Examiners’ commentaries 2022

Examiners’ commentaries 2022

FN1024 Principles of banking and finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2021–22. 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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FN1024 Principles of banking and finance

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 examination marks are not generally 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.

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.

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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 Examiners’ commentaries 2022

Examiners’ commentaries 2022

FN1024 Principles of banking and finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2021–22. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

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

Comments on specific questions – Zone A

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

Section A

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

Question 1

(a) Outline the key features of the Diamond model of banks as delegated monitors.
Discuss how it helps us explain the role of banks as intermediaries.
(13 marks)
(b) Explain how the adverse selection problem impacts lending and borrowing.
Discuss the solutions to this problem.
(12 marks)

Reading for this question

For (a), see the subject guide pages 81–2. For (b), see the subject guide pages 73–5.

Approaching the question

(a) The question contains two elements. The first is to outline the key features of the Diamond
model of 1984. This involves setting out the three conditions that are required for the

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FN1024 Principles of banking and finance

Diamond model and then to show, given these conditions, the cost of monitoring n
borrowers is lower when an intermediary does the monitoring compared to mn lenders.
The other element of the Diamond model that is often missed in answers is that monitoring
is important to reduce the moral hazard problem. The ability of banks to lower monitoring
costs provides a justification for the role of banks as intermediaries – the second element of
the answer. However, the existence of banks in the process introduces a new problem, that of
whether lenders should monitor the bank. Diamond argues that because of the large number
of loans banks make the banks have the ability to diversify and pool and so reduce risk.
This means the delegation cost – the cost of lenders monitoring the banks tends to zero.

(b) Adverse selection problem arises out of asymmetric information. Insights into this problem
were presented by Akerlof (1970).
In lending/borrowing it is the problem of lenders having less information than borrowers
about the probability of repayment and as a consequence will only lend at an interest rate
reflecting average risk. This leads to many good risks leaving the market (as they will have
to pay a higher interest rate). Therefore, there is a greater chance of a lender selecting a bad
risk/lower quality project.
Consequently, less lending will take place and fewer projects will receive finance.
Solutions to this problem all relate to lenders increasing information.
1. Private production and sale of information – ratings, i.e. bond market solution. Need to
discuss the free-rider problem.
2. Government regulation to force disclosure – for example, accounting disclosures – not
always successful.
3. Banks – expertise in selecting good credit risks.
Do not face the free-rider problem therefore banks have the incentive to produce enough
information to solve the problem as only they will benefit. Hence ‘3.’ is the optimal solution.

Question 2

(a) Explain the main features of the Basel 3 framework for the regulation of bank
capital and liquidity adequacy and discuss its effectiveness in addressing the
problem of pro-cyclicality.
(14 marks)
(b) Explain the main features of the safety net measures in bank regulation and
discuss their advantages and disadvantages.
(11 marks)

Reading for this question

For (a), see the subject guide pages 104–6. For (b), see the subject guide pages 98–101.

Approaching the question

(a) The first part of this question requires an explanation of the main changes introduced by
Basel 3:
1. Common equity (defined as ordinary or common shares plus retained earnings) should
form a greater part of tier 1 capital. There will be a minimum common equity to risk
weighted assets ratio of 4.5%.
2. Tier 1 equity (made up of common equity plus other more strictly defined capital
instruments – mainly preferred stock) to risk weighted assets must be greater than 6 per
cent (compared to 4 per cent under Basel 2).

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 Examiners’ commentaries 2022

3. Total capital (Tier 1 plus Tier 2 capital) to risk weighted assets must be greater than 8
per cent (no change compared to Basel 2).
4. A capital conservation buffer equal to 2.5 per cent of risk weighted assets and made up of
common equity. This buffer will allow banks to build up capital during ‘good times’
which can then be drawn on in times of financial stress.
5. In addition, national regulators will be able to impose an additional 2.5 per cent capital
buffer when credit growth is judged to be excessive and there is a build-up of
system-wide risk (this is known as a countercyclical capital buffer).
6. National regulators will also have further discretion to increase capital requirements for
large systemically important banks (to address the too-big-to-fail problem).
The second part of the question relates to how Basel 3 reduces the problem of
pro-cyclicality. This refers to the problem of banks facing reduced capital requirements in
times of economic growth (risk is low) hence increase lending creating a higher peak in
economic activity fuelled by excessive lending. This is repeated in the down cycle of
economic activity as banks reduce lending (risk of lending higher) thus creating a lower
trough. So, the economic cycle is amplified.
The solution introduced in Basel 3 is that of the capital conservation buffers (in times of
economic growth), i.e. higher capital required which slows lending growth. These buffers can
then be released to support extra lending in times of economic slowdown – this increases
lending in the downcycle thus leading to a faster correction (lower trough).

(b) The question has two elements. Several answers only addressed the first element – the main
features of the safety net – without addressing the second part – the advantages and
disadvantages.
The main features include:
1. Deposit insurance.
2. Lender of last resort facility.
3. Provision of capital to banks in times of distress.
Each of these features needs explanation. It is also helpful to provide examples.
Advantages – provide stability etc. at times of market stress.
Disadvantages – moral hazard problems created.
To deal with moral hazard problems, regulators engage in supervision of banks
capital/liquidity/risk management processes.

Question 3

(a) Explain the main types of risks faced by banks.

(8 marks)
(b) Explain the role of bank capital in protecting a bank from the risks outlined in
(a).
(10 marks)
(c) Explain how interest rate risk impacts a bank.
(7 marks)

Reading for this question

For (a), see the subject guide pages 116–20. For (b), see the subject guide page 101. For (c), see
the subject guide pages 117–8.

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FN1024 Principles of banking and finance

Approaching the question

(a) This is a relatively straightforward question. The main risks are:

• credit risk
• interest rate risk
• market risk
• liquidity risk
• operational risk.
Each of these need to be explained. It is also helpful to give an example.

(b) Capital provides protection against loss due to reduction in the value of assets – hence it
protects against all the risks outlined in part (a) except for liquidity risk and interest rate
risk. Answers need to explain how this protection occurs in relation to each risk and why it
does not directly impact liquidity risk and interest rate risk.
It is helpful to use an example of how capital protects against loss of value of assets
(resulting from credit, market, and operational risk). The reason why capital does not
directly impact liquidity risk is that this is a cash flow risk rather than a reduction in value
risk.

(c) Interest rate risk can affect banks in two main ways:
1. Income effect – changes in interest rates affect net interest income. This has two further
effects – reinvestment risk and refinancing risk. Both need to be explained.
2. Market value effect – changes in interest rates affect the rate of discounting of cash flows
to determine the value of assets and liabilities and hence net wealth or capital.
In each case, the use of examples is recommended.

Question 4

(a) Discuss the advantages and disadvantages of market-based systems compared to

bank-based systems.
(12 marks)
(b) Explain, giving examples, how speculative bubbles impact financial markets and
discuss whether or not they are consistent with efficient markets.
(13 marks)

Reading for this question

For (a), see the subject guide pages 50–3. For (b), see the subject guide pages 59–61 and 186.

Approaching the question

(a) Need to compare the two types of systems to identify the advantages/disadvantages.
Comparison based on the following criteria:
1. Integration of banking and commerce.
Either by banks ownership of firm’s equity or firm’s ownership of bank equity and the
influence these bring.
Bank-based systems – close integration (Keiretsu in Japan and Hausbank system in
Germany). Helps with reducing asymmetric information problems.
Market-based systems – not a close relationship. In some market-based systems equity
stakes prohibited.

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 Examiners’ commentaries 2022

2. Integration of banking and non-bank financial services.

In bank-based systems such as Germany the banks are Universal banks supplying a wide
range of services to firms – for example, traditional banking, underwriting, advisory etc.
Firms then deal with one bank (or closely connected group) for all their services.
In market-based systems firms will often obtain different financial services from different
banks. In US the integration of traditional banking and other financial services was
restricted until the repeal of Glass–Steagall.
The distinction between bank- and market-based systems also has implications for:
• household asset allocation
• importance of investment intermediaries in the financial system
• sources of finance for firms.
Each of these should be considered. The identification of advantages/disadvantages of each
system should be brought out in the discussion – for example, benefits of bank-based
systems for solving moral hazard problems.

(b) A bubble occurs when an asset or commodity becomes overinflated in value. These bubbles
in asset prices typically have three distinct phases:
1. Financial liberalisation results in an expansion in credit, which is accompanied by an
increase in asset prices such as real estates and shares. They rise as the bubble inflates.
2. The bubble bursts and asset prices collapse (often within a short period of time).
3. Default of many firms and other agents that have borrowed to buy assets at inflated
prices. A banking crisis may follow, causing problems in real sectors of the economy such
as industry.
The second part of this question concerns the efficient markets hypothesis (EMH). Two of
the key assumptions of the EMH are that investors are rational and all relevant information
is contained in prices. Therefore, prices are at fundamental valuation. Hence EMH is not
consistent with speculative bubbles.
Bubbles imply irrational investors. They imply prices can be above fundamental value, i.e.
do not reflect information only. Can be reconciled by explaining that bubbles can exist
temporarily but that in the long run prices return to fundamental value.

Section B

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

Question 5

Consider the following two stocks:

– Stock A is expected to pay a dividend of $12 forever

– Stock B is expected to pay a dividend of $9 next year, $10 in the second year
then dividends are expected to grow at an annual rate of 3% thereafter.

(a) If companies comparable to both companies A and B have required return on

equities of 9%, calculate the value of stock A and the value of stock B.
(6 marks)
(b) Explain what is meant by required return on equity.
(3 marks)
(c) Why are capital gains apparently absent from the dividend discount model used
to value stocks?
(9 marks)

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FN1024 Principles of banking and finance

(d) Compare and contrast the characteristics of common stock (ordinary shares)
and preferred stock (preference shares).
(7 marks)

Reading for this question

See the subject guide pages 32 and 152–5.

Approaching the question

(a) Stock A:
12
P = = 133.33.
0.09
Stock B:
9 10 10(1.03)/0.09 − 0.03
P = + 2
+ = 8.26 + 8.42 + 144.49 = 161.17.
1.09 (1.09) (1.09)2

(b) Required return refers to the return required by investors in this stock (level of risk) to
compensate for the risk they are exposed to.

(c) Answering this question requires deriving the dividend discount model to show that capital
gains are not absent. They are implicit in the formula.

(d) The key differences are set out below. Answers to this question though should not be in the
form of a list. The requirement is to find points of similarity and contrast.
Common stocks – uncertain dividend, infinite life, share in ownership of the firm, voting
rights, ranks lowest in event of insolvency.
Preferred stock – more certain (fixed dividend), infinite life, share in ownership, no voting
rights, ranks above common stock but below debt.

Question 6

Belvedere PLC is considering whether to invest in one of two mutually exclusive

projects (X or Y). These projects are of a similar risk to the existing activities of
the company. The estimates for the investment outlay and the resulting cash inflows
for the two projects are described on Table 1:

Table 1

Cash inflows
Investment outlay (Year 0) Year1 Year 2 Year 3
Project X £600,000 £250,000 £300,000 £300,000
Project Y £1,000,000 £450,000 £450,000 £450,000

(a) If the opportunity cost of capital for Belvedere PLC is 11%, calculate the net
present value (NPV) and internal rate of return (IRR) for the two projects.
Which project(s) would you recommend for investment? Justify your answer
(show all workings).
(9 marks)
(b) Explain the implications of the different discount rates used in the NPV and
IRR methods.
(6 marks)

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 Examiners’ commentaries 2022

(c) Bosanova PLC has 4 projects to consider. Capital has been rationed to $3
million by the head office. The four projects are not mutually-exclusive and the
firm’s cost of capital is 10%.
The cash flows and NPVs for the 4 projects are described in Table 2
Table 2

Initial cost ($m) NPV at 10% ($m)

A −2 4.351
B −1 3.200
C −1 2.375
D −3 6.420

The projects have to be undertaken completely (i.e. no fractions of projects)

and a project can only be undertaken once. Which project(s) should be chosen?
(6 marks)
(d) Discuss the limitations of the IRR method of investment appraisal.
(4 marks)

Reading for this question

See the subject guide pages 140–8.

Approaching the question

(a) The workings for answering this question are given in the following table:

X DF CF × DF Y DF CF × DF

−600,000 1 −600,000 −1,000,000 1 −1,000,000

250,000 0.9009 225,225 450,000 0.9009 405,405.4
300,000 0.81162 243,487 450,000 0.81162 365,230.1
300,000 0.731191 219,357 450,000 0.731191 329,036.1
NPV @ 11% 88,069.4 99,671.62
NPV @ 14% −9,875 −27,487

IRRX = 19%
IRRY = 17%

As the projects are mutually exclusive then need to rank.

NPV and IRR give inconsistent rankings.
Go with NPV ranking, i.e. choose project Y as it delivers the highest wealth.

(b) The NPV discount rate is the firm’s opportunity cost of capital, i.e. assumes reinvestment of
cash flows at firm’s cost of capital. Consistent with capital market equilibrium.
IRR discount rate is the IRR itself. Hence two projects with the same risk can have different
discount rates and hence reinvestment rates – not consistent with capital market theory.

(c) We have:

Feasible combinations Cost Total NPV

D 3 6.42
A&B 3 7.551
B&C 2 5.575
A&C 3 6.726

Hence A and B give the best outcome (highest NPV).

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FN1024 Principles of banking and finance

(d) The key limitations of the IRR method are:

• the discount rate is not a market determined rate of return
• it can give rankings that are inconsistent with NPV
• it can give no solution or multiple solutions.
A good answer will discuss the limitations noted above.

Question 7

(a) Briefly explain each of the following terms:

i. Minimum variance portfolio.
ii. Mean-standard deviation frontier.
iii. Beta coefficient (in CAPM).
iv. Risk-free rate of return.
(8 marks)
(b) Explain to an equity investor the benefits and limitations of diversification.
(5 marks)
(c) Demonstrate how, in portfolio theory, the introduction of a risk-free asset allows
us to identify the optimal portfolio for an investor. How is the efficient set
defined in the case of a portfolio containing risky assets and the risk-free asset
(the risk-free asset can have positive or negative weights)?
(8 marks)
(d) Discuss the limitations of the CAPM.
(4 marks)

Reading for this question

See the subject guide pages 166–77.

Approaching the question

(a) i. Minimum variance portfolio is the portfolio at the leftmost point on the efficient frontier
giving the lowest risk of feasible and efficient combinations of investments.
ii. Mean-standard deviation frontier – the outer edge of all feasible combinations of
investments. Contains both efficient and inefficient combinations.
iii. Beta – measures the sensitivity of the return on a stock to the return on the market
portfolio.
iv. Risk-free rate – the return on a risk-free asset. A theoretical concept that identifies the
return to compensate an investor for the loss of liquidity.

(b) Benefit – risk reduction. Need to demonstrate.

Limitations – cannot eliminate all risk (only specific risk). Market risk remains.
A good answer would use a diagram to illustrate.

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 Examiners’ commentaries 2022

(c) The introduction of a risk-free security to the universe of risky securities allows investors to
move to higher levels of utility as they can allocate their wealth to the risk-free security and
a portfolio of risky assets on the efficient frontier. This creates a new (linear) efficient
frontier – the CML. This should be demonstrated graphically.
The line from the risk-free rate to the efficient frontier that is the steepest (i.e. where the
line is just tangential to the (old) efficient frontier) is the optimal new efficient frontier – as
this will yield the set of combinations of risk-free asset and efficient risky portfolio that
delivers the highest expected return for a given risk.
The tangent portfolio will therefore be the portfolio of risky assets that all investors will
choose to invest in.
Investors will locate somewhere on the new efficient frontier (CML) according to their
preference for risk.

(d) There are both theoretical and practical limitations of the CAPM. The theoretical problems
relate to the use of the market portfolio in the CAPM. This is not observable. This causes
the dual hypothesis problem. In addition, the empirical evidence shows that the CAPM
does not fully capture variations in expected returns of stocks. Other models developed –
for example, APT and factor models – appear to explain more of the variation in expected
returns.

Question 8

(a) Discuss why the assumption of informational efficient markets is important for
traditional capital budgeting and asset pricing.
(7 marks)
(b) Explain what an excess return is in a financial market. Discuss the main
predictions of the Efficient Market Hypothesis (EMH).
(6 marks)
(c) Explain the weak form of the EMH and discuss its empirical evidence.
(12 marks)

Reading for this question

See the subject guide pages 185–95.

Approaching the question

(a) The main objective of capital budgeting is to maximise shareholder wealth, which implies
the maximisation of the value of the firm’s stock. Therefore, it is important that financial
markets are able to value the firm’s stocks correctly. The signal given by the financial
market to the stockholders (through the price) must reflect the firm’s decisions on
investment projects in a correct way.
Moreover, capital budgeting techniques use a discount rate for the appraisal of real assets. If
financial markets were inefficient, it would be virtually impossible for managers to take
rational capital investment decisions on behalf of stockholders because it would be
impossible to identify the opportunity cost of capital to be used in the Net Present Value
calculation.
One main assumption in portfolio theory is that a financial market is reasonably efficient. If
a financial market is inefficient in pricing securities, then the equilibrium return (measured
by the Capital Asset Pricing Model or the Arbitrage Pricing Theory) would lose credibility.

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FN1024 Principles of banking and finance

(b) Note that this question has two parts.

Excess return is a measure of the difference between the actual return and the equilibrium
return generated by a pricing model. If excess return exists then the EMH is violated.
Main predictions of EMH:
• Prices contain all information therefore cannot be predicted consistently (depends on
information set).
• Prices in financial markets are a fair game.

(c) Weak-form efficiency implies prices reflect all historical information. This needs explaining.
The empirical evidence which is supportive of weak form efficiency is:
• evidence of random walk effect
• evidence relating to success of technical trading rules.
The evidence against weak-form efficiency can be categorised as follows:
• calendar anomalies – for example, January effect
• evidence relating to mean reversion.

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 Examiners’ commentaries 2022

Examiners’ commentaries 2022

FN1024 Principles of banking and finance

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2021–22. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

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

Comments on specific questions – Zone B

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

Section A

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

Question 1

Examine the causes of the 2008 global financial crisis and discuss how regulators and
governments responded to the crisis.

(25 marks)

Reading for this question

See the subject guide pages 56–8.

Approaching the question

This question requires an essay type answer, so it is best to plan the structure of your answer
before writing. You should try to start with a brief introduction setting out what you are going
to cover and then a brief conclusion at the end.

Note there are two elements to the question: causes and responses.

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FN1024 Principles of banking and finance

Causes:

1. Long period of moderation – changed risk appetite.

2. Increase in demand for and supply of credit – linked to ‘1.’.
3. Relaxation of credit supply conditions, especially sub-prime lending in US.
4. Bubble in US housing market.
5. Financial innovations – credit risk models (gave banks the belief they could manage risk)
plus securitisation (magnified the risk and led to global spread of sub-prime risk).
6. Inadequate capital/liquidity held by banks.

Responses:

1. Basel 3 – increase in quantity and quality of capital + greater internal liquidity.

2. Macroprudential policy tools.
3. Countercyclical capital (also Basel 3).
4. More capital for trading of securities or banning trading (Volker rule).
5. Solutions to too-big-to-fail problem.

Will these be sufficient? Probably not. Some gaps in regulation closed but not all. Banks will
seek out new risks not captured by new regulations.

Question 2

(a) Discuss the advantages and disadvantages of regulating the banking system.
(10 marks)
(b) Explain the problem of pro-cyclicality arising from the regulation of the banking
system and discuss solutions to this problem.
(15 marks)

Reading for this question

For (a), see the subject guide pages 94–6. For (b), see the subject guide pages 104–5.

Approaching the question

(a) The key elements to cover in this question are the following.
Advantages include protection against:
• fragility of banks
• systemic risk
• protection of depositors.
Disadvantages include:
• cost
• restrictions on innovation and competition
• moral hazard created.
Conclude by weighing up the advantages and disadvantages to explain why most banking
systems are highly regulated.

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 Examiners’ commentaries 2022

(b) Pro-cyclicality arising from capital regulation refers to the problem of banks facing reduced
capital requirements in times of economic growth (where risk is low) hence increase lending
creating a higher peak in economic activity fuelled by excessive lending. This is repeated in
the down cycle of economic activity as banks reduce lending as the risk of lending is higher
thus creating a lower trough. So, the economic cycle is amplified.
Solutions include capital conservation buffers (in times of economic growth), i.e. higher
capital required which slows lending growth. These buffers can then be released to support
extra lending in times of economic slowdown – this increases lending in the downcycle thus
leading to a faster correction (lower trough). This has been implemented through Basel 3.
Other solutions include macro-prudential policy.

Question 3

(a) A firm is looking to raise additional finance to finance long term investments.
Compare and contrast the characteristics of common stock, preferred stock and
corporate bonds from the perspective of the issuing firm.
(10 marks)
(b) Distinguish between money markets and capital markets. Distinguish also
between over the counter and organised markets. Give examples of the financial
instruments traded in each of the four markets considered.
(8 marks)
(c) Explain the main functions of a financial system in supporting the operations of
the economy.
(7 marks)

Reading for this question

For (a), see the subject guide page 32. For (b), see the subject guide pages 33–4. For (c), see the
subject guide pages 16–7.

Approaching the question

(a) The key differences are set out below. Answers to this question though should not be in the
form of a list. The requirement is to find points of similarity and contrast. It should also be
written from the point of view of the issuing firm.
Common stocks – equity (long-term) capital raised, high servicing costs (dividends) as risk
to investors perceived to be high, low risk (as no contractual arrangement to pay dividends.
Preferred stocks – equity (long-term) capital raised, relatively high servicing costs
(dividends) as risk to investors perceived to be high (though lower than common stock), low
risk (as no contractual arrangement to pay dividends).
Corporate bonds – debt (long-term) capital raised, low servicing costs (interest) as investors
perceive lower risk of holding bonds relative to equity, high risk to the firm as there is a
contractual arrangement to pay interest.

(b) 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
transactions) where firms and financial institutions manage their short-term liquidity needs
(i.e. to earn interest on their temporary surplus funds).
Capital markets are markets in which long-term securities are traded. These long-term
instruments include equity instruments (infinite life), government bonds and corporate
bonds (original maturity of one year or greater).

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FN1024 Principles of banking and finance

Organised exchanges – more rules governing trading. In exchanges, buyers and sellers
(through their brokers) transact in one central location to conduct trades.
Over the counter (OTC) markets – fewer rules. Dealers at different locations have an
inventory of securities and are ready to buy and sell these securities ‘over-the-counter’ to
anyone willing to accept their price. Dealers are typically banks.

(c) The main functions of financial systems are to:

• provide the mechanisms by which funds can be transferred from units in surplus to units
with a shortage of funds in order to directly or indirectly facilitate lending and borrowing
• enable wealth holders to adjust the composition of their portfolios
• provide payment mechanisms
• provide mechanisms for risk transfer.
Looking for an explanation of how these functions support the economy – the following
points are expected:
• mobilise savings
• increase funds available to fund capital investments
• increase efficiency of economic activity.

Question 4

(a) Discuss the role of asymmetric information in explaining financial

intermediation.
(15 marks)
(b) Consider the role of liquidity insurance provision (Diamond and Dybvig) in
explaining financial intermediation.
(10 marks)

Reading for this question

See the subject guide pages 72–6.

Approaching the question

(a) Asymmetric information is the problem of one party to a transaction having less
information than the other party. In the case of lending/borrowing it is the lender who has
less information. This causes adverse selection and moral hazard problems for the lender.
Need to examine what these two problems are and how they can be solved. Answers need to
explain why banks are better at solving these problems than capital markets – no free-rider
problem.

(b) Need to cover Diamond and Dybvig (1983) notion of banks as liquidity insurers or
consumption smoothers. Based on the notion that not all depositors will be looking to
withdraw at the same time because of the low correlation between exogenous shocks to
depositors that require them to withdraw funds. Hence banks are able to lend but hold only
a fraction of deposits as a liquidity buffer to meet depositors’ withdrawal needs.

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 Examiners’ commentaries 2022

Section B

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

Question 5

Consider the following balance sheet of Bank Alaska:

Assets ($) Duration (years)

Variable rate mortgages 600 9.5
Fixed rate mortgages 250 4.2
Commercial loans 500 4.5
Physical assets 100
Total 1450

Liabilities ($) Duration (years)

Money market deposits 400 0.8
Savings deposits 600 2.7
Variable rate CDs 100 0.9
Equity 350
Total 1450

Assumptions

Fixed rate mortgages repaid in the coming year = 20%.

Savings deposits that become rate sensitive in the coming year = 15%.

All commercial loans are rate sensitive.

All money market deposits are rate sensitive.

(a) Using income gap analysis, calculate the change in net interest income over the
coming year if interest rates increase by 1% from 3% to 4%.
(6 marks)

(b) Explain runoff cash flows in the context of income gap analysis.
(3 marks)

(c) If Bank Alaska predicts interest rates may fall, how can the bank adjust its
portfolio of assets and liabilities in order to reduce its loss of income?
(5 marks)

(d) What is the duration gap for Bank Alaska?

(4 marks)

(e) What is the estimated change in the value of equity (in $) for Bank Alaska if
interest rates increase by 1% from 3% to 4%?
(3 marks)

(f ) Explain why the change calculated in part (e) is an estimate.

(4 marks)

Reading for this question

See the subject guide pages 125–30.

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Approaching the question

(a) We have:

RSA = 600 + 500 + 250 × 0.2 = 1,150

RSL = 400 + 100 + 600 × 0.15 = 590

Income gap = 1,150 − 590 = 560.

Change in net interest income for a 1% change in interest rates = 560 × 0.01 = 5.6.

(b) Run off cash flows refer to cash flows of rate insensitive assets and liabilities that become
rate sensitive over the forecast period for which the income gap analysis applies – for
example, in the example above the 20% of fixed rate mortgages paid early in the next year.
These run off cash flows are included in the income gap calculation.

(c) A fall in interest rates will lead to a fall in interest income from rate sensitive assets and a
fall in interest payments on rate insensitive liabilities. Given the positive income gap the
overall effect is a fall in interest income. To protect:
• switch some of the interest sensitive assets – for example, variable rate mortgages – to
rate insensitive – for example, fixed rate mortgages
• switch some of the rate insensitive liabilities to rate sensitive (to take advantage of the
lower interest costs).

(d) Duration of assets:

600 250 500
= × 9.5 + × 4.2 + × 4.5 = 6.207 years.
1,450 1,450 1,450
Duration of liabilities:
400 600 100
= × 0.8 + × 2.7 + × 0.9 = 1.8455 years.
1,100 1,100 1,100
Duration gap:
L 1,100
= Dur A − × Dur L = 6.207 − × 1.8455 = 4.8069 years.
A 1,450

(e) We have:
change in i 0.01
change NW/A = −Dur gap × = −4.8069 × = 0.0467.
1+i 1.03
Therefore:
change in NW = −0.0467 × A = −0.0467 × 1,450 = −$67.67.

(f) Because the formula used to calculate the change in net worth is modified duration. This
assumes a linear relationship between NW/A and i. The relationship is non-linear. Hence
the use of a linear approximation introduces error and is an estimate. A diagram to
illustrate the issue would be rewarded here.

Question 6

An investor is considering investing in the following two shares:

Beta
Fortress PLC 1.4
Castle PLC 0.5

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 Examiners’ commentaries 2022

(a) If the return on Treasury Bills is 5% and the market risk premium is 10%, what
is the expected return of a portfolio made up of 40% Fortress shares and 60%
Castle shares?
(4 marks)
(b) Explain Beta in the context of the CAPM and explain what the Betas for
Fortress and Castle shares imply about those shares.
(4 marks)
(c) Shares in Empire PLC have a Beta of 0.9 and are estimated to have an expected
return of 16%. Given the information in part (a), are Empire shares correctly
priced according to the CAPM? Explain your answer and explain what is likely
to happen to the shares in Empire PLC.
(6 marks)
(d) Explain what (i) the market risk premium and (ii) the risk-free rate of return in
the CAPM represent.
(4 marks)
(e) Explain why it is difficult to empirically test the CAPM.
(7 marks)

Reading for this question

See the subject guide pages 172–7.

Approaching the question

(a) Using the CAPM equation:

E(R) = Rf + Beta(E(Rm ) − Rf ).

Fortress:
E(R) = 5 + 1.4 × 10 = 19.
Castle:
E(R) = 5 + 0.5 × 10 = 10.
Therefore, the portfolio:

E(R) = 0.4 × 19 + 0.6 × 10 = 7.6 + 6 = 13.6%.

(b) Beta is the sensitivity of the shares return to the market portfolio return.
Fortress beta > 1, hence outperforms the market.
Castle beta < 1, hence underperforms the market.

(c) CAPM:
E(R) = 5 + 0.9 × 10 = 14%.
Actual return is 16%, hence lies above the SML and under-priced. Will lead to excess
demand which will push up the price of Empire shares and hence reduce E(R) until the
share sits on the SML.

(d) Market risk premium = return on the market portfolio minus the risk free rate. This
represents the compensation for exposure to market risk. Risk-free rate – the return on the
risk-free asset. Represents the compensation for loss of liquidity when investing. Both
concepts are theoretical.

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FN1024 Principles of banking and finance

(e) Main problem is that the market portfolio is a theoretical concept and hence the market
return is not observable. Have to use a proxy. This introduces measurement error. Creates
dual hypothesis problem, i.e. would like to test whether the CAPM is a valid proposition
but also testing (jointly) the validity of the proxy.

Question 7

(a) Derive the Capital Market Line (CML) by using the two-fund separation
theorem. Explain the concepts of the optimal risky portfolio and risk-free rate
of return.
(9 marks)
(b) An investor has $1,000,000 available for investment. Assume there are two
investment opportunities available: (1) the optimal risky portfolio, with
expected return of 12% and standard deviation of returns of 20%; (2) Treasury
Bills (TB) paying 4%.
Assume the investor can borrow or lend at the TB rate.
The investor is considering two portfolios to invest in:
• Portfolio A, made up of $300,000 invested in TBs and $700,000 in the
optimal risky portfolio.
• Portfolio B, made up of −$250,000 in TBs (i.e. money borrowed at the TB
rate) and $1,250,000 invested in the optimal risky portfolio.
Calculate the expected return and risk for portfolios A and B and draw the
Capital Market Line showing the optimal risky portfolio along with portfolios A
and B.
(7 marks)
(c) Explain how an investor would select a portfolio on the Capital Market Line.
(4 marks)
(d) Explain the differences and similarities between the Capital Market Line (CML)
and the Security Market Line (SML).
(5 marks)

Reading for this question

See the subject guide page 170–5.

Approaching the question

(a) The introduction of a risk-free security to the universe of risky securities allows investors to
move to higher levels of utility as they can allocate their wealth to the risk-free security and
a portfolio of risky assets on the efficient frontier. This creates a new (linear) efficient
frontier – the CML. This should be demonstrated graphically.
The line from the risk-free rate to the efficient frontier that is the steepest (i.e. where the
line is just tangential to the (old) efficient frontier) is the optimal new efficient frontier – as
this will yield the set of combinations of risk-free asset and efficient risky portfolio that
delivers the highest expected return for a given risk.
The tangent portfolio will therefore be the portfolio of risky assets that all investors will
choose to invest in. Investors will locate somewhere on the new efficient frontier (CML)
according to their preference for risk.

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 Examiners’ commentaries 2022

(b) A:
E(R) = 0.3 × 4 + 0.7 × 12 = 9.6% Risk = 0.7 × 20 = 14%.
B:
E(R) = −0.25 × 4 + 1.25 × 12 = 14% Risk = 1.25 × 20 = 25%.

(c) Using indifference curves representing risk-return trade-off for the investor – where
tangential to the CML = optimal portfolio.

(d) CML is a line in E(R)–standard deviation space that cuts the vertical axis at the risk-free
rate and contains the tangent portfolio. It contains all efficient portfolios. SML is a line in
E(R)–Beta space and cuts the vertical axis at the risk-free rate. It contains the market
portfolio. It contains all risky securities and portfolios. A diagram of the CML and SML
would be rewarded here.

Question 8

(a) Explain how bonds and stocks are valued and discuss the problems with valuing
both types of securities.
(6 marks)
(b) A US corporate bond has a coupon rate of 4%, a par (face) value of $1,000 and
will mature in 4 years. The current yield on similar bonds is 3%. Using the
data given and assuming coupons are paid annually, calculate the value of the
corporate bond.
(2 marks)
(c) Calculate the duration of the US corporate bond described in (b).
(4 marks)
(d) Define and explain Macaulay duration and describe the main characteristics of
Macaulay duration in relation to bonds.
(4 marks)
(e) Explain the yield curve for government bonds and discuss the main theories
behind the shape of the yield curve.
(9 marks)

Reading for this question

See the subject guide pages 30–2, 127–9 and 150–5.

Approaching the question

(a) Both valued using sum of discounted cash flows. Bond cash flows more certain = to fixed
interest payments plus redemption value paid at maturity. Equity cash flows more uncertain
– uncertain dividend payments. Infinite life of equity. Hence valuing equities more
problematical.

(b) We have:

Cf DF DCf
40 0.970873786 38.83495146
40 0.942595909 37.70383637
40 0.915141659 36.60566637
1,040 0.888487048 924.0265298
P= 1,037.170984

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FN1024 Principles of banking and finance

(c) We have:

t Cf DF DCf DCF × t
1 40 0.970873786 38.83495146 38.8349515
2 40 0.942595909 37.70383637 75.4076727
3 40 0.915141659 36.60566637 109.816999
4 1,040 0.888487048 924.0265298 3,696.10612
1,037.170984 3,920.16574
Dur = 3.77967163

(d) Macaulay duration takes into account the time of arrival (or payment) of all the cash flows
as well as the maturity of the asset (liability). Technically the Macaulay duration is a
weighted average of the maturities of the cash payments, where the weights are the relative
present values of each cash flow. It measures the period of time required to recover the
initial capital investment.
There are three important features of duration:
• Macaulay duration increases with the maturity of a bond.
• Macaulay duration decreases as market interest rate increases.
• Macaulay duration decreases as the coupon interest rate increases.

(e) The term to maturity influences the interest rate. Bonds with identical risk may have
different yields (interest rates) because of the difference in the time remaining to maturity.
A yield curve plots the yields (interest rates) of bonds with different maturities but the
same risk. The yield curve can be: upward (the long-term rates are above the short-term
rates); flat (short- and long-term interest rates are the same); and inverted (long-term
interest rates are below short-term interest rates).
There are a number of theories that attempt to explain the shape of the yield curve.
(a) Expectations theory
The expectations theory of the term structure of interest rates states that in equilibrium,
the long-term rate is a geometric average of today’s short-term rate and expected
short-term rates in the future.
In this theory, if the current long rate is higher than the current short rate, short-term
rates must be expected to rise in the future. Conversely, if the current long rate is lower
than the current short rate then short-term rates are expected to decline in the future: in
this instance, we will observe a downward-sloping yield curve. Finally, if no change is
expected in short rates, then the current long rate will equal the current short rate, and
we will observe a flat yield curve. Hence, the shape of the yield curve will be determined
by expectations of future interest rates.
(b) Liquidity premium theory
Liquidity premium theory asserts that, in a world of uncertainty, investors and lenders
will want to hold assets that can be converted into cash quickly. Therefore they will
demand a liquidity premium for holding long-term debt. Conversely, the same dislike for
uncertainty causes borrowers (for example, firms and governments) to prefer to borrow
for a longer period at a rate which is certain now – therefore they will be willing to pay a
liquidity premium and, therefore, a higher rate of interest on their longer-term debt.
This implies that the yield curve will normally be upward-sloping, in the absence of any
other influences. In reality, we need to consider the combined effect of expectations
together with liquidity preference. A downward-sloping yield curve will occur when
expectations of an interest rate fall are sufficient to offset the liquidity premium.
(c) Market segmentation
As well as the investors’ expectations with respect to future interest rates and their
preferences for liquidity, another theory, the market segmentation theory, suggests that
the bond market is actually made up of a number of separate markets distinguished by
time to maturity, each with their own supply and demand conditions. Different classes of

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investors and issuers will have a strong preference for certain segments of the yield curve
and, therefore, the curve will not necessarily move up, or down, over its entire range.
The test of a theory is (i) does it give us the different observed shapes for a yield curve
(for example, upward-sloping, downward-sloping, flat etc.) and (ii) does it explain why
the upward-sloping curve is more frequently observed.
All three can pass test (i) but liquidity preference is better for (ii).

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