Calculate the payback period for each project. If the company only accepts
projects that pay back within 3 years, identify which projects you would accept
and explain why.
(3 marks)

Reading for this question


See subject guide, Chapter 7, section headed Payback period method.

9
FN1024 Principles of banking and finance

Approaching the question


Payback for A = 3.5 years.
Payback for B = 2 years.
Based on the payback criteria of only accepting projects that payback within 3 years we
should accept project B and reject A.

(e) Compare and contrast the three investment appraisal methods used in parts
(a), (c) and (d).
(8 marks)

Reading for this question


See subject guide, Chapter 7, sections headed NPV and the valuation of real assets,
Internal rate of return and Payback period method.
Approaching the question
NPV and IRR are discounting methods therefore the time value of money is taken into
account. Payback is not a discounting method.
NPV shows the scale of the return.
IRR shows the return on the initial amount invested but with reinvestment of cashflows at
the projects IRR.
IRR has some practical problems, for example may have multiple or no IRR.
Payback is simple to use and takes into account risk (by only considering near-term
cashflows). However, it ignores cashflows after the payback point.

Question 6

(a) You have been asked by a friend to explain Markowitzs modern portfolio
theory (MPT). Outline the key features of MPT and explain the main benefits
of MPT for an investor (the use of diagrams in your answer is encouraged).
(12 marks)

Reading for this question


See subject guide, Chapter 8, sections headed The benefits of diversification and
Mean-standard deviation portfolio theory.
Approaching the question
Main lessons include:
investors look at return and risk when deciding which investments to invest in
diversification reduces risk (unless assets are perfectly positively correlated)
special characteristics of the investor should be reflected in the composition of the
investors portfolio
the riskiness of an asset can only be judged in terms of the overall portfolio
the only way to increase expected return on a well-run portfolio is by increasing risk.
Diagrams expected to show (i.) mean-variance frontier/efficient frontier, (ii.) effects of
changing correlation on the risk of the portfolio.

(b) An investor is considering investing in the following two stocks, X and Y:


Expected return Variance
X 9% 15%
Y 4% 7%

10
Examiners commentaries 2016

The correlation between the two securities returns is 0.4.


Calculate the expected return and standard deviation of the following four
portfolios:
Proportions (%)
Portfolio X Y
1 30 70
2 75 25
3 50 50
4 100 0
(6 marks)

Reading for this question


See subject guide, Chapter 8, section headed Risk and return of a portfolio.
Approaching the question
Portfolio Expected return Variance Standard deviation
1 5.5 3.058514612 1.748860947
2 7.75 7.337959475 2.708866825
3 6.5 3.450612633 1.85758247
4 9 15 3.872983346

(c) Discuss the limitations of the Capital Asset Pricing Model (CAPM).
(7 marks)

Reading for this question


See subject guide, Chapter 8, section headed Theoretical and practical limitations of the
CAPM.
Approaching the question
Limitations can be split into empirical and theoretical.
Theoretical the market portfolio is unobservable therefore not possible to test the EMH
joint hypothesis problem.
Empirical the evidence from testing the CAPM has found that it is not a good model
in terms of explaining expected returns. Other models are better, for example Fama and
French etc.

Question 7

(a) Consider the following stocks:


Stock Gamma is expected to pay an annual dividend of 5 forever.
Stock Zeta is expected to pay a dividend of 4 next year with dividend growth
expected to be 10% per annum for the first three years before settling down to
4% a year thereafter.
If the required return on similar equities is 9%, calculate the price of each stock.
(6 marks)

Reading for this question


See subject guide, Chapter 7, sections headed Dividend discount model and Zero growth
model.
Approaching the question
Gamma:
5
P = = 55.60.
0.09

11
FN1024 Principles of banking and finance

Zeta:
4 4(1.1) 4(1.1)2 [4(1.1)2 (1.04)/(0.09 0.04)]
P = + 2
+ 3
+ = 88.85.
1.09 (1.09) (1.09) (1.09)3

(b) Compare and contrast the characteristics of common stocks and preferred
stocks.
(6 marks)

Reading for this question


See subject guide, Chapter 7, section headed Common stocks.
Approaching the question
Common stocks:
uncertain dividend (variable dividend plus may not be paid)
volatile P
rank lower in event of liquidation
normally grant the right to vote on certain matters.
Preferred stocks:
more certain dividend (fixed dividend but may not be paid)
less volatile P
rank higher than common stocks in event of liquidation
do not normally grant the right to vote on certain matters.

(c) Formally derive and explain the dividend discount model used for the valuation
of common stocks.
(9 marks)

Reading for this question


See subject guide, Chapter 7, section headed Dividend discount model.
Approaching the question
The dividend discount model is based on the principle that the price of a stock is the
present value of all future cash flows received. The stock is assumed to have an infinite life
so the price of the stock is the sum of the present values of all future dividends through to
infinity. The present value of the terminal value at infinity is normally ignored as it is
infinitesimally small.
The formal derivation is expected and is given in the subject guide.

(d) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)

Reading for this question


See subject guide, Chapter 7, section headed Gordon growth model.
Approaching the question
Company must have paid dividends (to determine growth rate).
Assumes that dividend growth is constant (may not be true, may be different rates of
growth over different periods) generally useful for companies that are mature (not
expected to have different growth rates).
Cannot be used if growth rate of dividends > required return on equity.

12
Examiners commentaries 2016

Question 8

(a) Explain interest rate risk as it affects bonds.


(6 marks)

Reading for this question


See subject guide, Chapter 7, section headed Bonds.
Approaching the question
Some answers covered interest rate risk as it affects a bank. However, the question is specific
to bonds.
If market interest rates change then this will affect bond yields. If a bonds yield to maturity
(YTM) is now below market rates, then the price of the bond will fall in order to increase
the YTM. Therefore, there is an inverse relationship between interest rates and bonds.
For an investor not looking to hold the bond to maturity, a change in interest rates will
change the price at which the bond is sold. This can lead to a capital gain or loss for the
investor.
Interest rate changes also affect reinvestment rates for coupons. This is more severe for
longer term bonds. If interest rates fall, then reinvestment income falls.

(b) A US Treasury bond has an annual coupon rate of 5%, par (face) value of
$1,000 and will mature in 5 years. Similar US Treasury bonds have a yield to
maturity of 6%.
Using the data given above and assuming semi-annual coupons, calculate the
value of the US Treasury bond.
(4 marks)

Reading for this question


See subject guide, Chapter 7, section headed Bonds.
Approaching the question
We have:
25 25 1025
P = + 2
+ + = $957.35.
1.03 (1.03) (1.03)10

(c) Calculate the Macaulay duration of the US Treasury bond assuming


semi-annual coupons and a semi-annual discount rate.
(6 marks)

Reading for this question


See subject guide, Chapter 7, section headed Macaulay duration.
Approaching the question
Macaulay Duration = 8.9434 semi-annual periods = 4.4716 years.

(d) Assume annual interest rates increase by 0.5%. Using the duration calculated in
(c), calculate the approximate percentage change in the value of the US bond
assuming annual coupons and annual discount rate?
(4 marks)

Reading for this question


See subject guide, Chapter 7, section headed Modified duration.

13
FN1024 Principles of banking and finance

Approaching the question


We have:
 
4.4716
change in P = 0.005 = 0.021 (i.e. 2.1% fall in P ).
1.06

(e) Demonstrate, using a diagram, why the estimate of a bonds price change
obtained using modified duration will be an underestimate of the percentage
increase in the bond price when yields fall, and an overestimate of the
percentage decrease in the bond price when yields rise.
(5 marks)

Reading for this question


See subject guide, Chapter 7, section headed Modified duration.
Approaching the question
The essential reason why this occurs is because the relationship between a bonds price and
yield is non-linear. However, the method of modified duration assumes a linear relationship.
A suitable diagram showing how this leads to underestimation when yields fall and an
overestimate when yields rise is required.

14
Examiners commentaries 2016

Examiners commentaries 2016


FN1024 Principles of banking and finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 201516. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading


references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions Zone B

Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.

Section A

Answer one question and no more than two further questions from this section.

Question 1

(a) Outline the key features and implications of the Diamond model of banks as
delegated monitors.
(15 marks)

Reading for this question


See subject guide, Chapter 4, section headed A theory on financial intermediaries and
moral hazard: delegated monitoring.

Approaching the question


The Diamond model provides an explanation of why lenders delegate the monitoring of
ultimate borrowers to a specialist lender. Need to set out the model and the conditions
under which such a model works, i.e. many lenders to one borrower and the delegated bank
has a pooled and diversified portfolio of loans and therefore reduces risk for the ultimate
lender.

15
FN1024 Principles of banking and finance

(b) Explain how transaction costs and asymmetric information in credit markets
has changed in the last 20 years and assess the impact of these changes on
financial disintermediation.
(10 marks)

Reading for this question


See subject guide, Chapter 4, section headed The future for financial intermediaries.
Approaching the question
The reduction in transaction costs brought about by the growth of the internet has
encouraged disintermediation at the retail end of banking. Peer-to-peer lending services help
to reduce search and verification costs in particular.
Also, peer-to-peer lenders may produce information (credit reports etc.) and therefore help
to reduce the adverse selection problem that results from asymmetric information.
These developments have reduced the cost and information asymmetry problems associated
with direct lending at the retail end. The growth in direct lending has been modest so far
but, in the medium term, may result in significant loss of business for banks. At the
wholesale end of banking, disintermediation is better established with companies raising
funds directly from markets (generally with the support of a bank operating off the balance
sheet). This can be partly explained by a reduction in asymmetric information (increase in
information) through the growth in credit ratings published by credit rating agencies.

Question 2

(a) Distinguish between weak-form, semi-strong form and strong-form levels of


market efficiency. Discuss the implications of weak, semi-strong and strong form
efficient equity markets for investors in equity securities.
(6 marks)

Reading for this question


See subject guide, Chapter 9, section headed Levels of informational market efficiency.
Approaching the question
Weak form prices fully reflect all historical information.
Semi-strong prices reflect all public information.
Strong prices reflect all public and private information.
Better answers would define what each of these information sets are and explain that the
wider information sets nest the less wide sets (for example, the semi-strong information set
nests the weak).
The implications of weak-form efficiency for investors are that investors cannot use
models/technical analysis based on past data to predict future prices.
The implications of semi-strong efficiency are that investors cannot use fundamental analysis
to try to pick undervalued securities.
The implications of strong form efficiency is that excess returns cannot be obtained by using
private information, for example superior forecasting ability.

(b) Explain what an excess return is in a financial market. Explain why, in an


informationally efficient market, investors are not able to obtain consistent
excess returns.
(6 marks)

16
Examiners commentaries 2016

Reading for this question


See subject guide, Chapter 9, section headed Concept of excess return.
Approaching the question
The excess return is equal to the difference between the actual return on a security and the
equilibrium expected return. In a forward-looking perspective the expected equilibrium
return can be replaced by the optimal forecast return. Where a market is informationally
efficient investors will not be able to make excess returns consistently. Investors may make
excess returns occasionally (as price changes are a fair game and investors may guess the
change sometimes) but they will not predict price changes correctly consistently.

(c) Discuss the evidence relating to under- and over-reaction to information in


equity markets.
(13 marks)

Reading for this question


See subject guide, Chapter 9, section headed Empirical evidence on efficient markets.
Approaching the question
Answers should consider the evidence for under- and over-reaction to information events.
Note that the evidence here relates to the semi-strong hypothesis and evidence supporting
under- or over-reaction is against semi-strong efficiency. Answers should cite studies where
appropriate and explain the strategies for earning excess returns in these scenarios, i.e. a
contrarian strategy when there is over-reaction, and momentum when there is
under-reaction.

Question 3

(a) Distinguish between liquidity and solvency in relation to a bank. Explain how a
bank could become illiquid and how attempts to rectify this situation by the
bank could lead it to become insolvent.
(10 marks)

Reading for this question


See subject guide, Chapter 5, sections headed Bank capital requirements and Monitoring
of liquidity.
Approaching the question
Liquidity refers to having sufficient access to cash or cash equivalents that enable it to meet
its ongoing cash commitments (deposit repayments, new loans, staff salaries etc.).
Solvency refers to the prospective ability of a bank to meet its debts as they fall due.
Liquidity is a short-term concept and solvency is a long-term concept.
A bank can become insolvent (assets < deposit liabilities) as a result of reductions in the
value of assets (for example large loan defaults or write-downs of the value of market traded
assets), or losses from activities.
Capital refers to total assets deposit liabilities (essentially = equity in the bank). Capital
can absorb losses from asset write-downs and therefore keep the bank solvent. The regulator
places emphasis on banks holding sufficient capital to cover expected and unexpected losses.
A bank can become illiquid as a result of a run developing on the bank. This is usually a
consequence of a loss of confidence in a particular bank or because of contagion runs
spread throughout the banking system.
Attempts to rectify a liquidity problem could involve a fire-sale of assets (if markets will not
supply liquidity). Selling assets quickly is likely to yield below book value which could cause
the value of assets to fall below liabilities rendering the bank insolvent.

17
FN1024 Principles of banking and finance

(b) Critically evaluate the methods a bank can use to manage the liquidity risk it
faces.
(15 marks)

Reading for this question


See subject guide, Chapter 7, section headed Liquidity risk management.
Approaching the question
Liquidity risk can be managed using:
i. pooling and diversification of the deposit base
ii. access to external liquidity from markets
iii. keeping existing depositors from leaving in large numbers maintaining a sound bank,
i.e. holding sufficient capital
iv. access to liquidity from the central bank
v. securitisation of assets
vi. asset sales (see dangers of this discussed in part (a)).

Question 4

(a) Discuss the causes, consequences and solutions of the too big to fail problem in
banking.
(15 marks)

Reading for this question


See subject guide, Chapter 5, section headed Too big to fail problem.
Approaching the question
The too big to fail problem is the problem of systemically important banks being too big to
fail if they become insolvent. This was a problem during the 2008 global financial crisis.
The causes include repeal of GlassSteagall in the US and the light regulation for larger
banks under the Basel regime which encouraged banks to become bigger. The main
consequence is moral hazard. Also, we saw in 2008 that given the banks are too big to fail
then governments have to bail out the banks causing higher debt burdens.
The main solutions include (i.) reducing the size of banks, (ii.) increasing the resilience of
too big to fail banks, i.e. increasing capital and liquidity requirements and (iii.) living wills
allowing for easier resolution of failed banks.

(b) Distinguish between micro- and macro-prudential regulation and give examples
of how macro-prudential regulation might work in practice.
(10 marks)

Reading for this question


See subject guide, Chapter 5, section headed Macro-prudential policy.
Approaching the question
Micro-prudential regulation refers to ensuring the soundness of an individual institution, for
example by ensuring they maintain sufficient capital and good management of liquidity. It
used to be believed that by ensuring that an individual bank did not fail, the contagion
effects of bank failure are reduced and so there is less risk of systemic failure.
Macro-prudential regulation is aimed at preventing failure of the system by identifying and
reducing risks at the system level. In this approach, risks are seen to be partly endogenous.

18
Examiners commentaries 2016

The greater interconnections between banks through the interbank market or securitisation
create greater risk of systemic failure.
Regulators place greater emphasis on macro-prudential regulation as the lessons of the
banking crisis of 2007/08 have shown that the systemic risk that emerged was due more to
macro-prudential type risks than to imprudent behaviour of individual institutions. Both
types of regulation matter but there is now a greater awareness of the contribution to
systemic risk from interconnections between banks and macro-risks. This has led in the UK
to the formation of the Financial Policy Committee with a specific remit to assess and
recommend policy actions to address macro-prudential risk.
Examples of implementation include introducing limits on mortgage lending to prevent a
housing market bubble, or the counter-cyclical capital buffer introduced through Basel 3.

Section B

Answer one question and no more than two further questions from this section.

Question 5

Mainline is a manufacturing company considering two investment projects (A and


B). Project A will cost $210,000 whilst project B costs $130,000. The following
cashflows are predicted for each project:

Cash flows ($)


Project C1 C2 C3 C4 C5
A 40,000 70,000 70,000 70,000 40,000
B 70,000 50,000 20,000 10,000 10,000

where Cn refers to cash flow at end of year n.

(a) Assuming a discount rate of 7 per cent, what is the NPV of the two projects?
Based on the NPV criteria identify which projects you would accept and
explain why.
(5 marks)

Reading for this question


See subject guide, Chapter 7, section headed NPV and the valuation of real assets.
Approaching the question
Project A: NPV = $27,586.85.
Project B: NPV = $10,177.27.
Accept both projects as they are not mutually exclusive and both have positive NPVs.

(b) Examine the factors that a firm might consider in determining the discount rate
to use in the NPV calculation.
(4 marks)

Reading for this question


See subject guide, Chapter 7, section headed NPV and the valuation of real assets.
Approaching the question
Opportunity cost of capital, i.e. next best use of funds (what is being given up if the project
is invested in).
Firms cost of capital WACC.
Risk of project if the project is riskier than projects normally invested in then may need to
increase discount rate.

19
FN1024 Principles of banking and finance

(c) Calculate the IRR of each project. Using a hurdle rate equal to the discount
rate, identify which projects you would accept and explain why.
(5 marks)

Reading for this question


See subject guide, Chapter 7, section headed Internal rate of return.
Approaching the question
Project A: IRR = 12%.
Project B: IRR = 11%.
Accept both projects as they both deliver an IRR greater than the hurdle rate of 7% and
they are not mutually exclusive.

(d) Calculate the payback period for each project. Given the firm only accepts
projects that pay back within 3 years, identify which projects you would accept
and explain why.
(3 marks)

Reading for this question


See subject guide, Chapter 7, section headed Payback period method.
Approaching the question
Payback for A: just under 3.5 years.
Payback for B: 2.5 years.
Therefore, accept project B but reject project A.

(e) Compare the reinvestment assumptions of the NPV and IRR methods.
(5 marks)

Reading for this question


See subject guide, Chapter 7, section headed Limits of the IRR method.
Approaching the question
IRR reinvest cash flows at the projects computed IRR.
NPV reinvest cash flows at the discount rate (= market rate).
NPV more realistic as cash flows being invested at a market rate. The IRR may be
unrealistic.

(f ) Explain why the NPV method leads to decisions that are consistent with the
objective of wealth maximization.
(3 marks)

Reading for this question


See subject guide, Chapter 7, section headed NPV and the valuation of real assets.
Approaching the question
NPV determines the scale of returns this is the additional value generated by the
investment project. IRR identifies the % returns. As the firms objective is to maximise
value for the shareholder, then the NPV is in line with this objective.

20
Examiners commentaries 2016

Question 6

(a) You have been asked by a friend to explain Markowitzs modern portfolio
theory (MPT). Outline the key features of MPT and explain the main benefits
of MPT for an investor (the use of diagrams in your answer is encouraged).
(12 marks)

Reading for this question


See subject guide, Chapter 8, sections headed The benefits of diversification and
Mean-standard deviation portfolio theory.

Approaching the question


Main lessons include:
investors look at return and risk when deciding which investments to invest in
diversification reduces risk (unless assets are perfectly positively correlated)
special characteristics of the investor should be reflected in the composition of the
investors portfolio
the riskiness of an asset can only be judged in terms of the overall portfolio
the only way to increase expected return on a well-run portfolio is by increasing risk.

Diagrams expected to show (i.) mean-variance frontier/efficient frontier, (ii.) effects of


changing correlation on the risk of the portfolio.

(b) An investor is considering investing in the following two stocks, X and Y:

Expected return Variance


X 10% 15%
Y 6% 8%

The correlation between the two securities returns is 0.2.


Calculate the expected return and standard deviation of the following four
portfolios:

Proportions (%)
Portfolio X Y
1 25 75
2 75 25
3 50 50
4 100 0

(6 marks)

Reading for this question


See subject guide, Chapter 8, section headed Risk and return of a portfolio.

Approaching the question

Portfolio Expected return Variance Standard deviation


1 7 4.616 2.14846833
2 9 8.116 2.848844831
3 8 4.655 2.157441965
4 9 15 3.872983346

21
FN1024 Principles of banking and finance

(c) Discuss the Roll critique in relation to the empirical testing of the CAPM.
(7 marks)

Reading for this question


See subject guide, Chapter 8, section headed Theoretical and practical limitations of the
CAPM.

Approaching the question


The implementation of the CAPM requires the use of proxies for the market portfolio
because the exact composition of the market portfolio is unobservable. Roll (1977) argues
this makes the CAPM untestable. Given that the proxies used for the market portfolio may
be measured with error, it is not possible to test the CAPM. Therefore, there could be two
alternative situations.
i. It might be the case that the market portfolio is efficient (and hence the CAPM is valid),
but the proxy chosen is inaccurate (and hence the empirical tests incorrectly reject the
CAPM).
ii. The proxy for the market portfolio might be accurate (and hence the empirical tests
validate the CAPM), but the market portfolio itself is not efficient (and hence the
validation is false).

Question 7

(a) Consider the following stocks:


Stock Gamma is expected to pay an annual dividend of 4 forever.
Stock Zeta is expected to pay a dividend of 4 next year with dividend growth
expected to be 9% per annum for the next two years before settling down to 3%
a year thereafter.
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)

Reading for this question


See subject guide, Chapter 7, sections headed Dividend discount model and Zero growth
model.

Approaching the question


Gamma:
4
P = = 50.
0.08
Zeta:
4 4(1.09) 4(1.09)2 [4(1.09)2 (1.03)/(0.08 0.03)]
P = + + + = 88.93.
1.08 (1.08)2 (1.08)3 (1.08)3

(b) Compare and contrast the valuation of common stocks with corporate bonds.
(6 marks)

Reading for this question


See subject guide, Chapter 7, section headed Common stocks.

22
Examiners commentaries 2016

Approaching the question


Common stocks:
uncertain dividend (variable dividend plus may not be paid)
volatile P
rank lower in event of liquidation
normally grant the right to vote on certain matters.
Corporate bonds:
fixed interest, contractual obligation to pay
default risk
rank higher than common stocks in event of liquidation.

(c) Formally derive and explain the dividend discount model used for the valuation
of common stocks.
(9 marks)

Reading for this question


See subject guide, Chapter 7, section headed Dividend discount model.
Approaching the question
The dividend discount model is based on the principle that the price of a stock is the
present value of all future cash flows received. The stock is assumed to have an infinite life
so the price of the stock is the sum of the present values of all future dividends through to
infinity. The present value of the terminal value at infinity is normally ignored as it is
infinitesimally small.
The formal derivation is expected and is given in the subject guide.

(d) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)

Reading for this question


See subject guide, Chapter 7, section headed Gordon growth model.
Approaching the question
Company must have paid dividends (to determine growth rate).
Assumes that dividend growth is constant (may not be true, may be different rates of
growth over different periods) generally useful for companies that are mature (not
expected to have different growth rates).
Cannot be used if growth rate of dividends > required return on equity.

Question 8

(a) Explain the relationship between the price, coupon and yield to maturity of a
bond.
(6 marks)

Reading for this question


See subject guide, Chapter 7, section headed Bonds.

23
FN1024 Principles of banking and finance

Approaching the question


If market interest rates change then this will affect bond yields. If a bonds yield to maturity
(YTM) is now below market rates, then the price of the bond will fall in order to increase
the YTM. Therefore, there is an inverse relationship between interest rates and bonds.
For an investor not looking to hold the bond to maturity, a change in interest rates will
change the price at which the bond is sold. This can lead to a capital gain or loss for the
investor.
Interest rate changes also affect reinvestment rates for coupons. This is more severe for
longer term bonds. If interest rates fall, then reinvestment income falls.
Price and yield to maturity are inversely related YTM is the rate of discount of the future
cash-flows.
If the coupon is less than YTM then price will be below par (selling at a discount).
If the coupon is greater than YTM then price will be above par (selling at a premium).
If the coupon equals YTM then price will equal par.

(b) A US Treasury bond has an annual coupon rate of 4%, par (face) value of
$1,000 and will mature in 5 years. Similar US Treasury bonds have a yield to
maturity of 5%.
Using the data given above and assuming semi-annual coupons, calculate the
value of the US Treasury bond.
(4 marks)

Reading for this question


See subject guide, Chapter 7, section headed Bonds.
Approaching the question
We have:
20 20 1020
P = + 2
+ + = $956.24.
1.025 (1.025) (1.025)10

(c) Calculate the Macaulay duration of the US Treasury bond assuming annual
coupons and an annual discount rate.
(6 marks)

Reading for this question


See subject guide, Chapter 7, section headed Macaulay duration.
Approaching the question
Macaulay Duration = 9.139 semi-annual periods = 4.5695 years.

(d) Assume annual interest rates increase by 0.5%. Using the duration calculated in
(c), calculate the approximate percentage change in the value of the US bond
assuming annual coupons and annual discount rate?
(4 marks)

Reading for this question


See subject guide, Chapter 7, section headed Modified duration.
Approaching the question
We have:
 
4.5695
change in P = 0.005 = 0.022 (i.e. 2.2% fall in P ).
1.05

24
Examiners commentaries 2016

(e) Explain why the estimate of a bonds price change obtained using modified
duration will be an underestimate of the percentage increase in the bond price
when yields fall, and an overestimate of the percentage decrease in the bond
price when yields rise.
(5 marks)

Reading for this question


See subject guide, Chapter 7, section headed Modified duration.
Approaching the question
The essential reason why this occurs is because the relationship between a bonds price and
yield is non-linear. However, the method of modified duration assumes a linear relationship.
A suitable diagram showing how this leads to underestimation when yields fall and an
overestimate when yields rise is required.

25