FN1024 Commentary 2019

Examiners’ commentaries 2019

FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2018–19. 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.
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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.
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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, but 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 might not cover all topics in the syllabus in the same depth, but you
need to be aware that 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 available on the VLE. 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.
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Important note

references
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
Candidates should answer ONE question and NO MORE THAN TWO further questions from
this section.
Question 1
(a) Explain, giving examples, the main risks affecting banks.

(10 marks)
(b) Explain the importance of capital in protecting a bank from becoming insolvent.
(7 marks)
(c) Distinguish between reinvestment risk and refinancing risk for a bank. Give
examples of each.
(8 marks)
Reading for this question
For (a), see subject guide, Chapter 6, pages 116–20.
For (b), see subject guide, Chapter 5, pages 101–08.
For (c), see subject guide, Chapter 6, pages 117–18.
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Approaching the question
(a) The key risks affecting banks are liquidity risk, credit risk, market risk and operational risk.
Each of these risks should be explained, along with a relevant example to illustrate each risk.
A common issue in answering this part was to only provide explanations for each risk
without giving a relevant example.
(b) Capital is essentially shareholders’ funds. Alternatively, capital can be defined as the
difference between assets and deposits. It provides a buffer to protect depositors funds from
loss following losses from assets. Answers will need to define bank insolvency – a situation
where the value of assets falls below the value of deposits.
Better answers will illustrate with an example as provided in the subject guide.
(c) Both are manifestations of interest rate risk and are caused by mismatching maturities of
assets and liabilities.
Reinvestment risk occurs when a bank has a short-term asset but longer-term funding in
place. Refinancing risk occurs when a bank has longer-term assets financed by shorter-term
funding. The risk in each case is a form of interest rate risk with the bank vulnerable to a
change in interest rates. In the case of reinvestment risk the bank faces a reduction in
income if interest rates fall. In the case of refinancing risk banks will see a reduction in
income if interest rates rise. Examples are needed to illustrate both types of risk.
Better answers will explain that banks are more likely to face refinancing risk as they are
intermediaries and so have assets with maturities longer than liabilities.
Question 2
Discuss the main theories explaining why, in an economy, most funds passing from
surplus units to deficit units go through financial intermediaries such as banks.
(25 marks)
See subject guide, Chapter 4, pages 64–82.
This question requires a discussion of the main theories of financial intermediation. The three
main theories which need to be covered are the following.
• Different requirements of borrowers and lenders – gives rise to asset transformation. Banks
are able to transform the characteristics of funds as they pass from ultimate lenders to
ultimate borrowers hence reconciling the different requirements of each party.
• Transaction costs – banks are able to reduce transaction costs for each party due to their
specialisation and economies of scale.
• Adverse selection and moral hazard arising from asymmetric information – banks are better
able to mitigate these two problems as they make loans as private debt contracts rather
than traded debt which removes the free-rider problem.
Each theory needs to be explained in detail.
Better answers will show how the first two theories only explain a part of the reason for
intermediation. The last theory gives a fuller explanation.
Excellent answers will also discuss alternative theories of intermediation such as Diamond’s
model of delegated monitoring and Diamond and Dybvig’s model of consumption smoothing.
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Question 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. exchange traded and over-the-counter markets.
(4 marks)
(c) An investor is considering investing in the following securities:
i. Treasury bills – short term (money market), government debt.
ii. Corporate bonds – longer term (capital market) company debt.
iii. Common stocks – company equity with uncertain cash flow.
iv. Preferred stock company equity with fixed cash flow.
Explain the main characteristics (including risk, return and maturity) of each
type of investment.
(12 marks)
(a) The main functions are:

• to provide a payments mechanism
• to channel funds from surplus units to deficit units
• to provide mechanisms for risk transfer
• to allow agents to adjust portfolios.
Each function needs to be described carefully identifying how it contributes to the ‘real’
economy of production and consumption.
Better answers will provide examples of the different functions.
(b) i. Primary markets are where new securities are issued and hence new capital is raised – for
example, an IPO. Secondary markets are where existing securities are traded.
ii. Exchange traded markets – organised, standardised products. Over-the-counter – fewer
rules, bilateral trading.
Better answers will aim to distinguish (identify differences) rather than just describe the two
types of market and provide examples to illustrate the differences.
(c) i. Treasury bills – short term (money market), government debt. Low risk (as a
government is unlikely to default) and hence low return.
ii. Corporate bonds – longer term (capital market) company debt. Higher risk due to risk of
the issuing company becoming insolvent. Hence higher return than government-issued
bonds.
iii. Common stocks – company equity with uncertain cash flow. Most risky due to the
uncertainty of returns with potential for much higher or much lower returns than debt
(depending on the performance of the company). Therefore, investors require
compensation for this risk in the form of a higher return.
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iv. Preferred stock – company equity with fixed cash flow. Risky as it is a company-issued
security but less risky than common stock due to the characteristic of a more certain
cash flow in the form of a fixed dividend.
Better answers will identify how the return characteristic of each security is related to both
risk and maturity.
Question 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 differences between micro and macro prudential regulation of banks.
(6 marks)
(a) The Basel capital adequacy framework was established in 1998 although implemented in the
early 1990s and at its heart is the concept of the risk-assets ratio (RAR).
RAR = Capital/sum of risk-weighted assets.
The RAR relates capital to the risk exposures of the bank across various asset categories.
Each of the asset categories has a fixed risk weight ranging from zero for cash to 100% for
commercial loans.
Better answers will explain how the RAR has evolved through the implementation of Basel
2 in 1996 where the risk weights of commercial loans could vary according to the risk of each
individual loan, and Basel 3 after the 2008 global financial crisis where the capital required
increased in both quality and quantity.
(b) Pro-cyclicality is a situation where capital regulation promotes (increases the amplitude) of
the economic cycle. In boom times, risk is seen to be lower hence capital requirements are
lower leading to greater credit expansion hence pushing economic activity higher. The
opposite occurs in a recession with lending now pushed lower due to the need to have more
capital to support new lending. Basel 3 addresses this by introducing an additional capital
buffer in operation in boom times which slows down the growth of lending. This buffer can
then be released in a recession allowing more lending. The aim is to reduce the amplitude of
economic cycles.
Better answers will explain how the capital buffer works in practice.
(c) Micro-prudential – aimed at regulating individual banks. This form of regulation is referred
to as traditional regulation. By regulating individual banks to prevent failure then it is less
likely that contagion of failure will occur through runs spreading from bank to bank. So, by
preventing failure at the individual bank level, there should be lower systemic risk.
Macro-prudential regulation – aimed at preventing systemic risk directly. With this
approach there is a recognition that banks in the system face common exposures to external
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risks – for example, a housing market bubble which could cause many banks to become
insolvent when the bubble corrects.
Better answers will explain that macro-prudential regulation was introduced following the
lessons learnt by regulators after the global financial crisis in 2008. It should also be noted
that both forms of regulation play a role in preventing systemic risk in banking and so
should be seen as complementary.
Section B
this section.
Question 5
At the end of June 2019 a UK corporate bond has an annual coupon rate of 4%, par
(face) value of £5,000 and will mature in June 2023 (assume 4 years of coupons).
Similar UK bonds have an annual redemption yield of 5%.
(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 decrease by 1%. What will be the approximate
percentage change in the value of the UK bond assuming annual coupons and
annual discount rate?
(4 marks)
(d) Explain why the change in bond value, calculated in (c), is approximate.
(5 marks)
(e) Explain how interest rate risk affects bond investors.
(7 marks)
(a) & (b) Answers to (a) and (b) are provided in the following calculation:
Year t CF DF DCF DCF × t

1 200 0.952381 190.4762 190.4762
2 200 0.907029 181.4059 362.8118
3 200 0.863838 172.7675 518.3026
4 5200 0.822702 4278.053 17112.21
Sum = 4822.702 18183.8
Price = £4822.70
P P
Duration = DCF × t/ DCF = 18183.8/4822.702 = 3.7705 years.
Note that duration is measured in years.
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(c) Use the modified duration formula:
∆i
∆P = −Dur × .
1+i
Hence:
−0.01
∆P = −3.7705 × = 0.035909 (or 3.59%).
1.05
(d) The modified duration formula used to calculate the change in price for a bond given a
change in interest rate assumes a linear relationship between price and interest rate, but the
actual relationship is non-linear. Better answers will use a diagram to illustrate the actual
and modified duration relationships.
(e) A change in yield will change the price of a bond in an inverse way. For an investor not
holding the bond to maturity then this creates uncertainty about the future price (value) of
the bond at which they will sell. If interest rates rise, then bond prices will fall to adjust the
yield on the bond in line with the general change in interest rates. This can lead to a
situation where a bond investor has to sell the bond at a lower price than they paid for it.
Question 6
Consider the following information about two stocks, A and B:
Stock Expected return Standard deviation

A 9% 6%
B 4% 2%
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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For (d), see subject guide, Chapter 8, pages 170–1.
(a) Workings:
A B Expected return Variance Standard deviation
30 70 5.5 7.216 2.686261
75 25 7.75 22.3 4.722288
100 0 9 36 6
Hence:
Portfolio Expected return Standard deviation
1 5.5% 2.68%
2 7.75% 4.72%
3 9% 6%
(b) The best set of portfolios is the efficient set. This can be found by identifying the efficient
frontier which runs from the minimum variance portfolio to the maximum return portfolio.
‘Best’ means efficient which means the most return for a given level of risk (standard
deviation).
Better answers will use a diagram to illustrate the efficient frontier.
A common error is to state that the best portfolios are those which maximise return and
minimise risk. This is not possible as there is an inverse relationship between risk and return.
(c) Correlation between the returns on securities is bounded between +1 and −1. As correlation
reduces from +1 down to −1 the risk (standard deviation) of a portfolio reduces. When the
correlation is +1 the risk of the portfolio is the weighted average risk of the securities in the
portfolio. In other words there is no reduction in risk, i.e. no diversification benefits.
Minimum risk is achieved when the correlation = −1.
A diagram is useful to illustrate the relationship between correlation and risk reduction.
(d) The answer to this question requires an explanation of two-fund separation. A diagram is
useful to illustrate two-fund separation.
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A line is drawn from the return on the risk-free security to a portfolio on the efficient
frontier. As the slope of the line increases the risky portfolio on the efficient portfolio moves
to the right until the tangency portfolio is found (i.e. where the line drawn from the return
on the risk-free security is just tangential to the efficient frontier). The tangency portfolio is
the optimal risky portfolio for all investors. Note, this is not the same as the optimal
portfolio for all investors. This will be a combination of the risk-free security and the
optimal risky portfolio.
Question 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 −30,000 −25,000
1 17,000 10,000
2 17,000 10,000
3 12,000 15,000
(a) Using a discount rate of 10% 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 20%?
(3 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%.
(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)
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(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)
(a) We have:
DCF Y DCF Z
−30,000 −25,000
15,454.55 9,090.909
14,049.59 8,264.463
9,015.778 11,269.72
NPV = 8,519.91 3,625.09
As both projects have positive NPVs and the firm is selecting projects which are not
mutually exclusive and the firm is not capital constrained the decision should be to accept
both projects.
(b) We have:
DCF Y DCF Z
−30,000 −25,000
14,166.67 8,333.333
11,805.56 6,944.444
6,944.444 8,680.56
NPV = 2,916.667 −1,014.67
The decision now is to accept Y but reject Z.

(c) Using the method of linear interpolation:
IRR: Y = 26% and Z = 18%.
In both cases the IRR is greater than the hurdle rate, so both projects should be accepted.
(d) Payback for Y is < 2 years (accept). Payback for Z is > 2 years (reject).
(e) Advantages – the method is quick and simple to calculate, takes risk into account in a simple
way (as it gives more weight to nearer cash flows – future cash flows are more uncertain).
Disadvantages – no allowance for the time value of money, ignores cash flows after the
payback point.
(f) The additivity property for NPV can be represented by:
NPV(A + B) = NPV(A) + NPV(B).
Better answers will discuss the benefits of this property, particularly for capital-constrained
firms.
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Question 8
(a) Consider a three-factor Arbitrage Pricing Theory (APT) model for stock XYZ.
Factor risk premium Sensitivity to each factor
Change in GDP 4% 0.5
Change in interest rate 1.5% 0.8
Change in exchange rate 2% 0.2
Assuming a risk-free rate of 4%, calculate the expected return of stock XYZ.
(4 marks)
(b) What are the assumptions of APT? What is the expected risk premium?
(11 marks)
(c) What are the main advantages/disadvantages of APT in comparison to the
CAPM?
(4 marks)
(d) Discuss the joint hypothesis problem in relation to empirically testing the
CAPM.
(6 marks)
(a) Expected return = 4 + 4 × 1.5 + 1.5 × 0.8 + 2 × 0.2 = 7.6%.

(b) The four assumptions of the APT are:
i. no arbitrage opportunities
ii. returns of risky assets can be described by a factor model
iii. financial markets are frictionless (i.e. there are no transaction costs or related market
frictions)
iv. diversifiable risk does not exist.
Good answers would then identify 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. Therefore, 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.
Finally, answers should emphasise the characteristics of the risk premium, i.e. it is affected
only by macroeconomic factors, not by unique risk, and it varies in direct proportion to the
asset’s sensitivity to the factor.
(c) Advantages: We do not need to identify the market portfolio (unlike with the CAPM). We
are able to identify/observe the factors which explain the expected return on a stock.
Disadvantages: There is no theory to guide what the factors should be in the model
(contrast this with the CAPM where we know what the model should be).
(d) With the CAPM we cannot measure expected return on the market portfolio, so we have to
proxy it. This introduces measurement error which can be significant.
When testing the CAPM the hypothesis of interest is whether the CAPM is an accurate
model of expected returns. However, this hypothesis cannot be tested in isolation as it is
jointly tested with the hypothesis that the proxy for the return on the market portfolio is
accurate.
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Important note

references
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
this section.
Question 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)
14
(a) Credit risk is the risk of default on debt contracts.

Liquidity risk is the risk of running short of cash to meet cash commitments (typically
deposit withdrawals).
Market risk is the risk of loss associated with trading book assets. This arises from market
movements – for example, price changes.
Better answers should ‘distinguish between’ the three risks. For example, credit and market
risks are mitigated by holding capital, whereas liquidity risk is mitigated by holding liquid
assets.
(b) Illiquidity is a state where the bank is short of liquidity. This typically arises when deposit
withdrawals are higher than expected and insufficient liquid assets are available.
Insolvency is a state where assets are valued at less than deposit liabilities. This typically
arises when asset values fall due to loan defaults etc.
Better answers will explain the relationship between the two states and how insolvency is a
more serious problem.
(c) Both are manifestations of interest rate risk and are caused by mismatching maturities of
assets and liabilities.
Reinvestment risk occurs when a bank has a short-term asset but longer-term funding in
place. Refinancing risk occurs when a bank has longer-term assets financed by shorter-term
funding. The risk in each case is a form of interest rate risk with the bank vulnerable to a
change in interest rates. In the case of reinvestment risk the bank faces a reduction in
income if interest rates fall. In the case of refinancing risk banks will see a reduction in
income if interest rates rise. Examples are needed to illustrate both types of risk.
Better answers will explain that banks are more likely to face refinancing risk as they are
intermediaries and so have assets with maturities longer than liabilities.
Question 2
Explain the main causes of the 2008 global financial crisis and briefly explain how
Basel 3 addresses these causes.
(25 marks)
This is a single part essay-style question and so can be answered in a number of ways. The key
things to note in answering this question are the following.
• Answers which simply describe the causes of the crisis only can only achieve a bare pass
mark.
• Answers which describe the causes of the crisis plus describe Basel 3 would score better.
• Good answers will explain the causes of the crisis and then link those causes to Basel 3. For
example, the crisis revealed that banks had insufficient capital in relation to the risks they
faced. So Basel 3 increases capital requirements on banks.
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Question 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.
Explain the main characteristics (including risk, return and maturity) of each
type of investment.
(12 marks)
(a) The main functions are:

• to provide a payments mechanism
• to channel funds from surplus units to deficit units
• to provide mechanisms for risk transfer
• to allow agents to adjust portfolios.
Each function needs to be described carefully identifying how it contributes to the ‘real’
economy of production and consumption.
Better answers will provide examples of the different functions.
(b) i. Primary markets are where new securities are issued and hence new capital is raised – for
example, an IPO. Secondary markets are where existing securities are traded.
ii. Order driven markets – buyers and sellers trade directly without any intermediation.
Quote driven markets – dealer or market-maker is on one side of every trade.
Better answers will aim to distinguish (identify differences) rather than just describe the two
types of market and provide examples to illustrate the differences.
(c) i. Treasury bonds – longer term government debt. Low risk (as a government is unlikely to
default) and hence low return relative to equity.
ii. Corporate bonds – longer term (capital market) company debt. Higher risk due to risk of
the issuing company becoming insolvent. Hence higher return than government-issued
bonds.
iii. Common stocks – company equity with uncertain cash flow. Most risky due to the
uncertainty of returns with potential for much higher or much lower returns than debt
(depending on the performance of the company). Therefore, investors require
compensation for this risk in the form of a higher return.
16
iv. Preferred stock – company equity with fixed cash flow. Risky as it is a company-issued
security but less risky than common stock due to the characteristic of a more certain
cash flow in the form of a fixed dividend.
Better answers will identify how the return characteristic of each security is related to both
risk and maturity.
Question 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)
(a) The Basel capital adequacy framework was established in 1998 although implemented in the
early 1990s and at its heart is the concept of the risk-assets ratio (RAR).
RAR = Capital/sum of risk-weighted assets.
The RAR relates capital to the risk exposures of the bank across various asset categories.
Each of the asset categories has a fixed risk weight ranging from zero for cash to 100% for
commercial loans.
Better answers will explain how the RAR has evolved through the implementation of Basel
2 in 1996 where the risk weights of commercial loans could vary according to the risk of each
individual loan, and Basel 3 after the 2008 global financial crisis where the capital required
increased in both quality and quantity.
(b) Pro-cyclicality is a situation where capital regulation promotes (increases the amplitude) of
the economic cycle. In boom times, risk is seen to be lower hence capital requirements are
lower leading to greater credit expansion hence pushing economic activity higher. The
opposite occurs in a recession with lending now pushed lower due to the need to have more
capital to support new lending. Basel 3 addresses this by introducing an additional capital
buffer in operation in boom times which slows down the growth of lending. This buffer can
then be released in a recession allowing more lending. The aim is to reduce the amplitude of
economic cycles.
Better answers will explain how the capital buffer works in practice.
(c) Safety net arrangements include deposit insurance, lender of last resort and capital support.
The aim of the first two is to prevent liquidity problems for banks which may lead to
contagion and hence systemic risk. Both need to be explained. The aim of capital support
(seen in 2008/9 when banks were bailed out) is to deal with large insolvent banks – other
measures introduced for systemically important banks to reduce the need for capital support
in future.
17
Section B
this section.
Question 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)
(a) & (b) Answers to (a) and (b) are provided in the following calculation:
Year t CF DF DCF DCF × t
1 60 0.961538462 57.69230769 57.69230769
2 60 0.924556213 55.47337278 110.9467456
3 60 0.888996359 53.33978152 160.0193446
4 2060 0.854804191 1760.89 7043.59
Sum = 1927.40 7372.25
Price = £1927.40
P P
Duration = DCF × t/ DCF = 7372.25/1927.40 = 3.83 years.
Note that duration is measured in years.
(c) Use the modified duration formula:
∆i
∆P = −Dur × .
1+i
Hence:
0.005
∆P = −3.83 × = −0.01834 (or − 1.84%).
1.04
(d) The modified duration formula used to calculate the change in price for a bond given a
change in interest rate assumes a linear relationship between price and interest rate, but the
actual relationship is non-linear. Better answers will use a diagram to illustrate the actual
and modified duration relationships.
18
(e) Redemption yield is the discount rate on the bond cash flows. P is the present value of the
cash flows. Show with a formula. As the discount rate increases the present value of future
cash flows reduces – as the price is the sum of future cash flows then the price falls.
The inverse relationship could be explained in a more intuitive way. If yields on similar
bonds rise then to change the yield on a bond the price has to fall (as this is the only
characteristic not fixed to keep the yield on this bond in line with similar bonds).
The non-linear relationship between the price and discount rate arises because the discount
factor is raised to an increasing power. So, as the discount rate increases incrementally, the
price falls incrementally but the relationship between the incremental changes in discount
rate and price is non-linear.
Question 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)
For (d), see subject guide, Chapter 8, pages 170–1.
19
(a) Workings:
A B Expected return Variance Standard deviation

30 70 4.2 5.8545 2.419607
75 25 6 21.74063 4.662684
100 0 7 36 6
Hence:
Portfolio Expected return Standard deviation
1 4.2% 2.42%
2 6.0% 4.66%
3 7.0% 6.00%
(b) The best set of portfolios is the efficient set. This can be found by identifying the efficient
frontier which runs from the minimum variance portfolio to the maximum return portfolio.
‘Best’ means efficient which means the most return for a given level of risk (standard
deviation).
Better answers will use a diagram to illustrate the efficient frontier.
A common error is to state that the best portfolios are those which maximise return and
minimise risk. This is not possible as there is an inverse relationship between risk and return.
(c) Correlation between the returns on securities is bounded between +1 and −1. As correlation
reduces from +1 down to −1 the risk (standard deviation) of a portfolio reduces. When the
correlation is +1 the risk of the portfolio is the weighted average risk of the securities in the
portfolio. In other words there is no reduction in risk, i.e. no diversification benefits.
Minimum risk is achieved when the correlation = −1.
A diagram is useful to illustrate the relationship between correlation and risk reduction.
(d) The answer to this question requires an explanation of two-fund separation. A diagram is
useful to illustrate two-fund separation.
20
A line is drawn from the return on the risk-free security to a portfolio on the efficient
frontier. As the slope of the line increases the risky portfolio on the efficient portfolio moves
to the right until the tangency portfolio is found (i.e. where the line drawn from the return
on the risk-free security is just tangential to the efficient frontier). The tangency portfolio is
the optimal risky portfolio for all investors. Note, this is not the same as the optimal
portfolio for all investors. This will be a combination of the risk-free security and the
optimal risky portfolio.
Question 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.
(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%.
(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)
21
(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)
(a) We have:
DCF Y DCF Z
−40,000 −28,000
15,596.33 11,009.17
14,308.56 10,100.16
11,582.75 15,443.67
NPV = 1,487.64 8,553.00
As both projects have positive NPVs and the firm is selecting projects which are not
mutually exclusive and the firm is not capital constrained the decision should be to accept
both projects.
(b) We have:
DCF Y DCF Z
−40,000 −28,000
14,782.61 10,434.78
12,854.44 9,073.724
9,862.743 13,150.32
NPV = −2,500.21 4,658.83
The decision now is to reject Y but accept Z.

(c) Using the method of linear interpolation:
IRR: Y = 11% and Z = 24%.
In both cases the IRR is greater than the hurdle rate, so both projects should be accepted.
(d) Neither project pays back within two years so both projects are rejected under the payback
rule.
(e) Advantages – the method is quick and simple to calculate, takes risk into account in a simple
way (as it gives more weight to nearer cash flows – future cash flows are more uncertain).
Disadvantages – no allowance for the time value of money, ignores cash flows after the
payback point.
(f) The additivity property for NPV can be represented by:
NPV(A + B) = NPV(A) + NPV(B).
Better answers will discuss the benefits of this property, particularly for capital-constrained
firms.
22
Question 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)
(a) We have:
Value Beta Weighted Beta
140 0.7 0.16443
216 1 0.362416
240 1.4 0.563758
596 1.090604
Beta = 1.09. Beta is slightly aggressive, i.e. magnification of the return on the market.
(b) There are five main assumptions.
i. Investors maximise their utility only on the basis of expected portfolio returns and
return standard deviations.
ii. Unlimited amounts can be borrowed or loaned at the risk-free rate.
iii. Markets are perfect and frictionless (i.e. no taxes on sales or purchases, no transaction
costs, and no short sales restrictions).
iv. Investors have homogeneous beliefs regarding future returns, which means that all
investors have the same information and assessment about expected returns, standard
deviations and correlations of all feasible portfolios.
v. The market portfolio exists.
(c) Good answers are expected to write out the equation for the expected return under the
CAPM framework and need to provide accurate descriptions of the variables:
• E(rm ) = expected return on the market portfolio.
• (E(rm ) − rf ) = market risk premium, which is the amount by which the return of the
market portfolio is expected to exceed the risk-free rate.
23
(d) A stock above the SML would be undervalued (as the expected return is higher than
predicted by the CAPM, hence the price must be lower than predicted – inverse
relationship).
This stock would be attractive to investors – excess demand will increase the price (reduce
expected return) until it moves back to the SML.
(e) With the CAPM we cannot measure expected return on the market portfolio, so we have to
proxy it. This introduces measurement error which can be significant.
When testing the CAPM the hypothesis of interest is whether the CAPM is an accurate
model of expected returns. However, this hypothesis cannot be tested in isolation as it is
jointly tested with the hypothesis that the proxy for the return on the market portfolio is
accurate.
24

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Examiners’ commentaries 2019

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

Planning your time in the examination

What are the topics under examination?

What are the examiners looking for?

Key steps to improvement

Examination revision strategy

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

Comments on specific questions – Zone A

(a) Explain, giving examples, the main risks affecting banks.

Reading for this question

For (a), see subject guide, Chapter 6, pages 116–20.

For (b), see subject guide, Chapter 5, pages 101–08.

For (c), see subject guide, Chapter 6, pages 117–18.

Approaching the question

Reading for this question

See subject guide, Chapter 4, pages 64–82.

Approaching the question

Each theory needs to be explained in detail.

(a) Describe the main functions of a financial system.

Reading for this question

For (a), see subject guide, Chapter 2, pages 16–7.

For (b), see subject guide, Chapter 2, pages 32–3.

For (c), see subject guide, Chapter 2, pages 26–32.

Approaching the question

(a) The main functions are:

Reading for this question

For (a), see subject guide, Chapter 5, pages 102–6.

For (b), see subject guide, Chapter 5, pages 104–5.

For (c), see subject guide, Chapter 5, pages 106–7.

Approaching the question

Reading for this question

See subject guide, Chapter 6, pages 127–30.

Approaching the question

Year t CF DF DCF DCF × t

(c) Use the modified duration formula:

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

Stock Expected return Standard deviation

The correlation between the two securities returns is 0.4.

Reading for this question

For (a), see subject guide, Chapter 8, pages 160–1.

For (b), see subject guide, Chapter 8, pages 166–7.

For (c), see subject guide, Chapter 8, pages 169–70.

For (d), see subject guide, Chapter 8, pages 170–1.

Approaching the question

Reading for this question

See subject guide, Chapter 7, pages 142–9.

Approaching the question

NPV = 8,519.91 3,625.09

NPV = 2,916.667 −1,014.67

The decision now is to accept Y but reject Z.

IRR: Y = 26% and Z = 18%.

NPV(A + B) = NPV(A) + NPV(B).

Reading for this question

See subject guide, Chapter 8, pages 176–80.

Approaching the question

(a) Expected return = 4 + 4 × 1.5 + 1.5 × 0.8 + 2 × 0.2 = 7.6%.

Examiners’ commentaries 2019

Information about the subject guide and the Essential reading

Comments on specific questions – Zone B