THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL

FN1024 ZB

BSc DEGREES AND GRADUATE DIPLOMAS IN ECONOMICS, MANAGEMENT,

FINANCE AND THE SOCIAL SCIENCES, THE DIPLOMA IN ECONOMICS AND
SOCIAL SCIENCES AND THE CERTIFICATE IN HIGHER EDUCATION IN SOCIAL
SCIENCES EXAMINATION

Principles of Banking and Finance

Friday 3 May 2019: 14:30 – 17:30

Time allowed: 3 hours

DO NOT TURN OVER UNTIL TOLD TO BEGIN

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.

A handheld 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 2019

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SECTION A

Candidates should answer ONE question and NO MORE THAN TWO further
questions from this section.

1.
(a) Distinguish between credit risk, liquidity risk and market risk as they affect
banks
(10 marks)

(b) Explain the difference between illiquidity and insolvency in relation to banking.
(7 marks)

(c) Distinguish between reinvestment risk and refinancing risk for a bank. Give
examples of each.
(8 marks)

2. Explain the main causes of the 2008 global financial crisis and briefly explain how
Basel 3 addresses these causes.
(25 marks)

3.
(a) Describe the main functions of a financial system.
(9 marks)

(b) Distinguish between the following types of market:

(i) primary and secondary markets

(ii) order driven and quote driven markets
(4 marks)

(c) An investor is considering investing in the following securities:

(i) Treasury bonds

(ii) Corporate bonds
(iii) Common stocks
(iv) Preferred stock

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 Explain the main characteristics (including risk, return and maturity) of each
type of investment.
(12 marks)

4.
(a) Explain the risk-assets ratio underlying the Basel capital adequacy framework.
(8 marks)

(b) Discuss the problem of pro-cyclicality in capital regulation and explain how
Basel 3 aims to mitigate this.
(11 marks)

(c) Explain the ‘safety net’ mechanisms in protecting against systemic risk in
banking.
(6 marks)

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SECTION B
Candidates should answer ONE question and NO MORE THAN TWO further
questions from this section.

5. At the end of June 2019 a UK corporate bond has an annual coupon rate of 3%,
par (face) value of £2,000 and will mature in June 2023 (assume 4 years of
coupons). Similar UK bonds have an annual redemption yield of 4%.

(a) Using the data given above and assuming annual coupons, calculate the
value of the corporate bond.
(4 marks)

(b) Calculate the duration of the UK corporate bond assuming annual coupons.

(5 marks)

(c) Assume annual interest rates increase by 0.5%. What will be the approximate
percentage change in the value of the UK bond assuming annual coupons?

(4 marks)

(d) Explain why the change in bond value, calculated in (c), is approximate.

(5 marks)

(e) Explain why the relationship between the price of a bond and its redemption
yield is inverse and non-linear.
(7 marks)

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6. Consider the following information about two stocks, A and B:

Stock Expected return Standard Deviation

A 7% 6%

B 3% 1.5%

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
A B
1 30 70
2 75 25
3 100 0
(5 marks)

(b) How can investors identify the best set of portfolios of common stocks? What
does ‘best’ mean? (5 marks)

(c) Explain the impact of the correlation between securities returns on the
diversification benefits of combining securities in a portfolio (use a diagram to
illustrate). (6 marks)

(d) Demonstrate how the introduction of a risk-free security allows us to identify

the optimal risky portfolio that all investors will choose to invest in, irrespective
of their risk preference. (9 marks)

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7. A firm is considering two investment projects, Y and Z. These projects are NOT
mutually exclusive. Assume the firm is not capital constrained. The initial costs
and cashflows for these projects are:

Y Z
0 -40,000 -28,000
1 17,000 12,000
2 17,000 12,000
3 15,000 20,000

(a) Using a discount rate of 9% calculate the net present value for each project.
What decision would you make based on your calculations?
(4 marks)

(b) How would your decision change if the discount rate used for calculating the
net present value is 15%?
(3 marks)

(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 9%.
What decision would you make based on your calculations?
(6 marks)

(d) Calculate the payback period for each project. The company looks to select
investment projects paying back in 2 years. What decision would you make
based on your calculations?
(2 marks)

(e) Discuss the advantages and disadvantages of the payback rule of investment
appraisal.
(4 marks)

(f) Explain the additivity property of the NPV method.

(6 marks)

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8.

(a) Consider the following portfolio composed of three stocks (X, Y, Z):

Stock Quantity Price (£) Beta

X 100 1.4 0.7
Y 120 1.8 1
Z 200 1.2 1.4

What is the beta of this portfolio? Is this portfolio ‘defensive’ or ‘aggressive’

as an investment?
(5 marks)

(b) What are the assumptions underlying the CAPM (Capital Asset Pricing
Model)?
(5 marks)

(c) Under the CAPM framework, how do you express the expected return of a
stock? What is the security market line?
(4 marks)

(d) A stock lies above the security market line (SML). Explain what is likely to
happen to that stock so that the stock moves back on the SML.

(6 marks)

(e) Discuss the joint hypothesis problem in relation to empirically testing the
CAPM.
(5 marks)

END OF PAPER

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