This Paper Is Not To Be Removed From The Examination Halls

This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON 279 0024 ZA

996 D024 ZA
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diploma in Economics and Access Route for Students in the
External Programme
Principles of Banking and Finance
Friday, 23rd May 2008 : 10.00am to 1.00pm
Candidates should answer FOUR of the following TEN questions: ONE from Section A,
ONE from Section B and TWO further questions from either section. All questions carry
equal marks.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.
© University of London 2008

UL08/031 PLEASE TURN OVER
D04 Page 1 of 5
SECTION A
Answer one question from this section and not more than a further two questions. (You are
reminded that four questions in total are to be attempted with at least one from Section B.)
1. (a) What are the differences between commercial banks, savings and loan
associations, and credit unions? (9 marks)
(b) Describe the historical evolution of the savings and loan associations in the United
States. (7 marks)
(c) Explain how securities firms differ from investment banks. (4 marks)
(d) What has been the two main reactions of banks to the decline in their traditional
role? (5 marks)
2. (a) What is the difference between primary and secondary markets? What are the
main functions of secondary markets? (6 marks)
(b) What is the difference between money markets and capital markets? (4 marks)
(c) Explain how and why a stock market decline is a factor that causes financial
crises. (5 marks)
(d) Explain the main features of the financial crises in emerging market countries:
Mexico (1994-1995) and East Asia (1997-1998). (10 marks)
3. (a) What are the mechanisms of deposit insurance adopted in the USA and in the
UK? (4 marks)
(b) What are the methods used to handle a failed bank in the USA? (6 marks)
(c) Identify the possible solutions to the moral hazard problem arising from a system
of 100 per cent insurance of deposits. (6 marks)
(d) What is the solution to the moral hazard problem arising from the ‘too big to fail’
policy? (4 marks)
(e) What is the CAMEL system? (5 marks)
UL08/031
D04 Page 2 of 5
4. (a) What is meant by market risk and operational risk in relation to banking?
(6 marks)
(b) What are the reasons for the increased concern of regulators in relation to market
risk and operational risk in recent years? (6 marks)
(c) What is meant by credit risk? (5 marks)
(d) What forms of credit rationing currently exist? (8 marks)
5. (a) What is meant by liquidity risk? (4 marks)
(b) List the mechanisms used at the macroeconomic level to limit the possible
contagion of the liquidity problems. (3 marks)
(c) Identify typical aspects of a banks capital requirement as imposed by regulators.

(5 marks)
(d) Explain the risk-assets ratio under Basel 1 and discuss the main problems that
have been identified with it. How will it change under Basel 2? (13 marks)
SECTION B
reminded that four questions in total are to be attempted with at least one from Section A.)
6. (a) What is a factor model? (6 marks)
(b) Consider two stocks (A and B), whose returns are determined by the following
two-factor model:
R A = 0.03 + 0.9 F1 + 0.7 F2 + ε A ; R B = 0.06 + 0.8F1 + 0.6 F2 + ε B
Calculate the return of an equally weighted portfolio of the two assets: 50% in
stock A and 50% in stock B. (4 marks)
(c) What are the assumptions under the APT? What is the expected risk premium?
(11 marks)
(d) What are the main advantages/disadvantages of the APT in comparison to the
CAPM? (4 marks)
UL08/031
D04 Page 3 of 5
7. Consider the following information about two stocks, Red and Black:
Stock Expected return Variance

Red 8% 13
Black 3% 5
The correlation between the two securities returns is 0.3
(a) Calculate the expected return and standard deviation of the following three
portfolios:
Portfolio proportions (%)

Portfolio Red Black
A 30 70
B 75 25
C 100 0
(4 marks)
(b) How can investors identify the best set of efficient portfolios of common
stocks? What does ‘best’ mean? (9 marks)
(c) Under the CAPM framework, what is the tangency portfolio? What is the security
market line? Support your answer with graphical evidence. (3 marks)
(d) Discuss the theoretical and practical limitation of the CAPM. (9 marks)
8. (a) What is meant by interest rate risk? What are the two main effects of interest rate
risk? (5 marks)
(b) Explain how a bank can use income gap analysis to manage interest rate risk.
Critically discuss the problems associated with income gap analysis. (8 marks)
(c) Consider the following balance sheet of Bank Plus:
Assets (£) Duration Liabilities (£) Duration

Variable-rate mortgages 160 8.1 Money market deposits 350 1.9
Fixed-rate mortgages 140 5.1 Savings deposits 280 2.3
Commercial loans 560 3.5 Variable-rate CD (> 1 year) 120 3.1
Physical capital 240 Equity 350
Total 1100 Total 1100
What will be the change in net interest income at the year end if interest rates
decreased by 1 per cent, from 4 to 3 per cent? Explain using basic gap analysis.
(Use the following assumptions on the runoff of cash flows: fixed-rate mortgages
repaid during the year: 25 per cent; proportion of savings deposits and variable-
rate CD that are rate-sensitive: 25 per cent). (8 marks)
(d) What is the duration gap for Bank Plus? (4 marks)
UL08/031
D04 Page 4 of 5
9. Consider the following two financial assets:
(1) a UK stock is expected to pay a dividend of £50 next year with dividend growth
expected to be 2% per annum thereafter;
(2) a UK corporate bond with an annual coupon rate of 4.75%, par (face) value of
£100, and maturity in 2 years time.
(a) If the required return on similar UK equities is 11% and on similar UK bonds is
7%, calculate the value the UK stock and of the UK bond. (4 marks)
(b) Using the data given above and assuming an annual discount rate, calculate the
duration of the UK bond. (5 marks)
(c) Why are capital gains and losses apparently absent from the dividend discount
model used for the valuation of common stocks? (9 marks)
(d) What are the factors that affect Macaulay duration? (7 marks)
10. (a) Theoretically derive the efficient market hypothesis. (10 marks)
(b) Explain and theoretically derive the concept of excess return and the optimal
forecast of return using all available information. (9 marks)
(c) Discuss the joint hypothesis problem. (6 marks)
END OF PAPER
UL08/031
D04 Page 5 of 5
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON 279 0024 ZB

996 D024 ZB
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diploma in Economics and Access Route for Students in the
External Programme
Principles of Banking and Finance
Friday, 23rd May 2008 : 10.00am to 1.00pm
Candidates should answer FOUR of the following TEN questions: ONE from Section A,
ONE from Section B and TWO further questions from either section. All questions carry
equal marks.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.
© University of London 2008

UL08/032 PLEASE TURN OVER
D04 Page 1 of 5
SECTION A
reminded that four questions in total are to be attempted with at least one from Section B.)
1. (a) What are the differences between commercial banks, savings and loan
(b) Describe the historical evolution of the savings and loan associations in the United
States. (7 marks)
(c) Explain how long-term mutual funds differ from short-term mutual funds.
(4 marks)
(d) What has been the two main reactions of banks to the decline in their traditional
role? (5 marks)
2. (a) What is the difference between primary and secondary markets? What are the
main functions of secondary markets? (6 marks)
(b) What is the difference between money markets and capital markets? (4 marks)
(c) Explain how and why a stock market decline is a factor that causes financial
crises. (5 marks)
(d) Explain the main features of the financial crises in emerging market countries:
Mexico (1994-1995) and East Asia (1997-1998). (10 marks)
3. (a) What are the mechanisms of deposit insurance adopted in the USA and in the
UK? (4 marks)
(b) What are the methods used to handle a failed bank in the USA? (6 marks)
(c) Identify the possible solutions to the moral hazard problem arising from a system
of 100 per cent insurance of deposits. (6 marks)
(d) What is the solution to the moral hazard problem arising from the “too big to fail”
policy? (4 marks)
UL08/032
D04 Page 2 of 5
4. (a) What is meant by market risk and operational risk in relation to banking?
(6 marks)
(b) What are the reasons for the increased concern of regulators in relation to market
risk and operational risk in recent years? (6 marks)
5. (a) What is meant by liquidity risk? (4 marks)
(b) List the mechanisms used at the macro-economic level to limit the possible
contagion of the liquidity problems. (3 marks)
(c) Discuss the monitoring of liquidity in banking, with particular reference to the
UK. (5 marks)
(d) Explain the risk-assets ratio under Basel 1 and discuss the main problems that
have been identified with it. How will it change under Basel 2? (13 marks)
SECTION B
reminded that four questions in total are to be attempted with at least one from Section A.)
6. (a) What is a factor model? (6 marks)
(b) Consider two stocks (X and Y), whose returns are determined by the following
two-factor model:
R X = 0.02 + 0.8F1 + 0.4 F2 + ε X ; RY = 0.03 + 0.7 F1 + 0.3F2 + ε Y
Calculate the return of a portfolio with the following weights of the two assets:
25% in stock X and 75% in stock Y. (4 marks)
(c) What are the assumptions under the APT? What is the expected risk premium?
(11 marks)
(d) What are the main advantages/disadvantages of the APT in comparison to the
CAPM? (4 marks)
UL08/032
D04 Page 3 of 5
7. Consider the following information about two stocks, Yellow and Blue:

Yellow 7% 12
Blue 4% 6
The correlation between the two securities returns is 0.4.
(a) Calculate the expected return and standard deviation of the following three
portfolios:
Portfolio Proportions (%)

Portfolio Yellow Blue
1 30 70
2 75 25
3 100 0
(4 marks)
(b) How can investors identify the best set of efficient portfolios of common stocks?
What does ‘best’ mean? (9 marks)
(c) Under the CAPM framework, what is the tangency portfolio? What is the security
market line? Support your answer with graphical evidence. (3 marks)
8. (a) What is meant by interest rate risk? What are the two main effects of interest rate
risk? (5 marks)
(b) Explain how a bank can use income gap analysis to manage interest rate risk.
Critically discuss the problems associated with income gap analysis. (8 marks)

Commercial loans 5600 3.5 Variable-rate CD (>1 year) 1200 3.1
What will be the change in net interest income at the year end if interest rates
decreased by 0.5 per cent, from 4 to 3.5 per cent? Explain using basic gap
analysis. (Use the following assumptions on the runoff of cash flows: fixed-rate
mortgages repaid during the year: 25 per cent; proportion of savings deposits and
variable-rate CD that are rate-sensitive: 25 per cent). (8 marks)
UL08/032
D04 Page 4 of 5
9. Consider the following two financial assets:
(1) a US stock is expected to pay a dividend of $150 next year with dividend growth
expected to be 2.5% per annum thereafter;
(2) a US corporate bond with a annual coupon rate of 5%, par (face) value of $1000,
and maturity in 2 years time.
(a) If the required return on similar US equities is 10% and on similar US bonds is
7%, calculate the value the US stock and of the US bond. (4 marks)
(b) Using the data given above and assuming annual discount rate, calculate the
duration of the US bond. (5 marks)
(c) Why are capital gains and losses apparently absent from the dividend discount
model used for the valuation of common stocks? (9 marks)
10. (a) Theoretically derive the efficient market hypothesis. (10 marks)
(b) Explain and theoretically derive the concept of excess return and the optimal
forecast of return using all available information. (9 marks)
END OF PAPER
UL08/032
D04 Page 5 of 5
Examiners’ commentaries 2008
Examiners’ commentary 2008
24 Principles of banking and finance
General remarks
Learning outcomes
At the end of this unit and having completed the essential reading and
activities you should be able to:
• 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 or 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.
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 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.
1
All the questions asked in the examination 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
readings. You are reminded that the examination of this unit may test
any aspect of the syllabus.
What are the examiners looking for?

This is a foundation unit 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, 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 spending a few
minutes organising your answer before you begin writing, and by not
trying to fit a standard answer to the question.
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. Therefore Examiners 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 (e.g. question
8), alternative hypothesis are equally fine if you have been consistent
in the different parts of the question: in these cases the Examiners are
flexible in the allocation of marks.
Examination paper for 2009

There will be a change to the number of questions in the examination
paper for 2009. The total number of question for Section A will be four
and the total number of question for Section B will be four. Candidates
should answer FOUR of the EIGHT questions: ONE from Section A,
ONE from Section B and TWO further questions from either section.
All questions carry equal marks.
There will be no change to the format and style of the examination
paper for 2009: Section A contains general questions which cover the
syllabus. Section B questions test application: as such they generally
include both numerical and essay-based parts.
2
Specific comments on questions Zone A

A note on reading
It is assumed that where a reference is made here to sections of the
subject guide that candidates will also follow through to the essential
and further reading recommended in those sections of the subject
guide.
SECTION A
Question 1
(a) What are the differences between commercial banks, savings and loan
Students may like to refer to pp.14–15 of the subject guide.
A good way to tackle this question would be to critically analyse
depository institutions. One mark was awarded for the emphasis on
the need to consider all these financial institutions as depository
institutions (intermediaries with a significant proportion of their funds
derived from customer deposits).
The Examiners would then be expecting a balanced, essay-format
discussion of these three financial institutions (examiners consider
excellent candidates as those who are able to describe these
institutions by using the appropriate technical terms):
• Commercial banks – they accept deposits (liabilities) to make loans
(assets) and to buy government securities (1 mark). Candidates
should then describe the possible types of deposits and loans. Up to
2 marks were awarded for a detailed and technical description.
• Savings and loan associations (S&Ls) – historically they have
concentrated mostly on residential mortgages by acquiring funds
primarily through savings deposits (1 mark). To overcome the
effects of rising rates and disintermediation, in the early 1980s
S&Ls expanded their deposit-taking (i.e. to offer checking
accounts) and asset-investment powers (i.e. to make consumer and
commercial loans) (1 mark).
• Credit unions – they are non-profit institutions mutually organised
and owned by their members, who have to belong to a particular
group (1 mark). Their primary objective is to satisfy the depository
and lending needs of their members: the members’ deposits are
used to provide loans to other members, and earnings from these
loans are used to pay higher rates to member depositors (1 mark).
An outstanding answer would finally discuss the relative market share
of these institutions in the USA. Up to 2 marks were awarded for this.
1
(b) Describe the historical evolution of the savings and loan associations
in the United States. (7 marks)
Students may like to refer to pp.14−15 of the subject guide.
This part of the question requires candidates to focus on one of the
depository institutions analysed in part a): S&Ls. The Examiners would
award marks for candidates who constructed clear paragraphs which
made the following points:
In the 1950s and 1960s, S&Ls grew much more rapidly than
commercial banks (1 mark).
However, between 1979 and 1982 the change in the monetary policy
of the Fed determined a dramatic surge in interest rates (1 mark).
A good answer would then go on to discuss the effects for S&Ls of the
increase in the short-term rates:
a) S&Ls had negative interest spreads (interest income minus interest
expense) in funding the fixed-rate long-term residential mortgages (1
mark).
b) S&Ls had to pay more competitive interest rates on savings deposits
(1 mark).
A very good answer would discuss the actions taken to overcome the
effects of rising rates and disintermediation − in the early 1980s the
Congress passed acts allowing S&Ls to expand the deposit-taking (i.e.
to offer checking account) and asset-investment powers (i.e. to make
consumer and commercial loans) (1 mark).
An outstanding answer would finally discuss the consequences of the
new business model of S&Ls. For many S&Ls the new powers created
safer and more diversified institutions. But, for a small – but significant
– group of S&Ls, they created an opportunity to take more risk in the
attempt to improve profitability. As a result a large number of S&Ls
failed at the end of the 1980s and a new legislation – the FIRREA of
1989 – was adopted. (Up to 2 marks were awarded for the discussion
of these consequences).
(c) Explain how securities firms differ from investment banks. (4 marks)
The Examiners would expect candidates to begin with a clear
definition of these two types of investment intermediaries, focusing on
the differences between the two:
• Investment banks assist corporations or governments in the issue
of new debt or equity securities. Investment banking includes the
origination, underwriting and placement of securities in primary
financial markets (primary and secondary markets are discussed
next). It also includes corporate finance activities (such as advising
on mergers and acquisitions) (1 mark).
• Securities firms assist in the trading of existing securities in the
secondary markets. There are two main categories of securities
firms: brokers (agents of investors who match buyers with sellers
of securities), and dealers (agents who link buyers and sellers by
buying and selling securities) (1 mark).
2
Up to 2 marks were awarded for the explanation of the types of

securities firms and investment banks and for providing the names of
the major US players for each type.
(d) What has been the two main reactions of banks to the decline in their
traditional role? (5 marks)
Students may like to refer to p.61 of the subject guide.
The Examiners would award marks for candidates who constructed
clear paragraphs which made the following points:
• the growth in off balance sheet activities – which produce fee
income instead of interest income (2 marks)
• the expansion into new riskier areas of lending. A good answer
would illustrate this by focusing on the problems of the Japanese
banking system in the 1990s (2 marks).
Excellent answers would also refer to the stronger focus on trading
activities (1 mark).
Question 2
(a) What is the difference between primary and secondary markets? What
are the main functions of secondary markets? (6 marks)
definition of primary and secondary markets. A primary market is a
financial market in which new issues of financial securities (both bonds
and stocks) are sold to initial buyers (1 mark). A secondary market is
one in which securities that have been previously issued can be resold
(1 mark).
Then candidates should go on to discuss this in more detail to show
that they understand the different functions of primary and secondary
markets.
Primary markets facilitate corporations to acquire new financing, but
most of the trading takes place in the secondary markets (1 mark).
Secondary markets make financial securities more liquid (1 mark).
An outstanding answer would emphasise that the improvement in
liquidity makes securities more desirable to investors, and thus easier
for the firm to sell them in the primary market – 1 mark was awarded
for such a specification. Moreover, secondary markets set the price of
the securities the firm sells in the primary market (1 mark).
(b) What is the difference between money markets and capital markets?
(4 marks)
In a similar way to part (a), part (b) requires candidates to illustrate
the difference between two types of markets: money markets and
capital markers.
The Examiners would expect outstanding answers to identify clearly
the parameter according to which the distinction can be made − the
maturity of the securities traded. (1 mark was awarded for a correct
identification of this parameter).
3
Candidates should then go on to discuss in detail the characteristics of

money and capital markets:
• Money markets are financial markets where only short-term debt
instruments (maturity of less than one year) are traded. Money
markets are mainly wholesale markets (large size transactions)
where firms and financial institutions manage their short-term
liquidity needs (1.5 marks were awarded).
• Capital markets are markets in which long-term securities are
traded. Candidates were also expected to list the types of long-
term instruments. Capital markets securities are often held by
financial intermediaries, such as mutual funds, pension funds and
insurance companies (1.5 marks were awarded).
(c) Explain how and why a stock market decline is a factor that causes
financial crises. (5 marks)
In part (c) candidates are required to link their knowledge on financial
markets to financial crises: specifically they are expected to explain
how and why a stock market decline is a factor that causes financial
crises.
A sharp decline in the stock market is one of the possible reasons for a
serious deterioration in firms’ balance sheets, which in turn can
provoke a financial crisis. Given that share prices are the valuation of
firms’ net worth, a stock market decline implies a reduction in the
firms’ net worth (2 marks).
The lower value of net worth implies a lower value of the collateral,
which is property promised to the lender if the borrower defaults (1
mark).
The decline in the net worth makes banks less willing to lend because
they are less protected by these collaterals, and this causes a reduction
in investments and aggregate economic activities (1 mark).
In addition, the decline in net worth induces firms to take more risky
investments, as they lose less if they have to default. As a consequence,
lending is less attractive for banks, and thus there is a reduction in
investments and aggregate economic activities (1 mark).
(d) Explain the main features of the financial crises in emerging market
countries: Mexico (1994-1995) and East Asia (1997-1998). (10 marks)
Students may like to refer to p.396 of Mishkin and Eakins.
Part (d) requires candidates to discuss real cases of financial crises in
emerging marker countries. The skill candidates are expected to
demonstrate is the ability to produce an essay with clear paragraphs
for each of the steps describing the features of these crises. Candidates
should not focus too much on specific steps, but should provide the
overall picture with a focus on the links between the different steps.
Candidates could begin with a temporal location of financial crises:
The Mexican crises started in December 1994 and the East Asian crises
started in July 1997; Mexico began to recover in 1996, East Asian
countries in 1999.
4
An outstanding answer would then state that because of the different

institutional features of emerging-market countries’ debt markets, the
sequence of events in the Mexican and East Asian crisis is different to
what occurred in the US in the nineteenth and early twentieth
centuries (0.5 marks).
Candidates should then go on with the discussion of the sequence of
events in the Mexican and East Asian financial crises.
Several factors led up to both financial crises:
• Deterioration in banks’ balance sheets because of the increasing
loan losses due to weak supervision by bank regulators and a lack
of expertise in screening and monitoring borrowers at banks. This
caused an erosion of banks’ net worth (capital) (1 mark).
• Increase in interest rates abroad and internally (factor participating
to the Mexican but not East Asian crises, consistent with the US
experience). The rise in interest rates added to increased adverse
selection in Mexican financial markets because it made it more
likely that the parties willing to take on the most risk would seek
loans (1 mark).
• Stock market decline and increase in uncertainty (consistent with
the US experience) (0.5 mark).
The above factors worsened adverse selection and moral hazard
problems. On the one hand, it became harder to screen out good and
bad borrowers. On the other hand, the decline in capital decreased the
value of firms’ collateral and increased their incentives to make risky
investments because there was less equity to lose if the investments
were unsuccessful (1 mark).
At this point speculative attacks developed in the foreign exchange
markets, plunging these countries into a full-scale crisis. This in turn
worsened adverse selection and moral hazard problems (1 mark).
The institutional structure of debt markets in Mexico and East Asia
now interacted with the currency devaluations to push the economies
into full-fledged financial crises. This happened because so many firms
in these countries had debt denominated in foreign currencies, and the
depreciation of their currencies resulted in increases in their
indebtedness in domestic currency terms, even though the value of
their assets remained unchanged (1 mark).
The collapse of currencies also led to a rise in actual and expected
inflation rates in these countries, and in market interest rates. The
increase in interest payments caused reductions in households’ and
firms’ cash flow, which led to further deterioration in their balance
sheet. Given that debt contracts have very short duration in these
countries (typically less than one month), the effect on cash flows was
substantial (1 mark).
The resulting economic activity decline and the deterioration in
balance sheets led to a worsening banking crisis. The problems of firms
and households meant that many of them were no longer able to pay
off their debts, resulting in substantial losses for banks (1 mark). Even
more problematic for banks was that they had many short-term
5
liabilities denominated in foreign currencies, and the sharp increase in

the value of these liabilities after the devaluation led to a further
deterioration in the banks’ balance sheet (1 mark). Under these
circumstances, the banking system would have collapsed in the
absence of a government safety net. With the assistance of the
International Monetary Fund these countries were in some cases able
to protect depositors and avoid bank panic (1 mark).
Question 3
(a) What are the mechanisms of deposit insurance adopted in the USA and
in the UK? (4 marks)
This question focuses on several aspects of banking regulation. In part
(a) candidates are expected to discuss deposit insurance schemes
adopted in the USA and in the UK.
An outstanding answer should begin with a discussion on the rationale
of deposit insurance. To avoid runs on banks and bank panics,
governments have established deposit insurance schemes to provide
protection for depositors. Under these schemes the bank pays a
premium to a deposit insurance company, such as the Federal Deposit
Insurance Corporation (FDIC) in the USA, and in exchange its
depositors have their deposit insured up to a fixed limit in case the
bank fails (1 mark).
Candidates should then move to the analysis of the modalities in which
deposit insurance is adopted in the USA and in the UK:
• Insurance may be compulsory (all the members of the Federal
Reserve System in the USA) or simply voluntary (non-members if
they meet the FDIC admission criteria) (1 mark).
• Insurance’s limit may differ widely (from $100,000 in the USA to
£18,000 in the UK) (1 mark).
• Insurance may cover different percentage of deposits (100 per cent
of deposits up to a value of $100,000 at a bank in the USA, 90 per
cent of deposits to a customer up to a maximum of £18,000 in the
UK) (1 mark).
(b) What are the methods used to handle a failed bank in the USA? (6
marks)
The Examiners would expect excellent answers to discuss the two
primary methods to handle a US failed bank by making the following
points:
• Payoff method: the FDIC pays off deposits up to the $100,000
insurance limit. After the bank’s liquidation, then FDIC lines up
with other creditors of the bank and receives its share of the
proceeds from the liquidated assets. Typically, account holders
with deposits in excess of the $100,000 limit get back more than
90 per cent (but the process can take several years). (Up to 3
marks were awarded for making these points).
6
• Purchase and assumption method: the FDIC finds a merger partner

who takes over all the deposits of the failed bank (not just those
under $100,000) so that no depositors lose any money. This
method has been used to implement the FDIC’s policy called ‘too
big to fail’: the big insolvent banks would get a large infusion of
capital from the FDIC, who then would find a merger partner to
take over the insolvent banks and their deposits. Originally the
policy was limited to the 11 largest US banks, but has now been
extended to big banks in general. (Up to 3 marks were awarded for
making these points).
(c) Identify the possible solutions to the moral hazard problem arising
from a system of 100 per cent insurance of deposits. (6 marks)
The Examiners would expect candidates to make a link with point (a),
where the 100 per cent deposit insurance scheme was introduced.
Specifically, candidates are now required to discuss the solutions to the
moral hazard problem associated to such a scheme.
An outstanding answer would be structured as an essay-style answer
which covered the following points on the two possible solutions to the
moral hazard problem:
• ‘Least cost’ approach, as adopted in the USA in 1991 by
introducing the Federal Deposit Insurance Corporation
Improvement Act (FDICIA) (1 mark). Riskier banks are required to
pay higher insurance premiums to the FDIC. If there is a system of
risk-based deposit insurance premiums then banks will have an
incentive to reduce these risks. (Up to 2 marks for the description
of this solution).
• ‘Co-insurance’ approach, as adopted in the UK (1 mark). The
amount of deposit insured under the scheme would be less than
100 per cent (in the UK 90 per cent up to a maximum of £18,000).
Depositors have greater incentives to monitor (because of the
threat of losing some of the deposits), but the percentage lost has
to be kept to a (low) level that gives the incentive not to join a run.
Note that banks pay a flat rate premium linked to their amount of
deposits. (Up to 2 marks for the description of this solution).
(d) What is the solution to the moral hazard problem arising from the ‘too
big to fail’ policy? (4 marks)
The examiners would expect candidates to make a link with point (b),
where the ‘too big to fail’ policy was introduced. Specifically,
candidates are now required to discuss the solution to the moral
hazard problem associated with such a policy.
An outstanding answer would state that the solution has been a
substantial limitation of the use of the ‘too big to fail’ policy under the
Federal Deposit Insurance Corporation Improvement Act (FDICIA). The
FDIC must now close failed banks using the ‘least cost’ approach, thus
it is more likely that uninsured depositors will suffer losses. (Up to 2
marks were awarded for making these points).
7
This limitation has been associated with a prompt corrective action

provision. Banks are now classified into five groups based on their
capital and the FDIC has to take specific actions if a bank falls out of
the ‘well capitalised group’. (Up to 2 marks were awarded for making
these points).
The Examiners would expect candidates first to clarify that the CAMEL
system is an internationally recognised framework used by bank
examiners to evaluate banks (1 mark).
A good answer should then explain how the CAMEL system works −
banks are scored on a scale of 1 (the best) to 5 (the worst) assessing
five areas (1 mark): capital adequacy, asset quality, management
quality, earnings’ performance, and liquidity (2 marks). The Examiners
equally awarded marks to candidates referring to the CAMELS system.
Finally excellent answers should refer to the consequences for banks if
the CAMEL rating is sufficiently low − regulators can take formal
actions to alter bank’s behaviour (or even close the bank) (1 mark).
Question 4
(a) What is meant by market risk and operational risk in relation to
banking? (6 marks)
definition of market risk – the risk related to the uncertainty of a bank’s
earnings on its trading portfolio caused by changes in the market
conditions, such as interest rates, equity return, exchange rates, market
volatility, and market liquidity (1 mark). Outstanding answers would
explain that market risk is associated with active trading of assets and
liabilities (and derivatives) rather than holding them over longer
horizons (1 mark). Specifically, it is the incremental risk incurred by
banks when interest rates, foreign exchange and equity return risks are
combined with an active trading strategy, especially over short
horizons (1 mark).
To define operational risk candidates could phrase the definition
provided by the Basel Committee on Bank Supervision, ‘the risk of
direct or indirect loss resulting from inadequate or failed internal
processes, people, and systems or from external events’. Outstanding
answers would note that under Basel 2 (effective from the end of
2006), operational risk will be a new type of risk to be considered in
determining banks’ capital requirements (2 marks).
(b) What are the reasons for the increased concern of regulators in
relation to market risk and operational risk in recent years? (6 marks)
The Examiners expect candidates to state that the greater importance
for market risk is due to increase in trading activities of banks as banks
have sought other sources of income to replace the income from
traditional intermediation business (2 marks).
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A good answer would then add that this greater importance has led
regulators to introduce an additional capital requirement in the market
risk amendment (1997) (1 mark).
Also, the greater importance of operational risk is recognised by
additional capital requirement proposed under Basel 2 (2 marks).
Outstanding answers would also refer to the failure of Barings to
illustrate both market risk (loss due to trading activities) and
operational risk (poor operating procedures) (1 mark for this, or for
similar examples).
Here candidates are expected to define another type of risk in banking:
credit risk – the risk that the promised cash flows from loans and
securities held by banks may not be paid in full (1 mark).
A good answer makes clear that credit risk is related either to the risk
of default of a specific borrower, or to the risk of delay in servicing the
loan (1 mark). In either case, the present value of the bank’s assets
declines, and this undermines the solvency of the bank (1 mark).
The Examiners would also expect good candidates to mention that
credit risk is the most important risk connected with the assets held by
a bank (1 mark).
Excellent candidates would finally state that credit risk is affected by
screening and monitoring, credit rationing, use of collateral,
endorsement and diversification (1 mark).
A good answer would begin with the explanation of the two forms of
credit rationing:
1. A bank refuses to make a loan of any amount to a borrower, who is
willing to pay even a higher interest rate (1 mark).
2. A bank makes the loan but reduces the size of the loan to a lower
amount than the one the borrower requires (1 mark).
An outstanding answer would then relate each form of credit rationing
to adverse selection and moral hazard. Specifically, the following
points should be made:
• The first type of credit rationing is justified by the adverse selection
problem. The loan rate should consist of a market rate, a risk
premium (the riskier the borrower, the higher the risk premium),
and administration costs. However, because of adverse selection, a
borrower may agree to pay a higher rate because she/he knows
that her/his default probability is high. High loan rates may
increase the probability of loan default. The bank would therefore
not make any loan (even at the higher rate). (Up to 3 marks for
providing this explanation).
• The second type of credit rationing aims to solve the moral hazard
problem. The larger the loan, the higher the incentive of the
borrower to engage in activities that increase the default
9
probability. As a consequence, in retail markets, banks normally

quote one loan rate (or a very narrow range of rates) and then
restrict the amount individuals or firms can borrow according to
some criteria (such as wealth). (Up to 3 marks for providing this
explanation).
Question 5
(a) What is meant by liquidity risk? (4 marks)
Here we have another question on the risks faced by banks, and also
on the relevant regulatory mechanisms introduced to limit these risks.
definition of liquidity risk as the risk that an unexpected massive
withdrawal by depositors (and the consequent obligation for the bank
to make payments) may oblige the bank to liquidate assets in a very
short period of time and at low prices (1 mark). Outstanding answers
should point out that this type of risk comes from the specificity of the
demand deposit contract: depositors are allowed to demand their
money at any time (1 mark).
Excellent answers would then briefly comment on the different
implications of liquidity management at the micro- and macro-
economic levels. At the micro-economic level, liquidity management is
not fundamentally different for banks than for other industrial and
commercial firms (1 mark). However, at macro-economic level, the
situation is different because the liquidity problems of a single bank
can affect other banks very quickly, and give rise to so-called systemic
risk (1 mark).
(b) List the mechanisms used at the macroeconomic level to limit the
possible contagion of the liquidity problems. (3 marks)
Students may like to refer to page 86–87 of the subject guide.
Following from the macroeconomic implications of liquidity
management discussed in part a), candidates are expected to list the
mechanisms used to limit systemic risk. Three mechanisms are used:
• deposit insurance (1 mark)
• lender of last resort (1 mark)
• capital requirements (1 mark).
(c) Identify typical aspects of a banks capital requirement as imposed by
regulators. (5 marks)
The Examiners would expect candidates to begin with the motivation
behind the bank capital requirements imposed by bank regulations – to
reduce the bank’s incentive to take risks (1 mark).
Candidates should then list the four mechanisms most widely used:
• restriction on holding risky assets (1 mark)
• limitation on the amount of loans, in particular the categories or
the individual borrowers (1 mark)
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• reduction of the risk of the loan portfolio by diversification (1

mark)
• maintenance of a sufficient level of bank capital (1 mark).
(d) Explain the risk-assets ratio under Basel 1 and discuss the main
problems that have been identified with it. How will it change under
Basel 2? (13 marks)
Candidates should begin by showing that they understand that risk-
assets ratio is the ration of capital to risk adjusted assets (1 mark).
Candidates are then expected to explain the risk-assets ratio under
Basel 1. The Examiners would be expecting points to be made such as:
• Capital is divided into tier 1 (issued share capital and disclosed
accumulated reserves) and tier 2 (medium- and long-term
subordinated debt + general provisions and unpublished profits)
(2 marks are awarded for this).
• The value of each category of asset is risk adjusted in a crude way
according to its exposure to credit risk. Risk weights of 0, 20%,
50% and 100% are used. Off balance sheet items are also
converted to credit equivalents and then risk weighted (3 marks).
• An additional 2 marks are awarded if examples are given. The
minimum ratio required by Basil 1 is 8% (1 mark).
• Individually negotiated with regulator (1 mark).
Candidates should then discuss the main problems associated to the
risk–assets ratio under Basel 1:
• 100% risk weight is applied to all commercial non-bank loans. This
implies that it does not reward diversification (1 mark was
awarded for this).
• Relative risk weights may not reflect relative risks and can also
lead to misallocation of resources (1 mark was awarded for this).
• Assumption of independence of risks (1 mark was awarded for
this).
Candidates should finally explain that under ‘The New Basel Capital
Accord’ (so-called Basel 2, effective from the end of 2006), although no
change is envisaged for the definition of capital, and the minimum
capital co-efficient of 8 per cent is also to remain unchanged, several
changes have been introduced as regards the credit risk assessment. In
particular, the present risk–asset ratio will be modified by separating
loans into different classes according to their risk measured by credit
ratings from rating agencies. This overcomes the problem with the
current risk–asset ratio, which treats all loans as equally risky. (2 marks
were awarded for this).
SECTION B
Question 6
(a) What is a factor model? (6 marks)
11
The Examiners would expect candidates to define either a one-factor

model or a multi-factor model and to carefully explain all the variables
used in the model.
Candidates should first explain that the basic idea of factor models is
that all common variations in stock returns are generated by
movements in one factor (or a set of factors) (1 mark).
A one-factor model assumes that there is only one factor. Formally, it
can be written as:
A multi factor model becomes:
(1 mark for either of the above equations)

where:
ai = expected level of return for stock i if all factors have a value of
zero (1 mark for correct definition of the variable).
F1,2,… = value of the factor 1 that affects the returns on stock i. The
factor is posited to affect all stock returns, although different stocks can
have different sensitivities. The factor can be represented by
macroeconomic conditions, financial conditions or political events. (2
marks for correct definition of the variable).
εI = random error term. This random stock return is termed the
idiosyncratic return component for stock i (1 mark for correct
definition of the variable).
(b) Consider two stocks (A and B), whose returns are determined by the
following two-factor model:
R A = 0.03 + 0.9 F1 + 0.7 F2 + ε A ; R B = 0.06 + 0.8F1 + 0.6 F2 + ε B
Calculate the return of an equally weighted portfolio of the two assets:
50% in stock A and 50% in stock B. (4 marks)
Here candidates were expected to apply the factor model discussed in
part (a).
To determine the return of an equally weighted portfolio of the two
assets (1/2 stock A and 1/2 stock B), candidates simply need to form a
weighted average of the stock sensitivities of individual factors: (1
mark for providing this explanation).
α p = 0.5 • (0.03 + 0.06) = 0.045 (1 mark for correct answer)
β 1 = 0.5 • (0.9 + 0.8) = 0.85 (0.5 mark for correct answer)
β 2 = 0.5 • (0.7 + 0.6) = 0.65 (0.5 mark for correct answer)

Thus the portfolio return can be written as:
R p = 0.045 + 0.85F1 + 0.65 F2 + ε p (1 mark for correct answer)
12
(c) What are the assumptions under the APT? What is the expected risk
premium? (11 marks)
Candidates should begin with the discussion of the assumption of the
APT. A good answer would explain each of the four assumptions under
the APT as follows:
1. There are no arbitrage opportunities (1 mark). Arbitrage
opportunities represent the possibility of earning riskless profits by
taking advantage of differential pricing for the same asset. (1 mark
for this further elaboration)
2. Returns of risky assets can be described by a factor model, as
described in part (a) (1 mark).
3. Financial markets are frictionless (i.e. there are no transaction
costs or related market frictions) (1 mark).
4. There is a large number of securities and so investors hold well-
diversified portfolios. This implies that diversifiable risk does not
exist. (1 mark).
Candidates should then move to the definition of the expected risk
premium under the APT. Good answers would begin with the
statement that the key to the APT is that a factor model with no
arbitrage opportunities implies that assets with the same factor
sensitivities must offer the same expected returns in financial market
equilibrium (1 mark). Candidates should then infer that the expected
risk premium on an individual asset (equal to the expected return on
an individual asset minus the risk-free rate) depends on the sum of the
expected risk premium associated with each factor multiplied by the
asset sensitivity to each of these factors (2 marks).
Good answers will then provide the formal derivation of the expected
return on an individual asset:
where:
λj = (RFj – Rf), which is the risk premium over the risk-free rate
associated with factor j (1 mark).
From the above equation, excellent answers should conclude that the
risk premium is affected only by macroeconomic factors, and not by
unique risk (note the similarity with the CAPM). Moreover, it varies in
direct proportion to the asset’s sensitivity to the factor (2 marks).
(d) What are the main advantages/disadvantages of the APT in
comparison to the CAPM? (4 marks)
An excellent answer would mention that the advantage of the APT is
that it does not require us to identify and measure the market portfolio
(solving most of the problems presented in the previous subsection on
the theoretical limitations of the CAPM). The disadvantage is that it
does not tell us what the underlying factors are (unlike the CAPM,
13
which collapses all the macroeconomic factors into the market

portfolio).
Question 7
Consider the following information about two stocks, Red and Black:
Red 8% 13
Black 3% 5
The correlation between the two securities returns is 0.3
(a) Calculate the expected return and standard deviation of the following
three portfolios:
Portfolio proportions (%)
Portfolio Red Black
A 30 70
B 75 25
C 100 0
(4 marks)
Portfolio A: E(R)=0.045
σ = (13 * 0.32 ) + (5 * 0.70 2 ) + ( 2 ∗ 0.30 ∗ 0.70 ∗ 0.30 * 13 ∗ 5 ) = 2.153
Portfolio B: E(R)=0.0675
σ = (13 * 0.752 ) + (5 * 0.252 ) + ( 2 ∗ 0.25 ∗ 0.75 ∗ 0.30 * 13 ∗ 5 ) = 2.921
Portfolio C: E(R)=0.08
σ = (13 *12 ) + ( 5 * 0 2 ) + ( 2 ∗ 0 ∗ 1 ∗ 0.3 * 13 ∗ 5 ) = 3.605

One mark was awarded for correct answer for expected return for all
the three portfolios; 1 mark for standard deviation formula; 1 mark for
correct input data into standard deviation formula; 1 mark for correct
answer for standard deviation for all the three portfolios.
(b) How can investors identify the best set of efficient portfolios of
common stocks? What does ‘best’ mean? (9 marks)
The Examiners were expecting candidates to identify the best set of
efficient portfolios of stocks in the presence of risk-free assets, and
below we provide a discussion based on this assumption. Nevertheless
answers not considering risk-free assets have been considered equally
fine.
Candidates should first provide the graph here below and state that the
optimal portfolio is represent by point K in Figure 1 (2 marks).
14
Good candidates should then explain more in depth the meaning of

point K. The optimal portfolio lies on the tangency between the
indifference curve of the investor and the capital market line (2
marks). By choosing both the risky portfolio K and the risk-free asset,
the investor lies on the capital market line (CML1) that dominates in
utility terms any other capital market line (such as CML2) (1 mark). In
the presence of a risk-free asset and N risky assets, the efficient set is
exactly the optimal capital market line (CML1) (1 mark).
A better answer to this question would mention the two-fund
separation theorem. Any risk-averse investor can form the optimal
portfolio by combining two funds. The first is the risk-free asset, the
second is the risky asset portfolio K. The degree of risk-aversion
determines the portfolio weights placed on the two funds. For example
in Figure 1, investor A is more risk-averse than investor B, and thus A
puts more weight on the risk free asset. The two-fund separation
theorem forms the launch point for the important Capital Asset Pricing
Model (up to 3 marks are awarded for this).
Expected return (E)R
B
CML1
A
K CML2
Rf
M-SD frontier
Standard deviation (σ)
Figure 1: Mean-Standard deviation frontier (risk-free asset and N risky assets)
(c) Under the CAPM framework, what is the tangency portfolio? What is
the security market line? Support your answer with graphical evidence. (3
marks)
The Examiners awarded 1 mark for providing the graph below (Figure
2).
A good answer would define the tangency portfolio as follows – under
the CAPM, in equilibrium the tangency portfolio of risky assets must be
the market portfolio (1 mark).
15
A good answer would define the security market line as follows – the
linear relationship between the expected return and β. (1 mark)
Expected return (E)R
M
E(RM)
SML
R
1 Beta (β)
Figure 2: Security market line
Students may like to refer to p.133–134 of the subject guide.
Good answers to this question will discuss the theoretical and practical
limitations of the CAPM. Excellent answers would also mention the
relevant empirical evidence to support/contrast each limitation.
Specifically candidates should demonstrate their ability to handle
opposing views/theories.
The Examiners would expect candidates to begin with the main
theoretical limitation of the CAPM – that the implementation of the
CAPM requires the use of proxies for the market portfolio because the
exact composition of the market portfolio is unobservable (1 mark).
Excellent answers would discuss the empirical evidence provided by
Roll (1977) (i.e. the unobservability of the market portfolio makes the
CAPM untestable). Specifically, given that the quality of the proxies
used for the market portfolio cannot be guaranteed, it is not possible to
test the CAPM (1 mark for referring to this empirical evidence). The
Examiners would also expect excellent answers to elaborate further on
this: there could be two alternative situations:
• It might be the case that the market portfolio is efficient (and
hence the CAPM is valid), but the proxy chosen is inefficient (and
hence the empirical tests incorrectly reject the CAPM) (1 mark for
this further elaboration).
• The proxy for the market portfolio might be efficient (and hence
the empirical tests validate the CAPM), but the market portfolio
itself is not efficient (and hence the validation is false) (1 mark for
this further elaboration).
Candidates should then make clear that academics have been debating
whether the CAPM is testable for many years without arriving at a
consensus (nevertheless the model is widely applied by practitioners).
(1 mark for this point). Excellent answers would then discuss these
tests. Overall, these tests provide broad support for the CAPM by
16
showing that the expected return increased with beta over the period
1931–1991, even if less rapidly than the CAPM predicts (1 mark).
However, critics of the CAPM pointed out two problematic pieces of
empirical evidence.
• In recent years the slope of the security market line has been much
flatter than one would expect from the CAPM. This means that
high-beta stocks performed better than low-beta stocks, but the
difference in their actual returns was not as great as the CAPM
predicts (1 mark).
• Factors other than beta (such as firm size, book-to-market ratio,
price-to-earnings ratio, and dividend yield) have all contributed to
explain ex-post realised returns (after controlling for beta). This
contrasts with the CAPM, which predicts that beta is the only
factor that expected returns differ (1 mark). Outstanding
candidates would then discuss the related empirical evidence on
small-cap (1 mark).
Question 8
(a) What is meant by interest rate risk? What are the two main effects of
interest rate risk? (5 marks)
A good definition of interest rate risk states that interest rate risk is the
risk of market interest rates changing when the maturities of assets and
liabilities are mismatched – hence a consequence of maturity
transformation (1 mark).
that they understand the definition and have not simply learnt it from
a book. The Examiners would award marks for candidates who
constructed clear paragraphs which explained the two main elements
of interest rate risk:
1. Income effect as a result of:
(i) refinancing risk – the risk that the cost of re-borrowing funds will be
higher than the returns earned on assets (1 mark)
(ii) reinvestment risk – the risk that the returns on funds to be
reinvested will be lower than the cost of funds (1 mark).
The Examiners would also award 1 mark for illustrative example.
2. Market value effect – change in the present value of cash flows on
assets and liabilities (1 mark).
(b) Explain how a bank can use income gap analysis to manage interest
rate risk. Critically discuss the problems associated with income gap
analysis. (8 marks)
Excellent answers should make the following points.
The basic intuition is that under the income gap analysis (maturity
approach), banks report the gap in each maturity bucket, calculated as
the difference between rate-sensitive assets (RSA) and rate-sensitive
liability (RSL) on their balance sheets. Candidates should then provide
the formula for the calculation of the gap:
17
GAP = RSA – RSL
(1 mark awarded for the correct intuition and correct equation).

Candidates should clarify that a positive GAP implies sensitive assets >
sensitive liabilities. They should also illustrate the consequences of a
change in interest rates in such a situation: the rise in interest rates will
cause a bank to have interest revenue rising faster than interest costs;
thus the net interest margin and income will increase. The decline in
interest rates will increase liabilities costs faster than assets returns; as
a consequence the net interest margin and income will decrease (1
mark awarded for the correct explanation of the consequences of the
rise/fall in interest rates).
Candidates should then make clear the link between the gap measure
and the possibility to use it in the management of interest rate risk.
Banks’ managers can calculate the income exposure to changes in
interest rates in different maturity buckets, by multiplying GAP times
the change in the interest rate:
ΔI= GAP * Δi
where ΔI = change in the banks’ income; Δi = change in interest rate.
(1 mark awarded for correct link, correct equation and correct
definition of the variables).
Finally candidates should explain the three main problems associated
with income gap analysis:
• It ignores market value effects of interest rates changes (1 mark).
• Even rate-insensitive assets and liabilities (whose interest rates are
not re-priced) actually have a component that is rate sensitive (i.e.
a runoff cash flow). Examples of these items were expected. Banks’
managers can deal with this problem by identifying for each asset
and liability the estimated runoff cash flow, to be added to the
value of the rate-sensitive assets and liabilities (3 marks).
• It ignores the effects of the changes in interest rates on off balance
sheet instruments (1 mark).
Variable-rate
160 8.1 Money market deposits 350 1.9
mortgages
Commercial loans 560 3.5 Variable-rate CD (> 1 year) 120 3.1
What will be the change in net interest income at the year end if interest
rates decreased by 1 per cent, from 4 to 3 per cent? Explain using basic
18
gap analysis. (Use the following assumptions on the runoff of cash flows:
fixed-rate mortgages repaid during the year: 25 per cent; proportion of
savings deposits and variable- rate CD that are rate-sensitive: 25 per
cent). (8 marks)
Three steps are needed to answer to part (c).
i. To determine the amount of rate-sensitive assets:
Commercial loans £560
Fixed-rate mortgages (25%*140) £35
Variable-rate mortgages £160
£755
(1 mark was awarded for correct procedure; 1 mark for correct input
data; 1 mark for correct answer).
ii. To determine the amount of rate-sensitive liabilities:
Money market deposits £350
Savings deposits (25%*280) £70
Variable-rate CD (25%*120) £30
£450
(1 mark was awarded for correct input data; 1 mark for correct
answer).
iii. What happens when interest rates decrease by 1%?
Decrease in income on assets (=1%*755) £7.55
Decrease in payments on liabilities (=1%*450) £4.50
Decrease in net income £3.05
data; 1 marks for correct answer).
Following from part (c):
Weighted asset duration
= 8.1 × (160/1100) + 5.1 × (140/1100) + 3.5 × (560/1100)
= 3.61 years
(1 mark was awarded for correct answer).
Liability duration
= 1.9 × (350/750) + 2.3 × (280/750) + 3.1 × (120/750)
= 2.24 years
(1 mark was awarded for correct answer).
⎛L ⎞
DUR gap = DURa − ⎜ × DURl ⎟ = 3.61 − (750 / 1100) × 2.24
⎝A ⎠
= 2.08 years
(1 mark was awarded for correct equation; 1 mark for correct answer).
19
Question 9
Consider the following two financial assets:
(1) a UK stock is expected to pay a dividend of £50 next year with
dividend growth expected to be 2% per annum thereafter;
(2) a UK corporate bond with an annual coupon rate of 4.75%, par (face)
value of £100, and maturity in 2 years time.
(a) If the required return on similar UK equities is 11% and on similar UK
bonds is 7%, calculate the value the UK stock and of the UK bond. (4
marks)
The price of UK stock is £555.56.
The price of the UK bond is:
4.75 104.75
PUKbond = + = £95.93
1.07 (1.07 )2
(2 marks for correct value of the UK stock, 2 marks for the correct
value of the UK bond).
(b) Using the data given above and assuming an annual discount rate,
calculate the duration of the UK bond. (5 marks)
T CF PV(CF) T x PV(CF)
1 4,75 4,44 4,44
2 104,75 91,49 182,99
95,93 187,42
Macaulay duration = 1.95 years

(1 mark was awarded for correct calculation scheme; 1 mark for
correct T values; 1 mark for correct CF values; 1 mark for correct DF
values; 1 mark for correct duration calculation).
(c) Why are capital gains and losses apparently absent from the dividend
discount model used for the valuation of common stocks? (9 marks)
Excellent answers should not simply list the set of equations used in
the derivation of the dividend discount model, but should provide the
economic intuition behind each equation, as shown here below. The
Examiners do not award a pass to candidates for simply listing a set of
equations.
The expected return on a stock over the next year can be written as:
DIV1 + P1 − Po
E ( R) = (1)
P0
where: DIV1 = expected dividend to be paid at time 1; P0 = current
price of the stock; P1 − P0 = capital gain on the stock (1 mark).
Rearranging equation (1), we can predict the current price of a stock in
terms of forecasted dividends and expected price next year. Formally,
this is:
20
DIV1 + P1
P0 = (2)
1 + re
where: re = required annual rate on similar equity stocks. (1 mark)
Equation (2) is the fundamental valuation formula. It represents a
market equilibrium condition: if it does not hold, stocks will be under-
priced or over-priced.
When we come to use this equation, we immediately realise that we
must estimate the price of the stock at time 1 in order find the value
today. However, future stock prices are not easy to determine. What
does determine future stock prices? (2 mark)
The answer is contained in the same equation (2). The expected price
at time t can be expressed as the expected dividends at time t+1 plus
the price at the end of year t+1. Therefore, in equation (2), P1 could be
replaced by (DIV2+P2)/(1+re):
DIV1 DIV2 + P2
P0 = + (3)
1 + re 1 + re
The current price of a stock relates to the expected dividends for two
years (DIV1 and DIV2) plus the forecasted price at the end of year two
(P2). Accordingly, in equation (3), P2 could be expressed as (DIV3+
P3)/(1+ re) (2 marks).
Can you see that we can look as far into the future as we like? If we
consider a period of N years, by extending equation (3), we predict the
current price of a stock in terms of dividends over N years and the price
at the end of year N: (1 mark)
DIV1 DIV2 DIV3 DIVN + PN
P0 = + + + ... +
(1 + re ) (1 + re ) (1 + re )
2 3
(1 + re )N
(4)
N
DIVt PN
=∑ +
t =1 (1 + re )t (1 + re )N
(1 mark was awarded for this equation).
As the horizon period N approaches infinity, the value of common
stocks equals the present value of future periodic dividends that
stockholders expect the firm to distribute forever. This is known as the
dividend discount model. Formally, the price today of a common stock
(P0) can be written as:
∞
DIVt
P0 = ∑
t =1 (1 + re )
t
(5)
(1 mark).
The Examiners expect candidates not only to identify the factors that
affect Macaulay duration, but also the type of effect generated by each
factor. There are three important factors that affect Macaulay duration:
21
• Maturity of a bond: Macaulay duration increases with the maturity

of a bond (1 mark).
• Market interest rate increases: Macaulay duration decreases as
market interest rate increases (1 mark). Candidates should then
demonstrate their understanding of this relationship by explaining
that higher rates discount later cash flows more heavily, and the
weights of those later cash flows decline when compared to earlier
cash flows (2 marks).
• Coupon interest rate: Macaulay duration decreases as coupon
interest rate increases (1 mark). Similarly, here candidates are
expected to demonstrate that their understanding of this
relationship by explaining that the larger the coupons, the more
quickly cash flows are received by investors and the higher the
weights of those cash flows (2 marks).
Question 10
(a) Theoretically derive the efficient market hypothesis. (10 marks)
Excellent answers should not simply list the set of equations used in
the derivation of the efficient market hypothesis, but should provide
the economic intuition behind each equation, as shown here below.
The Examiners do not award a pass to candidates for simply listing a
set of equations.
In order to derive a theoretical framework for informational market
efficiency, candidates need to recall the equation for the estimation of
the expected rate of return on a stock (E(R)). Candidates can
generalise this equation for every financial asset (both bonds and
stocks) in any period t to t + 1 by writing the following equation:
C + Pt +1 − Pt
E ( R) = (1)
Pt
where:
C = cash flow received from the security (dividend or coupon) in the
period t to t + 1
Pt = price of the security at time t
Pt+1 = Price of the security at time t + 1
(1 mark for the correct equation and correct explanation of each item
in the equation).
Candidates should then recall that the efficient market hypothesis
(EMH) assumes that financial markets are efficient when security
prices incorporate all available information. Therefore, in efficient
markets the expected value has to be equal to the forecasted value
using all available information (1 mark). This means that in efficient
markets the expected return on a security (E(R)) will equal be to the
optimal forecast of the return using all available information (RF). (1
mark) Candidates are expected to write the formal derivation:
E ( R) = R F (2)
22
(1 mark for the correct equation).

Candidates should then state that although we cannot observe the
expected return, we know how to measure the value of E(R). Therefore
equation (2) has important implications for how prices of securities
change on financial markets (1 mark). As in equilibrium (when the
quantity of securities demanded is equal to the quantity supplied), the
expected return (E(R)) equals the equilibrium return (E(R*)), derived
either with the Capital Asset Pricing Model (CAPM) or the Asset Pricing
Theory (APT) (1 mark). Implicit in the notion of efficient market is the
assumption that a fair price for a security exists. This fair price is
known as the equilibrium price. Formally, in equilibrium:
E ( R) = E ( R* ) (3)
(1 mark for intuition on the fair price, correct equation and correct
explanation).
To describe the pricing behaviour in efficient markets, we can replace
E(R) with E(R*) in equation (2). Thus we obtain:
E ( R* ) = R F (4)
(1 mark for the correct intuition, correct equation and correct
explanation).
Candidates should conclude by stating that equation (4) means that
current prices in financial markets have to be set so that the optimal
forecast of a security return equals the expected return in equilibrium
(1 mark).
Candidates should finally refer to the alternative way to express this
concept – in efficient markets security prices fully reflect all available
information. Therefore from equation (1):
C + Pt +1 − Pt
RF = = E(R* ) (5)
Pt
(1 mark for the correct intuition, correct equation and correct
explanation).
(b) Explain and theoretically derive the concept of excess return and the
optimal forecast of return using all available information. (9 marks)
Students may like to refer to p.144–145 of the subject guide.
Part (b) is logically linked to part (a), and similarly it requires
candidates to provide the economic intuition behind each equation
used in the theoretical derivation, as shown here below.
The examiners would expect candidates to begin with a clear definition
of excess return as the difference between the actual return on the
market and the equilibrium expected return (1 mark). Candidates
should then derive the formal definition of the excess return at time t
(RtX), which is:
X
Rt = Rt − E ( Rt )
*
(6)
(1 mark for the correct equation)
where:
23
Rt = actual return on the market at time t

E(Rt*) = expected equilibrium return at time t
(1 mark for the correct definition of the variables).
Candidates should now introduce the optimal forecast of return using
all available information (RF). The excess return notion still holds.
Candidates could use the following example to clarify. Consider a stock
with an equilibrium return of 15 per cent, and a price at time t lower
than the expected price at time t+1. If the optimal forecast of the
return is equal to 30 per cent, there is an excess return. Investors can
earn an abnormally high rate of return because RF>E(R*) (1 mark). In
an efficient market this implies that investors would buy more of this
stock, and this in turn will drive up its current price relative to the
expected future price, thereby lowering RF (1 mark). When the current
price has increased sufficiently so that RF=E(R*), the efficient market
condition is satisfied. Similarly, if the optimal forecast of the return is 5
per cent, and the equilibrium return is 10 per cent, the stock would be
a poor investment [RF<E(R*)]. Therefore, investors would sell the
stock, the current price will be driven down relative to the expected
future price, and the optimal forecast of the return will increase until
when RF=E(R*) (1 mark).
The Examiners now expect candidates to take a forward-looking
perspective. In such a perspective, we can still define excess return by
replacing the actual return of a security on the financial market with
the optimal forecast return. The excess return at time t (RtX) is the
difference between the optimal forecast of the return and the expected
return in equilibrium (1 mark):
X F
Rt = Rt − E ( Rt )
*
(7)
(1 mark for the correct equation).

To make clear the logical link between parts (a) and (b) of this
question, candidates should conclude by stating that the objective of
our attention when testing the efficient market hypothesis is the excess
return derived in equations (6) and (7). Particularly, the efficient
market hypothesis is concerned with the ability of investors to make an
excess return based on certain information sets. In an efficient market,
no investor can make excess returns based on the available set of
information. They can only earn normal returns, which here means
equilibrium returns (1 mark).
The Examiners expect candidates first to identify the logical link
between parts (b) and (c) of this question. In fact, the choice of the
model used to adjust actual returns in the excess return calculation
may be wrong. Hence abnormal returns may be incorrectly quantified,
and then used in the test of the efficient market hypothesis (1 mark).
This implies that the same efficient market hypothesis would become
untestable because of the joint hypothesis problem (1 mark).
24

that they understand the statement made here above. The test is
affected by two problems:
a. informational efficiency (1 mark)
b. accuracy of the equilibrium expected returns (1 mark).
If the test indicates the presence of excess return, this would imply that
markets are inefficient (1 mark). However, the inefficiency of the
markets could be determined by the use of an incorrect technique for
the measurement of the excess return. Therefore we do not know
whether the market is efficient but either the excess return
measurement is wrong, or the market is actually inefficient (1 mark).

There will be a change to number of questions in the examination
25
Specific comments on questions Zone B

A note on reading
It is assumed that where a reference is made here to sections of the
subject guide that students will also follow through to the essential and
further reading recommended in those sections of the subject guide.
SECTION A
Question 1
(a) See Zone A
(b) See Zone A
(c) Explain how long-term mutual funds differ from short-term mutual funds.
(4 marks)
The Examiners would expect candidates to provide a clear definition of
these two types of investment intermediaries, focusing on the
differences between the two:
• Long-term funds comprise bond funds (funds that contain fixed-
income debt securities), equity funds (funds that contain stock
securities) and hybrid funds (funds that contain both debt and
stock securities) (2 marks).
• Short-term fund are represented by money market mutual funds,
funds that contain various mixes of money market securities and
partially allow shareholders to write cheques against the value of
their holdings (1 mark). An outstanding answer would emphasise
that the presence of deposit-type accounts makes money market
mutual funds to some extent similar to depositary institutions (1
mark).
(d) See Zone A
Question 2 – see Zone A
Question 5
(a) See Zone A
(b) See Zone A
(c) Discuss the monitoring of liquidity in banking, with particular reference to
the UK. (5 marks)
1
The Examiners would expect candidates to begin with the list of

mechanisms through which liquidity can be provided:
• holding cash or assets which are easily liquefied (1 mark)
• holding an appropriately mismatching of portfolio cash flows from
maturing assets (1 mark)
• maintaining an appropriately diversified deposit base. (1 mark)
Candidates should then move to the methods used for monitoring
liquidity in the UK. In the UK, the regulator does not apply any specific
liquidity ratio to all banks (1 mark). Instead the Bank of England uses
liquidity gap analysis to ensure that liquidity is within reasonable
limits. Outstanding answers should explain that this implies the
preparation of a maturity ladder, showing the accumulated mismatch
of short-term asset and liabilities over a set of time periods up to one
year (1 mark).
(d) See Zone A
SECTION B
Question 6
(a) See Zone A
(b) Consider two stocks (X and Y), whose returns are determined by the
following two-factor model:
R X = 0.02 + 0.8F1 + 0.4 F2 + ε X ; RY = 0.03 + 0.7 F1 + 0.3F2 + ε Y
Calculate the return of a portfolio with the following weights of the two
assets: 25% in stock X and 75% in stock Y. (4 marks)
Here candidates were expected to apply the factor model discussed at
point a).
To determine the return of an equally weighted portfolio of the two
assets (1/2 stock A and 1/2 stock B), we simply need to form a
weighted average of the stock sensitivities of individual factors: (1
mark for providing this wordy explanation)
α p = 0.25 • 0.02 + 0.75 • 0.03 = 0.0275 (1 mark for correct
answer)
β 1 = 0.25 • 0.8 + 0.75 • 0.7 = 0.725 (0.5 mark for correct answer)
β 2 = 0.25 • 0.4 + 0.75 • 0.3 = 0.325 (0.5 mark for correct answer)
Thus the portfolio return can be written as:
R p = 0.0275 + 0.725F1 + 0.325 F2 + ε p (1 mark for correct answer)
(c) See Zone A
(d) See Zone A
Question 7
Consider the following information about two stocks, Yellow and Blue:
Yellow 7% 12
2
Blue 4% 6
The correlation between the two securities returns is 0.4.
(a) Calculate the expected return and standard deviation of the following
three portfolios:
Portfolio Proportions (%)
Portfolio Yellow Blue
1 30 70
2 75 25
3 100 0
Portfolio 1: E(R)=4.9%
σ = (12 * 0.30 2 ) + (6 * 0.70 2 ) + (2 ∗ 0.30 ∗ 0.70 ∗ 0.40 * 12 ∗ 6 ) = 2.33
Portfolio 2: E(R)=6.25%
σ = (12 * 0.75 2 ) + (6 * 0.25 2 ) + (2 ∗ 0.25 ∗ 0.75 ∗ 0.40 * 12 ∗ 6 ) = 2.90
Portfolio 3: E(R)=7%
σ = (12% *12 ) + ( 6% * 0 2 ) + (2 ∗ 0 ∗ 1 ∗ 0.4 * 12 ∗ 6 ) = 3.46
One mark was awarded for correct answer for expected return for all
the three portfolios; 1 mark for standard deviation formula; 1 mark for
correct input data into standard deviation formula; 1 mark for correct
answer for standard deviation for all the three portfolios.
Question 8
(a) See Zone A
(b) See Zone A
Commercial loans 5600 3.5 Variable-rate CD (>1 year) 1200 3.1
What will be the change in net interest income at the year end if interest
rates decreased by 0.5 per cent, from 4 to 3.5 per cent? Explain using basic
gap analysis. (Use the following assumptions on the runoff of cash flows:
fixed-rate mortgages repaid during the year: 25 per cent; proportion of
savings deposits and variable-rate CD that are rate-sensitive: 25 per cent). (8
marks)
Three steps are needed to answer to point c).
i. To determine the amount of rate-sensitive assets:
3
Commercial loans £5600

Fixed-rate mortgages (25%*1400) £350
Variable-rate mortgages £1600
£7550
data; 1 mark for correct answer).
ii. To determine the amount of rate-sensitive liabilities:
Money market deposits £3500
Savings deposits (25%*2800) £700
Variable-rate CD (25%*1200) £300
£4500
(1 mark was awarded for correct input data; 1 mark for correct
answer).
iii. What happens when interest rates decrease by 0.5%?
Decrease in income on assets (=0.5%*7550) £37.75
Decrease in payments on liabilities (=0.5%*4500) £22.5
Decrease in net income £15.25
data; 1 marks for correct answer).
(d) – See Zone A
Question 9
Consider the following two financial assets:
(1) a US stock is expected to pay a dividend of $150 next year with dividend
growth expected to be 2.5% per annum thereafter;
(2) a US corporate bond with a annual coupon rate of 5%, par (face) value of
$1000, and maturity in 2 years time.
(a) If the required return on similar US equities is 10% and on similar US
bonds is 7%, calculate the value the US stock and of the US bond. (4 marks)
The price of US stock is $2000.
The price of the US bond is:
50 1050
PUSbond = + = $963.84
1.07 (1.07 )2
(2 marks for correct value of the US stock, 2 marks for the correct
value of the US bond).
(b) Using the data given above and assuming annual discount rate, calculate
the duration of the US bond. (5 marks)
T CF PV(CF) t x PV(CF)
1 50 46,73 46,73
2 1050 917,11 1.834,22
4
963,84 1.880,95
Macualay duration = 1.95 years
(1 mark was awarded for correct calculation scheme; 1 mark for correct
T values; 1 mark for correct CF values; 1 mark for correct DF values; 1
mark for correct duration calculation).
(c) See Zone A
(d) See Zone A
Question 10
See Zone A

There will be a change to number of questions in the examination

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UNIVERSITY OF LONDON 279 0024 ZA

Principles of Banking and Finance

Friday, 23rd May 2008 : 10.00am to 1.00pm

© University of London 2008

(e) What is the CAMEL system? (5 marks)

(c) What is meant by credit risk? (5 marks)

(d) What forms of credit rationing currently exist? (8 marks)

5. (a) What is meant by liquidity risk? (4 marks)

(c) Identify typical aspects of a banks capital requirement as imposed by regulators.

6. (a) What is a factor model? (6 marks)

Stock Expected return Variance

The correlation between the two securities returns is 0.3

Portfolio proportions (%)

(c) Consider the following balance sheet of Bank Plus:

Assets (£) Duration Liabilities (£) Duration

(d) What is the duration gap for Bank Plus? (4 marks)

(c) Discuss the joint hypothesis problem. (6 marks)

UNIVERSITY OF LONDON 279 0024 ZB

Principles of Banking and Finance

Friday, 23rd May 2008 : 10.00am to 1.00pm

© University of London 2008

(e) What is the CAMEL system? (5 marks)

(c) What is meant by credit risk? (5 marks)

(d) What forms of credit rationing currently exist? (8 marks)

5. (a) What is meant by liquidity risk? (4 marks)

6. (a) What is a factor model? (6 marks)

Stock Expected return Variance

The correlation between the two securities returns is 0.4.

Portfolio Proportions (%)

(c) Consider the following balance sheet of Bank Plus:

Assets (£) Duration Liabilities (£) Duration

(d) What is the duration gap for Bank Plus? (4 marks)

(c) Discuss the joint hypothesis problem. (6 marks)

Examiners’ commentary 2008

24 Principles of banking and finance

Planning your time in the examination

What are the topics under examination?

What are the examiners looking for?

Key steps to improvement

Examination paper for 2009

Examiners’ commentary 2008

24 Principles of banking and finance

Specific comments on questions Zone A

Up to 2 marks were awarded for the explanation of the types of

Candidates should then go on to discuss in detail the characteristics of

An outstanding answer would then state that because of the different

liabilities denominated in foreign currencies, and the sharp increase in

• Purchase and assumption method: the FDIC finds a merger partner

This limitation has been associated with a prompt corrective action

probability. As a consequence, in retail markets, banks normally

• reduction of the risk of the loan portfolio by diversification (1

The Examiners would expect candidates to define either a one-factor

A multi factor model becomes:

(1 mark for either of the above equations)

β 1 = 0.5 • (0.9 + 0.8) = 0.85 (0.5 mark for correct answer)

β 2 = 0.5 • (0.7 + 0.6) = 0.65 (0.5 mark for correct answer)

which collapses all the macroeconomic factors into the market

Stock Expected return Variance

Portfolio proportions (%)

Portfolio Red Black

σ = (13 * 0.32 ) + (5 * 0.70 2 ) + ( 2 ∗ 0.30 ∗ 0.70 ∗ 0.30 * 13 ∗ 5 ) = 2.153

σ = (13 * 0.752 ) + (5 * 0.252 ) + ( 2 ∗ 0.25 ∗ 0.75 ∗ 0.30 * 13 ∗ 5 ) = 2.921

σ = (13 12 ) + ( 5 0 2 ) + ( 2 ∗ 0 ∗ 1 ∗ 0.3 * 13 ∗ 5 ) = 3.605

σ = (12% 12 ) + ( 6% 0 2 ) + (2 ∗ 0 ∗ 1 ∗ 0.4 * 12 ∗ 6 ) = 3.46