CARDIFF SCHOOL OF MANAGEMENT

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Module Title: Money, Banking and Risk

Module Number: BAC5013

Student Name:
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Examination Period: ………….2022

Examination Duration: 2 hours

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INSTRUCTIONS TO CANDIDATES:

1. This is a closed book examination.

2. Please complete a separate answer book for each question.

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ANSWER ALL OF THE FOLLOWING QUESTIONS
All questions carry equal marks.

QUESTION 1
(a) Critically clarify the differences between nominal and real interest rate? Can real
interest rate be negative? Give clear examples.
(15 marks)
Suggested answer:
(a). The interest rate makes no allowance for inflation, and it is more precisely referred to
as the nominal interest rate. The real interest rate is the interest rate that is adjusted by
subtracting expected changes in the price level (inflation) so that it more accurately reflects
the true cost of borrowing. This interest rate is more precisely referred to as the ex ante
real interest rate because it is adjusted for expected changes in the price level. The ex
ante real interest rate is very important to economic decisions, and typically it is what
economists mean when they make reference to the “real” interest rate. The interest rate
that is adjusted for actual changes in the price level is called the ex post real interest rate.
It describes how well a lender has done in real terms after the fact.
The real interest rate is more accurately defined from the Fisher equation, named for Irving
Fisher, one of the great monetary economists of the twentieth century. The Fisher
equation states that the nominal interest rate i equals the real interest rate r plus the
expected rate of inflation :
e
i=r + π
Obviously, in the time when inflation is increasing, the real interest rate could be lowered if
nominal interest rate remains constant. Yes, however they are rarely observed in global
financial markets. The Fisher equation suggests that a negative interest rate could occur
when the expected rate of deflation (a negative term) exceeds the real rate of interest. The
real rate of interest is always positive because we assume that human nature is such that
nearly all market participants have a positive time preference for consumption. Practically
speaking, negative interest rates might occur when a country is in a deep and prolonged
recession. During such a time, the real rate of interest should be low and the economy
could suffer falling asset prices (deflation).
Example: In November 1998, the interest rate on Japanese Treasury bills declined to a
negative interest rate.

(b) Explain how central banks can make intervention in foreign exchange market in the
time when foreign currency is stronger relative to domestic currency.
(10 marks)
Total: 25 marks
Suggested answer:
Suppose the Fed decides to sell $1 billion of its foreign assets in exchange for $1 billion of
U.S. currency. The Fed’s purchase of dollars has two effects. First, it reduces the Fed’s
holdings of international reserves by $1 billion. Second, because the Fed’s purchase of
currency removes it from the hands of the public, currency in circulation falls by $1 billion.
Because the monetary base is made up of currency in circulation plus reserves, this
decline in currency implies that the monetary base has fallen by $1 billion. If, as is more

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likely, the persons buying the foreign assets pay for them with checks written on accounts
at domestic banks rather than with currency, then the Fed deducts the $1 billion from the
reserve deposits it holds for these banks. The result is that deposits with the Fed
(reserves) decline by $1 billion. In this case, the outcome of the Fed sale of foreign assets
and the purchase of dol- lar deposits is a $1 billion decline in reserves and, as before, a $1
billion decline in the monetary base, because reserves are also a component of the
monetary base.
Normally, a central bank’s purchase of domestic currency and corresponding sale of
foreign assets in the foreign exchange market leads to an equal decline in its international
reserves and the monetary base. And vice versa, a central bank’s sale of domestic
currency to purchase foreign assets in the foreign exchange market results in an equal rise
in its international reserves and the monetary base. When monetary base change, the
interest rate is affected. The increasing in monetary base can lead to lower interest rate,
which makes domestic currency to depreciate in relative to foreign currency and vice
versa.
When foreign currency is stronger relative to domestic currency, central banks have the
tendency to sell foreign reserves to buy domestic currency, in order to prevent it from
depreciating.

QUESTION 2
(a) Calculate the standard deviation of the stock that has price performance as following:
Year Price
2017 150
2018 190
2019 175
2020 108
2021 97
2022 130
(15 marks)
Suggested answer:
Year Price Return Difference Square
with average
return
2017 150
2018 190 26.67% 25.77% 0.0664
2019 175 -7.89% -8.79% 0.0077
2020 108 -38.29% -39.19% 0.1536
2021 97 -10.19% -11.09% 0.0123
2022 130 34.02% 33.12% 0.1097
Average Sum =0.3497
return = 0.9%

(10 marks)

Variance = 0.009/5 = 0.0018 (3 marks)

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 SD = √ Variance = 0.0424 (2 marks)

(b) Caculate the average rate of return of the stock with following information.
Year Beginning of year Price Dividend paid at year
end
2016 $198 $5
2017 $230 $5
2018 $200 $5
2019 $206 $5
(10 marks)
Total: 25 marks
Suggested answer:

Year (Capital gain + Dividend)/Price

2016-2017 (230 - 198 + 5)/198 18.69%
2017-2018 (200 - 230 + 5)/230 -10.87%
2018-2019 (206 – 200 + 5)/200 5.5%
(6 marks)
Arithmetic mean: (18.69% + (-10.87%) + 5.5%)/3 = 4.44% (2 marks)
Geometric mean: (1.1869 x 0.8913 x 1.055)1/3 -1 = 0.0165 or 3.72% (2 marks)

QUESTION 3
(a) Critically explain risk management, and from that point, clarify whether the main
objectives of risk management is minimizing risks?
(10 marks)
Suggested answers:
Risk management can be understood as the core of managing any financial organization;
it is too important a responsibility for a firm’s managers to delegate. Managing risk is about
making the tactical and strategic decisions to control those risks that should be controlled
and to exploit those opportunities that can be exploited. Although managing risk does
involve those quantitative tools and activities generally covered in a “risk management”
textbook, in reality, risk management is as much the art of managing people, processes,
and institutions as it is the science of measuring and quantifying risk. Risk management,
as I just argued, is the responsibility of managers at all levels of an organization. To
support the management of risk, risk measurement and reporting should be consistent
throughout the firm, from the most disag- gregate level (say, the individual trading desk) up
to the top management level. Notably, although risk usually refers to the downside of
random outcomes, risk management is about taking advantage of opportunities:
“controlling the downside and exploiting the upside.”

(b) Critically clarify the reasons why it is important to distinguish between systemic and
idiosyncratic risk. Give clear example of each type of risk.
(15 marks)
Total: 25 marks

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Suggested answer:
There is an important distinction, when thinking about risk, between what we might call
“idiosyncratic risk” and “systemic risk.” This distinction is different from, although
conceptually related to, the distinction between idiosyncratic and systemic (beta or
marketwide) risk in the capital asset pricing model. Idiosyncratic risk is the risk that is
specific to a particular firm, and systemic risk is widespread across the financial system.
The distinction between the two is sometimes hazy but very important. Barings Bank’s
1995 failure was specific to Barings (although its 1890 failure was related to a more
general crisis involving Argentine bonds). In contrast, the failure of Lehman Brothers and
AIG in 2008 was related to a systemic crisis in the housing market and wider credit
markets.
The distinction between idiosyncratic and systemic risk is important for two reasons. First,
the sources of idiosyncratic and systemic risk are different. Idiosyncratic risk arises from
within a firm and is generally under the control of the firm and its managers. Systemic risk
is shared across firms and is often the result of misplaced government intervention,
inappropriate economic pol- icies, or exogenous events, such as natural disasters. As a
consequence, the response to the two sources of risk will be quite different. Managers
within a firm can usually control and manage idiosyncratic risk, but they often cannot
control systemic risk. More importantly, firms generally take the macroeco- nomic
environment as given and adapt to it rather than work to alter the systemic risk
environment.
The second reason the distinction is important is that the consequences are quite different.
A firm-specific risk disaster is serious for the firm and individ- uals involved, but the
repercussions are generally limited to the firm’s owners, debtors, and customers. A
systemic risk management disaster, however, often has serious implications for the
macroeconomy and larger society. Consider the Great Depression of the 1930s, the
developing countries’ debt crisis of the late 1970s and 1980s, the U.S. savings and loan
crisis of the 1980s, the Japanese crisis post-1990, the Russian default of 1998, the various
Asian crises of the late 1990s, and the worldwide crisis of 2008, to mention only a few.
These events all involved systemic risk and risk management failures, and all had huge
costs in terms of direct (bailout) and indirect (lost output) costs.
It is important to remember the distinction between idiosyncratic and systemic risk
because in the aftermath of a systemic crisis, the two often become conflated in
discussions of the crisis. Better idiosyncratic (individual firm) risk management cannot
substitute for adequate systemic (macroeconomic and policy) risk management. Failures
of “risk management” are often held up as the primary driver of systemic failure. Although
it is correct that better idiosyncratic risk management can mitigate the impact of systemic
risk, it cannot substitute for appropriate macroeconomic policy. Politicians—indeed, all of
us participat- ing in the political process—must take responsibility for setting the policies
that determine the incentives, rewards, and costs that shape systemic risk.

QUESTION 4
(a) Critically evaluate the benefits of financial disaster stories.
(10 marks)

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Suggested answer:
Stories of financial disasters hold a certain unseemly interest, even providing an element
of schadenfreude for those in the financial markets. Nonetheless, there are real and
substantive benefits to telling and hearing stories of financial disaster.

First is the value of regular feedback on the size, impact, and frequency of financial
incidents. This feedback helps to remind us that things can go badly; importantly, it can
remind us during good times, when we tend to forget past disasters and think that nothing
bad can possibly happen. This effect helps protect against “disaster myopia”: the tendency
for the memory of disasters to fade with time. It is the “regular accurate feedback” that is
necessary for good avalanche decision making. (5 marks)

The second benefit is very practical: learning how and why disasters occur. We learn
through mistakes, but mistakes are costly. In finance, a mistake can lead to losing a job or
bankruptcy; in avalanches and climbing, a mistake can lead to injury or death. Learning
from mistakes can help you identify when and how to make better decisions, and studying
others’ mistakes can reduce the cost of learning. (5 marks)

(b) Consider two assets: ABC stock and XYZ stock. ABC stock either provides a rate of
return of 12% or -8%, with equal probability. XYZ stock either provides a return of 17% or
2%, with equal probability. You decide to hold a portfolio by investing half of your money in
ABC stock and the other half in XYZ stock. Calculate the expected return and standard
deviation of stock ABC and XYZ and the portfolio with two stocks

(15 marks)
Total: 25 marks

Suggested answer:
 ABC stock
Expected return = 0.5 x (12%) + 0.5 x (-8%) = 0.02 = 2%
Variance = 0.5 x (12% - 2%)2 + 0.5 x (-8%-2%)2 = 0.01
Standard deviation = 0.1
 XYZ stock
Expected return = 0.5 x (17%) + 0.5 x (2%) = 0.095 =9.5%
Variance = 0.5 x (17% - 9.5%)2 + 0.5 x (2%-9.5%)2 = 0.005625
Standard deviation = 0.075
 The portfolio
Expected return = 0.5 x 0.02 + 0.5 x 0.095 = 0.0575
Standard deviation = 0.5 x 0.1 + 0.5 x 0.075 = 0.0875

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