CH 8 Liquidity and Treasury Risk Measurement and Management LAJIDIDVB2

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FRM Part II Exam
By AnalystPrep
Questions with Answers - Liquidity and Treasury Risk

Measurement and Management
Last Updated: Mar 13, 2023
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Table of Contents
123 - Liquidity Risk 3

124 - Liquidity and Leverage 27
125 - Early Warning Indicators 55
126 - The Investment Function in Financial Services Management 64
127 - Liquidity and Reserves Management: Strategies and Policies 74
128 - Intraday Liquidity Risk Management 96
129 - Monitoring Liquidity 111
130 - The Failure Mechanics of Dealer Banks 130
131 - Liquidity Stress Testing 141
132 - Liquidity Risk Reporting and Stress Testing 161
133 - Contingency Funding Planning 177
134 - Managing and Pricing Deposit Services 192
135 - Managing Nondeposit Liabilities 207
136 - Repurchase Agreements and Financing 225
137 - Liquidity Transfer Pricing: A Guide to Better Practice 242
The US Dollar Shortage in Global Banking and the
138 - 257
International Policy Response
Covered Interest Rate Parity Lost: Understanding the Cross-
139 - 272
Currency Basis
Risk Management for Changing Interest Rates: Asset-
140 - 300
Liability Management and Duration Techniques
141 - Illiquid Assets 313
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© 2014-2023 AnalystPrep.
Reading 123: Liquidity Risk
Q.2255 Liquidity risk is best defined as:
A. T he risk that a counterparty in a transaction will delay meeting their financial obligation,
thereby subjecting an institution to a shortage of funds.
B. T he risk that an institution will not be able to meet its financial needs at some future date.
C. T he risk that the amount of money in circulation within an economy is too low.
D. Inability to meet short-term debt obligations without giving up capital or income.
T he correct answer is D.
Liquidity risk occurs when an institution cannot meet its day-to-day financial needs as a result of an
inability to liquidate assets without giving up capital or substantial income in the process. T he
difficulty to liquidate could be caused by an inefficient market with very few willing buyers and
sellers.
Q.2257 Joseph Bradley, FRM, works at I&M bank. As per the results of his intensive research, the
US T reasury has issued bonds with a nominal value of approximately 800 billion dollars. I&M holds
bonds worth 20 million dollars. T his implies that:
A. T he bid-ask spread is exogenous to the bank.
B. T he bid-ask spread is endogenous to the bank.
C. T he bank is in a position to influence market price of T reasury bonds.
D. T he bank has too big an investment in gilts.
T he correct answer is A.
Looking at the size of the bond market as a whole, I&M bank’s position is very small. T he bank’s
trading activities would have an insignificant effect on the market price of bonds. T his implies that
the bid-ask spread is exogenous to the bank.
3
Q.2258 Which of the following statements is correct regarding the bid-ask spread of a financial
instrument?
A. T he bid-ask spread is limited to 1%.
B. T he bid-ask spread is limited to 0.5%.
C. T he bid-ask spread ranges between 0.5% and 1%, depending on the type of security being
traded.
D. T he bid-ask spread is not limited.
T he bid-ask spread is not limited. It’s, in fact, a random variable that can be influenced by several
market factors, including the perceived riskiness of the security, size of the market, and general
economic conditions.
Q.2262 Bilco Bank has implemented the LaR (liquidity at risk) method based on a 95% probability and
a 1-day holding period. Suppose its calculations for the next day result in a figure of USD 15 million.
What would that imply?
A. T he maximum loss over the next day is $15 million with a probability of 95%.
B. T he maximum profit over the next day is $15 million with a probability of 95%.
C. T he worst outcome over the next day is an inflow of cash of $15 million with a probability
of 95%.
D. T he worst outcome over the next day is an outflow of cash of $15 million with a
probability of 95%.
A positive LaR means that the likely 'worst' outcome, from a cash flow perspective, is an outflow of
cash; and a negative LaR means that the likely worst outcome is an inflow of cash.
4
Q.2266 Redding bank is in process of implementing a LaR framework. In the process, risk analysts
realize that the bank has very similar hedging positions, albeit with different counterparties, in
different sectors. In this scenario, which type of risk would be paramount?
A. Credit risk
B. Market risk
C. Compliance risk
D. Reputation risk
In this scenario, the bank's exposure to credit risk is paramount, as similar positions with different
counterparties do not offset each other and increase the risk of simultaneous defaults.
On the other hand, having similar positions with different counterparties can result in low market
risk as any negative impact on one position can be offset by the opposite position held with another
counterparty. In fact, clearing all positions can help reduce credit risk, while not affecting market
risk.
5
Q.2727 In a stressed market, find the LVaR to VaR ratio given that µ = 0, & stressed standard
deviation is 0.03, stressed standard deviation of proportional bid-offer spread is also 0.03, spread =
0.025, and confidence interval is 95%.
A. 1.19
B. 1.10
C. 0.76
D. 1.75
Liquidity-adjusted VaR (LVaR) incorporates exogenous liquidity risk into Value at Risk (VaR). It can be
defined as:
LVaR = V aR + Exogenous Liquidity Cost (ELC)
Exogenous liquidity cost is defined as the worst expected half spread at a particular confidence level.
T hus:
LVaR = (-expected return + standard deviation of asset∗z-score)

+ 0.5∗ (spread+ standard deviation of spread∗ z-score)
And
VaR = (-expected return + standard deviation of asset∗ z-score)
LVaR (0.03 × 1.645) + 0.5(0.025 + 0.03 × 1.645)

= = 1.7533
VaR (0.03 ∗ 1.645)
6
Q.2977 Suppose that XYZ Company has a current stock price of $40 and a daily standard deviation of
1%. T he current bid-ask spread is 2%. Calculate LVaR at the 95% confidence level. Assume a
constant spread.
A. 0.2452
B. 1.3526
C. 1.0981
D. 1.06
Using the constant spread approach,
LVAR = (V × Zα × σ) + (0.5 × V × spread)
Where:
V = asset (or portfolio) value
Zα = confidence parameter (Normal distribution)
σ = standard deviation of returns
LV AR = (40 × 1.65 × 0.01) + 0.5 × 40 × 0.02 = $1.06
7
Q.3132 Quadruple Funds only wants to invest in equity instruments which have 30-day liquidity
adjusted VaR of 5% at 95% confidence in a stressed market.
Suppose an instrument has a 30-day standard deviation of 5% and its bid-ask spread is 83 basis points
with a volatility of 2%. What should be its expected return to fulfill the entity’s criteria?
A. 0.05315
B. 0.04217
C. 0.05
D. 0.06975
When both spread and asset are normally distributed, the LVaR can be computed as follows:
LVaR =(-expected return + standard deviation of asset∗z-score)

+ 0.5∗ (spread+ standard deviation of spread∗z-score)
5% = (-expected return + 5% ∗1.65) + 0.5∗ (0.83% + 2% ∗1.65)

⇒ 5% − 0.5∗ (0.83% + 2% ∗1.65) − 5% ∗1.65
⇒ expected return = − (5% ∗ − 2.065% − 8.25%) = 5.315%
Q.3214 T im Lauren is an analyst at a large commercial bank. He plans to invest in Grantson

Automobile stock with bid and ask prices equal to $53.70 and $54.10, respectively. Given this
information, the proportional bid-ask spread for Grantson Automobile stock is closest to?
A. 0.74%.
B. 1.48%.
C. 2.35%.
D. 1.45%.
(ask-price − bid-price)
Proportional Bid-ask spread =
[(ask-price + bid-price) × 0.5]
($54.10 − $53.70)
=
[($54.10 + $53.70) × 0.5]
= 0.0074 or 0.74%
8
Q.3873 Suppose that the liquidity division in QPR bank has bought 25 million shares of one company
and 35 million ounces of a commodity. Assume that the shares are bid $90.8, offer $92.4, and the
commodity is bid $24, offer $ 26.2. Calculate its liquidation cost in a normal market.
A. $45.67million
B. $58.49 million
C. $23.56million
D. $32.08million
T he correct answer is B.
T he mid-market value of the position of the shares is equivalent to:
25 × 91.6 = $2, 290 million
Note that the mid-market price is halfway between the offer price and the bid price.
T he mid-market of the position in the commodity is:
25.1 × 35 = $878.5 million
T he proportional bid-offer spread for the position of the shares is:
Offer price-Bid price

s=
Mid-market price
(92.4 − 90.8)
= = $0.017467
91.6
Similarly, the proportional bid-offer spread for the commodity;
(26.2 − 24)
= $0.087649
25.1
Hence the cost of liquidation in a normal market is;
(0.5 × 0.017467 × 2, 290) + (0.5 × 0.087649 × 878.5) = $58.49 million
9
Q.3940 Cathleen Wilson is the liquidity manager for CPR bank. She decides to invest in 50 million
shares of one company and 20 million ounces of a commodity. Assume that the shares’ bid price is
$80.4, offer price $80.8, and the commodity’s bid is $30.6. However, she is not able to remember the
commodity’s offer price. Given the cost of liquidation to be $12.0 million and the mid-market position
in the commodity to be $614 million, calculate the offer price for the commodities in a normal
market.
A. 30.8
B. 31.6
C. 34.6
D. 28.9
T he mid-market price for shares is 80.6 ×50=$4,030
0. 4
T he proportional bid-offer spread for the share is = 0.004963
80. 6
We let the proportional bid-offer for the share be x, and the offer price be w
T hen
0.004963 × 4, 030 (x × 614)

+ = 12.00
2 2
= 1.99754 = 307x
X=0.0065066, which is the proportional bid-offer price for the commodity
(w − 30.6)
⇒ = 0.0065066
0.5 × (w + 30.6)
(2w − 61.2)
= 0.0065066
(w + 30.6)
T hus
w = 30.8
10
Q.3941 Suppose that a bank invests in shares and a commodity whose mid-market position is $1,400
million, and $840 million respectively. You are also provided with the following information:
Mean Standard Deviation

Bid-offer spread for the shares $1.0 million $1.1 million
Bid-offer spread of the commodity $0.1 million $0.1 million
Proportional bid-offer spread for the shares 0.034 0.018
Proportional bid-offer spread for the commodity 0.0044 0.0044
Assuming the distribution of the spreads is normal, calculate the cost of liquidation in a stressed
market at a 95% confidence level.
A. $40.10million
B. $50.23million
C. $49.42million
D. $107.93million
T he correct answer is C.
n (μj + λσj)α j
Cost of liquidation (stressed market) = ∑
j=1 2
1,400 × (0.034 + 1.645 × 0.018)
2
840 × (0.0044 + 1.645 × 0.0044)
+
2
= $49.415 million
In this question, we are considering the mean and standard deviation for the proportional bid-offer
spread for both shares and the commodity, bearing in mind that n=2.
Additionally, αj is the mid-market position, μJ represents the mean for the proportional bid-offer, λ
represents the constant factor given as 1.645 at 95% confidence level, and the σ represents the
standard deviation for the propositional bid-offer spread.
11
Q.3942 Fatou James, the liquidity manager for CPQ bank, invests in shares and a commodity whose
mid-market value of the positions are1,426, and 814 respectively. T he mean and standard deviation of
the position in shares are $1.12 and $1.45, respectively. Suppose that the mean and standard deviation
for the commodity are both $0.63, and the mean for the proportional bid-offer spread for the shares
is 0.0467, while the standard deviation for the proportional bid-offer spread for the shares is
unknown. Given that the mean and standard deviation for the proportional bid-offer spread for the
commodity are both 0.006857. Assume that the distribution of the spreads is normal. Further, the
cost of liquidation under a stressed market condition at a 99% confidence level is 82.264. Calculate
the standard deviation for the proportional bid-offer spread for shares.
A. $0.0630
B. $0.0480
C. $0.0560
D. $0.0239
Let the value of the standard deviation for the proportional bid-offer spread for shares be w.
T hen,
1, 426 × (0.0467 + 2.326 × w) 814 × (0.006857 + 2.326 × 0.006857)

+ = $82.264m
2 2
33.2971 + 1, 658.438w + 9.2822 = $82.264
1, 658.438w = $39.6847
T hus
w = 0.02393
12
Q.3943 A liquidity division for HT C bank invests in shares and a commodity. T he mid-market value of
the position in shares is $W while the mid-market value of the position in the commodity is $413.
T he mean and standard deviation of the bid-offer spread for the shares are $1.24 and $1.02,
respectively. On the other hand, the mean and standard deviation of the bid-offer spread for the
commodity are $0.67 and $0.34. Further, the mean and standard deviation of the proportional bid-
offer spread for the shares is 0.0721 and 0.0675, respectively, while the mean and standard deviation
of the proportional bid-offer spread for the commodity is 0.00524 and 0.00463, respectively.
Assuming that the distribution of the spreads is normal, and the cost of liquidation at the 99%
confidence level in a stressed market condition is $95.062, calculate W, the mid-market value of the
position in shares.
A. $905
B. $809
C. $801
D. $1,579
W × (0.0721 + 2.326 × 0.0675)413 × (0.00524 + 2.326 × 0.00463)

+ = $95.062m
2 2
0.5W(0.229105) + 3.3059 = $95.062m
$91.75606
W=
0.1145525
= $801
13
Q.3944 A liquidity division for HT C bank invests in shares and a commodity whose mid-market
position is $801, and $413, respectively. If the proportional bid-offer spread for the shares is
0.001879, and that for the commodity is 0.002488, What is the cost of liquidation in a normal market.
A. 2.0982
B. $1.2663
C. $1.8990
D. $2.7660
0.001879 × 801 0.002488 × 413

+ = $1.2663 million
2 2
14
Q.3945 Richard Watson, the liquidity manager of RT C bank, has been finding ways of boosting the
liquidity for the bank. He decides to invest in W shares of one company and 19 million ounces of a
commodity. Assume that the shares are bid $70.4, offer $72.8, and the commodity is bid is $46.6,
offer $47.2. T he mid-market value of the position in shares is $2,506 million. Calculate, W, the
number of shares, and the cost of liquidation in a normal market.
A. 35million and $47.699
B. 37million and $42.076
C. 20 million and $65.000
D. 17 million and $34.985
Since the mid-market value of the position in shares is $2,506 million, W, the number of shares, can
be calculated as follows:
70.4 + 72.8
$2, 506m = ×W
2
T hus
W = 35 million
T he mid-market value of the position in the commodity =46.9×19=$891.1million
47. 2−46. 6
T he proportional offer spread for the commodity is = 0.01279, while the proportional bid-
46. 9
offer spread for the share is;
72.8 − 70.4
= 0.03352
71.6
T hen the cost of liquidation in a normal market;
0.03352 × 2, 506 0.01279 × 891.1

+ = $47.699 million
2 2
15
Q.3946 JCT bank has a position in two assets - shares of company X and a separate commodity Y. T he
following data has been extracted from the bank's liquidity division:
T he mid-market price of the shares is $72, and the mid-market price of the commodity is
$47.
T he mean and standard deviation for the bid-offer spread for the shares are $1.30 and
$1.03, respectively.
T he mean and standard deviation for the bid-offer spread for the commodity are $1.32 and
$0.88, respectively.
T he bank holds 1 million units in each of the two positions.
Calculate the cost of liquidation at a 99% confidence level, assuming the spread distribution is
approximately normal in a stressed market.
A. $2,500,000
B. $3,500,650
C. $3,531,536
D. $7,063,072
Shares
Mean, proportional bid-offer spread: $1.3 / $72 = 0.0181
Standard deviation, proportional bid-offer spread: $1.03 / $72 = 0.0143
Commodi ty
Mean, proportional bid-offer spread: $1.32 / $47 = 0.0281
Standard deviation, proportional bid-offer spread: $0.88 / $47 = 0.0187
$72,000, 000 × (0.0181 + 2.326 × 0.0143)

$47, 000, 000 × (0.0281 + 2.326 × 0.0187
Cost of liquidation = +
2 2
= $3,531, 536
16
Q.3947 James Farouk, the liquidity manager of CRP financial institution, has been struggling with
boosting liquidity in his institution. Farouk consults Richard Taylor, one of the staff in RCP seeking
help on how he can source liquidity for the institution. Which of the following choices is not likely to
be one of the choices offered by Taylor, assuming he was right?
A. Liquidation of trading book positions
B. Holdings of cash and treasury securities
C. Increasing investments in real estate
D. Ability to borrow money at short notice
The correct answer i s C:Increasing investment in real estate leads to an increase in the solvency
status of the bank, but does not increase its liquidity
A i s i ncorrect: liquidation of trading book positions is one of the sources of liquidity for financial
institutions.
B i s i ncorrect: holdings of cash and treasury skills is a source of liquidity for a financial institution.
D i s i ncorrect: the ability to borrow money at short notice is a source of liquidity
Q.3948 A credit downgrade of three notches (e.g., from AA+ to A+) is one of the acute stresses
incorporated in the 30-day period considered in the calculation of the liquidity coverage ratio (LCR).
Which of the following most accurately states the other stress events?
A. Partial loss of deposits and decreased haircuts
B. Drawdowns on lines of credit and partial loss of deposits
C. Drawdowns on lines of deposits and decreased haircuts
D. Reduced haircuts
T he 30-day period considered in the calculation of LCR is one of acute stress involving a downgrade
of three notches (e.g., from AA+ to A+), a partial loss of deposits, a complete loss of wholesale
funding, increased haircuts on secured funding, and drawdowns on lines of credit.
17
Q.3949 T homas Wong, one of the traders in the security market, has been a positive feedback trader.
In his interview with a business analyst, Wong stated the factors that cause him to be a positive
trader. Which choice among the following accurately states the reason as to why Wong practices
positive trading?
A. Urgent need for cash
B. Need for liquidity
C. Competition
D. Predatory trading
The correct answer i s D:"Positive feedback trader" is the strategy to buy a stock when the price
rise or sell it when the price decrease while,
Predatory trading is a directional trading strategy in which a trader believes that a stock will either
increase or drop in value and hence places a trade according to their belief. As such, this matches a
"positive feedback" strategy.
A i s i ncorrect: Urgent need for cash is not a cause of positive feedback trade.
B i s i ncorrect: T he need for liquidity is not a cause of positive feedback trade.
C i s i ncorrect: Competition is none of the causes of positive trading
18
Q.3950 T he following statistics extracted from RT C bank’s balance sheet reflect some of the
underlying transactions conducted by the bank. T he balance sheet has distinguished short-term and
long-term liabilities and assets, according to Basel III. Use the data with the weighted factors to
calculate the net stable funding ratio (NSFR) for the bank.
Assets Short Long NSFR LCR Liabilities Short Long NSFR LCR
Term Term Term Term
Cash 950 90% Owners 90 100%
Equity
Loans 4, 200 3, 000 100% Deposits 500 100%
Corporates
Mortgages 3, 200 100% 25% Unsecured 250 2, 500 75% 45%
Debt
Issuance
Corporates 950 1, 400 85% 15% Deposits 540 5, 000 10% 100%
Financial
Institution
Expenses 230 6, 600 100%
Notes Payable 700 0 0 50%
A. 127%
B. 133%
C. 108%
D. 75%
NSFR is equivalent to;
Amount of stable funding

≥ 100%
Required amount of stable funding
500 + 250 × 0.75 + 540 × 0.10 + 230 + 2, 500 × 0.75 + 5, 000 × 0.10 + 6, 600
=
950 × 0.9 + 3, 000 + 3, 200 + 1, 400 × 0.85 + 4, 200 + 950 × 0.85
9, 946.5
=
13, 252.5
= 0.75053 ≈ 75%
Q.3951 Suppose that the following statistics extracted from the RT C bank’s balance sheet refers to
its trade. T he balance sheet has distinguished short-term and long-term liabilities and assets,
according to the Basel III. Use the data with the weighted factors to calculate the Liquidity Coverage
Ratio (LCR) for the bank.
19
Assets Short Long NSFR LCR Liabilities Short Long NSFR LCR
Term Term Term Term
Cash 90 100% Owners 950 90%
Equity
T-notes 500 100%
Loans 250 2, 500 75% 45% Deposits 4, 200 3, 000 100% 25%
corporates
Mortgages 540 5, 000 10% 100% Unsecured 3, 200 100%
debt
issuance
corporates 230 6600 100% Depossits 950 1, 400 85% 15%
financial
institution
loans 700 0 0 50%
financial
institution
A. 49%
B. 85%
C. 50%
D. 43%
High-quality liquid assets (HQLA) are categorized into two;

- Level 1 Assets, which are included without a limit (For example, cash at hand) and,
- Level 2 Assets.
Assets to be included in each of the Levels 1 and 2 are those that the bank is holding on the first day
of the stress period. T he maximum amount of the adjusted Level 2 assets in the stock of high-quality
liquid assets is equivalent to two-thi rds of the adjusted amount of Level 1 assets after haircuts have
been applied. T his is in line with Basel III Requirements.
Stock of high quality liquid assets

LCR =
Total Net Cash Outflows
Stock of high quality liquid assets = Level 1 Assets + Maximum amount of adjusted Level 2 Assets
2
= Level 1 Assets + × Level 1 Assets
3
2
= (90 + (90 × )) = 150
3
Consistent with Basel III principles, the term total net cash outflows is the total expected cash
20
outflows less than the total expected cash inflows in the particular stress scenario for the
subsequent 30 calendar days.
Total expected cash outflows are equivalent to the product of the outstanding balances of several
types of liabilities and off-balance sheet commitments by their respective weights. In other words,
Total net cash outflows = Total expected cash outflows – Min {total expected cash inflows; 75% of
total expected cash outflows}
3
= ((4200 × 0.25) + (950 × 0.15) − Min [⟨(250 × 0.45) + 540 + (700 × 0.50)⟩ , ⟨ × (4200 × 0.25) + (950 ×
4
150
LCR = = 0.503 ≈ 50
298.125
T his is equivalent to;
(90 + (90 × 23 )) 600

4× = = 0.503 ≈ 50
((4200 × 0.25) + (950 × 0.15)) 1192.5
21
Q.3952 T he following table represents a section extracted from ABC bank’s balance sheet. Use the
provided data to determine the Liquidity Coverage Ratio of the bank for 2018 and 2019, respectively.
Description 2018 2019

High Liquid assets 2100 1458
Average monthly withdrawals 1200 2458
Expected monthly outflows in a stressed scenario 1600 1700
A. 126% and 145 %
B. 131% and 86%
C. 80% and 124%
D. 129% and 134%
T he Liquidity Coverage ratio is equivalent to;
High-quality liquid asset

≥ 100%
Net cash outflows in a 30-day period
2100
LCR for 2018 = = 1.312 = 131%
1600
1458
T he LCR for 2019 = = 0.857 = 86%
1700
22
Reading 124: Liquidity and Leverage
Q.2274 Balasz Bank’s risk management team is developing the bank’s liquidity risk policy. In order to
implement a sound liquidity risk management system, all sources or elements of liquidity risk must
be defined. What are the main elements that should be mentioned in the policy?
A. Liquidity credit risk, liquidity counterparty risk, and market liquidity risk.
B. Liquidity credit risk, transaction liquidity risk, and systemic risk.
C. Systemic risk, liquidity credit risk, and transaction liquidity risk.
D. Systemic risk, transaction liquidity risk, and funding liquidity risk.
T he term 'liquidity risk' is used to describe several distinct but related phenomena: T ransaction
liquidity risk is the risk of moving the price of an asset adversely in the act of buying or selling it.
Balance sheet risk or funding liquidity risk is the risk that creditors either withdraw credit or change
the terms on which it is granted in such a way that the positions have to be unwound and/or are no
longer profitable. Systemic risk refers to the risk of a general impairment of the financial system.
Q.2275 CRG Bank has a large portfolio of securities that could be quickly sold without significant
price fluctuations. Such securities are said to be:
A. Liquid
B. Perfectly liquid
C. Illiquid
D. Perfectly illiquid
An asset is said to be liquid if it is “near” or a good substitute for cash. Such an asset can be
converted to cash cheaply, and without moving the price “too much.”
23
Q.2276 T ransaction liquidity risk can be best defined as:
A. T he risk of reducing the demand for an asset by increasing the number of transactions.
B. T he risk of moving the price of an asset adversely in the act of buying or selling it.
C. T he risk of moving the supply of an asset adversely in the act of buying or selling it.
D. T he risk that too many transactions on the trading floor could render the firm unable to
meet its day-to-day operation costs.
T ransaction liquidity risk is the risk associated with adverse movement in the price of a product
triggered by buying/selling activities.
Q.2277 Nathan James, a trader for Nathan Capital, works on the short-term funding desk at his firm.
Over the past few months, markets have been highly volatile but Nathan Capital still enjoys a large
capital base and is financially stable. In his monthly report to the liquidity subcommittee of the board
of directors, James reports that in the last month, Nathan Capital's chief lender has been steadily
increasing collateral requirements to roll over repo contracts. From the perspective of Nathan
Capital, this represents:
A. T ransactions liquidity risk
B. Balance sheet risk
C. Systematic risk
D. Maturity transformation risk
Funding liquidity risk (balance sheet risk) is the risk that creditors either withdraw credit or change
the terms on which it is granted in such a way that the positions have to be unwound and/or are no
longer profitable. Funding liquidity can be put at risk because the borrower’s credit quality is, or at
least perceived to be, deteriorating, but also because financial conditions as a whole are
deteriorating. T his is the case with Nathan Capital. T he lender is increasing the haircut and is thus
changing the terms of credit. T his is despite the fact that Nathan Capital is financially sound and there
are no signs that its financial position has worsened.
24
Q.2278 Yemi Bank was recently ordered to pay a hefty fine as punishment for engaging in certain
illegal trades. Following this event, creditors have expressed fears over their investment and would
want to introduce more conditions governing the use of funds lent to the bank. T his scenario gives an
example of:
A. Liquidity credit risk
B. Strategic risk
C. Systemic risk
D. Balance sheet risk
Balance sheet risk, or funding liquidity risk, is the risk that creditors either withdraw credit or
change the terms on which it is granted in such a way that the positions have to be unwound and/or
are no longer profitable.
Q.2279 Elipsa Bank has witnessed a dramatic deterioration of the credit quality of its borrowers in its
loan portfolio. As a result, the bank's balance sheet position has worsened. T he bank will most likely
have to contend with:
A. Systemic risk
B. Funding liquidity risk
C. Reputation risk
D. Strategic risk
Funding liquidity risk or balance sheet risk results when a borrower’s credit position is either
deteriorating or is perceived by market participants to be deteriorating. Since the bank's asset value
has worsened, the bank would find it difficult to negotiate new credit terms for its own funding
needs. Potential lenders and investors are unlikely to be willing to lend to the bank at the same terms
as before. New funding for the bank may be tied to tougher credit terms, e.g., higher interest rates.
25
Q.2280 Egda Bank has had a rough year in which its financial health and performance substantially
deteriorated. An intensive study of the market by its risk management department has attributed the
deterioration to bad market conditions. T he study also found out that a majority of players in the
banking sector have had almost identical problems. T his scenario gives an example of:
A. Maturity transformation risk
B. Balance sheet risk
C. Systemic risk
D. Banking sector liquidity risk
Systemic risk refers to the risk of a general impairment of the financial system. In situations of
severe financial stress, the ability of the financial system to allocate credit, support markets in
financial assets, and even administer payments and settle financial transactions may be impaired.
Q.2281 Aruba Commercial Bank’s risk management division has raised the alarm over increased
exposure to funding liquidity risk. Which of the following could be the cause of the increased
exposure?
A. Financing short-term loans mostly with short-term deposits.
B. Financing long-term loans mostly with long-term deposits.
C. Financing long-term loans mostly with short-term deposits.
D. Financing short-term loans mostly with long-term deposits.
Many banks are largely short-term borrowers (via deposits), so their capacity to maintain long-term
positions and their flexibility when circumstances or expectations change is limited. If the bank uses
deposits to fund long-term loans, there’s a big possibility that it will not have cash readily available as
and when the depositor comes calling.
26
Q.2282 What do you understand by matched funding as used in the context of lending?
A. Financing long-term loans with borrowed funds.
B. Financing loans with reserve cash saved over a period of time.
C. Financing long-term assets with long-term debt.
D. Giving a particular facility to the beneficiary who qualifies for it, taking into consideration
their full credit profile.
Funding longer-term assets with longer-term debt is called matched funding. T his would be the ideal
scenario, but is normally not practiced. Banks perform the so-called maturity transformation by using
short-term deposits to finance long-term loans.
Q.2283 Which of the following best explains why a bank may be incentivized to finance long-term
loans with short-term deposits, despite the grave liquidity issues this could create?
A. It is much easier to find long-term deposits than short-term deposits.
B. Interest rates on long-term loans are usually higher than those on short-term loans.
C. It is much easier to find clients for long-term financing.
D. Long-term facilities are less risky than short-term ones.
Yield curves are typically upward-sloping. Intermediaries, therefore, have a powerful incentive to
introduce maturity mismatches into their balance sheets. Since short-term rates are generally lower
than long-term rates, there is a powerful incentive to borrow short-term if possible. Funding long-
term assets with short-term debt expose an intermediary to rollover risk, the risk that the short-
term debt cannot be refinanced, or can be refinanced only on highly disadvantageous terms.
27
Q.2284 At a meeting between two senior risk managers, one of them pointed out that rollover risk
was increasingly becoming a threat to their employer – a Chinese bank. T he manager most likely
meant that:
A. T he bank was increasingly lending money to high-risk individuals, thereby increasing its
exposure to credit risk.
B. T he amount recovered from non-performing loans was gradually declining, thereby

increasing the bank’s losses.
C. T he bank was increasingly financing long-term loans with short-term deposits, thereby
making it hard to repay its own short-term debt.
D. T he bank’s portfolio at risk was growing at a relatively higher rate.
Funding long-term assets with short-term debt exposes an intermediary to rollover risk, the risk that
the short-term debt cannot be refinanced, or can be refinanced only on highly disadvantageous terms.
Q.2285 A certain bank has a portfolio of CDOs (Collateralized Debt Obligations). In order to improve
its liquidity position, its finance department has proposed an entry to secondary markets by selling
the CDOs under a repo agreement. Is the proposal viable?
A. No, because CDOs are ineligible for repo agreements.
B. No, because liquidity positions can only be improved via direct sale of assets.
C. Yes, because CDOs are always eligible for repo transactions regardless of their credit
quality.
D. Yes, because CDOs can be used as collateral in repo agreements provided their credit
quality is high.
CDOs could be eligible collateral or subject of repo transactions. A very important property
regarding CDOs and their eligibility is their credit rating.
28
Q.2286 Baraba bank is in the process of calculating its leverage. An extract of its balance sheet is as
follows:
Assets: $50 million
Equity: $20 million
Deposits: $30 million
What is the level of leverage?
A. 1
B. 2.5
C. 1.67
D. 1.5
Leverage should be calculated as (all $ amounts in million):
Total Assets 50
= = 2.5
Equity 20
Q.2288 Barakuda is considering borrowing additional funds to in order to finance an ambitious

expansion plan. In what circumstances would it be appropriate for the bank to borrow funds and go
ahead with its plan?
A. If its return on assets is equal to expenses of additional borrowing.
B. If the cost of borrowing equals the expenses of the existing borrowing.
C. If the cost of borrowing is less than the return on assets.
D. If the total value of existing assets is less than the total value of existing debt.
In cases when the cost of borrowing is less than the return on assets, taking a new loan is justified.
T hat way, the bank is able to repay capital while still earning a profit.
29
Q.2291 Liman Bank has the following balance sheet structure:
Investments $100 million

Deposits $80 million
Capital $20 million
Return on assets 10%
Cost of funds 6%
T he bank is considering the possibility of additional borrowing in the amount of $50 million. If the
stated borrowing occurs with constant return on assets, what will the return on capital amount to?
A. 40%
B. 6%
C. 4%
D. 36%
Return on equity is calculated as (all $ amounts in million):
((investments + new investments) × return on assets − (liabilities + new liabilities) × cost of funds
ROE =
capital
((100 + 50) × 10% − (80 + 50) × 6%)
=
20
(15 − 7.8)
= = 36%
20
30
Q.2730 You have been given the following information about a Cima Tech:
Total assets $2 million

Return on assets 6%
Cost of debt 5%
Hurdle rate/Return on equity 9%
Which of the following leverage ratios is Cima Tech most likely to choose?
A. 3
B. 4
C. 2
D. 5
rE = LrA − (L − 1)rD
⇒ 9% = L × 6% − (L − 1)5%
⇒ 0.09 = L × 0.06 − (L − 1)0.05
⇒ 0.09 = 0.01L + 0.05
⇒L=4
31
Q.2731 T he shares of a company currently trade at a bid/ask rate of $20.20 and $20.35. If the sample
standard deviation of the spread is $0.0003, what will be the expected transaction cost assuming a
99% confidence interval on transaction cost?
A. $0.321
B. $0.065
C. $0.082
D. $0.820
1
T ransaction costs = ±P × (s + 2.33σ)
2
Where
P = midprice
S = expected bid-ask spread
Bid price + Ask price 20.2 + 20.35

P = = = $20.275
2 2
Ask price– Bid price 20.35– 20.20

S= = = $0.0074
Midprice 20.275
T hus,
1
T ransaction costs = ±20.275 × (0.0074 + 2.33(0.0003))
2
1
= ±20.275 × (0.0074 + 2.33(0.0003))
2
= $0.082
32
Q.2980 To understand the causes of illiquidity, we focus primarily on asset liquidity under a standard
set of characteristics of market liquidity. What does tightness mean in this context?
A. It describes how large an order it takes to adversely move the market.
B. It is the length of time for which the market is moved away from the equilibrium price by
a lumpy order.
C. It refers to the cost of a round-trip transaction and measured typically by the bid-ask
spread and the commissions of the broker.
D. It is the condition that makes markets to be closely related to the rate at which
transactions can be executed by participants in the market.
T ightness is the cost of a round-trip transaction that is typically measured by the commissions of the
broker and the bid-ask spread.
Q.2982 In the period of the global financial turmoil, the collapse of the financial institutions can
largely be attributed to both illiquidity and insolvency. Which of the following does NOT describe the
sequence of events in the collapse of an intermediary?
A. Issues about the solvency of the company were raised by the reports of losses at the
intermediary, or at other institutions.
B. All companies, financial intermediaries, and non-financial companies are still willing to lend
to the intermediary.
C. To raise funds, the intermediary is forced to liquidate assets, which might lead to losses in
a distressed market.
D. Being aware that the challenges faced by the intermediary are now being compounded by
the realized mark-to-market losses, the lenders become more and more reluctant to extend
credit to the intermediary.
Instead of displaying willingness to lend the intermediary, the firms, financial intermediaries, and non-
financial companies will all be very reluctant to lend to the intermediary. T his will be evident
through the high credit spreads, but most crucially it will be reflected in an inability to acquire the
previous volume of loan proceeds, by the affected company.
33
Q.3134 A firm has 50% stake amounting to $3.9 million in a company whose 1-day 95% VaR is 1.19%.
T he firm wants to liquidate its entire position over the next four days in equal proportions each day.
T he shares are expected to trade at a constant spread of 0.5%. T here are no endogenous liquidity
risks.
What is the 4-day 95% LVaR?
A. 162,900
B. 114,259
C. 2,456,000
D. 73,281
When a position is liquidated over time, say in 4 days, we cannot simply multiply 1 day VaR by the
square root of 4 because not the entire position is held for that period.
Instead the following formula is used:
LV aR( Liquidation Period ) = VaR{(one day) }

[(1 + no. of days) (1 + 2×no. of days)]
×⎷{ } + spread×0.5
6×no. of days
[(1 + 4) (1 + 2×4)]
= 1.19%×⎷{ } + spread×0.5
6×4
= [1.629% + 0.25%]3, 900, 000 = 73, 281
Q.3135 A firm has a return on asset of 2.5% and a value at risk of 2.45% at 95% confidence. Its cost
of debt is 2%.
What should be its debt equity ratio if its desired return on equity is twice its 95% VaR.
A. 2.4
B. 3.4
C. 5.8
D. 4.8
34
An entity’s return on equity can be computed using the following formulas:
rE = LrA − (L − 1)rD
Where:
rA = return on assets
rE = return on equity
rD = cost of debt
(Equity+Debt) Debt
L = leverage ratio = = 1 + Equity
Equity
You may also want to express this in words as:
ROE = (leverage ratio × ROA) − [(leverage ratio − 1) × cost of debt]

ROE = 2 × V aR = 2 × 0.0245 = 0.049
T hus,
0.049 = L × 0.025 − (L − 1)0.02

0.049 = 0.025L − 0.02L + 0.02
0.049 = 0.005L + 0.02
0.029
L= = 5.8
0.005
D
L = 1+
E
D
= 5.8 − 1 = 4.8
E
35
Q.3225 Mark Sanders is a chief investment officer at Kremlin Pension Fund managing defined benefit
plan for state employees. His fund manager has calculated the 1-day value at risk (V aR ) of the
position at $62 million. However, given the magnitude of the position it is most likely that any
liquidation will take place over four trading days. In this scenario, what will be the liquidity-adjusted
V aR for Kremlin?
A. $116,250,000
B. $84,897,000
C. $22,897,000
D. $54,250,000
1 (1 + T ) (1 + 2T )
V aR i (α , ) (X ) × √
252 6T
(1 + 4 × 1 + 8)
liquidity-adjusted VaR = $62, 000, 000 × ⎷[ ] = $84, 897, 000.
6×4
36
Q.3226 Samar Sarkar Brokerage specializes in providing margin loans to U.S. hedge funds that intend
to buy securities on margin. One of the brokerage's clients, Xenon Hedge Fund, wants to take a
$3,000,000 equity position while putting up the minimum equity amount required by the Federal
Reserve. Determine the margin loan amount and the leverage ratio of this position.
A. Margin Loan $3,000,000; Leverage Ratio 1.0
B. Margin Loan $1,500,000; Leverage Ratio 1.0
C. Margin Loan $1,500,000; Leverage Ratio 2.0
D. Margin Loan $3,000,000; Leverage Ratio 0.0
According to Regulation T of the Federal Reserve Board, one may borrow up to 50 percent of the
purchase price of securities that can be purchased on margin. T herefore, the margin loan will be
$1, 500, 000(= $3, 000, 000 × 50%). T he remaining $1,500,000 has to be financed by equity. T he
leverage ratio is calculated as total assets divided by equity. T herefore, the hedge fund’s leverage
$3,000,000
ratio is 2.0 (= ).
$1,500,000
Note: By buying on margin, you borrow money from a broker. Margin accounts increase an
investor's purchasing power and allow them to use other people's money to increase financial
leverage.
Q.3227 Bob Woolmer is a fund manager at Fortune Investment. He is analyzing shares of Bell
Aviation which currently have a bid price of $32.45 and an ask price of $32.90. T he sample standard
deviation of this bid-ask spread is 0.004. Given this information, determine the 99 percent confidence
interval on the transactions cost, in dollars per unit of the asset, and the 99% spread risk factor for a
transaction involving Bell Aviation.
A. T ransactions Cost: $0.759; Spread Risk Factor: 0.0232
B. T ransactions Cost: $0.759; Spread Risk Factor: 0.0139
C. T ransactions Cost: $0.378; Spread Risk Factor: 0.0116
D. T ransactions Cost: $0.379; Spread Risk Factor: 0.0139
Ask price − Bid price Ask price − Bid price

37
Ask price − Bid price Ask price − Bid price

S=2 =
Ask price + Bid price Mid Price
S is an estimate of the expected or typical bid-ask spread,and P is the asset's mid-price.
¯¯¯¯
Under zero-mean normality, the hypothesis is that S = S.
¯¯ 1 ¯¯¯¯
± ¯¯
P (S + 2.33σS )
2
1
Expected transactions cost = P × [S + 2.33(0.004)]
2
($32.90 + 32.45)
Midprice P = = $32.68
2
($32.90 − 32.45)
Expected bid-ask spread (S) = = 0.0138
$32.68
1
Expected transactions cost = $32.68 × [0.0138 + 2.33 (0.004)] = $0.378
2
¯¯¯¯
Where P is an estimate of the next day asset mid-price,and since P = P , the 99 percent risk factor
is referred to as:
1 ¯¯¯¯
(S + 2.33σS )
2
1
99% spread risk factor = [0.0138 + 2.33 (0.004)] = 0.01156
2
38
Q.3228 Tom Daniel is a portfolio manager at XinWin pension fund investing in common stocks.
XinWin has a policy around liquidity risk measure to limit each of its holdings to a maximum of 45%
of its 30-day average value traded. If the fund size is $7 billion, what is the maximum allocation that
the fund can hold in a stock with a 30-day average value traded of $390 million?
A. 17.56%
B. 2.25%
C. 2.51%
D. 5.57%
390 × 0.45 = $175.5 million
175.5
% of allocation in fund = = 0.0251 or 2.51%
7000
39
Q.3230 Abraham Maslow is an equity strategist at FinteeseCapital. He intends to use leverage to

increase the returns on a convertible arbitrage strategy. T he expected return on assets of the
strategy is 11%. T he fund has $16 million invested in the strategy and will finance the investment
with 60% borrowed funds. T he cost of borrowing is 7%. Using this information, the return on equity
(ROE) is closest to:
A. 17%
B. 13.66%
C. 10.66%
D. 11%
Debt = $16 × 0.60 = $9.6 million

total assets
Leverage ratio =
equity
16
leverage ratio = Leverage ratio = = 2.5 times
(16 − 9.6)
re = Lra − (L − 1) rd
Where:
ra = return on assets
re = return on equity
rd= cost of debt
L = leverage ratio
Return on equity = 2.5 × 11% − [(2.5 − 1) (7%)] = 27.5% − 10.5% = 17%
40
Q.3875 T here's always a risk that the price of an asset will move adversely in the act of buying or
selling it. T his risk is low if assets can be liquidated or a position can be covered quickly, cheaply, and
without moving the price too much. T he risk described here is:
A. Balance sheet risk
B. T ransactions liquidity risk
C. Systematic risk
D. funding liquidity risk
Transacti on l i qui di ty ri sk is the risk of moving the price of an asset adversely in the act of
buying or selling it. T ransaction liquidity risk is low if assets can be liquidated or a position can be
covered quickly, cheaply, and without moving the price too much. An asset is said to be liquid if it is
'near' or a good substitute for cash. An asset is said to have a liquidity premium if its price is lower
and expected return higher because it isn't perfectly liquid. A market is said to be liquid if market
participants can put on or unwind positions quickly, without excessive transactions costs and
without excessive price deterioration.
Bal ance sheet ri sk or fundi ng l i qui di ty ri sk is the risk that creditors either withdraw credit
or change the terms on which it is granted in such a way that the positions have to be unwound
and/or are no longer profitable. Funding liquidity can be put at risk because the borrower’s credit
quality is, or at least perceived to be, deteriorating, but also because financial conditions as a whole
are deteriorating.
Systemi c ri sk refers to the risk of a general impairment of the financial system. In situations of
severe financial stress, the ability of the financial system to allocate credit, support markets in
financial assets, and even administer payments and settle financial transactions may be impaired.
41
Q.3876 Convertible arbitrage hedge funds experienced significant losses during the 2007-2009
subprime crisis. T hese losses were most likely due to:
A. Increase of the target’s stock price due to stock market corrections
B. Unavailability of financing due to market conditions
C. T he decline of the acquirer’s price as they filed for bankruptcy during the crisis
D. Selling of the highly liquid assets
The correct answer i s B. Convertible arbitrage strategies depend on leverage to enhance returns.
When financing is unavailable due to market conditions, as experienced subprime crisis, convertible
bond values drop significantly. T he growing redemptions even worsened the funding liquidity
problem.
Additionally, convertible bonds have a limited “clientele” among investors. When the clientele
develops an aversion to the product during a period of market stress, it is dif?cult to sell the product
smoothly without significant price declines. T he gap between convertible bond prices and replicating
portfolios widened significantly, with no-arbitrage capital brought into the market. T he theoretical
price is the value of the replicating portfolio, taking the credit, risk-free rates, and the embedded
option into account.
A and D are i ncorrect: Hedge funds involved in merger arbitrage experienced losses in the early
stages of the subprime crisis as merger plans were abandoned for lack of ?nancing. Mergers typically
increase the target acquisition price, and decrease the acquirer’s price, since the acquirer often
takes on additional debt to ?nance the acquisition. T he risk arises from uncertainty as to whether the
transactions will be closed.
D i s i ncorrect: selling highly liquid assets lead to fewer adverse price impacts. T his lowers the
losses but leaves the hedge fund with a more illiquid portfolio.
42
Q.3877 ABC Ltd. is a US-based food processing firm. T he firm has a ROA of 10%, total assets equal to
$5, equity capital equal to $2. T he firm’s cost of debt is 3%. Calculate the firm’s ROE.
A. 19.8
B. 20.1
C. 20.5
D. 21.2
A E+ D D
T he firm’s leverage = = = 1+
E E E
5
L= = 2.5
2
Its
ROE = (ROA × Leverage ratio) − [(Leverage ratio − 1) × cost of debt]

= (0.10 × 2.5) − [(2.5 − 1) × 0.03] = 0.205 or 20.5%
43
Q.3878 ABC Ltd. is a US-based food processing firm. T he firm has a ROA of 10%, total assets equal to
$7, equity capital equal to $2. T he firm’s cost of debt is 3%. Calculate the firm’s ROE.
A. 25.5
B. 27.5
C. 30.5
D. 33.5
7
Leverage ratio = = 3.5
2
ROE = (ROA × Leverage ratio) − [(Leverage ratio − 1) × cost of debt]

= (0.10 × 3.5) − [(3.5 − 1) × 0.03] = 0.275 or 27.5%
Given the cost of debt of 3%, increasing the leverage factor from 2.5 to 3.5 increased the ABC’s
ROE by 7%
Q.3879 Suppose that an investor borrows $200. He then invests collateral of $225. Calculate the
haircut of this transaction.
A. 25.0
B. 45.0
C. 212.50
D. 225.0
A haircut is equivalent to the value of the collateral less the amount borrowed. T he $25 difference is
the one referred to as the haircut. T he lender aims to ensure that the loan amount is less than the
collateral. From the lender’s perspective, the haircut is the extent to which collateral value can fall
and still be fully collateralized.
44
Q.3880 A hedge fund has $1000,000 in cash, corresponding to an initial placement of $1000,000 in
equity by its owners. T he hedge fund wants to to finance a long position $1000,000 worth of stocks
at the Reg T margin requirement of 50 percent. A broker facilitates the trade by lending the hedge
fund $500,000. Determine the new leverage ratio for the hedge fund.
A. 0.5
B. 1.0
C. 2.0
D. 1.5
Before the trade, this is how the hedge fund's balance sheet looks like:
Assets
Cash: 1,000,000
Li abi l i ti es
Equity: 1.000,000
After the trade, here's the hedge fund's balance sheet:
Assets
Cash: 500,000
Stocks: 1000,000
Li abi l i ti es
Equity: 1,000,000
Margin loan: 500,000
T he leverage ratio (LR) is equal to total assets divided by equity.

LR = 1,500,000/1000,000 = 1.5
Thi ngs to Remember
Regulation T specifies the amount of credit brokers-dealers may extend to investors for the
purchase of securities and also sets forth regulations for the use of cash accounts. A margin account
is required for investors who wish to purchase securities with broker-dealer credit. Under Reg T,
investors may borrow a maximum of 50% of the purchase price and must pay the remaining balance
in cash.
45
Q.3881 Suppose a company traded at an ask price of $335 and a bid price of $331. T he sample
standard deviation of the spread is 0.00019. Calculate the expected transaction cost following the
zero mean normality assumption and 95% confidence interval on the transaction cost.
A. 2.03
B. 2.05
C. 1.06
D. 0.06
1
Expected transaction cost = P × (s + λ( standard deviation of spread))
2
335 + 331
Midprice (P) = = 333
2
ask price-bid price 335 − 331

s= = = 0.0120
midprice 333
1
Expected transactions cost = 333 × (0.0120 + 1.65(0.00019)) = 2.05
2
46
Q.3882 Suppose Delight Inc. traded at an ask price of $200 and a bid price of $199. T he sample
standard deviation of the spread is 0.0004. Calculate the 99% spread risk factor for the transaction.
A. 0.00297
B. 0.00325
C. 0.00353
D. 0.00381
T he 99% confidence interval of transaction cost in dollars, i.e., 99% spread risk factor is expressed
as:
1
±P × (s + 2.33σs )
2
and
1
99% spread risk factor = (s + 2.33σs )
2
ask + bid 200 + 199

mid market price = = = 199.5
2 2
and,
ask − bid 200 − 199

s= = = 0.00501
mid market price 199.5
T hus,
1
99% spread risk factor = (0.00501 + 2.33(0.0004)) = 0.00297
2
47
Q.3883 A trader estimates that the number of trading days (T ) required for the orderly liquidation of
a position. Position is eight trading days (T = 8). By what percentage is the trader most likely to
adjust the VaR?
A. 79%
B. 179%
C. 18.75%
D. 118.75%
To adjust for the fact that the position could be liquidated over several days, the following formula
can be used:
(1 + T )(1 + 2T )
VaR t × ⎷
6T
T he adjustment to the overnight VaR of the position is
(1 + 8)(1 + (2 × 8))
⎷ = 1.7854
6 ×8
T his means that the trader should increase VaR by 79%.
48
Q.3884 Velma Jones placed an order to sell a stock when the market price was $50. Due to market
volatility, by the time Jones’s broker sold the stock, the price had fallen to $48. In the market, this
phenomenon is known as:
A. Bid-ask spread
B. Adverse price impact
C. Slippage
D. Leverage effect
Slippage refers to the deterioration in the market price triggered by the amount of time it takes to
get a trade done. If the market is trending, the market can go against the trader, even if the order is
not large enough to influence the market.
A i s i ncorrect: fluctuation o the bid-ask spread introduces liquidity risk.
B i s i ncorrect: Adverse price impact is the impact on the equilibrium price of the trader’s actions.
D i s i ncorrect: T he leverage effect is the increase in the firm’s return on equity (ROE). It results
from increasing leverage and is equivalent to the difference between the return on assets (ROA) and
the cost of funding.
49
Reading 125: Early Warning Indicators
Q.3844 An indicator that provides information and significant potential stress before the occurrence
of an actual event is most likely known as a:
A. Sharp indicator
B. Granular indicator
C. Leading indicator
D. Lagging indicator
A leading (forward-looking) indicator is one that provides information and signals potential stress
before the occurrence of an actual event. It is specifically crucial in preparing for systematic risks.
A and B are incorrect. T he granularity and specificity of a particular indicator as it pertains to an
institution’s profile is known as its sharpness. A sharp (sufficiently granular) indicator is a signal that
does not go unnoticed within the mass of data.
For example, detecting a drop in overall deposit balances is an acceptable EWI. However, detecting
drops in deposit balances of more volatile segments, such as high-net-worth customers or rate-
sensitive products balances, brings into focus that certain essential classes of customers are leaving
the bank.
D is incorrect. A lagging indicator reports on events that have already occurred, such as government
reported GDP figures. A bank can develop proxies for the performance of the general economy from
internal loan portfolio metrics.
50
Q.3845 Early warning indicator triggers are used to initiate management discussions and actions that
call for formal documentation. Which of the following actions is least likely a cost-benefit decision?
A. Increasing high liquid assets
B. Continuing to comply with LCR requirements
C. Setting a minimum standard for liquidity buffer according to the bank’s risk appetite
D. Using a set and forget approach to make cost-benefit decisions
A basic “set and forget” approach does not allow for the strategic management of catastrophic
impacts of not having enough liquidity against a dynamic market.
A i s i ncorrect: Holding more high liquid assets ensures that a bank can meet its financial
obligations. It is ultimately a cost-benefit decision.
B i s i ncorrect: T he management should take note of fluctuations in the bank’s Liquidity Coverage
Ratio (LCR). For example, a decline below a specified threshold. It should then employ corrective
actions to ensure that the bank continues to comply with LCR requirements.
C i s i ncorrect: A minimum standard for the liquidity buffer is set per the risk appetite of the bank.
Increasing buffers before times of stress can cost-effectively extend the survival horizon as a bank
avoids being caught short of liquidity when the market freezes. Being in a strong balance sheet
position during times of stress opens opportunities for significant gains in market share as well as
acquisitions that may not be otherwise available in the ordinary course of business.
51
Q.3846 Companies with substantial trading focus use intraday reporting because they are more
exposed to external market conditions. Intraday liquidity monitoring indicators include the following,
except:
A. Intraday credit lines stretched out to financial institution customers
B. Daily minimum liquidity requirement
C. Daily maximum liquidity requirement
D. Available intraday liquidity
Daily minimum liquidity requirement is not outlined in the BCBS-2012 fundamental supervisory
guideline as an intraday liquidity monitoring indicators. Other indicators as given in the guideline
include:
Intraday liquidity monitoring indicators include
Daily maximum liquidity requirement
Available intraday liquidity
Total payments
T ime-specific and other critical obligations
T he value of customer payments made on behalf of financial institutions customers
Intraday credit lines stretched out to financial institution customers
T he timing of intraday payments
Intraday throughput
Q.3847 Your supervisor asks you to prepare a list of sound early warning indicators for liquidity
problems for your bank. Which of the following are sound early warning indicators of a potential
liquidity problem?
I. Negative publicity regarding an asset class owned by the institution

II. Stock price declines
III. Widening debt/credit-default-swap spreads
52
IV. Increase in credit lines

V. Significant deterioration in the bank’s financial condition
VI. Increase in the weighted average maturity of liabilities
A. I, II, III, V
B. I, II, IV, VI
C. II, III, IV, V
D. III, IV, V, VI
T he Basel Committee on Banking Supervision (BCBS) provided its “Principles of Sound Liquidity
Management and Supervision”1 (Sound Principles) in September 2008, following the global financial
crisis of 2007-2008. T he following figure is a non-exhaustive list of EWIs recommended by the BCBS.
Rapid asset growth, especially when funded with probable volatile liabilities
Growing concentrations in assets or liabilities
Increases in currency mismatches
Decrease of weighted average maturity of liabilities
Recurring incidents of positions approaching or breaching internal or regulatory limits
Negative trends associated with a particular product line
Significant deterioration in the bank’s financial condition
Negative publicity Credit rating downgrade
Stock price declines
Rising debt costs
Widening debt/credit-default-swap spreads
Rising wholesale/retail funding costs
Counterparties requesting additional collateral or resisting entering into new transactions
53
Drop-in credit lines
Increasing retail deposit outflows
Increasing redemptions of CDs before maturity
Difficulty accessing longer-term funding
Difficulty placing short-term liabilities
Q.3848 Fredric Pete is a risk manager at ABC Bank. Pete wants to forecast the bank’s losses. He
starts by assessing simple measures that indicate whether the bank’s risks are changing over time
(i.e., early warning signs). Fred then applies regression techniques, for example, to forecast the
losses. T he early warning signs that Pete assesses most likely include:
I. Audit scores
II. Staff turnover
III. T rade volumes
IV. Stock prices
A. I and IV
B. II and III
C. I, II and IV
D. All of the above
Early warning indicators are tools that can be used to detect problems before they hit. T hey help to
reveal whether a firm is headed in the right direction and if there are any reasons to get worried. In
this case, the warning signs would be a decline in audit scores, trade volume, and stock prices and an
increase in staff turnover. If to many of your employees are leaving, that could point to a serious
underlying issue such as dissatisfaction, feeling overworked or underappreciated. All that would
affect productivity in a negative way.
54
Q.3849 T he primary purpose of putting in place early warning indicators is to:
A. It is a measure used in management to indicate how risky an activity is.
B. Ensure that the bank holds enough liquid assets to enable it to meet financial obligations
C. Safeguard asset quality and ensure that liability limits are not breached
D. Initiate management discussion and necessary corrective action
Early warning indicators are analogous to warning lights on an automobile dashboard. For example,
the engine oil indicator relays the message that a top-up is needed to avert possible damage. T his is
analogous to a fall in the liquidity coverage ratio or the current ratio. T he primary purpose of EWIs
is to initiate management discussions to take corrective action and avert impending financial distress.
Q.3850 What is a sharp early warning indicator?
A. An indicator that highlights the past performance
B. An indicator that depends on another performance measure
C. A highly granular indicator, involving a subset of data
D. An indicator that needs professional experience and quantitative skills to decode
Sharp indicators are highly granular signals that do not go unnoticed within the mass of data. T hey
point to a change within a subset of data. A good example would be the detection of drops in deposit
balances of more volatile customer segments, such as high-net-worth customers. Such an indicator
relays the message that certain crucial classes of customers may be on their way out of the bank.
55
Q.3851 Exim bank wishes to establish a forward-looking view of its liquidity risk. Brian McLeish, a
junior analyst at the bank, has managed to gather a wealth of information as follows:
I. Balance sheet copies for each of the last four quarters

II. Cash flow statement for each of the last four business quarters
III. A list of ongoing legal proceedings filed against the bank
IV. Collateralized debt obligations held by a unique purpose entity guaranteed and are guaranteed
by the bank
Which of the above sources of information is least likely to be used by the analyst?
A. III
B. IV
C. II
D. None – all the sources are relevant for the purpose at hand
To obtain a forward-looking view of liquidity risk, a bank must employ metrics that examine the
structure of the balance sheet in addition to metrics that project cash flows and future liquidity
positions, taking into account off-balance sheet risks.
Off-Balance-Sheet risk is the risk posed by factors not appearing on the bank’s balance sheet. Both
III and IV are off-balance sheet items that expose the bank to liquidity risk. Legal proceedings come
with costs such as attorney’s fees and any possible fines or compensation awarded to litigants. T he
bank has guaranteed the CDOs being sold by the SPE, and hence the likelihood of default and the
guaranteed amount must be assessed beforehand.
56
Q.3852 Early warning signs can be identified using a set of parameters and processes that identify
probable risks at a nascent stage. When potential risk events are recognized at an earlier stage, an
investment bank is able to prepare itself as the event develops. Which one of the following is
LEAST likely an early warning sign for such events?
A. Narrowing of debt or credit default swap spreads
B. Increases in currency mismatches
C. Drop-in credit lines
D. Increasing redemptions of CDs before maturity
Narrowing of credit or debt swap spreads is an indication that the investment is in a good position.
But if it widens, it is an early warning sign for an expected adverse event.
All the other options are early warning signs for an investment bank.
Q.3853 In which of the given circumstances is it most optimal to track early warning indicator
metrics?
A. After an industrial-wide decline in performance
B. During a business as usual environment
C. During periods of institution-specific stress
D. After the occurrence of a loss-causing event
Early warning indicators provide signals or act as a heads-up in the lead-up to a potential disaster. As
such, it is most optimal to make use of EWIs during as business as usual environment when
everything appears to be in order, or at least going as per expectations. By so doing, any deterioration
in EWI metrics is detected easily, setting in motion a series of steps to avert the impending danger. If
the bank’s liquidity coverage ratio, for example, decreases below a specified threshold, the
management can immediately direct the relevant personnel to liquidate long-term assets and correct
the situation.
57
Q.3854 To accurately monitor liquidity risk, firms are advised to use a spotlight system in
representing and communicating their performance against the thresholds of the EWIs. Which of the
following indicators should a firm be most concerned with?
A. Red
B. Blue
C. Amber
D. Green
A green indicator implies that the measure is within the normal range, and there’s no imminent
danger. An amber measure should be further investigated, while a red indicator should be an alarm to
a significant concern and may warrant an immediate response.
Q.3855 Swift Investments, a U.S. based firm, is a clearing member at the Chicago Mercantile
Exchange. T he firm has put together a comprehensive liquidity risk management framework that
involves the use of a set of early warning indicators to help the firm detect liquidity distress at a
nascent stage. To prudently manage its liquidity risk, which of the following reporting schedules is
most appropriate for the firm’s EWI dashboard?
A. Daily
B. Weekly
C. Intraday
D. Monthly
For businesses with limited trading, the EWI dashboard should be reported daily to provide managers
with adequate time to adjust in response to potential crises.
For companies with a substantial trading focus, such as cleating members of a derivatives exchange,
the use of intraday reporting is paramount because they are more exposed to external market
conditions.
58
Reading 126: The Investment Function in Financial Services

Management
Q.3856 A security issued by the United States federal government which matures in one year
following the date of issue is most likely a:
A. T reasury note
B. T reasury bond
C. T reasury bill
D. Structured note
A T reasury bill is a debt obligation issued by the federal government that should mature in one year
following the date of issue.
A and B are incorrect. A T-notes is an investment instrument available in various maturities that
range from 1 year to 10 years when issued and in large volumes. On the other hand, a T reasury bond
is investment security with an original maturity of more than 10 years, traded in a more limited
market with wider price fluctuations.
D is incorrect: A structured note a debt security issued by financial firms, not by the federal
government.
Q.3858 To safeguard public funds, depository institutions in the united states cannot accept deposits
from federal, state and local governments unless they post collateral acceptable to these government
units. T his is most likely known as:
A. Statutory requirements
B. Pledging requirement
C. Investment requirements
D. Operational requirements
Pledging requirements refer to any legal requirements for securities to be pledged as collateral for
specific deposits. Depository institutions, for example, in the UnitedStates, reject deposits from
federal, state, and local governments unless they post collateral, which is acceptable to these
governmental units. State and local government deposit pledging requirements differ widely from
state to state, though most allow a combination of federal and municipal securities to meet
government pledging requirements.
59
Q.3859 Assume that an investor currently holds a bond whose par value is $2,000. T he bond is
currently priced at $1,600, matures in 5 years, and pays an annual coupon of 8%. Calculate the yield
to maturity of the bond.
A. 13.80%
B. 16.38%
C. 16.59%
D. 17.34%
T he coupon amount is 0.08×2,000=$160
160 160 160 160 2, 160

1,600 = + + + +
(1 + YT M)1 (1 + YT M)2 (1 + YT M)3 (1 + YT M)4 (1 + YT M)5
YT M = 13.80%
Q.3860 Any securities which reach maturity within one year is most likely regarded as:
A. Money market securities
B. Capital market securities
C. Federal agency securities
D. Certificates of deposits
Money market securities are low risk and readily marketable securities that have a maturity term of
one year.
B is incorrect: Capital market instruments have a higher expected rate of return and capital gains
potential with a maturity term of beyond one year.
C is incorrect: T hese are marketable notes and bonds sold by agencies owned by or sponsored by the
federal government.
D is incorrect: A certificate of deposit is short term security, which has a fixed interest rate and
maturity date issued by a depository institution such as a bank to raise funds from the secondary
money market.
60
Q.3861 An investor wants to purchase a $1,500 par-value treasury note that has a 10% coupon rate
and is expected to mature in 5 years. However, the investor decides to sell the security at the end of
the second year for $1,375. If the current price of the T reasury note is $1,200, calculate the holding
period yield of the note.
A. 18.23%
B. 18.98%
C. 19.15%
D. 19.89%
150 (1, 375 + 150)

1, 200 = +
(1 + HPY)1 (1 + HPY)2
Now, using a financial calculator with N=2, PV=-1,200, PMT =150, and FV=1,375:
I /Y = H P Y = 19.15%
61
Q.3862 Suppose that Aaa-rated corporate bonds have an average gross yield to maturity of 8%, the
prime rate on top-quality corporate loans is 6%, and Aaa-rated municipal bonds have a 5% gross yield
to maturity. Calculate the expected after-tax gross returns for the Aaa-rated corporate bonds for a
taxed financial firm in the top 35% federal income tax bracket.
A. 2.80%
B. 5.20%
C. 7.50%
D. 8.00%
After-tax gross yield = Before-tax gross yield

× (1 − Firm's marginal income tax rate)
T hus,
Aaa-rated corporate bonds : 8% × (1 − 0.35) = 5.2%
62
Q.3863 Suppose that Aaa-rated corporate bonds have an average gross yield to maturity of 8%, the
prime rate on top-quality corporate loans is 6%, and Aaa-rated municipal bonds have a 5% gross yield
to maturity. Calculate the tax-equivalent yield (T EY) for the Aaa-rated municipal bonds for a taxed
financial firm in the top 35% federal income tax bracket.
A. 5.00%
B. 6.52%
C. 7.69%
D. 14.29%
After-tax return on a tax-exempt investment

T EY =
(1 − Investing firm’s marginal tax rate)
Recall that municipal bonds are tax-exempt; thus, the expected after-tax gross returns for Aaa-rated
municipal bonds will be:
5% × (1 − 0) = 5%
5%
T EY = = 7.69%
(1 − 0.35)
T his measure means that the Aaa-rated corporate bond and the prime-rated loans would have to have
a before-tax yield of 7.69% to match the Aaa-municipal bond’s after-tax yield of 5.0%.
63
Q.3864 Which of the following statements is not true?
A. T reasury bills are the long term debt obligations issued by the federal government
B. Inflation risk is the likelihood that rising prices for goods and services will erode the
purchasing power of interest income and repaid principal from security or loan
C. Bankers' acceptances are considered to be among the safest of all money market
instruments
D. Investment securities are expected to help stabilize financial institutions' income
U.S. T reasury bill is a debt obligation of the united states government that should mature in one year
following the date of issue (short-term). T-bills are issued in weekly or monthly auctions, and their
high degree of security makes them very attractive.
B i s true: Rising prices of goods and services distort the purchasing power of interest income and
repaid principal from security or loan. T his is known as inflation risk.
C i s true: Because they represent a bank’s promise to pay the holder a designated amount of money
on a designated future date, bankers’ acceptances are considered to be among the safest of all money
market instruments.
D i s true: Investment security portfolios help to stabilize income, so that revenues level out over
the business cycle—when loan revenues fall, income from investment securities may rise.
64
Q.3865 T he risk that the bank must sell part of its investment portfolio before its maturity for a
capital loss is known as:
A. Credit risk
B. Business risk
C. Default risk
D. Liquidity risk
Financial institutions must always be mindful of the possibility they will be required to sell
investment securities in advance of their maturity due to liquidity needs and be subjected to liquidity
risk.
A and C are incorrect: Credit/Default risk is the risk that the security issuer may default on the
principal or interest owed.
B is incorrect: Financial institutions of all sizes face significant risk that the market area economy
that they operate in may serve may turn down, with falling sales and rising unemployment. T hese
adverse developments are known as business risk.
65
Q.3866 Money market instruments which represent a bank's commitment to pay a specified amount
of money on a specific future date under specific conditions, which are often used in international
trade are known as:
A. Eurocurrency deposits
B. Government agency securities
C. Bank qualified bonds
D. Corporate bonds
International Eurocurrency deposits are typically short-term, fixed maturity deposits issued in
million-dollar units by the world’s largest banks headquartered in financial centers around the globe.
B is incorrect: Government agency securities are marketable notes and bonds sold by agencies
owned by the government or sponsored by the government.
C is incorrect: Bank qualified bonds are those issued by smaller local governments, i.e., governments
issuing no more than $10 million of public securities per year. Banks buying bank-qualified bonds are
allowed to deduct 80% of any interest paid to fund these purchases. T his tax advantage is not
available for nonbank-qualified bonds.
D is incorrect: Corporate bonds are long term debt obligations of significant corporations.
66
Q.3867 T he most aggressive investment maturity strategy that requires the bank to regularly shift
the maturities of its securities in responses to fluctuations in interest rates called the:
A. Front-End Load Maturity Policy
B. Back-End Load Maturity Policy
C. Barbell Strategy
D. Rate Expectation Strategy
T he rate expectation strategy is the most aggressive of all maturity strategies and is mostly used by
the most significant financial firms. It involves continually shifting maturities of securities in line
with current forecasts of interest rates and the economy. T his approach calls for shifting
investments toward the short end of the maturity spectrum when there is an expectation of a rise in
interest rates and toward the long end when falling interest rates are expected.
A is incorrect: T he front-end load maturity policy involves purchasing short-term securities only and
placing all investments within a short interval of time. T he method has the advantage of
strengthening the liquidity position of a financial institution and avoids significant capital losses in
case of a rise in the market interest rates.
B is incorrect: T he back-end load maturity policy is an investment maturity strategy that requires
the bank to hold all of their investment assets in long term maturities.
C is incorrect: T he investment maturity strategy that requires the bank to have one half of its
investment portfolio in short term assets and one half of its investment portfolio in long term assets
is known as the barbell investment portfolio strategy.
67
Q.3868 Loans will be terminated or paid off ahead of schedule. T his is a particular problem with
residential home mortgages and other consumer loans that are pooled and used as collateral in
securitized assets. T his risk is known as:
A. Liquidity risk
B. Prepayment risk
C. Call risk
D. Business risk
Prepayment risk is the risk of early repayment of a loan by the borrower. It is specific to asset-
backed securities which arise since the realized interest and principal payments from a pool of
securitized loans may be different from the original expected cash flows. For example, mortgage-
backed securities where the underlying is a pool of mortgages (home loans).
A is incorrect. Liquidity risk is the risk of losses due to the need to liquidate positions to meet
funding requirements. T his occurs when financial firms are forced to sell investment securities in
advance of their maturity due to liquidity needs.
C is incorrect: Call risk is the risk that the company whose bonds the financial institution owns may
retire the entire issue of corporate bonds in advance of their maturity, leaving the bank with the risk
of earnings losses resulting from reinvesting the cash at lower interest rates.
D is incorrect: Business risk is the risk that the economy of the market area they service may take a
downturn in the future.
68
Q.3871 T he practice of protecting securities purchased from loss of return, no matter which way
interest rates go is regarded as:
A. Portfolio shifting
B. Duration
C. Portfolio immunization
D. Securitization
Portfolio immunization is a strategy that involves protecting securities purchased from loss of
return, no matter which way interest rates go. T he investment officer focuses on the tradeoff
between price risk and reinvestment risk in an investment portfolio.
A is incorrect: Portfolio shifting refers to selling selected securities to offset taxable income from
other sources and to restructure a financial firm's asset portfolio to one that is more appropriate for
current market conditions.
B is incorrect: Duration is a present-value-weighted measure of the maturity of an individual security

or portfolio of securities. It measures the average amount of time needed for all of the cash flows
from a security to reach the investor who holds it. In other words, it measures a security’s price
sensitivity to interest rate changes.
D is incorrect: Securitization refers to the process of pooling diverse types of contractual debt such
as residential mortgages and commercial mortgages and selling their related cash flows to third party
investors as securities.
69
Reading 127: Liquidity and Reserves Management: Strategies and

Policies
70
Q.3885 ABC Bank Limited predicts its cash inflows and outflows over the next one day to be as in the
following table:
Predicted Cash Inflows and Outflows for ABC Bank Ltd.
Deposit withdrawals $129 Sales of bank assets 61

Deposit inflows $119 Stockholder dividend payments 172
Scheduled loan repayments $122 Revenues from sale of 118
non-deposit services
Acceptable loan requests $90 Repayments of bank borrowings 84
Borrowings from the $110 Operating expenses 70
money market
Calculate the bank’s projected net liquidity position within the next one day.
A. -$15
B. -$23
C. $15
D. $23
Cash Inflows Amount Cash Outflow Amount

Deposit inflows $119 Deposit withdrawals $129
Borrowings from the $110 Acceptable loan requests $90
money market
Sales of bank assets 61 Stockholder dividend 172
payments
Revenues from sale of 118 Repayments of bank 84
non-deposit services borrowings
Scheduled loan repayments $122 Operating expenses 70
Total Cash Inflows $530 Total Cash Outflow $545
A financial firm’s net liquidity position = Supplies of liquidity flowing into the financial firm -
Demands on the financial firm for liquidity
= Total cash inflow– Total cash outflow

= $530 − $545 = −$15
T herefore, ABC Bank Ltd. has a projected net liquidity deficit of $15
71
Q.3886 Prime savings has a projected net liquidity surplus of $31 million in the coming week. Given
the following table showing Prime Savings’ supply and demand for liquidity, calculate the total
expected stockholder dividend payments for the coming week.
Supplies of Liquidity Flowing into ABC Bank Ltd. Savings
Deposit inflows $31

Revenues from nondeposit service sales $23
Scheduled repayments of previous $5
made customer loans $28
Asset sales $15
Money market borrowings $20
Total supply of liquidity 122
T he demand for liquidity flowing from ABC Bank Ltd. savings
Expected quality loan demand $31

Necessary repayments of previous $26
borrowings
Deposit withdrawals $22
Disbursements to cover operating expenses $10
Total demand for liquidity excluding $89
stockholder dividend payments
A. $ 3 million
B. $2 million
C. $7 million
D. $11 million
Net Liquidity Surplus = Total liquidity supply– Total liquidity demand

– Stockholder dividend payments
$31 million = $122 million − $89 million
− Stockholder dividend payments
T herefore, expected stockholder dividend payments must equal $2 million for the coming week.
72
Q.3888 XYZ Bank has the following forecasts for its checkable deposits, time and savings deposits,
commercial loans, and consumer loans over the next eight months as follows.
XYZ Bank Forecasts for Deposits and Loans Over the Next Eight Months in US$
Month Checkable T ime and Savings Commercial Consumer

Deposits Deposits Loans Loans
January 219 639 729 209
February 216 591 731 267
March 203 593 783 265
April 189 580 785 213
May 210 562 797 211
June 187 589 789 234
July 189 626 791 232
August 209 618 768 230
Employ the sources and uses of funds approach to determine the month, which is likely to have a
liquidity surplus.
A. February
B. March
C. June
D. August
Total Deposits = Checkable Deposits + T ime & Saving Deposits
Total Loans = Commercial Loans + Consumer Loans
Change in Previous Total Month's Deposits = Current month's total deposits - Previous months total
deposits
Change in Previous Total Month's Loans = Current month's total loans - Previous month's total loans
Estimated Liquidity Deficit or Surplus = Change from previous month's total deposits - Change from
73
previous month's total loans
Month Total Change from Total Change from Estimated

Deposits Previous Loans Previous Liquidity Defecit
Month's T.Deposits Month's T.Loans or Surplus
January 858 0 938 0 0
February 807 −51 998 60 −111
March 796 −11 1048 50 −61
April 769 −27 998 −50 23
May 772 3 1008 10 −7
June 776 4 1023 15 −11
July 815 39 1023 0 39
August 827 12 998 −25 37
T he bank has projected surpluses in April, July, and August. T he surpluses should be invested
profitably.
74
Q.3889 XYZ Bank has the following forecasts for its checkable deposits, time and savings deposits,
commercial loans, and consumer loans over the next eight months as follows.
XYZ Bank Forecasts for Deposits and Loans Over the Next Eight Months in US$
Month Checkable T ime and Savings Commercial Consumer

Deposits Deposits Loans Loans
January 219 639 729 209
February 216 591 731 267
March 203 593 783 265
April 189 580 785 213
May 210 562 797 211
June 187 589 789 234
July 189 626 791 232
August 209 618 768 230
Using the sources and uses of funds approach, which of the following months are likely to result in a
liquidity deficit?
A. February
B. April
C. July
D. None
XYZ Bank has liquidity deficits in half of the months, i.e., February, March, May, and June as in the
following table:
Month Total Change from Total Change from Estimated

Deposits Previous Liabilities Previous Liquidity Deficit
month month or Surplus
January 858 0 938 0 0
February 807 −51 998 60 −111
March 796 −11 1048 50 −61
April 769 −27 998 −50 23
May 772 3 1008 10 −7
June 776 4 1023 15 −11
July 815 39 1023 0 39
August 827 12 998 −25 37
75
Q.3890 XYZ can use the following methods to meet its liquidity deficit. Which of the options does not
apply?
A. Aggressive advertising to attract NOW deposits
B. Selling some of their securities
C. Aggressively issuing new loans
D. Selling securities under agreements to repurchase
Aggressively issuing new loans is a strategy to meet a bank’s liquidity surplus. Other ways a bank can
employ to meet its deficit include:
Borrowing from the Federal Reserve district bank
Borrowing Federal funds
Issuing negotiable CDs in the money market
If they have a holding company, it may exchange commercial paper for sale proceeds.
T hese are then passed through to the bank subsidiary
A combination of a number of these alternatives
76
Q.3891 Suppose that a bank's liquidity division estimates that it holds $20 million in hot money
deposits and other IOUs against which it holds 75% liquidity reserve, $12 million in vulnerable funds
against which it plans to hold a 15% reserve and $15 million in stable funds against which it holds a
10% liquidity reserve. Its loans are currently standing at $130 million, but have recently reached as
high as $150 million and that the bank expects its loans to grow by 8% annually. Assuming that the
reserve requirements on liabilities currently stand at 4%, what is the bank’s total liquidity
requirement.
A. $49.57
B. $68.30
C. $73.68
D. $75.60
Liability liquidity reserve=0.75 × Hot money deposits and non-deposit funds

− legal reserves held
+ 0.15 × (Vulnerable deposit and
non-deposit funds-Legal reserves held)
+ 0.10 × (Stable deposits and non-deposit funds
− Legal reserves held) + Loan liquidity requirement
= 0.75 × (20 − 0.04 × 20)
+ 0.15 × (12 − 0.04 × 12)
+ 0.10 × (15 − 0.04 × 15)
+ 150 × 0.08 + (150 − 130)
= $49.57 million
(held in liquid assets and additional borrowing capacity)
Q.3892 A thrift institution has analyzed its deposit accounts thoroughly and separated them as
follows: It holds a 65% reserve in liquid assets or borrowing capacity for each dollar of hot money
deposits, a 20% reserve behind vulnerable deposits, and a 15% reserve for its holdings of core funds.
It also assumes that time and savings deposits carry a 0% reserve requirement, and all checkable
deposits carry a 5% reserve requirement. Its loans are currently standing at $1,500 million, but a
week ago, they were standing at $1,680. Its expected annual growth for loans is about 10%. Calculate
the institution’s high estimate of the total liquidity requirement given further the following
information:
77
Millions of Checkable Savings T ime

Dollars deposits deposits deposits
Hot money funds $17 $0 $809
Vulnerable funds $27 $169 $569
Stable (core) funds $33 $300 $203
A. $534 million
B. $825 million
C. $763 million
D. $1,117million.
Deposit Liquidity Requirement = 0.65[Net “Hot Money" Funds] + 0.20 [Net Vulnerable Funds] +
0.15 [Net "Stable" Funds]
Source Amount in Millions

Net hot money funds $825.15
Net vulnerable funds 763.65
Net Stable (core) funds $534.35
Where:
Net Hot Money Funds = [$17 million - ($17 million× 0.05)] + [$0 million] + [$809 million]=$825.15
million
Net Vulnerable Funds = [$27 million - ($27 million×0.05)] + [$169 million] + [$569 million]=$763.65
millon
Net Core Funds = [$33 million - ($33 million×0.05)] + [$300 million] + [$203 million]=$534.35
million
Total depository liquidity requirement =(0.65×$825.15)+(0.20×$763.65)+(0.15×
$534.35)=$769.23million or $769 million
Total liquidity requirement = Additional loan demand + Deposit liquidity requirement
T he institution’s loans are currently standing at $1,500 million, but a week ago, they were standing at
$1,680. T hus, there is an addition of $180 million. Further, the annual loan growth rate is about 10%.
78
Expected additional loan demand (low estimate) = $1, 500 × 1.10 = $1, 650
Anticipated additional loan demand (high estimate) = $1, 680 × 1.10 = $1, 848
Total liquidity requirement (high estimate) = $769 + ($1, 848 − $1, 500) = $1, 117 million.
79
Q.3894 T he following financial information pertains to Daylight Bank:
Assets: Amount
in US$in
millions
Cash and due from depository institutions 546
U.S. T reasury securities 382
Other securities 550
Pledged securities 503
Federal funds sold and reverse 396
repurchase agreements
Net loans and leases 2, 374
Total Assets 3, 431
Liabilities:
Demand deposits 741
Savings deposits 976
T ime deposits 1, 351
Total deposits 2, 686
Core deposits 1, 111
Brokered deposits 214
Federal funds purchased and 488
Other money market borrowings 186
Calculate Daylight Bank’s net federal funds and repurchase agreements position.
A. -11.54%
B. -2.68%
C. 2.68%
D. 11.54%
Net federal funds and repurchase agreements position

=(Federal funds sold and reverse repurchase agreements
−Federal funds purchased and repurchase agreements
Total assets
396 − 488
= = −2.68%
3431
80
Q.3895 T he following financial information pertains to Daylight Bank:
Assets: Amount
in US$in
millions
Cash and due from depository institutions 546
U.S. T reasury securities 382
Other securities 550
Pledged securities 503
Federal funds sold and reverse 396
Net loans and leases 2, 374
Total Assets 3, 431
Liabilities:
Demand deposits 741
Savings deposits 976
T ime deposits 1, 351
Total deposits 2, 686
Core deposits 1, 111
Brokered deposits 214
Federal funds purchased and 488
Other money market borrowings 186
Calculate Daylight Bank’s cash position ratio.
A. 7.97%
B. 11.13%
C. 15.91%
D. 32.38%
Cash and cash deposits due from depository institutions

Cash position indicator =
total assets
546
= = 15.91%
3431
A higher proportion of cash implies that the institution is in a stronger position to handle immediate
cash needs.
81
Q.3896 T he following indicators are negative liquidity indicators. Which is the odd one out?
A. Capacity ratio
B. Pledged securities ratio
C. Hot money ratio
D. All of the above
The correct answer i s C. Hot money ratio indicates whether the institution has balanced the
volatile liabilities it has issued with the money market instruments that it holds that could be sold
quickly to cover the liabilities.
A i s i ncorrect: Capacity ratio is a negative liquidity indicator because loans and leases are the most
illiquid of the assets.
B i s i ncorrect: Pledged securities ratio is also a negative liquidity indicator. T his is because the
higher the proportion of securities pledged to back U.S. government deposits, the less the securities
available to sell when liquidity needs arise.
D i s i ncorrect: Hot money ratio is not a negative liquidity indicator.
82
Q.3897 No financial institution can confidently tell if it has sufficient liquidity until it has passed the
market’s test. Which of the following is a signal that the management should take note of
A. Stock price behavior
B. Public confidence
C. Borrowings from the central bank
D. All of the above
Stock pri ce behavi or: If the investors perceive that the institution is experiencing a liquidity
crisis, the firm's stock prices decline.
Publ i c confi dence: T he firm’s customers may lose confidence in it if they believe there is
expected danger making the firm unable to meet its obligations.
Borrowi ngs from the central bank : T he management should consider if the firm has been
forced to borrow in larger volumes and more frequently from the central bank in its home territory
(such as the Federal Reserve or Bank of Japan). Additionally, it should examine if the central bank
officials have begun to question the institution's borrowings.
83
Q.3898 One who is responsible for ensuring that the institution maintains an adequate level of legal
reserves is known as?
A. Chief finance officer
B. Chief operational officer
C. Money position manager
D. None of the above
The correct answer i s C. T he money position manager makes quick decisions that have potential
long-run consequences on profitability. Smaller banks and thrifts often hand this job over to more
significant depositories with whom they have a correspondent relationship (that is, that hold deposits
to help clear checks and meet other liquidity needs).
A i s i ncorrect: A chief finance officer (CFO) ensures that reporting of the financial information is
done accurately and identifies new areas of business
B i s i ncorrect: A chief operating officer is responsible for the company’s daily operations.
84
Q.3899 A contractual agreement between bank and customer that permits the bank to move funds
out of a customer checking account to generate higher returns for the customer and lower reserve
requirements for the bank is known as:
A. Clearing balance
B. Sweep account
C. Legal reserve
D. Reserve Maintainance
The correct answer i s B. T he above is the definition of a sweep account. Sweep accounts help in
lowering the overall cost of the bank’s funds while allowing the customer to access their deposits
for payments.
A i s i ncorrect: T he clearing balance is the minimum balance held at fed that can be a benefit
because the institution earns credits from holding this balance. T he credit is utilized to make
payment for the Federal charges for services.
C i s i ncorrect: A legal reserve is an asset that a central bank requires depository institutions to
hold as a required reserve behind their deposits or other liabilities
D i s i ncorrect: Reserve maintenance period is the two week period of time over which a bank
must hold the required amount of legal reserves demanded by the law.
85
Q.3900 You are provided with a simple balance sheet for Loud bank. When the bank’s depositors
withdraw $200 million, the bank faces a liquidity challenge.
Assets Amount
Cash $48
Securities $940
Loans $3, 932
Total assets 4, 920
Liabilities and Equity
Deposits $3, 948
Other liabilities $440
Equity $532
Total Liabilities and equity $4, 920
If Loud bank employs the asset conversion method and decides to sell its securities to cover the
deposit drain, what happens to the size of the bank due to withdrawal?
A. Increase
B. Decrease
C. No change
D. Cannot establish from the information
T he size of the bank would decrease (shrink) by the amount of deposit withdrawal. T herefore, the
total assets would decline to $4,920-$200 = $4,720 million
86
Q.3901 You are provided with a simplified balance sheet for Loud bank. When the bank’s depositors
withdraw $200 million, the bank faces a liquidity challenge.
Assets Amount
Cash $48
Securities $940
Loans $3, 932
Total assets 4, 920
Deposits $3, 948
Equity $532
Suppose that Loud bank’s management depends on borrowed liquidity (liability management strategy)
to cover the deposit drain. What happens to the size of the bank?
A. Increase
B. Decrease
C. No change
Liability management (purchased liquidity) strategy entails borrowing immediately spendable funds to
cover all anticipated demands for liquidity. It allows the firm to leave its volume and composition of
its assets portfolio unchanged if it is satisfied with the assets it currently holds. If we consider the
situation as a whole, then the withdrawal of 200M plus additional borrowing; the size of the balance
sheet decreases, then increases. If the borrowing amount is equal to the 200M, then the balance
sheet size would not change.
87
Q.3902 You are provided with a simplified balance sheet for Loud bank. T he bank faces liquidity
challenge the moment the bank depositors withdraw $200 million
Assets Amount
Cash $48
Securities $940
Loans $3, 932
Total assets 4, 920
Deposits $3, 948
Equity $532
Loud Bank requires cash to cover its unexpected loan demand. T he loan officer has $400 million in
loans that she wants to make. Using Loud Bank’s balance sheet, what would happen to the size of the
Loud bank if liability management strategy is used to provide funds for the loans?
A. Increase
B. Decrease
C. No change
T he size of the bank increases by the amount of the total new loans. T herefore, total assets will
increase to $4,920+ $400 = $5,320
88
Q.3903 Suppose that a bank has a clearing balance averaging $2.5 million during a certain two-week
maintenance period and the Federal funds' interest rate over this same period averaged 8%. Calculate
the Federal Reserve credit that it would earn:
A. $547.95
B. $6,575.34
C. $ 7,777.8
D. $15,342.47
Reserve credit = Average clearing balance × Annualized federal funds rate

14days
×( )
360days
14
= $2, 500, 000 × 0.08 × = $7, 777.8
360
89
Q.3904 Suppose Grand Bank's liquidity manager estimates that the bank experiences a liquidity
deficit of $500 million in the coming month with a probability of 45%, a $575 million liquidity deficit
with a probability of 20%, a liquidity surplus of $350 million with a probability of 25%, and a $100
million liquidity surplus with a probability of 10% What is the bank’s expected liquidity requirement?
A. -$10.00
B. -$242.50
C. $22.75
D. $30.00
Liquidity Deficit or Probability Expected Value

Surplus in Millions
$(500.00) 45% $(225.00)
$(575.00) 20% $(115.00)
$350.00 25% $87.50
$100.00 10% $10.00
100% $(17.50)
Expected Liquidity Requirement = 0.45 ∗ (−$500million) + 0.20 ∗ (−$575million)+

0.25 ∗ (+$350million) + 0.10 ∗ (+$100million)
= −$225million − $115million
+ $87.50million + $10million
= −$242.50million
T he bank is faced with an expected liquidity deficit of -$242.5 million in the coming month.
90
Reading 128: Intraday Liquidity Risk Management
Q.3905 Andera Jeremy is a bank treasurer in ABC bank; he realizes that the bank is experiencing
liquidity shortage during the day, and it is unable to pay XYZ bank for its foreign transaction services
owed. Jeremy suggests the use of intraday liquidity as a remedy. Which of the following definitions
best applies to Jeremy's use of the funds?
A. Asset purchasing and funding.
B. Funding for Nostro accounts
C. Collateral pledging
D. Outgoing wire transfers
Since the primary purpose for getting the intraday fund is to pay XYZ bank, the funds' purpose falls
under the use “funding of Nostro accounts.” Funding of Nostro accounts refer to cash transfer to a
correspondent bank for services provided. Banks manage the cash they place in a correspondent
bank account to a target average monthly balance as part of the return for providing banking
services.
A i s i ncorrect: Asset purchasing/funding is where intraday liquidity is used to fund other balance
sheets. T hese assets include securities purchases for investment portfolios, client loans, and fixed
asset purchases.
C i s i ncorrect: Collateral pledging refers to using assets to secure a loan. T he borrower pledges
assets to the lender to guarantee a loan. However, this is not the case for ABC bank.
D i s i ncorrect: For outgoing wire transfers, money is borrowed for any use as opposed to the
funding of Nostro accounts, which is specific to pay debts owed to other banks.
91
Q.3907 A bank treasurer has been getting liquidity recovery during the day by borrowing Fed funds,
London interbank offered rate, and Eurodollar deposits. Which of the following most accurately
states the source under which the credit mentioned above falls?
A. Other term funding
B. Liquid assets
C. Overnight borrowing
D. Intraday credit
Fed funds, LIBOR, and Eurodollar deposits lie under the overnight borrowing source of intraday
liquidity. T hey provide quick intraday liquidity for the bank. T hese kinds of borrowings are not paid
on the same day.
A i s i ncorrect: Under other term funding, the bank can tap into other funding sources such as
Federal Home Loan Banks (FHLB) borrowings and term repos if the lenders are in a capacity to
offer funding at a time of day that is appropriate for the bank’s intraday funding needs.
B i s i ncorrect: Liquid assets include cash, money market deposits, and short-term government
debt, and other assets that can be promptly converted into cash.
D i s i ncorrect: Intraday credit refers to a credit line or overdraft permitted during business hours
and covered by close of business.
92
Q.3908 A bank treasurer working for FGH bank has been given an intraday credit whose use had
been determined according to the following characteristics, which he had considered and approved
before the credit processing. T he characteristics are listed below:
1. Have a single settlement per day, which is done majorly in the late afternoon timeframe.
2. May either serve as a source or use of funds reliant on the net position of a participant on
any given day.
3. T hey can be forecast for securities that have multi-day settlements more difficult for same-
day settlement activity
Which of the following choices most accurately outlines the use under which the intraday credit
should be classified?
A. Outgoing wire transfers
B. Funding for Nostro accounts
C. Collateral pledging
D. Settlements at Payment, Clearing, and Settlement (PCS) Systems
T he above are the characteristics of the settlements at PCS systems A is incorrect: In Outgoing
wire transfers, payment lasts the entire business day and follows a reasonably predictable pattern.
B i s i ncorrect: In funding of Nostro accounts, banks manage the cash they place in a
correspondent bank account to a target average monthly balance as part of the return for providing
banking services.
C i s i ncorrect: Collateral pledging pertains to banking activities that require a bank to earmark and
set aside collateral.
93
Q.3909 A group of investors was discussing intraday credit as a source of intraday liquidity. An expert
was invited to take them through the characteristics of intraday credit:
I. Intraday credit is permitted during business hours and covered by the close of business.
II. Lines are often uncommitted and provided without interest charges.
III. Central banks are the only sources of intraday credit for the banking system
IV. Low-interest rates are attached to intraday credit lines.
Which of these statements accurately outlines the characteristics of intraday credit?
A. I & IV
B. III and IV
C. I & II
D. All of the above
Credit lines are often uncommitted and provided without interest rates, however, we have some
changes, especially in Europe.
Moreover, the credit is permitted during business hours and covered by the close of business.
Statement III i s i ncorrect: Central banks are not the only sources of intraday credit as FMUs,
and other institutions can extend the credit to their banks.
Statement IV i s i ncorrect: Intraday credit is issued free of interest
94
Q.3910 A sound intraday risk structure for overseeing intraday liquidity is of the utmost importance
in risk management. Which of the following accurately states the characteristics of a sound intraday
risk structure?
A. Active risk management
B. Integration with risk governance
C. Risk assessment
D. All of the above
T he correct answer is D:
All of the above provide characteristics of an effective governance structure for overseeing intraday
liquidity risk.
Q.3911 FRM students were discussing the measures for quantifying and monitoring risk levels. T hey
finally agreed to write down every two measures they think are accurate. Which of the following
states the most accurate measures?
A. Daily maximum intraday liquidity usage and client intraday credit usage
B. Client intraday credit usage and total bank intraday credit lines available and usage
C. Total bank intraday credit lines available and usage and total intraday credit lines to clients
and counterparties.
D. T ime-sensitive obligations like settlement positions and payment throughput
A is correct: Daily maximum intraday liquidity usage and client intraday credit usage are among the
measures for quantifying risk levels.
B i s i ncorrect: Client intraday credit usage is one of the measures for quantifying risk levels, but
total bank intraday credit lines available, and usage is a measure for understanding intraday flows.
C i s i ncorrect: Both options in B are measures for understanding intraday flows.
D i s i ncorrect: T ime-sensitive obligations, which are identical to settlement positions is a measure
for understanding intraday flows while payment throughput is a measure for quantifying risk levels.
95
Q.3912 A junior liquidity manager at XYZ Ltd. inquiries from his colleagues about the perspectives
employed by leading institutions to monitor their intraday liquidity risk. He gets the following
options:
I. T he amount of intraday credit the institution utilizes

II. T he amount of intraday credit that the institution extends to clients
III. Total payments
IV. Settlement positions
Which of the following options are correct?
A. I and II
B. I and III
C. II and III
D. None
T he two perspectives for monitoring intraday liquidity risk are the amount of intraday credit the
institution is extending to clients and the amount of intraday credit the institution utilizes.
B i s i ncorrect: Total payment is a measure for understanding intraday flows but not a perspective.
D i s i ncorrect: Settlement positions is a measure for understanding intraday flows but not a
perspective.
96
Q.3913 A bank has been keeping statistics necessary for understanding intraday flows. T he statistics
have been listed below: identify the pair that states the most accurate statistics for understanding
intraday flows.
A. Payment amounts and times for each processing step in the payment workflow.
B. T ime received or originated and credit status
C. Past credit position and any suspensions of the payment
D. Payer and payee and past credit position
payment amounts and times for each processing step in the payment workflow are the necessary
statistics for understanding intraday flows.
B i s i ncorrect; although time received or originated statistics are essential in understanding
intraday flows, credit status statistics are not of importance when seeking to understand intraday
flows.
C i s i ncorrect; the past credit position is not a significant statistic when seeking to understand
intraday flows.
D i s i ncorrect; Although payer and payee statistics are significant in measuring intraday flow, past
credit position statistics are not significant.
97
Q.3914 A bank has been keeping statistics on payer and payee information as a way of understanding
its intraday flows, payment system used, any suspensions of the payment, time received or
originated, and routing information. Under which measure of understanding intraday flow does the
above statistics most accurately lie?
A. Total payments
B. Other cash transactions
C. Settlement positions
D. Total intraday credit lines to clients and counterparties
A i s correct: T he statistics in the question best defines the total payment as a measure for
understanding intraday flows.
B i s i ncorrect: For other cash transactions, a bank should monitor intraday and end-of-day
settlement positions at every financial market utility in which it participates and no statistics as in
total payments.
C i s i ncorrect: Settlement positions are used in cases where banks have no complete data for
reconstructing account positions.
D i s i ncorrect: Total intraday credit lines to clients and counterparties involve monitoring credit
lines extended to clients and counterparties.
98
Q.3915 Which of the following measures is derived by comparing a client's peak daily intraday
overdraft to the established credit line?
A. Client intraday credit usage
B. Payment throughput
C. Daily maximum intraday liquidity usage
D. Total bank intraday credit lines available and usage
The correct answer i s A: Client intraday credit usage is obtained by comparing a client’s peak daily
intra-day overdraft to the established credit line. T racking the total intraday credit exposures
furnishes a bank with an indicator of the necessary liquidity required to support its clients’ business
activities.
B i s i ncorrect: Payment throughput is a measure that tracks the percentage of outgoing payment
activity relative to the time of day.
C i s i ncorrect: Daily maximum intraday liquidity usage is a measure of the bank’s usage of an
intraday credit extension.
D i s i ncorrect: Total bank intraday credit lines available and usage is not a measure for quantifying
intraday flows but a measure for understanding intraday flows.
99
Q.3916 A bank XYZ usually monitors intraday and end-of-day settlement positions at every financial
market utility in which it participates. It further maximizes the volume of the transaction-level. T he
details are taken and stored for further analysis. Which of the following indicates the most accurate
measure for understanding intraday flow that the bank uses?
A. Other cash transactions
B. Total payments
C. Total bank intraday credit lines available and usage
D. Settlement positions
The correct answer i s A: For other cash transactions, a bank monitors intraday and end-of-day
settlement positions at every financial market utility in which it participates. Furthermore, the bank
maximizes the volume of transaction-level detail taken and stored for further analysis.
B i s i ncorrect; For total payments, a bank and it's intraday management team keeps statistics on
the amount of payments accrued on all electronic payments systems in which it participates.
C i s i ncorrect: Total intraday credit lines available and usage regulators involve anticipating
financial institutions to manage the size of systemic risk they pose to the financial system among
risks posed to taxpayers and industry-funded insurance plan.
D i s i ncorrect: For settlement positions, if a bank has no complete data for reconstructing account
positions at any time of the day, it at least keeps data on its settlement positions with all its FMUs.
100
Q.3917 Which of the following denotes the methods for tracking intraday flows and monitoring risk
levels?
A. Measures for understanding income flows
B. Measures for quantifying and monitoring risk levels
C. Measurement of credit level
D. Measures for risk aversion
The correct answer i s B: Measures for quantifying and monitoring risk levels is a method for
tracking intraday flows and monitoring risk levels.
A i s i ncorrect: Measures for understanding income flows is not a method for tracking intraday
flows and monitoring risk levels.
C i s i ncorrect: Measurement of credit level does not apply in tracking intraday flows and
monitoring risk levels.
D i s i ncorrect: Measures for risk aversion is not a measure for tracking intraday flows and
monitoring risk levels.
101
Q.3918 ABC Bank has been a participant of FMU for a significant period. T he bank has been actively-
measuring and tracking the flow of outgoing payment transactions relative to total payments or time
markers. Which one of the following is not a reason for the bank to perform that?
A. To track its volume patterns to aid in ensuring that all the day’s payments are processed
on a timely basis.
B. To meet FMU requirements for submitting a target percentage of payments by a deadline.
C. To identify and track its peak periods over time and the correlation of this activity with its
intraday liquidity on hand and intraday credit usage.
D. To be able to know which means are best for acquiring intraday liquidity.
The correct answer i s D: T he bank does not actively-measure and track the flow of outgoing
payment transactions relative to total payments or time markers to know the best means of
acquiring intraday credit.
A i s i ncorrect: T he banks actively-measures and tracks the flow of outgoing payment transactions
relative to total payments or time markers to track its volume patterns to aid in ensuring that all the
day’s payments are processed on a timely basis.
B i s i ncorrect; the bank actively-measures and track the flow of outgoing payment transactions
relative to total payments or time markers to meet FMU requirements for submitting a target
percentage of payments by a deadline.
C i s i ncorrect: T he bank actively-measures and tracks the flow of outgoing payment transactions
relative to total payments or time markers to identify and track its peak periods over time and the
correlation of this activity with its intraday liquidity on hand and intraday credit usage.
102
Q.3919 XYZ Bank Ltd. has been obtaining money from Fed funds to pay debts owed to ABC Bank Ltd.
then servicing the foreign exchange services owed to fed fund providers the next morning. Which of
the following set of choices consists of the source of funds for XYZ and the use for which the bank
puts the funds into?
A. Cash balances and Outgoing wire transfers
B. Incoming funds flow and intraday credit and settlements at payment
C. Overnight borrowings and funding for Nostro accounts
D. Liquid assets and outgoing wire transfers.
The correct answer i s C: Overnight borrowing involves borrowing from Fed funds, London
interbank offered rate (LIBOR), and Eurodollar deposits while funding for Nostro accounts refer to
cash transfer to a correspondent bank for foreign transaction services provided. Banks manage the
cash they place in a correspondent bank account to a target average monthly balance as part of the
return for providing banking services.
A i s i ncorrect; Cash balances are the starting cash held on the bank while outgoing wire transfers
are essential to use of intraday liquidity whereby payment lasts the entire business day and follows a
reasonably predictable pattern.
B i s i ncorrect: Incoming flows from payments and FMU settlements form the largest source of
intraday funding during the normal market function while intraday credit and settlement at payment
systems may either serve as a source or use of funds reliant on the net position of a participant on
any given day.
D i s i ncorrect; Liquid assets are assets that can be converted quickly into cash. T hey include cash,
money market deposits, and short-term government debt (e.g., T-Bills), while outgoing wire transfers
are typically the essential use of intraday liquidity whereby payment lasts the entire business day and
follows a reasonably predictable pattern.
103
Reading 129: Monitoring Liquidity
Q.3920 In monitoring liquidity, it is essential to understand the identification and taxonomy of cash
flows that occur during the business activities of a financial institution. A group of FRM students
were asked to state the two perspectives of classifying cash flows. T he students were then grouped
into four sets, depending on their responses as follows. Group A: T ime and amount Group B: T ime
and Credit scores Group C: Credit potential and amount Group D: Term structure and time Which
group of students stated the most accurate perspectives?
A. Group A
B. Group B
C. Group C
D. Group D
The correct answer i s A: T he two perspectives of classifying cash flows are time and amount. For
classification based on time, deterministic cash flows are cash flows that occur at future instants
that are predictable or known with certainty at the reference time of their appearance. On the other
hand, stochastic cash flows are those that manifest themselves at some random instants in the future
in an unpredictable manner.
On the other hand, under classification based on the amount, deterministic cash flows occur in an
amount known with certainty at the reference time. On the contrary, stochastic cash flows are
those whose amount cannot be fully determined.
B i s i ncorrect: T hough time is a cash flow classification perspective, credit scores are not one of
the perspectives.
C i s i ncorrect: Credit potential is not a perspective of classifying cash flows.
D i s i ncorrect: T ime structure is none of the cash flow classification perspective.
104
Q.3921 Both deterministic and stochastic cash flows have specific characteristics that demarcate
one from each other. Four students were asked to state the characteristics that differentiate
deterministic cash flow from stochastic ones in their assessment text for FRM exams; their
responses were as follows:
A. Deterministic cash flows manifest themselves at some random instants in the future, and
their amount cannot be fully determined
B. Deterministic cash flows occur at future instants that are predictable and occur in an
amount known with certainty
C. Deterministic cash flows amount cannot be predicted, and they occur at future instants
that are predictable.
D. Deterministic cash flows are unpredictable, both in amount and time perspective.
The correct answer i s B: T he two characteristics that distinguish deterministic cash flows from
stochastic ones is that deterministic cash flows occur at future instants that are predictable and
occur in an amount known with certainty.
A i s i ncorrect: Both characteristics given by A define stochastic cash flows.
C i s i ncorrect: Deterministic cash flows amount is predictable at the reference time of their
appearance.
D i s i ncorrect: Option D states the characteristics of stochastic cash flows.
105
Q.3923 An FRM tutor gave his students some characteristics of cash flows and told them to identify
the cash flows. T he characteristics were as follows;
a. T hey are related to financial contracts such as fixed-rate bonds or fixed-rate mortgages or
loans, bonds issued, and loans received by the bank held in its liabilities;
b. T hey are produced by payments of periodic interests and periodic repayments of the capital
installments if the asset is amortizing.
Which of the following most accurately states the correct cash flows under which the above
characteristics fall?
A. Deterministic cash flows
B. Behavioral cash flows
C. Stochastic cash flows
D. Credit-related cash flows
The correct answer i s A: T he above-stated characteristics pertain to deterministic cash flows.
B i s i ncorrect: Behavioral cash flows arise when a bank’s clients decide to prepay the outstanding
amount of their loans or mortgages and credit lines that are open to the client’s withdrawals
occurring at any time until the expiry of the contract and in an uncertain amount, although within the
limits of the line.
C i s i ncorrect: Stochastic cash flows manifest themselves at some random instants in the future,
and their amount cannot be fully determined.
D i s i ncorrect: Credit-related cash flows are stochastic cash flows that occur when the
uncertainty of the amount is due to credit events, such as the default of one or more of the bank’s
clients.
106
Q.3924 T he liquidity option impact is considered in two ways. A student was asked to give the ways,
and the following choices were recorded as her responses after repeated trials. Which of the
choices give the most accurate answer?
A. Liquidity impact on the balance sheet, and a (positive or negative) financial impact on cash
flows.
B. A (positive or negative) financial impact and contract deposit rate.
C. Contract deposit rate and liquidity impact on the balance sheet
D. Available cash reserves and financial impact
The correct answer i s A: Even though liquidity options can be prompted by factors other than
financial convenience, the impact on the bank may be considered twofold, namely; the balance sheet
and a (positive or negative) financial impact.
B i s i ncorrect: Contract deposit rate is not a way of considering liquidity option
C i s i ncorrect: Contract deposit rate is not a way of considering liquidity option
D i s i ncorrect: Although the choice of financial impact is correct, available cash reserves is not a
way of considering liquidity options.
107
Q.3925 You are given the assets, liabilities, and their respective expiry terms of a financial institution
XYZ, as shown in the table below. Given that the assets bear no default risk, no liquidity options are
embedded within the deposit, and both the assets and the liabilities have been ordered according to
their maturity, disregarding which kind of contract they are. Study the table for building a T SECF for
the institution.
Expiry Notional Interest Notional Interest

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 20 6 0 −4
2 0 5 −10 −4
3 0 5 0 −3
4 0 5 0 −3
5 50 5 0 −3
6 0 2 0 −3
7 0 2 −70 −3
8 0 2 0 0
9 0 2 0 0
10 30 2 0 0
> 10 0 − −20 0
Calculate the T SECCF for the assets and liabilities with 1-year expiry term.
A. 22
B. 24
C. 26
D. 30
T he term structure of expected cash flows (T SECF) refers to the collection, ordered by date, of
positive and expected cash flows, up to expiry referring to the contract with the longest maturity,
say tk:
T SECCF(t0 ,tk )
= {Cf + − + − + −
e (t0 ,t0 ),Cf e (t0, t0 ),Cf e (t0, t1), Cf e (t0 , t1), … … , Cf e (t0 ,tk ), Cf e (t0 ,tk )} .
For the first year, T SECF = 20 + 6 + 0 − 4 = 22
Q.3926 You are given the assets, liabilities, and their respective expiry terms of a financial institution
XYZ, as shown in the table below. Given that the assets bear no default risk, no liquidity options are
108
the institution.
Expiry Notional Interest Notional Interest

1 20 6 0 −4
2 0 5 −10 −4
3 0 5 0 −3
4 0 5 0 −2
5 50 5 0 −3
6 0 2 0 −3
7 0 2 −70 −3
8 0 2 0 0
9 0 2 0 0
10 30 2 0 0
> 10 0 − −20 0
Calculate the T SECCF for the assets and liabilities with 6 years expiry term.
A. -2
B. -1
C. 18
D. 69
You are given the assets, liabilities, and their respective expiry terms of a financial institution XYZ,
as shown in the table below. Given that the assets bear no default risk, no liquidity options are
the institution.
Assets and Liabilities Classified According to Maturity
109
Expiry Notional Interest on Notional on Interest on T SECCF

1 20 6 0 −4 22
2 0 5 −10 −4 13
3 0 5 0 −3 15
4 0 5 0 −2 18
5 50 5 0 −3 70
6 0 2 0 −3 69
7 0 2 −70 −3 −2
8 0 2 0 0 0
9 0 2 0 0 2
10 30 2 0 0 34
> 10 0 − −20 0 14
In generating the T SECCF we calculate the T SECF for the first year and then cumulate the amounts
until the 6th year following T SECCF as follows,
T SECCF(t0 , t6 ) = {CF(t0 , t0 , t1), CF(t0, t0, t2 ),. . ., CF(t0, t0 , t6 )}
T he cumulated amounts are as in the above table.
110
Q.3927 ABC bank has repoed one of its real estates from XYZ bank. T he FRM manager for ABC bank
has realized that this transaction has affected the bank’s cash flows and liquidity generation capacity
in several ways. Which of the following is not one of the effects?
A. T he term structure of the available assets (T SAA) is reduced by an amount equal to the
notional of the repo agreement.
B. T he cash flows that the bank receives at the beginning and the negative cash flow at the
end leads to an increase in the term structure of liquidity generation capacity (T SLGC)
C. T he transactions yield a liability in the balance sheet.
D. T he transaction leads to an increase in the Bank’s T SAA.
The correct answer i s D: T he choice does not give an effect of the repo on the bank’s cash flow
and LGC.
A i s i ncorrect: T he T SAA of the asset is reduced by an amount equal to the notional of the repo
agreement.
B i s i ncorrect: the cash flows received by the bank at the start and negative cash flow at the end
leads to an increase in the T SLGC.
C i s i ncorrect: T he transactions yield a liability in the balance sheet.
111
Q.3929 Brook Austin, an FRM student, was asked to state the pair of financial transactions that would
help a struggling manager for ABC bank to increase the T SAA for the bank. Austin listed the four
pairs of the transactions he deemed would lead to an increase in T SAA. Which of the following
options is the most accurate?
A. Security lending and Buy/sell back transactions.
B. Repo and purchases
C. Reverse repo and repo
D. Buy/sell back and security borrowing transactions
The correct answer i s D: Buy/sell-back transactions, as well as security borrowing transactions,

cause an increase in the term structure of the available assets.
A i s i ncorrect: Security lending leads to a decrease in the T SAA while buy/sell back transaction
increases the T SAA. C is incorrect: Both repo and purchases decrease the term structure of
available assets.
D i s i ncorrect; Although reverse repo transaction causes an increase in T SAA, a repo transaction
causes a decrease in T SAA.
Detailed Explanation:
Buy/sellback transactions are similar to reverse repo transactions in terms of the exchange of cash
and of the asset, with the only the difference being that ownership passes to the buyer (the bank) at
the initiation of the agreement, as does possession. T his implies that the payments received for the
asset before the sellback belong to the bank, so that they enter the T SECF and the T SECCF, along
with the cashflows at the start and end that relate to the purchase and sale, since they are contract
flows. T hus, the T SAA of the asset is increased by an amount equal to the notional of the
buy/sellback agreement. Buy/sellback transactions represent an asset for the period of the contract.
112
Q.3930 Which of the following statements is least accurate about T SECF based on financial risk
management?
A. In T SECF, cash flows are adjusted to include liquidity options, and thus behavioral models
are used for typical banking products such as sight deposits, prepaying mortgages, and credit
link usage.
B. T SECF Includes the cash flows from all current contracts that include the assets and
liabilities. Cash flows are stochastic in many cases because they link to market indices, such
as Libor or Euribor fixings.
C. Cash flows originated by new business increasing the assets are included; they are
typically stochastic in both the amount and time dimensions, so they are treated employing
models that consider all related risks.
D. T SECF does not include the cash flows from all current contracts that include the assets
and liabilities.
The correct answer i s D: It is not true that T SECF does not include the cash flows from all
current contracts that include the assets and liabilities.
A i s i ncorrect: It is true that In T SECF Cash flows are adjusted to include liquidity options, and
hence behavioral models are used for typical banking products such as sight deposits, credit link
usage, and prepayment of mortgages.
B i s i ncorrect: T SECF Includes the cash flows from all current contracts that include the assets
and liabilities.
C i s i ncorrect: Cash flows originated by new business are indeed included; they are typically
stochastic in both the amount and time dimensions, so they are treated employing models that
consider all related risks.
113
Q.3931 Suppose that you are given assets, liabilities, and their respective expiry terms of a financial
institution, as shown in the table below. Given that the assets bear no default risk, no liquidity
options are embedded within deposits, and the assets and the liabilities have been ordered according
to their maturity, disregarding which kind of contract they are. Study the table to build the T SECF for
the institution.
Expiry Notional Interest on Notional on Interest on

1 25 7 0 −5
2 0 5 −20 −6
3 0 5 0 −3
4 0 5 0 −3
5 60 8 −35 −3
6 0 2 0 −3
7 0 2 −20 −3
8 0 2 0 0
9 0 2 0 0
10 15 2 0 0
> 10 0 − −25 0
Calculate the T SECCF for the assets and liabilities with a term of two years to expiry.
A. -21
B. 6
C. 7
D. 27
T he term structure of cumulated expected cash flows (T SECCF) is the collection of expected
cumulated cash flows, starting at t0 and ending at tb ordered by date.
T SECF for year 1 = 25 + 7 + 0 + −5 = 27
T SECCF for year 2 = 27 + 5 − 20 − 6 = 6
Q.3932 Suppose that you are given assets, liabilities, and their respective expiry terms of a financial
institution, as shown in the table below. Given that the assets bear no default risk, no liquidity
options are embedded within deposits, and the assets and the liabilities have been ordered according
to their maturity, disregarding which kind of contract they are. Study the table to build the T SECF for
114
the institution.
Expiry Notional Interest on Notional on Interest on

1 25 7 0 −5
2 0 5 −20 −6
3 0 5 0 −3
4 0 5 0 −3
5 60 8 −35 −3
6 0 2 0 −3
7 0 2 −20 −3
8 0 2 0 0
9 0 2 0 0
10 15 2 0 0
> 10 0 − −25 0
Calculate the T SECCF for the assets and liabilities with a term of more than 10 years to expiry.
A. 10
B. 14
C. 27
D. 39
In generating the T SECCF, we calculate the T SECF for the first year and then cumulate the amounts
until the 6th year following T SECCF as follows,
T SECCF(t0 , t>10 ) = {CF(t0 , t0 , t1), CF(t0, t0, t2 ),. . ., CF(t0, t0 , t>10 )}
T his is as calculated in the following table.
115
Expiry Notional Interest on Notional on Interest on T SECCF

1 25 7 0 −5 27
2 0 5 −20 −6 6
3 0 5 0 −3 8
4 0 5 0 −3 10
5 60 8 −35 −3 40
6 0 2 0 −3 39
7 0 2 −20 −3 18
8 0 2 0 0 20
9 0 2 0 0 22
10 15 2 0 0 39
> 10 0 − −25 0 14
Q.3935 Assume that a bank decides to sell a quantity of the bond equal to a notional of 300,000 after
10 months (or 0.833 years) for 99.95. Keeping in mind that this trade can be dealt with to generate
liquidity, calculate the term structure of cumulated liquidity generation capacity (T SCLGC) inflow
resulting from this transaction given the interest rate is 10%
A. 324,840
B. 324,890
C. 494,675
D. 543,785
T he calculations are as follows;
T he term structure of cumulated liquidity generation capacity (T SCLGC) records an inflow
equivalent to:
Inflow =Amount× price,including the accrued interest

99.95
300, 000 × ( + 10% × 0.833) = 324, 840
100
116
Q.3936 A liquidity division in XYZ bank operates a buy/sell back operation. Assume that the bank
buys a bond worth 200,000, 3 months (0.25 years) after it is issued with an interest rate of 10% and
sells it back after 6 months at the forward price. Assume that the purchase price is 99.50 of the par
value. Calculate the amount the bank pays at the start of the contract.
A. 204,000
B. 309,400
C. 403,600
D. 508,300
T he amount the bank pays is given by;
200, 000 × (99.50% + 10% × 0.25) = 204, 000
Q.3937 A liquidity division in XYZ bank operates a buy/sell back operation. Assume that the bank
buys a bond worth 200,000, 3 months (0.25 years) after it is issued with an interest rate of 10% and
sells it back after 6 months at the forward price. Assume that the purchase price is 99.50 of the par
value. Which of the following most correctly states the effect of this transaction on the cash flows
and liquidity generation capacity?
A. T he T SECF decreases
B. T he bond amount decreases
C. both T SECF and the bond amount decreases
D. T he T SECF and the quantity of the bond available increases and T SCLGC is not affected
The correct answer i s D: T he transaction causes an increase in both T SECF and the amount of
the available bonds and T SCLGC not affected.
A i s i ncorrect: T he buy/sell back transaction causes an increase in T SECF
B i s i ncorrect: T he increase in both the bond amount and T SECF increases the T SAA.
C i s i ncorrect: the buy/sell back operation causes an increase in both T SECF and bond amount.
117
Q.3938 A liquidity division in XYZ bank operates a buy/sell back operation. T he bank buys a bond
worth 200,000 with semi-annual coupons of 10% and immediately gets into a forward contract to sell
it back after six months. Assume that the purchase price is 99.50 of the par value and the six-month
forward price is 99.90 of the par value. Calculate the total amount received by the bank after six
months.
A. 202,000
B. 209,800
C. 406,780
D. D. 409,600
Remember that the sum it receives includes accrued interest:
200, 000 × (99.90% + 10% × 0.50) = 209, 800
Q.3939 A liquidity division for RPQ bank decides to lend 600,000 of a bond after 3 months from
purchase for a period of 6 months. In the process, they realize that T he T SECF does not record any
cash flow at the inception of the contract, whereas the T SAA shows a reduction of the available
quantity of 600,000. After 6 months, the bond is returned to the bank whereby the bank receives a
fee for the lending, which we assume to be equal to 3.5% p.a. Calculate the value of the received fee
for the lending.
A. 4,800
B. 6,700
C. 10,500
D. 4,200
T he received fee for lending is calculated as follows:
600, 000 × (3.5% × 0.5) = 10, 500
Note that 600,000 represents the notional, 3.5% is the interest rate, and 0.5 represents the
maturity(half-year).
118
Reading 130: The Failure Mechanics of Dealer Banks
Q.2292 Coliseu Bank from Porto, Portugal, is a large dealer bank considered “too big to fail” and,
therefore, can expect support from the government and central bank in case of distress. T his
support “guarantee” is associated with certain behaviors that may have potentially disastrous
consequences. Which of the following gives an example of such behaviors?
A. Manipulation of financial statements.
B. Taking more inefficient risks.
C. Offering products at exorbitant prices.
D. Only doing business with high net-worth firms and individuals.
T he common knowledge that large financial institutions will receive support when they are
sufficiently distressed – in order to limit disruptions to the economy – provides an incentive to large
financial institutions to take inefficient risks, and for their creditors to cooperate by financing them
at a lower cost than would be available without the implicit backstop of government support.
119
Q.2293 Molino Bank from Zaragoza, Spain, is experiencing serious problems following the decline in
their capital position due to previous trading losses. At some point in time, Molino’s clearing bank
starts refusing to process its “daylight overdrafts” transactions. Molino is unable to execute trades
or send cash to meet its obligations. What is the result of the situation concerning Molino Bank?
A. A moderate decrease in daily trading.
B. A severe decrease in daily trading.
C. T he bank declares bankruptcy.
D. T here is no effect on the bank’s business.
T he provided example thoroughly explains a sequence of events leading to the protagonist bank’s
bankruptcy, following loss of confidence in the protagonist bank by its investors: Consider a
protagonist dealer bank, whom we shall call Alpha Bank, whose capital position has just been
severely weakened by trading losses. Alpha seeks new equity capital to shore up the value of its
business, but potential providers of new equity question whether their capital infusions would do
much more than improve the position of Alpha's creditors. Alpha has been operating a significant
prime brokerage business, holding the hedge funds' cash and securities. T hey begin to shift their cash
and securities to better capitalized prime brokers or, safer yet, custodian banks. Alpha's short-term
secured creditors see no good reason to renew their loans to Alpha. Most of them fail to renew their
loans to Alpha in the form of repurchase agreements, or "repos" (which) have a term of one day. (...)
In the normal course of business, Alpha's clearing bank allows Alpha and other dealers the flexibility
of "daylight overdrafts" of cash for the intraday financing of trades. Finally, however, Alpha receives
word that its clearing bank has exercised its right to stop processing Alpha's cash and securities
transactions given the exposure of the clearing bank to Alpha's overall position. Unable to execute
trades or to send cash to meet its obligations, Alpha declares bankruptcy.
T he situation in which Molino Bank has found itself results in an inability to do business or fulfill its
obligations, therefore Molino Bank declares bankruptcy.
120
Q.2294 Bens bank from Brussels, Belgium, is a dealer bank. It operates in both primary and
secondary markets. In the primary market, the bank most likely intermediates between:
A. Issuers and investors of securities
B. Sellers and buyers
C. Other banks
D. Corporate clients
Dealer banks intermediate in the primary market between issuers and investors of securities, and in
the secondary market among investors. In the primary market, the dealer bank, sometimes acting as
an underwriter, effectively buys equities or bonds from an issuer and then sells them over time to
investors.
Q.2295 Kralingen Bank from Rotterdam is a dealer bank. It operates in both primary and secondary
markets. In the latter, the bank most likely intermediates between:
A. Issuers and investors of securities
B. Sellers and buyers
C. Other intermediaries
D. Corporate clients
Dealer banks intermediate in the primary market between issuers and investors of securities, and in
the secondary market among investors. In secondary markets, a dealer stands ready to have its bid
prices hit by sellers and its ask prices hit by buyers.
121
Q.2296 Arrenberg Bank is a large dealer bank performing many over-the-counter trades. What is the
manner in which its over-the-counter trades are negotiated?
A. T rades are negotiated both publicly or privately.
B. T rades are negotiated publicly.
C. T rades are negotiated privately.
D. T rades are negotiated publicly with some portions of the contract kept secret.
Dealer banks dominate the intermediation of over-the-counter securities markets, covering bonds
issued by corporations, municipalities, certain national governments, and securitized credit products.
Over-the-counter trades are privately negotiated.
Q.2297 Grochowska Bank from Poznan, Poland, is intermediating for repurchase agreements (repos).
In the Bank’s repo agreements, what does the term “haircut” mean?
A. “Haircut” is not used in repo agreements.
B. A reduction in returns of a repo.
C. An increase in returns of a repo.
D. A form of risk mitigation for a repo.
Securities dealers intermediate in the market for repurchase agreements, or “repos.” A repo is, in
essence, a short-term cash loan collateralized by securities. One counterparty borrows cash from
the other, and as collateral against performance on the loan, that counterparty posts government
bonds, corporate bonds, securities from government-sponsored enterprises, or other securities such
as collateralized debt obligations. T he performance risk on a repo is typically mitigated by a “haircut”
that reflects the risk or liquidity of the securities.
122
Q.2298 Which of the following best explains how dealer banks benefit from over-the-counter
derivative trading?
A. Charging transaction fees from investors in the form of the bid-ask spread.
B. Taking almost equal but opposite trading positions.
C. Charging a monthly premium with respect to every client.
D. Selling the underlying commodities at a profit.
For most OT C derivatives, one of the parties is a dealer bank. T he bank lays off all or part of the risk
associated with derivative positions by running a “ matched book” – a large cache of equal but
opposite trading positions.
T he banks, however, benefit from charging transaction fees from investors in the form of the bid-ask
spread.
Q.2299 Utvin Bank from T imisoara, Romania, trades in over-the-counter derivatives as a dealer.
What’s the primary source of profit for the bank?
A. T ransaction commission
B. Differences between bid and offer terms
C. Interest rate
D. Change in value of securities
For most over-the-counter derivatives trades, one of the two counterparties is a dealer. T he dealer
usually lays off much or all of the risk of its client-initiated derivatives positions by running a
“matched book,” that is, by aiming for offsetting trades, profiting on the differences between bid and
offer terms. As in their securities businesses, dealer banks also conduct proprietary trading in over-
the-counter derivatives markets.
123
Q.2300 Which of the following derivatives are widely held by banks thanks to the nature of their
business?
A. Futures contracts
B. Options contracts
C. Forward contracts
D. Interest-rate swaps
Banks make a huge percentage of their profits from differences in interest rates. For example, they
accept deposits from customers and promise to pay interest at a certain rate. T hey then use the
deposits to finance loan facilities, but charge a premium on top of the cost of deposits, thereby
making a profit. T hus, the majority of over-the-counter derivatives are interest-rate swaps, which
are commitments to make periodic exchanges of one interest rate, such as the variable London
Interbank Offered Rate (LIBOR), for another interest rate, such as a fixed rate, on a stated notional
principal until a stipulated maturity date.
Q.2302 Fridau Bank from Leoben, Austria, trades in over-the-counter derivatives. T he bank has
purchased 25 positions of 50,000 shares and bonds worth USD 30 per share/bond. Five of those
positions have defaulted, each with USD 50,000 cost in legal and other fees. How does this influence
the total wealth on the derivatives market?
A. T he total wealth on the derivatives market is reduced by USD 250,000.
B. T he total wealth on the derivatives market is reduced by USD 50,000.
C. T he total wealth on the derivatives market is decreased by USD 0.
D. T he total wealth on the derivatives market is reduced by USD 3,750,000.
It is an accounting identity that the total market value of all derivatives contracts must be zero – that
is, the total amount of positive (purchased) positions is equal to the total amount of negative (sold)
positions. Contingent on events that may occur over time, derivatives transfer wealth from
counterparty to counterparty, but do not directly add to or subtract from the total stock of wealth.
Indirectly, however, derivatives can cause net losses through the frictional costs of bankruptcies,
such as legal fees, and other costs associated with financial distress.
124
Q.2303 Bodrum bank has an exposure of $20m with respect to Aurora bank. T he latter has posted
collateral worth $15m. In case Aorora bank defaults, how much does Bodrum stand to lose?
A. $10m
B. $20m
C. $15m
D. $5m
A useful gauge of counterparty risk in the over-the-counter market is the amount of exposure to
default presented by the failure of counterparties to perform their contractual obligations. T hese
exposures can be reduced through collateral.
In this example, Bodrum has covered only a part of its exposure to Aurora. In case the latter
defaults, the former would only recover a maximum of $15m by selling the collateral, thus would
lose ($20m - $15m).
Q.2304 Asker Bank from Oslo, Norway, is a dealer bank. It has been evident for some time that the
bank is having difficulty meeting its obligations, and is on the verge of a solvency crisis. One of the
bank’s counterparties is looking for ways to reduce its exposure to the bank. What are the
counterparties’ available options?
A. Harvest cash from any derivatives positions.
B. Borrow funds from the bank.
C. Enter new trades with the bank, causing the bank to pay out cash for a derivatives
position.
D. All of the above.
One way for an over-the-counter derivatives counterparty to mitigate the risk of a dealer bank's
potential solvency crisis is to reduce its exposure by seeking out new borrowing opportunities.
T hrough this approach, the counterparty can reduce its exposure to the bank. To reduce exposure
even further, the counterparty could enter into trades with the dealer that require it to pay out cash.
Moreover, if a derivatives position has become more favorable to the counterparty over time, they
can "harvest" any accrued profits and use them to reduce their overall exposure.
125
Q.2305 Bank A is a dealer bank. It is headed in the direction of a solvency crisis. T he bank’s
counterparties in over-the-counter are alarmed and are hastily harvesting assets from the bank to
reduce their exposure. What can the bank do to regain the confidence of its counterparties?
A. Refuse some trades with relatively smaller counterparties.
B. Allow all trades with counterparties based on terms prevailing in the market.
C. Borrow short-term.
D. Raise new equity.
If a dealer bank is perceived to have some risk of a solvency crisis, an over-the-counter derivatives
counterparty would look for opportunities to reduce its exposure to that dealer bank. If the dealer
wants to avoid an adverse signal of its weakness, the dealer cannot afford to refuse its counterparties
the opportunity to make these trades at terms prevailing elsewhere in the market.
T herefore, the bank will be forced to allow all trades with the counterparties or risk triggering a
death spiral.
Q.2983 T he following standard policy tools are applicable in the treating of the social costs of bank
failures. Which one is NOT ?
A. Regulatory supervisions and the requirements for risk-based capital, which reduces the
chance of a solvency threatening capital loss.
B. Deposit insurance, a measure implemented in to protect bank depositors.
C. Regulatory resolutions mechanisms, through which the authorities are given powers to
liquidate or restructure a bank efficiently.
D. Regulatory requirements guiding the departure of prime brokerage customers.
When treating the social costs of bank failures, the standard policy tools that are used include:
regulatory supervision and requirements for risk-based capital, deposit insurance, and regulatory
resolutions mechanisms.
126
Q.2984 T he collapse of a dealer bank can be attributed to all the following key mechanisms,
EXCEPT :
A. T he flight of short-term creditors.
B. Prime brokerage clients’ departure.
C. Various cash-draining undertakings by derivatives counterparties designed to lower their

exposures to the dealer banks.
D. Additional clearing-bank privileges.
T he failure of a dealer bank can be due to key mechanisms which are: the flight of short-term
creditors, the departure of prime brokerage clients, various cash-draining undertakings by
derivatives counterparties designed to lower their exposures to the dealer banks, and the loss of
clearing-bank privileges.
Q.2985 Which of the following ways is NOT applicable to the mitigation of the risk of liquidity loss?
A. Establishing lines of bank credit.
B. Dedicating a buffer stock of cash and liquidity securities for emergency liquidity needs.
C. Establishing regulatory measures of compliance.
D. Laddering the maturities of its liabilities to refinance only a small portion of the debt
within a short period of time.
T he risk of a liquidity loss can be mitigated by the dealer bank in the following ways due to a run by
short-term creditors: lines of bank credit should be established, a buffer stock of cash and liquidity
securities should be dedicated to emergency liquidity needs, and laddering the maturities of its
liabilities to refinance only a small portion of the debt within a short period of time.
127
Reading 131: Liquidity Stress Testing
Q.4124 ABC bank is a fictional institution in Canada. Its liquidity management wishes to undertake a
stress test for the institution. Which of the following factors is not integrated into keeping a robust
stress testing framework for the bank?
A. Performance measurement
B. Capital stress test
C. Portfolio components
D. Risk measurement and monitoring
Portfolio components are not considered as necessary for integration in a robust stress test.
A i s i ncorrect: Performance measurement is integrated into a liquidity stress test framework.
B i s i ncorrect: Capital stress test is integrated with the liquidity stress test for a robust stress
test.
D i s i ncorrect: Risk measurement and monitoring is an essential factor for integration in a robust
stress test.
128
Q.4125 T he stress testing committee for the RT C bank is preparing to undertake a stress test for
the bank. Which of the following factors is unlikely to be considered in the stress test process?
A. Development of critical assumptions
B. Scenario development
C. T he suitable scope and structure of the liquidity stress test
D. Profit margins related to the process
Profit margins related to the process are not part of a stress testing process.
A i s i ncorrect: Development of critical assumptions is part of liquidity stress testing process.
B i s i ncorrect: Scenario development is an essential step in liquidity stress testing.
C i s i ncorrect: T he suitable scope and structure of the liquidity stress test is considered in a
liquidity stress testing process.
129
Q.4127 Axon, a fictional financial institution in Liverpool, has been using its available liquidity for
funding of the business and doing orderly clearance of payment transactions. Under which category
of liquidity use does this purpose fall?
A. Contingent liquidity
B. Operational liquidity
C. Strategic liquidity
D. Restricted liquidity
T he above-stated use of liquidity falls under operational liquidity. Operational liquidity involves the
cash needed for daily funding of the business and orderly clearing of payment transactions.
A i s i ncorrect: Contingent liquidity is the liquidity available to meet general financial obligations.
C i s i ncorrect: Strategic liquidity involves the cash an institution holds for future business needs
that may arise without the course of normal operations such as funding future acquisitions or capital,
but it’s not to support the bank during times of stress.
D i s i ncorrect: Restricted liquidity entails liquid assets maintained to be used mainly for
specifically defined purposes.
130
Q.4128 Which of the following components is not considered in the generation of the current liquid
asset buffer?
A. Stressed outflows
B. Stressed inflows
C. Liquid asset buffer
D. Restricted liquidity
Restricted liquidity is not a component in generating the current liquid asset buffer. It is a purpose of
liquidity, which entails liquid assets maintained to be used mainly for specifically defined purposes.
A i s i ncorrect: Stressed outflows are critical components in generating the current liquid asset
buffer. T hey occur during stressed scenarios and results from the need to prematurely settle non-
contractual maturity obligations and incapability to refund contractual maturity obligations that could
roll over under normal conditions.
B i s i ncorrect: Stressed inflows are essential in the construction of the current liquid asset buffer.
T hey partly offset the stressed outflows and include secured funding transaction maturities,
drawdowns on liquidity facilities available to the institution, and loan repayments from customers.
C i s i ncorrect: Liquid asset buffer is combined with the other components to generate the current
liquid asset buffer. It refers to a stock of unencumbered high-quality liquid assets usually held to
protect against failure under liquidity stress. It represents the contingent liquidity that is currently
available for an institution.
131
Q.4129 Which of the following choices is right about designing a stress testing model?
A. Liquidity stress testing begins with identifying the risk and doing event analysis
B. In liquidity stress testing the list of scenarios don’t need to capture material liquidity
appropriately
C. Liquidity stress testing process begins with coming up with assumption
D. T he liquidity stress testing process should begin with developing a list of scenarios
capturing material liquidity.
A liquidity stress testing begins with identifying the risk and doing event analysis.
B i s i ncorrect: T he list of scenarios needs to capture material liquidity accurately in liquidity
stress testing.
C i s i ncorrect: Assumptions are developed after identifying the risk and performing event analysis.
D i s i ncorrect: T he list of scenario development follows identifying the risk and event analysis.
132
Q.4130 In a liquidity stress testing scenario, the organizational scope is a crucial component for
consideration. Among the following choices, which one is NOT an entity under which a separate
liquidity stress test should be done?
A. T he parent organization
B. Subsidiary legal entities
C. Shared service centers
Although the consolidated stress test should be the fulcrum of any liquidity risk framework, it may be
necessary to conduct stress testing on subsidiary entities within the organization. An institution
should perform a separate liquidity stress test on organizational levels such as parent, service
business unit, subsidiary legal entities, lines of business, and shared service centers. For less
material entities or entities with manageable risk assessment, simple entity-level liquidity risk
reporting might be appropriate.
A i s i ncorrect: Separate liquidity stress test is performed on the parent organization.
B i s i ncorrect: Separate liquidity stress test is done on the subsidiary legal entities.
C i s i ncorrect: Shared service centers qualify for a separate liquidity stress test.
133
Q.4131 Afro Bank, a fictional financial institution in T urkey, has liquidity transfer restrictions. Which
one of the following choices states the best initiative the bank should take in its liquidity stress
testing?
A. T he bank should source help to emancipate from the transfer restrictions
B. It should assess the effect of the restrictions on enterprise-level liquidity for both typical
operating environment and stressed conditions
C. T he bank should stop the liquidity stress testing scenario until the end of the restrictions
D. T he bank should source other types of liquidity to include in the liquidity stress testing
menu
T he bank should asses the effects the restrictions on enterprise-level liquidity for both typical
operating environment and stressed conditions.
A i s i ncorrect: Sourcing help to emancipate form transfer restrictions may be unfeasible.
C i s i ncorrect: Restricted transfers should not stop liquidity stress testing test.
D i s i ncorrect: sourcing other types of liquidity to replace the restricted transfers may create a
wrong picture of institutions funding liquidity level.
134
Q.4132 Among the following statements, which one is correct about the currency consideration in a
consolidated liquidity stress testing process?
A. T he liquidity stress test is performed based on the available currency
B. Liquidity impact of currency conversion is not necessary in consolidated stress testing as

any currency can be used
C. T here should be considerations of liquidity impact of currency conversion requirements

to avoid currency mismatch for offshore subsidiaries.
D. In a consolidated liquidity stress test, the home currency can be used together with any
other available currency.
Currency mismatch should be avoided by considering the liquidity impact of currency conversion.
A i s i ncorrect: Liquidity stress test is performed based on the currency of the home country
B i s i ncorrect: Liquidity impact of currency conversion is essential in consolidated stress testing,
and only the currency of the home country should apply.
D i s i ncorrect: In consolidated liquidity stress testing, only the home currency of the entity been
tested should be used.
135
Q.4133 According to U.S. regulations, specific foreign banking organizations should conduct liquidity
stress tests for intermediate holding companies and branches. Which of the following choices is the
most valid reason for this regulation?
A. To prevent foreign banks operating in the country from been over-reliant on offshore
funding.
B. Intermediate holding companies and branches share a common currency, hence no

currency conversion.
C. Intermediate companies and branches are more likely to face liquidity challenges during
stress periods
D. It is just a way of monitoring the liquidity levels for the intermediate holding companies.
Liquidity stress test is done on holding companies and their branches for foreign banks to prevent
over-reliance on offshore funding
B i s i ncorrect: Intermediate companies and branches may not share a common currency, and even
if they do, it is not a reason for a liquidity stress test to be done on them
C i s i ncorrect: It is not true that intermediate holding companies and branches are more likely to
face liquidity challenges during the stress period
D i s i ncorrect: T he core purpose for doing liquidity stress testing on intermediate holding
companies and branches is to prevent the foreign banking institutions from been over-reliant on
offshore funding.
136
Q.4134 FT C bank, a fictional financial institution operating in Tokyo, Japan, has been doing a liquidity
stress test for a time Horizon of more than 12 months. Which of the following choices most
accurately state the disadvantage related to such a time horizon?
A. Banks usually continue to operate expensively indefinitely under stress without employing
a recovery or resolution process.
B. Longer-term projections may be affected by forecast error according to the baseline

balance sheet and statement of income budgeting time horizon.
C. Longer-term projections may lead to unnecessary confusion to those doing the liquidity
stress testing program
D. No institution would keep data for long-term liquidity stress testing
T he disadvantage of long-term projections are the related forecasting errors.
A i s i ncorrect: it is not feasible for the bank to continue operating in a stressed condition unless
recovery or resolution process.
C i s i ncorrect: longer-term projections may not cause any confusion to those doing liquidity stress
testing; hence that is not a disadvantage associated with long-term liquidity stress testing.
D i s i ncorrect: D is not a valid statement; hence it is not a challenge why an institution may
discourage a long-term stress testing program.
137
Q.4135 A financial institution manager for a bank wants to do a liquidity stress test for the bank. In
the process, it reaches a point where he must choose between several testing techniques to employ
in the process. Which among the following is likely to be one of the options available for the
manager?
A. Historical statistical techniques
B. Deterministic models
C. Monte Carlo simulation
D. All of the above
Historical statistical technique is applicable in liquidity stress testing. T his stress testing technique
models an institution’s historical pro forma cash flow subject to the observed cash flow volatility of
the institution. An example is the cash flow at risk approach (CFaR).
Deterministic models are useful in liquidity stress testing. T hey model the liquidity effect of a
forward-looking or historical-based scenario that has been developed by the institution. An example
of such a model is the development of hypothetical liquidity stress scenarios.
Monte Carlo simulation is one of the available options when doing liquidity stress testing. It is based
on simulation modeling and applies in assessing the liquidity risk done by stress testing variables over
a future time frame.
T herefore, the manager can use any of the methods.
138
Q.4136 T he treasury committee in a liquidity stress testing program for RT C bank were considering
a hypothetical scenario in the process of liquidity stress testing. Which of the following
characteristics is not considered in the scenario?
A. Define the scenario
B. Distinguish between systematic and idiosyncratic risk
C. Distinguish between sources of liquidity
D. Distinguish between levels of severity
Sources of liquidity is not a characteristic to consider in a hypothetical scenario.
A i s i ncorrect: Definition of a scenario is vital in hypothetical scenario development.
B i s i ncorrect: In a hypothetical scenario, the systematic risk is distinguished from idiosyncratic
risk. T he bank should develop scenarios for each of the cases of systemic, idiosyncratic, and for both
to capture these fluctuating impacts.
D i s i ncorrect: In a hypothetical scenario, a distinction in the levels of severity is made. For an
institution to widen its view of liquidity risk and applicable limits, it should undertake graduating
levels of severity, such as developing adverse and severely adverse variations of the idiosyncratic
scenario.
139
Q.4137 In developing a liquidity stress test assumption, several essential factors are considered.
Which of the following choices is not among those factors?
A. Qualitative assessment of the expected liquidity behavior for each type of cash flow to
identify where there is significant liquidity risk
B. Quantitative modeling assumptions based on any existing historical data.
C. Matrices of relative modeling assumptions based on scored risk levels and historical
baseline data
D. Matrices of relative modeling assumptions irrespective of scored risk levels and current
data
We consider building matrices of relative modeling assumptions based on scored risk levels and
historical baseline data, not current data
A i s i ncorrect: Qualitative assessment of the expected liquidity behavior for each type of cash
flow to identify where there is significant liquidity risk is a considered characteristic.
B i s i ncorrect: Matrices of relative modeling assumptions based on scored risk levels and historical
baseline data is a considered characteristic in liquidity stress testing
C i s i ncorrect: Matrices of relative modeling assumptions based on scored risk levels and historical
baseline data are mostly considered in a liquidity stress assumption development.
140
Q.4139 A financial institution is attempting to develop assumptions for its liquidity stress testing.
Which of the following assumptions is NOT considered?
A. Deposit outflows
B. Investment portfolio haircuts
C. Collateral requirement
D. Deposit inflows
T he deposit inflow is not among the assumptions considered in a liquidity stress test.
A i s i ncorrect: Deposit outflows are among the considered assumptions in a liquidity stress test.
T hese outflows create a substantial threat to both liquidity and the behavioral dynamic of the model.
B i s i ncorrect: Investment portfolio haircut is among critical assumptions considered in liquidity
stress test. T he available sources of liquidity and haircut pose a critical impact on available liquidity
under stress. For systematic stress scenarios, the haircut widens, just like in times of liquidity crisis.
For this reason, the model should include different haircut assumptions for securities with different
liquidity characteristics.
C i s i ncorrect: Collateral requirement is among the underlying assumptions considered in a liquidity
stress test. Assumptions for collateral call levels are developed depending on the level of required
detail.
141
Q.4140 In liquidity stress testing, among the considered outputs are stress testing assumptions,
liquidity position metrics, prospective liquidity position metrics, and capital and performance
metrics. Which of the following choices is not among the four key stress testing assumptions?
A. T he assumption about the overall stress level represented by the scenario
B. T he assumption about the indication of the nature of the scenario, such as systemic,
idiosyncratic, or both systemic and idiosyncratic
C. Assumptions on the expected returns
D. T he assumption on the discussion of the impact of the scenario on cash flow
Assumption on the expected returns is not among the assumptions considered in liquidity stress
testing.
A i s i ncorrect: Assumption about the overall stress level represented by the scenario is among the
assumptions in a liquidity stress testing.
B i s i ncorrect: Assumption about the indication of the nature of the scenario, such as systemic,
idiosyncratic, or both systemic and idiosyncratic, is considered.
D i s i ncorrect: T he impact of the scenario on cash flow is considered.
142
Q.4141 In the governance and control of the liquidity stress testing process, the treasury committee
is considered to be instrumental in the whole process. Which among the following choices most
accurately states one of the responsibilities undertaken by the treasury?
A. Recommends stress testing scenarios
B. Recruits members for the asset-liability committee (ALCO)
C. Designs liquidity risk policy limits relative to stress test results and escalating exceptions
D. Undertakes the liquidity stress testing frame-work periodical review, procedures, and
controls to keep compliance with policy, regulatory, and control requirements.
T reasury recommends stress testing scenarios.
B i s i ncorrect: It is not the responsibility of the treasury to recruit members of ALCO. T he
treasury reviews and monitors components of the institution’s assets and liabilities and recommend
to the ALCO on matters relating to stress testing assumptions.
C i s i ncorrect: Designing liquidity risk policy limits relative to stress test results and escalating
exceptions is the responsibility of the asset-liability committee.
D i s i ncorrect: Internal audit is responsible for undertaking liquidity stress testing frame-work
periodical review, procedures, and controls to keep compliance with policy, regulatory, and control
requirements.
143
Q.4142 A group of FRM students was given the following characteristic to identify the committee of
liquidity stress testing governance they belong to: T he committee provides independent validation
and control over the management governance of the liquidity stress testing model concerning the
institution’s model risk management policy. Which of the following committee meets the above
description?
A. T he asset-liability committee
B. Internal audit
C. Model risk management
D. T he T reasury
T he model risk management performs the described function.
A i s i ncorrect: T he ALCO is responsible for the establishment, review, and approval of a liquidity
stress testing policy.
B i s i ncorrect: T he internal audit undertakes the liquidity stress testing frame-work periodical
review, procedures, and controls to keep compliance with policy, regulatory, and control
requirements.
D i s i ncorrect: T he treasury is responsible for maintaining the liquidity stress testing procedures,
among other responsibilities.
144
Q.4143 Which of the following choices is correct about Liquidity stress testing and capital stress
testing integration?
A. To link liquidity stress testing and capital stress testing requires an institution to
incorporate any essential capital infusions of subsidiary entities.
B. For every liquidity stress test scenario, the institution should develop capital impact
assumptions based only on the idiosyncratic conditions that occur under the scenario
C. For every liquidity stress test scenario, the institution should develop capital impact
assumptions based only on the overall market conditions that occur under the scenario
D. For every liquidity stress test scenario, the institution should develop capital impact
assumptions based only on the overall market conditions that occur under the scenario arise
through investment portfolios.
To link liquidity stress testing and capital stress testing requires an institution to incorporate any
essential capital infusions of subsidiary entities
B i s i ncorrect: T he developed capital impact assumptions should be based on both the overall
market and idiosyncratic scenarios.
C i s i ncorrect: T he capital impact assumptions should relate to both idiosyncratic and overall
market scenarios.
D i s i ncorrect: Liquidity impact analysis should be done since extra capital impacts arise through
investment portfolios
145
Reading 132: Liquidity Risk Reporting and Stress Testing
Q.4050 Which of the following details would not be obtained from a deposit tracker report?`
A. Month-end actuals for deposits by customer type
B. Each month-end change
C. Each month-end forecast for the position to the end of the year
D. Annual loan to deposit ratio (LT D)
T he deposit tracker only reports on a weekly/monthly basis, hence annual loan to deposit ratio is
NOT included in the deposit tracker report.
A i s i ncorrect: T he deposit tracker report provides the details on deposit month-end actuals
organized by customer type.
B i s i ncorrect: T he deposit tracker report usually provides the details on month-end changes.
C i s i ncorrect: T he month-end position forecast for the whole year is provided in a deposit tracker
report basically on the objective judgment.
146
Q.4051 VT R bank has been receiving most of its funding from current accounts and rolling deposits.
Under what circumstance will the bank treat overnight balances as long-term according to
regulation?
A. If the overnight balances can be demonstrated to be acting as long-term in “behavioral”

terms
B. If the overnight deposits are predictable
C. If the overnight deposits are the primary funding source for bank
The correct answer i s A: Overnight deposits are only treated as long-term if they can be shown to
be acting as such in “behavioral” terms. In this case, it is worthwhile for the bank to undertake a
marketing exercise to determine if customers may be interested in moving their deposits into fixed-
term or notice accounts. Any increase in the size of the latter improves the firm’s liquidity metrics.
B i s i ncorrect: Predictability of overnight deposits don’t guarantee their treatment as long-term.
C i s i ncorrect: Unless overnight deposits are stable for long time, been the significant funding of
the bank may not make them be treated as long-term.
147
Q.4052 RT C bank, a fictional financial institution in T hailand, has been preparing a daily liquidity
report after stress testing for years. Which among the following is not correct about the bank’s daily
liquidity report?
A. It presents the bank’s marketable assets and liabilities
B. It is prepared for up to one-year maturity and beyond
C. It only presents the bank’s marketable assets
D. It reports the end-of-day liquidity position
T he daily liquidity report is a straightforward spreadsheet detailing the bank’s liquid and marketable
assets, together with liabilities, up to 1-year maturity and beyond. It provides an end-of-day of the
bank’s liquidity position for the T reasury and Finance departments. T herefore, the daily liquidity
report presents not only the bank’s marketable securities but also its liquid assets as well as
liabilities.
A i s i ncorrect: T he daily liquidity report indeed presents the bank’s marketable assets and
liabilities, which helps in gauging the liquidity position of the bank.
B i s i ncorrect: It is true that the daily liquidity report is prepared for up to one year maturity or
even beyond.
D i s i ncorrect: T he daily liquidity report presents the end-of-day liquidity position.
148
Q.4053 MCT bank has been preparing a mismatch report after a stress testing process. Which among
the following statements is accurate about mismatch reports?
A. T he mismatch report reflects the maturity gap for all assets and liabilities per time bucket
and with an adjustment for liquid securities.
B. T he report doesn’t apply in generating the horizon report for cash flow
C. It presents the bank’s marketable assets and liabilities
D. It reports the end-of-day liquidity position
T he mismatch report usually comprises of the cumulative liquidity cash flow of both liquidity daily
liquidity report and deposit tracker report
B i s i ncorrect: T he mismatch report is used to generate the survival horizon report for cashflows.
C i s i ncorrect: T he bank’s marketable assets and liabilities are presented in a daily liquidity report
D i s i ncorrect: T he end of day liquidity position is presented in a daily liquidity report.
Q.4054 A financial institution is preparing a large depositor concentration report for a banking group.
What is the most accurate meaning of the word “large” in this case?
A. Someone that owns the majority of shares
B. Someone that undertakes more than USD 50 million withdrawals
C. Someone that deposits a deposit of 5% of total liabilities.
In a large depositor concentration, the term “large” refers to someone that deposits a deposit of 5%
of total liabilities.
A i s i ncorrect: Someone that owns most shares is not referred to as “large” in deposit
concentration
B i s i ncorrect: Large deposit concentration is defined in terms of deposits, not withdrawals
149
Q.4055 Off-balance-sheet items serve as potential stress points for a bank’s funding. Which among
the following is not an off-balance sheet item?
A. Liquidity lines
B. Letters of credit
C. Revolving credit facilities
D. Liquid assets
Liquid assets do not form part of the off-balance sheet items. T hey are found within the asset portion
of an institution’s balance sheet.
A i s i ncorrect: Liquidity lines are off-balance sheet items committed by a bank in favor of a
company to provide it with funding.
B i s i ncorrect: Letter of credit is an off-balance sheet negotiable instrument whereby the issuing
bank pays the beneficiary or any other bank nominated by the beneficiary.
C i s i ncorrect: Revolving credit lines are off-balance sheet items where a customer pays a
commitment fee to a financial institution to borrow funds.
150
Q.4056 T he liability profile is a simple breakdown of the share of each type of liability at the bank.
Which of the following is not a part of the liability profile?
A. Customer individuals
B. Highly liquid security repo
C. Asset-backed securities
D. Highly liquid assets
Highly liquid assets have a similar treatment to cash and are not part of the liability profile.
A i s i ncorrect: Customer individual is a crucial component of liability profile
B i s i ncorrect: Highly liquid security repo is a vital component of liability profile
C i s i ncorrect: Asset-backed securities form an essential component of liability profile
151
Q.4057 Which among the choices is not considered in regular liquidity qualitative reporting
concerning individual liquidity adequacy standards (ILAS)?
A. Details on any increase or decrease in retail deposits
B. Details on average day-to-day opening cash position
C. Details on shrinkage or growth of asset books
D. Details on deposit month-end actuals by customer type
Details of deposit month-end actuals by customer type are a part of the deposit tracker report
A i s i ncorrect: Details of any increase or decrease in retail deposits are details required in
qualitative liquidity reporting
B i s i ncorrect: Details on average day-to-day opening cash positions are details to consider in
liquidity qualitative reporting
C i s i ncorrect: Details of shrinkage or growth of assets are considered in liquidity qualitative
reporting
152
Q.4058 T he following is an excerpt from Bright Bank’s Deposit T racker from End of the year 2018
to July 2019.
Deposit tracker Month-end actuals Month-end Forecasts

31/12/2018 31/01/2019 31/05/2019 30/06/2019
Total customer deposits 612,152 423,804 651,112 599,774
Total customer loans 547,478 373,381 520,829 480,122
Calculate the bank’s loan-to-deposit ratio as at 31/12/2018
A. 0.84
B. 0.86
C. 0.87
D. 0.89
Total customer loans

Loan-to-deposit (LT D) ratio =
Total customer deposits
547,478
=
612,152
= 89%
153
Q.4059 T he following is an excerpt from Bright Bank’s Deposit T racker from End of the year 2018
to July 2019.
Deposit tracker Month-end actuals Month-end Forecasts

31/12/2018 31/01/2019 31/05/2019 30/06/2019
Total customer deposits 612, 152 423, 804 651, 112 599, 774
Total customer loans 547, 478 373, 381 520, 829 480, 122
How much does the bank need to increase its total customer loans by to meet its targeted loan-to-
deposit ratio of 85% on 30/06/2019?
A. 22445
B. 29685
C. 31587
D. 33465
Total customer loans

Loan-to-deposit (LT D) ratio =
Total customer deposits
x
85% =
599, 774
x = 509, 807
Increment = 509, 807 − 480, 122 = 29, 685
154
Q.4060 Which among the following choices is correct about derivatives value or notional treatment
concerning UK regulations?
A. For off-balance sheet items, derivative values are not included in the calculation of the
liquidity ratio
B. Derivatives are not included to the extent of collateral payable or receivable under an
ISDA/CSA agreement
C. For off-balance sheet items, coupons receivable or payable are not included on their pay
dates
According to the UK regulations, derivative values/nationals are not included in the calculation of the
liquidity ratio for off-balance sheet items.
B i s i ncorrect: Derivatives are included to the extent of collateral payable or receivable under an
ISDA/CSA agreement.
C i s i ncorrect: Only coupons receivable or payable are included on their pay dates, not the
derivative values.
155
Q.4061 In preparation of a deposit tracker report, Cate Wilson, the manager of the bank preparing
the report, realized that most of the retail bank deposits consisted of the current accounts and rolling
deposits. How should the bank treat these funds in the regulation process?
A. As long-term liabilities
B. As liquid assets
C. As short-term liabilities
Current accounts and rolling deposits make a significant contribution to the retail bank deposits while
there is little fixed-term deposit. For regulation, these funds are treated as short-term liabilities and
don’t assist the bank’s regulatory liquidity metrics, which emphasizes long-term funds. However, the
local regulator can allow the bank to treat overnight balances as longer-term, if they are
demonstratable to be acting as long-term in “behavioral” terms.
A i s i ncorrect: Current accounts and rolling deposits are short-term liabilities; however, a
customer can transfer the deposits into a fixed-term or notice accounts.
B i s i ncorrect: Current accounts and rolling deposits are liabilities, hence cannot be treated as
assets.
156
Q.4062 T he regulatory authority for ACB bank generated a funding yield curve after conducting a
stress test. T hey then compared the curve with the ones generated by their peers. T he bank’s
management realized that their curve had risen significantly beyond the curves of its peers. What is
the possible implication of these results?
A. ABC is experiencing funding stress
B. ABC is experiencing high liquidity levels
C. ABC has more liabilities than assets
D. ABC has a high level of solvency
If the curve rises significantly beyond the curves for its peers, it indicates a funding stress.
B i s i ncorrect: A significant rise in a funding yield curve implies funding stress, whereas high
liquidity would imply that there is no funding stress.
C i s i ncorrect: A rise in a funding yield curve does not necessarily insinuate that the level of
liabilities surpasses that of assets.
D i s i ncorrect: High level of solvency arises when an institution has more assets than liabilities, a
rise in the funding yield curve has no such an implication.
157
Q.4063 A qualitative monthly report is prepared and send to the head office group treasury for the
banking groups operating across country jurisdictions or multiple subsidiaries for a good
understanding of the liquidity position in the respective countries. Among the components of the
report, the liquidity gap is captured, what is a liquidity gap in this context?
A. A mismatch in the supply or demand for a security or the maturity dates of securities
B. Lower liabilities than assets
C. T he difference between the average maturity of assets and liabilities
A liquidity gap is a discrepancy in supply or demand for a security or the maturity dates of security
causing cash shortage.
B i s i ncorrect: Lower liabilities than assets imply positive solvency.
C i s i ncorrect: T he difference between the average maturity of assets and liabilities is referred to
as a maturity gap.
158
Q.4064 A report is based on granular analysis of the firm’s marketable asset holdings, prepared every
month, and submitted in 15 business days after the month-end. Which of the following reports is most
accurately described in the given description?
A. Daily flows report
B. Wholesale liabilities report
C. Liquidity buffer qualifying securities report
D. Currency analysis report
A liquidity buffer qualifying securities report based on granular analysis of the firm’s marketable
asset holdings, prepared every month, and submitted in 15 business days after the month-end.
A i s i ncorrect: T he daily flows report is based on daily cash flows out to analyses survival of 3
months, prepared weekly, and submitted end of the day in the following business day.
B i s i ncorrect: T he wholesale liabilities report includes daily transaction prices and the transacted
level for wholesale unsecured liabilities, prepared weekly and submitted in the end-of-day T uesday 15
business days after month-end.
D i s i ncorrect: Currency analysis report is based on the analysis of foreign exchange (FX)
exposures on a firm’s balance sheet, prepared quarterly, and submitted in 15 business days after
month-end.
159
Q.4065 How various specific types of cashflow are treated is an essential question in liquidity
reporting. Under what circumstance should a bank treat 50% of deposit funds as long-term funds?
A. If it is evident that they can remain relatively stable over time
B. If their stability is uncertain
C. If they contribute to the highest portion of the bank’s funding
A deposit is a short-term fund. However, according to the regulatory authority, if there is evidence
that deposits can remain stable for a longer time, then 50% of the deposits can be treated as long-
term funds.
B i s i ncorrect: If the stability of deposits is uncertain, then they should be treated as short-term
funds.
C i s i ncorrect: Deposits’ high contribution to the bank’s funding does not guarantee them to be
treated as long-term funds.
160
Reading 133: Contingency Funding Planning
Q.4066 Ashley Mathias is the financial risk manager at Sycamore Bank. Ashley plans to design a
contingency funding plan (CFP) for the institution. As a financial risk manager, which of the following
considerations, will she not be mindful of when conducting this exercise? Ashley should ensure:
A. Support by a communication plan
B. Integration with broader risk management frameworks
C. Inclusion of appropriate stakeholder groups
D. No liquidity gap before beginning the exercise
In designing a CFP, the onset of the exercise does not depend on whether there exists a liquidity gap
or not, liquidity gap analysis is a component of a CFP framework, hence a part of the whole exercise,
but not a factor to consider before the exercise.
A i s i ncorrect: In designing a CFP, communication to clients, analysts, counterparties, and
regulators with timely and accurate information is critical for enhancing confidence in the
institution.
B i s i ncorrect: CFP should be integrated into other components of enterprise risk management
(ERM) disciplines to increase its effectiveness and consistency.
C i s i ncorrect: Including the appropriate stakeholders when designing a CFP is critical. Appropriate
stakeholders provide a robust forum in which potential issues or challenges can be openly discussed
and addressed. Such groups include the asset-liability committee (ALCO), risk and capital committee,
investment committee, business units, finance, corporate treasury, risk, operations, and technology.
161
Q.4067 T he design of a CFP should integrate with the broader risk management frameworks. Which
among the following choices is not part of the risk management frameworks under consideration?
A. Enterprise risk management (ERM)
B. Business continuity and crisis management
C. Financial management
D. Capital management
Financial management framework is not among the frameworks in a CFP design. However, it is an
essential framework in the long-term council community plan (LT CCP) analysis.
A i s i ncorrect: CFP is blended with enterprise risk management (ERM) components to enhance its
effectiveness and consistency.
B i s i ncorrect: Integration of a CFP with the business continuity and crisis management is
necessary as it reinforces significant operational and communication protocols in times of crisis.
D i s i ncorrect: T he capital management framework is necessarily integrated with the CFP as it
reinforces its effectiveness.
162
Q.4068 Roy Jakes, the financial risk manager for Pathway financial institution, is preparing a design
for a CFP. As an essential consideration in the plan, he must include appropriate stakeholders. Which
among the following members is NOT part of the considered stakeholders?
A. Internal audit committee
B. Risk and capital committee
C. Management committee
D. Operations and technology
Internal audit committee is not a stakeholder when designing a CFP. However, internal audit is
involved with periodical reviews on the liquidity stress testing framework and procedures.
B i s i ncorrect: Risk and capital committee is an essential stakeholder responsible for setting the
principles and parameters for measuring and assigning risk and capital within the business.
C i s i ncorrect: Different management committees such as the asset-liability committee (ALCO),
risk and capital committee, and investment committee are key stakeholders in CFP.
D i s i ncorrect: T he operational and technology committee reviews and approves the institution’s
technology planning and strategy.
163
Q.4069 In JCL bank, Fatou James is the head of the corporate treasury. Which among the following
choices best lists the roles of her committee?
A. It serves as an advisor and counsel to the management committee and LCT teams
B. It monitors the ongoing business, funding, risk, and liquidity profile as part of its BAU
activities.
C. It provides recommendations on CFP actions.
D. It provides oversight of the LCT and does a consultation with the board of directors to
monitor the institution’s liquidity risk profile
T he corporate treasury monitors the ongoing business, funding, risk, and liquidity profile as part of
its BAU activities. T he treasury can consult the CFO and others to invoke the CFP and convene the
liquidity crisis team (LCT ) regarding a review of the markets, liquidity stress testing results, among
others.
A i s i ncorrect: It is the role of the board of directors to advice and counsel the management
committee and LCT teams.
C i s i ncorrect: It is the role of the liquidity crisis team (LCT ) to provide recommendations on CFP
actions. Moreover, the LCT designs the CFP, and submits it to the senior management for review and
approval.
D i s i ncorrect: T he management committee conducts the oversight of the LCT in consultation
with the board of directors.
164
Q.4070 An effective CFP should ensure that there are contingency plans in place to cushion the bank
when certain events that can potentially impact liquidity happen. Which among the following events
does NOT have a negative liquidity impact on a financial institution?
A. Presence of predatory trade
B. Unavailability of the Federal Home Loan Bank Funding
C. Shifting allocation from short-term funding to long-term funding sources
D. When the intraday debit cap with Fedwire is exceeded
Shifting allocation from short-term funding to long-term funding sources is a contingent action/ capital
recovery action that strengthens the institution’s liquidity position.
A i s i ncorrect: T he presence of predatory trade causes liquidity dryness in the market, resulting in
liquidity stress.
B i s i ncorrect: When Federal Home Loan Bank funding becomes unavailable, the financial
institution under review may face liquidity stress.
D i s i ncorrect: When a financial institution exceeds its intraday cap, it implies that no more
intraday liquidity can be issued, a situation that leads to liquidity stress.
165
Q.4072 Several market factors can affect the institution’s ability to take contingent actions that l
help in strengthening the institution’s liquidity position. Which among the following factors does
NOT pose such an effect to institutions?
A. Shutdown of securitization markets
B. Deposit runoff
C. Failure of the counterparties to roll over their deposits
D. Withdrawal of debit caps
Withdrawing debit caps, though it may not be a typical scenario, does not have any effect on the
institution’s ability to take contingent actions. It just allows them to access more intraday credit.
A i s i ncorrect: Shutdown of securitization markets affects the institution’s ability to take
contingent actions as some of those actions rely on the security markets.
B i s i ncorrect: Deposit runoff affects the institution's ability to take contingent actions since some
of the actions depend on the deposits.
C i s i ncorrect: Unwillingness of counterparties to roll over their deposits affects the institution’s
ability to take contingent actions.
166
Q.4073 When designing a CFP, monitoring and escalation is a key component of the CFP framework.
In the framework, Institutions are required to define early warning indicators using market and
business factors. Which of the following factors is NOT a potential factor considered?
A. Macro-environment measures
B. Industry measures
C. Financial measures
D. Institution-specific measures
Institutions do not necessarily need information obtained from financial measures to define to
monitor trends in the market as well as among the institution’s peer group. Moreover, a financial
measure is a broad term.
A i s i ncorrect: Macro-environment factors may not directly correspond to individual liquidity
challenges that an institution may face; however, they can provide insight into general market
distress and a systemic withdrawal of liquidity, like the freezing of the repo markets during the
financial crisis.
B i s i ncorrect: Industrial measures gauge the profitability trend of the financial sector and the
recent rating agency. Industry factors include trends in the profitability of the financial sector,
recent rating agency action, banking industry capital adequacy, S&P financial institution sector
movement, and other factors. Competitor analysis can also be applied to evaluate the trends in the
industry to detect potential performance problems in an institution’s peer group.
D i s i ncorrect: Institution-specific measures aid the management in assessing the market’s
perception of the institution’s financial strength and the possibility of a liquidity crisis through
external information. Internal measures provide greater insight into the operations of the institution
and their potential impact on its liquidity position.
167
Q.4074 Early warning indicators (EWIs) should act as warning signs to the management to evaluate
how changing market conditions and the institution’s business strategy may be impacted. T his should
prompt the management to act in advance of oncoming market disruptions proactively. Which among
the following factors is NOT an EWI encompassing market and business factors?
A. A spike in the market volatility
B. An increase in asset quality
C. Real or perceived negative publicity
D. Canceling loan commitments and refusing to renew maturing loans
An increase in asset quality is not an EWI; however, a decrease in asset quality is.
A i s i ncorrect: A spike in market volatility is a warning sign of the onset of liquidity stress.
C i s i ncorrect: When there is negative publicity, whether real or perceived, especially about an
institution’s liquidity, a stress scenario may arise.
D i s i ncorrect: Canceling loan commitments and refusing to renew maturing loans indicate
impending liquidity stress.
168
Q.4075 An institution must monitor a suite of liquidity health ratios besides reviewing macro-
economic and industry measures as part of a CFP framework. T hese ratios aid in quantifying the
impact of liquidity risks and supporting decision making on the CFP actions under consideration. T he
used capacity to total borrowing capacity is one of the liquidity health ratios. Which of the following
accurately describes this measure?
A. Measures the borrowing capacity available to the institution, based on used capacity
relative to the total borrowing capacity
B. Measures the cushion that liquid assets offer over obligatory funding needs and can be
used to track the level of liquid assets available to offset volatile funding
C. Measures the exposure to credit facilities that may be required at a future date
D. Measures the funding and borrowing enough to finance the institution’s increased lending
banking activities
Used capacity to total borrowing capacity measures the borrowing capacity available to the
institution, based on the used capacity relative to the total borrowing capacity.
B i s i ncorrect: Liquid assets to volatile liabilities measure the primary surplus (cushion) that liquid
assets offer over obligatory funding needs and can be used to track the level of liquid assets available
to offset volatile funding.
C i s i ncorrect: Loans to commitments measures the exposure to credit facilities that may be
required at a future date. As these commitments are drawn down, utilization increases, prompting a
further need for funding to meet the obligations.
D i s i ncorrect: T he description in D refers to the projected net funding requirements to current
unused funding capacity measure. It provides an approach to assess the institution’s future lending
obligations in proportion to the total funds available at the institution.
169
Q.4076 In designing a CFP, institutions develop a series of escalation levels adequately aligned to the
scenarios, contingency actions, and liquidity measures. However, there are no guidelines in the
number of escalation levels required by CFPs. Which among the following statements is correct
about the first level of escalation?
A. At this level, the institution focuses mainly on survival
B. It represents the elevated monitoring of market conditions and its effect on the business
performance
C. At this level, the institution has experienced noticeable markets and idiosyncratic events
that are adversely affecting its business and liquidity risk profile
T he first level of escalation represents the elevated monitoring of market conditions and their effect
on the institution’s business segments and performance.
A i s i ncorrect: T he description in A refers to the final level of escalation. At the later stages of the
crisis, the institution would have taken dramatic steps to stabilize its liquidity position, potentially
including significant curtailing of liquidity intensive business activities or disposition/sales of
businesses.
C i s i ncorrect: T he description provided in C refers to the second level of escalation.
170
Q.4077 In designing a CFP, liquidity health measures need to be put into consideration. Which among
the following choices most accurately states the significance of these measures as part of the
monitoring and escalation component of the CFP framework?
A. T hey indicate the institution’s liquidity base and strength
B. T hey indicate the institution’s management policy
C. T hey indicate the institution’s liquidity profile
Health indicators are essential for indicating the institution’s liquidity base and strength. Measures
such as short-term funding as a proportion of total funding, deposits-to-loan for depository
businesses, and the firm’s credit rating, are more targeted in that deterioration in these metrics
reflect a direct and adverse impact on the institution’s current and projected liquidity profile and
strength. B is incorrect: Health indicators do not indicate the institution’s management policy.
C i s i ncorrect: Health indicators do not measure the liquidity profile of an institution.
171
Q.4078 Which among the following choices is FALSE about scenario and liquidity gap analysis, a key
component of the CFP framework?
A. Institutions should align their CFP stress scenarios to those in its liquidity stress testing
framework.
B. T he scenarios should align to those in other frameworks such as the recovery and
resolution plans
C. T he liquidity stress testing scenarios should cover both systemic and institution-specific
risks
Institutions should align their CFP stress scenarios to those in its liquidity stress testing framework,
as well as to other frameworks such as the recovery and resolution plans. T he liquidity stress
testing scenarios cover both systemic (general market) and idiosyncratic (institution-specific) risks.
T herefore, all the choices are correct.
A i s i ncorrect: For a CFP, the scenario should align to scenarios in liquidity stress testing.
B i s i ncorrect: T he CFP scenarios should also align with scenarios in recovery and resolution plan
frameworks.
C i s i ncorrect: T he scenario in CFP should cover both the systematic and idiosyncratic risk for
stress periods.
172
Q.4079 Institutions need to document their CFPs and ensure alignment with other risk management,
business continuity, and recovery planning-related policies and procedures. Which of the following
choices is NOT a central part of the CFP policy outline?
A. Governance
B. Monitoring and escalation
C. Planning
D. Reporting
In CFP, planning does not fall under the policy outline.
A i s i ncorrect: Governance is a crucial section in CFP, under governance, different roles and
responsibilities, review and approval, and periodic review are outlined.
B i s i ncorrect: Monitoring and escalation is part of a CFP outline; under this section, the institution
can document regular monitoring and risk management, liquidity gap analysis, and contingent actions.
C i s i ncorrect: Reporting is the final section in a CFP; it comprises of the reporting frequency and
briefing decks and reports.
173
Q.4080 Which of the following components is NOT a part of the CFP framework?
A. Governance and oversight
B. Liquidity monitoring
C. Contingent actions
D. Monitoring and escalation
Liquidity monitoring is a thorough process by itself, and it is not a component of the CFP framework.
A i s i ncorrect: Governance and oversight is an essential component under the CFP framework.
C i s i ncorrect: Contingent actions are necessarily included in the CFP framework; they are actions
that can be employed when an institution requires to recover capital.
D i s i ncorrect: Monitoring and escalation is also a component under the CFP framework; it gives
the different levels of escalation and steps taken in each level to mitigate liquidity crisis.
174
Reading 134: Managing and Pricing Deposit Services
Q.4081 T he following are the major types of deposit plans that depository institutions offer today.
Which one is NOT?
A. T ransaction deposits
B. T hrift deposits
C. Hybrid deposits
Deposit plans can be divided broadly into transaction deposits, thrift or non-transaction deposits, and
hybrid deposits. T he primary function of transaction deposits is to make payments, and these
deposits include regular checking accounts and NOW accounts. T he principal purpose of thrift
deposits is to serve as accumulated savings and include passbook and statement savings accounts,
CDs, and other time deposit accounts. Hybrid deposits combine transactions and thrift features and
include money-market deposit accounts and Super NOWs.
A i s i ncorrect: T ransaction deposits are deposit plans whose primary function of transaction
deposits is to make payments, and these deposits include regular checking accounts and NOW
accounts.
B i s i ncorrect: T hrift deposits are savings accounts that serve as accumulated savings and include
passbook and statement savings accounts, CDs, and other time deposit accounts.
C i s i ncorrect: Hybrid deposits combine transactions and thrift features and include money-market
deposit accounts and Super NOWs.
175
Q.4082 Which of the following statements about deposit pricing methods is correct?
A. Cost-plus deposit pricing encourages banks to determine the costs they incur in labor and,
management, and materials, among others, in offering each deposit service.
B. Relationship pricing makes the customers less concerned about the prices of other
competing financial institutions.
C. Conditional pricing is whereby a depository institution sets up a schedule of fees in which

the customer pays a low cost or no fee given that the deposit balance is above some
minimum level.
D. All of the above
A i s correct: Cost-plus deposit pricing encourages banks to determine the costs they incur in labor
and management, and materials, among others, in offering each deposit service. Cost-plus pricing
typically calls for a bank to charge deposit service fees enough to cover all the costs of providing the
service in addition to a small margin for profit.
B i s correct: In relationship pricing, the depository institution prices deposits according to the
number of services purchased or utilized. T he depositor may be given lower fees or have a part of
the cost waived if they have used two or more services.
Relationship pricing increases the dependency of customers on the institution which promotes
greater customer loyalty. T his also makes the customers less concerned about the prices of other
competing financial institutions.
C i s correct: Depository institutions use conditional pricing as a tool to attract the kind of
depositors they want to have as customers. In this case, a depository institution sets up a schedule of
fees in which the customer pays a low cost or no fee, given that the deposit balance is above some
minimum level but is liable to higher charges if the average balance drops below that minimum level.
T herefore, the price paid by customers is conditional on how they use their deposit accounts
176
Q.4083 XYZ bank determines that its basic checking account costs the bank $5.00 per month in
servicing costs (assume the servicing costs are labor and computer time) and $3.00 per month in
overhead expenses. T his account requires a $500 minimum balance. Additionally, the bank also tries
to build a $0.40 per month profit margin on these accounts. Determine the monthly fee that the bank
should charge each customer.
A. $5.00
B. $7.60
C. $8.00
D. $8.40
Recall that a bank should price every deposit service high enough to recover all or most of the cost
of offering that service, using the following cost-plus pricing formula:
Unit price charged the customer for each deposit service

= (Operating expense per unit of deposit service
+ Estimated overhead expense allocated to the deposit service function
+ Planned profit margin from each service unit sold)
In this case,
Unit price charged per month = $5.00 + $3.00 + $0.40 = $8.40
177
Q.4084 XYZ bank determines that its basic checking account costs the bank $5.00 per month in
servicing costs (assume the servicing costs are labor and computer time) and $3.00 per month in
overhead expenses. T his account requires a $500 minimum balance. Additionally, the bank also tries
to build a $0.40 per month profit margin on these accounts. Further analysis of ABC Savings Bank
customer accounts reveals that for each $120 above the $500 minimum balance maintained in its
checking accounts, the bank saves about 6% in operating expenses with each customer account. For
a customer who is consistent in maintaining an average monthly balance of $860, how much should
the bank charge to protect its profit margin?
A. $4.25
B. $5.00
C. $7.00
D. $7.5
If the bank saves about 6% in operating expenses for each $120 held in balances above the minimum
of $500, then a customer who maintains an average monthly balance of $860 saves the bank 18% in
operating expenses.
New operating expenses = $5.00– (18% × $5.00) = $4.1
T he appropriate amount that the bank should charge to protect its profit margin is therefore
$4.1 + 3.00 + 0.40 = $7.5 per month
178
Q.4085 Spike Bank determines from an analysis of its cost-accounting figures that for each $1,000
minimum-balance checking account it transacts, account processing and other operating costs will
average $10.00 per month. Further, its overhead expenses will run an average of $4.00 per month.
T he bank’s goal is to achieve a profit margin over these particular costs of 5% of the total monthly
expenses. What monthly fee should it charge a customer who opens a checking account?
A. $7.00
B. $10.00
C. $14.04
D. $14.70
T he appropriate formula is:
Unit price charged per month

= Operating expense per unit + Overhead expense per unit
+ Planned profit margin per unit
Unit price charged per month = $10.00 + $4.00 + (0.05 × (10.00 + 4.00)) = $14.70
179
Q.4086 For depository organizations to price their deposits adequately, they must know the cost of
the deposits. Different approaches may be used in determining deposit costs. Which one is the most
appropriate?
A. Historical average cost approach
B. Marginal cost deposit pricing approach
C. Average percentage yield approach
T he marginal cost deposit-pricing method focuses on the weighted average cost of new funds raised
from various sources of funds the bank draws upon or plans to draw upon in the current period.
Depository institutions prefer the marginal cost pricing approach over historical average cost as
frequent changes in interest rates will make the historical average cost an unreliable standard for
pricing.
A i s i ncorrect: T he historical average cost approach focuses on the past. It looks at the funds that
the bank has raised to date and the cost of the funds. However, frequent changes in interest rates
makes historical average cost an unreliable standard for pricing.
C i s i ncorrect: APY is not an approach to determining deposit costs. It is one of the requirements
of the T ruth in Savings Act that requires depository institutions to make greater disclosure of the
terms attached to the deposits they sell the public
180
Q.4087 Use the APY formula needed by the T ruth in Savings Act for the following calculation.
Sundeep Raichura is a customer at Bright Bank. Raichura holds a savings deposit in the bank for a
year. T he balance in the account stood at $5,000 for 100 days and $200 for the remaining days of the
year. Assume that Bright Bank paid Raichura $20.00 in interest earnings for the year, what APY did
Raichura receive?
A. 0.01
B. 0.0132
C. 0.0154
D. 0.0199
T he right formula is:
365
⎡ Interest earned Days in period ⎤
APY earned = 100 ⎢1 + ( ) − 1⎥
⎣ Average account balance ⎦
($5, 000 × 100 days) + ($200 × 265 days)
Average account balance = = $1, 515
365 days
365
⎡ $20.00 365 ⎤
APY = 100 (1 + ) − 1 = 1.32%
⎣ $1,515 ⎦
181
Q.4088 Brainstorm Savings Bank posts the following fees schedule for its small business transaction
accounts.
Average Monthly Account Balances
Range Monthly Maintenance Fee Charge Per Check

Over $1, 000 $0 $0
$500 − $1, 000 $2 $0.10
Less than $500 $4 $0.20
What form of business pricing is this?
A. Relationship pricing
B. Conditional pricing
C. Cost-plus profit pricing
D. Marginal cost approach
Brainstorm Savings bank has posted a deposit fee schedule that has an allowance of free checking for
average account balances of over $1,000. Lower balances can only be assessed at an increasing
monthly maintenance fee plus an increased per check charge in line with falling average monthly
account balances. T his is conditional pricing designed to encourage large and stable accounts. T his
would perhaps give the bank more money available for usage and a more stable funding base. T he
condition of the higher fee on under $500 accounts is strict and stiff, and that may chase away small
depositors to other banks.
A i s i ncorrect: Under relationship pricing, depository institution prices deposits according to the
number of services purchased or utilized. T he depositor may be given lower fees or have a part of
the cost waived if they have used two or more services.
C i s i ncorrect: Cost-plus deposit pricing encourages banks to determine the costs they incur in
labor and management time, materials, among others, in offering each deposit service. Cost-plus
pricing typically calls for a bank to charge deposit service fees enough to cover all the costs of
providing the service in addition to a small margin for profit.
D i s i ncorrect: T he marginal cost deposit-pricing method focuses on the weighted average cost of
new funds raised from various sources of funds the bank draws upon or plans to draw upon in the
current period.
182
Q.4089 XYZ Bank establishes that it can attract the following amounts of deposits if it agrees to offer
new depositors and those rolling over their maturing term deposits the interest rates in the following
table:
Expected Amount of New Deposits Rate of Interest Offered to Depositors

6, 000, 000 3.00%
10, 000, 000 3.25%
12, 000, 000 3.50%
15, 000, 000 3.75%
20, 000, 000 5.50%
Management hopes to invest any new deposits raised in loans yielding 7%. How far should this thrift
institution go in raising its deposit interest rate to maximize total profits (excluding operational
costs)?
A. 0.0325
B. 0.035
C. 0.0375
D. 0.055
Funds Average Total Marginal Change in Expected Difference Total

Raised Rate Interest Cost Total Revenue Expected Additional
Paid Cost less Profit
Marginal
6, 000, 000 3.00% 180, 000 180, 000 3.00% 7.00% 4.00% 240, 000
10, 000, 000 3.25% 325, 000 145, 000 3.63% 7.00% 3.38% 375, 000
12, 000, 000 3.50% 420, 000 95, 000 4.75% 7.00% 2.25% 420, 000
15, 000, 000 3.75% 562, 500 142, 500 4.75% 7.00% 2.25% 487, 500
20, 000, 000 5.50% 1, 100, 000 537, 500 10.75% 7.00% −3.75% 300, 000
T he calculations are as follows:
Total interest = Funds raised× Average Rate Paid

= 6, 000, 000 × 3.00% = 180, 000
183
Marginal cost = Change in total cost

= New interest rates × Total funds raised at new rate
− Old interest rate× Total funds raised at old rate
= (3.25 × 10, 000, 000) − (3.00% × 6, 000000) = 145, 000
Alternatively, marginal cost is the additional interest earned in new deposit money.
Marginal cost = 325, 000– 180, 000 = 145, 000

Marginal cost
Change in Total Cost =
New Funds Raised
180, 000
= = 3.00%
6, 000, 000
For the second case,
145, 000
Change in Total Cost = = 3.63% and so on.
10, 000000 − 6, 000000
XYZ Bank should raise its deposit rate to 3.75%, attracting $15,000,000 in new deposits; because up
to then, the marginal revenue rate is higher than the marginal cost rate, and total profits are also
rising. At 5.50%, the marginal cost rate is higher than the marginal revenue rate, and overall profits
have fallen from a high of $487,500 back down to $300,000.
184
Q.4090 Young Money Savings Bank realizes that its basic transaction account, which requires a $300
minimum balance, costs this savings bank an average of $3.00 per month in servicing costs (including
labor and computer time) and $1.50 per month in overhead expenses. T he savings bank also tries to
build in a $0.70 per month profit margin on these accounts. What monthly fee should the bank charge
each customer?
A. $3.00
B. $4.50
C. $5.00
D. $5.20
Following the cost-plus-profit approach, the monthly fee should be:
Monthly fee = $3.00 + $1.50 + $0.70 = $5.20 per month.
185
Q.4091 Young Money Savings Bank realizes that its basic transaction account, which requires a $300
minimum balance, costs this savings bank an average of $3.00 per month in servicing costs (including
labor and computer time) and $1.50 per month in overhead expenses. T he savings bank also tries to
build in a $0.70 per month profit margin on these accounts. Further analysis of customer accounts
reveals that for each $50 above the $300 minimum in the average balance maintained in its
transaction accounts, Young Money Savings Bank saves about 2% in operating expenses with each
account. For a customer who consistently holds an average balance of $400 per month, how much
should the bank charge to cushion its profit margin?
A. $4.00
B. $4.82
C. $5.08
D. $5.10
If the bank saves about 2% in operating expenses for each $50 held in balances above the minimum
of $300, then a customer who maintains an average monthly balance of $400 saves the bank 4% in
operating expenses.
T hat is,
$100
$400 − $300 = = 2 ∗ 2% = 4%
$50
saving in the operating costs
New operating expenses = $3.00– (4% × $3.00) = $2.88
T he appropriate amount that the bank should charge to protect its profit margin is therefore
$2.88 + 1.50 + 0.70 = $5.08$ per month
Note: Overheads are the expenditure which cannot be conveniently traced to or identified with any
particular cost unit, unlike operating expenses such as raw material and labor. T hat's why we add the
$1.5 overhead as a separate item.
Q.4092 Neha Datta maintains a savings deposit with XYZ Credit Union. In 2019, Datta received
$12.25 in interest earnings from her savings account. Her savings deposit had the following average
186
balance each month:
Month Account Balance

January 520
February 380
March 440
April 300
May 385
June 470
July 530
August 615
September 750
October 810
November 845
December 530
What was the annual percentage yield (APY) earned on Datta’s savings account?
A. 0.0125
B. 0.0156
C. 0.0196
D. 0.0223
365
APY earned = 100 ⎢(1 + ) − 1⎥
187
Month Account Balance Number of Days AC Balance*

in the Month Days
January 520 31 16, 120
February 380 28 10, 640
March 440 31 13, 640
April 300 30 9, 000
May 385 31 11, 935
June 470 30 14, 100
July 530 31 16, 430
August 615 31 19, 065
September 750 30 22, 500
October 810 31 25, 110
November 845 30 25, 350
December 530 31 16, 430
Total 365 200, 320
200,320
Average account balance = = $548.82
365 days
365
⎡ $12.25 365 ⎤
APY = 100 (1 + ) − 1 = 2.23%
⎣ $548.82 ⎦
188
Q.4093 A hypothetical Bank of India quotes an APY of 4.0% on a one-year money market Certificate
of Deposit sold to one of the businesses in town. T he firm posted a balance of $3,000 for the first
100 days of the year, $2,500 over the next 100 days, and $1,000 for the remainder of the year. How
much in total interest earnings did this business customer receive for the year?
A. 56.70
B. 60.54
C. 78.36
D. 80.46
Using the APY formula, we proceed as follows:
365
APY earned = 100 ⎢(1 + ) − 1⎥
Average account balance

$3,000 × 100 days) + ($2, 500 × 100 days) + ($1,000 × 165 days)
= = $1, 959
365 days
365
⎡ Interest 365 ⎤
4.0% = 100 ⎢(1 + ) − 1⎥
⎣ $1, 959 ⎦
Interest earned = $78.36
189
Q.4094 Fatou Heckerman has been holding $ 250,000 in Smart-way Bank and another $250,000 in
Pathway Savings Bank. In December last year, Fatou learned that the two institutions had merged a
month before. Fatou reported the case to FDIC to ensure appropriate deposit coverage. How much
should be the total protection offered to Fatou given the above scenario?
A. $50,000
B. $250,000
C. $500,000
D. $25,000
If two formerly independent institutions merge, for example, and a depositor holds $250,000 in each
of these two merging institutions, the total protection afforded this depositor would then be a
maximum of $250,000, not $500,000, as it would have been before the merger. T herefore, Fatou will
have deposit coverage of a maximum of $250,000.
Q.4095 Suppose that a bank plans to raise $65 million in new deposits by offering its depositors an
interest rate of 8.5%. What will be the total interest cost of new funds raised?
A. $6.980 million
B. $3.450 million
C. $5.525 million
D. $4.653 million
Total interest cost of new funds will be equivalent to:
Interest rate × expected amount = 0.085 × $65 = $5.525 million
Q.4096 ABC Credit Union is launching a new deposit campaign next week in anticipation of bringing
in from $200 million to $700 million in new deposit money, which it expects to invest at a 7% yield.
T he management believes that an offer rate on new deposits of 3% would attract $200 million in new
deposits and rollover funds. To attract $300 million, the bank would probably be forced to offer 4%.
ABC’s forecast suggests that $400 million might be available at 4.25%, $500 million at 4.50%, $600
million at 4.75%, and $700 million at 5.25%. What volume of deposits should the institution try to
190
avoid to ensure that marginal cost does not exceed marginal revenue?
A. $300 Million
B. $400 Million
C. $600 Million
D. $700 Million
Expected Rate Total Marginal Marginal Marginal Expected Total

Inflows in Offered on Interest Interest Cost Revenue Difference In Profits
Millions New Cost Cost Rate Rate Marginal Earned
Funds
Revenues
and
Costs
200 3.00% 6.00 6.00 3.00% 7.00% 4.00% 8.00
300 4.00% 12.00 6.00 6.00% 7.00% 1.00% 9.00
400 4.25% 17.00 5.00 5.00% 7.00% 2.00% 11.00
500 4.50% 22.50 5.50 5.50% 7.00% 1.50% 12.50
600 4.75% 28.50 6.00 6.00% 7.00% 1.00% 13.50
700 5.25% 36.75 8.25 8.25% 7.00% −1.25% 12.25
Total Interest Costs = $Expected inflows x Rate of new funds%
Marginal Interest Costs = Total interest costs for the current expected inflow - Total interest costs
for the previous expected inflow
Marginal Cost Rate = Marginal costs ÷ Increase in the expected inflows
Increase in the Expected Inflows = Current expected inflow - Previous expected inflow
Marginal Revenue Rate = Expected investment yield
Expected Difference in Marginal Revenues and Costs = Marginal revenue rate - Marginal costs rate
191
Total Profits Earned = (Marginal revenue rate - Rate offered on new funds)% x Expected inflows
From the table above, at $700 million, the marginal cost rate of 8.25%% is greater than the marginal
revenue rate of 7.00%. T herefore, ABC Credit Union should try to avoid $700 million in new
deposits.
192
Reading 135: Managing Nondeposit Liabilities
Q.4097 Promise Bank takes out a loan of $30 million overnight through a repurchase agreement
(RP), which is collateralized by T reasury bills. T he current RP rate is 4%. Calculate the interest
costs that the bank pays due to this borrowing.
A. $3,333.33
B. $6,657.67
C. $8,768.90
D. $9,754.78
Interest cost of RP
Amount borrowed× Current RP rate × Number of days in RP borrowing
=
360 days
1
= $30, 000, 000 × 4% × = 3, 333.33
360
193
Q.4098 Short term notes with maturities of 3 or 4 days to 9 months issued by well-known companies
are known as:
A. Commercial paper
B. Negotiable CDs
C. Eurocurrency deposits
T he commercial paper market involves short-term notes with a maturity period of three or four
days to nine months, issued by well-known companies to raise working capital. T hey are sold at a
discounted price from their face value.
B i s i ncorrect: A negotiable CD is a source of short-term funds for commercial banks developed to
tap temporary surplus funds held by large corporate and wealthy individual customers. It is an
interest-bearing receipt evidencing the deposit of funds in the bank for a specified period for a
specified interest rate. It is a hybrid account since it is legally a deposit.
C i s i ncorrect: T he Euro currency deposit market is the most significant unregulated financial
market place in the world. It involves a group of banks that accept deposits and also make loans in
foreign currencies outside their country of issue. T hey were initially developed in western Europe
to provide liquid funds to swap among institutions or act as loans to customers. T he Eurodollar
market is one of these markets. Eurodollars are dollar-denominated deposits placed in banks outside
the United States.
194
Q.4099 A bank with immediate reserve needs can borrow from the federal reserve. It can acquire
different types of loans, based on its obligations. Gift Bank is a sound financial institution. Its
management agrees to borrow a short term loan whose rate is higher than the federal funds rate.
Which of the following refers to this type of loan?
A. Primary credit
B. Secondary credit
C. Seasonal credit
Primary credit refers to loans available for the short-term and only to institutions in sound financial
conditions. T he interest rate is higher than the federal funds rate. In this case, Gift bank is a sound
financial institution and decides to borrow for a short term.
B i s i ncorrect: Secondary credit is available to institutions that do not qualify for primary loan but
at a higher interest rate. Secondary credit is, however, tracked by the central bank to avoid excess
risk.
C i s i ncorrect: Seasonal credit is a loan that covers more extended periods relative to primary
credit. Seasonal credits are mostly utilized by small and medium firms that experience seasonal
fluctuations in deposits and loans.
195
Q.4100 T rust Bank purchases a 50-day negotiable CD with a $10 million denomination from Promise
Bank, bearing a 5% annual yield. How much interest is the bank obliged to pay at the maturity of the
CD?
A. $10,456
B. $12,567
C. $50,678
D. $69,444
Days to maturity
Interest owed = Principal × × Annual interest rate
360 days
50
Interest owed = $10, 000000 × × 5% = $69, 444
360
Q.4101 Central Credit Union borrows $200 million overnight through a repurchase agreement (RP),
which is collateralized by T reasury bills. T he current RP rate is 5%. What is the interest cost that
the bank should pay for this borrowing?
A. $27,777.80
B. $30,433.76
C. $33,333.67
D. $46,879.20
Interest cost of RP
=
360 days
1
= $200,000, 000 × 5% × = $27,777.80
360
196
Q.4102 Prime Limited is expecting new deposit inflows of $400 million and deposit withdrawals of
$600 million next month. T he bank has projected that new loan demand will reach $500 million, and
customers with approved credit lines will need $200 million in cash. T he bank will sell $375 million
in securities but plans to add $100 million in securities to its portfolio. Calculate the projected
available funds gap.
A. $600
B. $625
C. $800
D. $975
Available funds gap (AFG) = Current and projected loans and investments the lending institution
desires to make l ess current and expected deposit inflows and other available funds)
Projected funds gap = $500 + $200 + ($100 − $375) − ($400 − $600)

= $625
Note:
Current and expected deposit inflows = current and expected inflows - current and expected deposit
outflows
In other words, current and expected deposit inflows is simply the net inflow, which in this case is
negative because the outflows exceed the inflows.
197
Q.4103 Suppose that Bluemont bank borrows $85 million using an RP transaction with a government
bond collateral for twelve days, and the current RP rate in the market is 4%. How much would be
the bank’s total interest cost?
A. $113,333.33
B. $123,445.90
C. $134,670.08
D. $167,346.78
Interest cost of RP
=
360 days
12
= $85,000, 000 × 4% × == $113,333.33
360
Q.4104 Suppose a depository institution promises a 7% annual interest rate to a buyer of a $320,000,
150 days Negotiable CD. How much will the depositor have at the maturity date?
A. $9,345
B. 14678
C. $329,333
D. $339,345
Amount due CD customer

Days to marturity
= Principal + principal × × Annual rate of interest
360 days
150
= $320, 000 + 320, 000 × × 7% = $329,333
360
198
Q.4105 Suppose that a commercial bank has a new loan request that meets its quality standards of
$660 million; it expects to purchase $330 million in new T reasury securities being issued on Friday
the same week and expects drawings on credit lines from its best corporate customers of $358
million. Deposits and other customer funds received today total $456 million, and those expected in
the coming week will inject another $265 million. If the current funding gap is zero, what is the
bank’s estimated available funds gap (AFG) for the coming week?
A. $326
B. $423
C. $347
D. $627
Available funds gap (AFG) = (Current and projected loans and investments the lending institution
desires to make LESS current and expected deposit inflows and other available funds)
AFG = ($660 + $330 + $358) − ($456 + $265) = $1, 348 − $921 = $627 million.
Q.4106 Suppose that banks and other lending affiliates within Niche Bank Holding Company have a
substantial loan demand from several companies that have a significant expansion project of their
facilities before the beginning of the next financial year. T he holding company and the bank in charge
have a plan to raise $1 billion in short term funds this week, of which $0.9 billion will be used to
meet these new loan requests. T he following table shows the current annual interest rates on
alternative sources of funds.
Market Interest Noninterest cost

rates rates
Federal Funds 2.10% 0.42%
Negotiable CDs 2.25% 0.42%
Eurodollars 2.15% 0.52%
Commercial paper 2.20% 0.67%
Fed Discount Rate 3.10% 0.42%
Calculate the effective cost rates of the Federal Funds and Negotiable CDs, respectively.
A. 2.10% and 2.25%
B. 2.80% and 2.97%
C. 2.97% and 3.19%
199
D. 2.80% and 3.91%
Market Noninterest Market Noninterest

Interest Cost Rates Interest Cost
Rates Cost
Federal Funds 2.10% 0.42% 21, 000, 000 4, 200, 000
Negotiable CDs 2.25% 0.42% 22, 500, 000 4, 200, 000
Effective cost rate on deposit and nondeposit sources of funds

(Current interest cost on amounts borrowed
+ Noninterest costs incurred to access these funds)
=
Net investable funds raised from this source
Where:
Current interest cost on amounts borrowed

= Prevailing interest rate in the money market × Amount of funds borrowed
For Federal Funds,
market interest cost = 2.10% × 1, 000, 000, 000 = 21, 000, 000
Noninterest cost = 0.42% × 1, 000, 000, 000 = 4, 200, 000
21,000,000+4,200,000
T hus the effective cost rate of the Federal Funds is 900,000,000 = 2.80%
22,500,000+4,200,000
Similarly, the effective coat rate of the Negotiable CDs = 900,000,000 = 2.97% .
Q.4107 Suppose that banks and other lending affiliates within Niche Bank holding company have a
substantial loan demand from several companies that have a significant expansion project of their
facilities before the beginning of the next financial year. T he holding company and the bank in charge
have a plan to raise $1billion in short term funds this week, of which $0.9 billion will be used to meet
these new loan requests. T he following table shows the current annual interest rates on alternative
sources of funds.
200
Market Interest Noninterest cost

rates rates
Federal Funds 2.10% 0.42%
Negotiable CDs 2.25% 0.42%
Eurodollars 2.15% 0.52%
Commercial paper 2.20% 0.67%
Fed Discount Rate 3.10% 0.42%
Assume that you are to advise Niche Bank Holding Company management on the best source of
funding to use. Which one would you recommend?
A. Federal Funds
B. Negotiable CDs
C. Eurodollars
D. Federal Discount Rate
We determine the cheapest cost of funding. T he following table shows the corresponding calculation
of the interest costs of each of the funding sources:
Market Noninterest Market Noninterest

Interest Cost Rates Interest Cost
Rates Cost
Federal Funds 2.10% 0.42% 21, 000, 000 4, 200, 000
Negotiable CDs 2.25% 0.42% 22, 500, 000 4, 200, 000
Eurodollars 2.15% 0.52% 21, 500, 000 5, 200, 000
Commercial paper 2.20% 0.67% 22, 000, 000 6, 700, 000
Fed Discount Rate 3.10% 0.42% 31, 000, 000 4, 200, 000
Total 118, 000, 000 24, 500, 000
Effective Cost
Rate
Effective Federal Cost Rate 2.80%
Effective CD Cost Rate 2.97%
Effective Eurodollar Cost Rate 2.97%
Effective Commerical Paper Cost Rate 3.19%
Effective Cost of borrowing from the Fed 3.91%
Where,
Current interest cost on amounts borrowed

= Prevailing interest rate in the money market × Amount of funds borrowed
201
For Federal Funds, market interest cost = 2.10%×1,000,000,000=21,000,000
Noninterest cost = 0.42% × 1, 000, 000, 000 = 4, 200, 000
21,000,000+4,200,000
T hus the effective cost rate of the Federal Funds is 900,000,000 = 2.80%
22,500,000+4,200,000
Similarly, the effective coat rate of the Negotiable CDs = 900,000,000 = 2.97% , and so on.
T hus, the cheapest source of funding would be borrowing from the federal market.
Q.4109 Suppose that ABC Bank Ltd receives $1,530 million from the following sources. T hese
sources are listed below with their associated costs:
Funding Amount Interest Noninterest Additional Total

source Costs Costs costs Costs
Money-Market 275 3.03% 0.24% 0.24% 3.51%
Borrowings
T ime and Savings 580 2.27% 0.23% 0.60% 3.10%
Deposits
Checkable 385 0.52% 1.96% 0.80% 3.28%
deposits
Stockholders 290 12.75% 12.75%
Equity
Assuming that the bank has earning assets worth $1,240 (i.e.,$1,530-$290), calculate the break-even
cost rate.
A. 1.9%
B. 5.0%
C. 3.2%
D. 6.2%
Total funding costs

Break even cost rate =
Earning assets
202
Funding Source Amount Interest Cost Other Cost Total

Money-Market Borrowings 275 8.33 1.32 9.65
T ime and Savings Deposits 580 13.17 4.81 17.98
Checkable deposits 385 2.00 10.63 12.63
Stockholders Equity 290 36.98 − 36.98
Total 1, 530 23.50 16.76 77.24
Interest cost = $Amount x Interest costs %
Other costs = $Amount x (Non-interest costs + Additional costs)%
Total costs = $ Interest costs + $Other costs
77.24
Break even cost rate = = 6.2%
1,240
Q.4110 Suppose that Mug Bank, a fictional financial institution in the Netherlands, has an estimated
cost of overhead expenses and salaries of $13 million. T he earning assets are worth $540 million.
Suppose further that the total interest cost is $127 million. Evaluate the bank’s break-even cost rate
on borrowed funds invested in earning assets.
A. 26%
B. 28%
C. 32%
D. 40%
Break-even cost rate on borrowed funds invested in earning assets

Interest cost + (Other operating costs)
127 + 13
= = = 26%
(Total earning assets) 540
203
Q.4111 T he financial data in the following table belongs to Pathway Bank. Use the data to evaluate
the weighted average overall cost of capital for the institution.
Break-even cost 14.50%

T he after-tax cost of stock of stockholder's investment 12%
Tax rate 15%
Stockholder’s investment $260, 000
Earning assets $340, 000
A. 12.9%
B. 15.7%
C. 22.7%
D. 25.3%
Weighted average overall cost of capital

= Break-even cost
After-tax cost of stockholders’ investment
Stockholders’ investment
+ ×
(1– Tax rate) Earning assets
Which is equivalent to:
12% $260, 000

14.5% + × = 25.3%
(1– 0.15) $340, 000
T hus, 25.3% is the lowest rate of return overall fund-raising costs Pathway Bank can afford to earn
on its assets if its equity shareholders invest $260,000 in the institution.
204
Q.4112 Which of the following choices is a factor to consider when determining the non-deposit
funding sources to use?
A. Relative cost of raising funds associated with each source.
B. T he risk of each funding source
C. T he maturity of the funds
D. All of the above
Factors to be considered when evaluating the best non-deposit source to use to cover the available
funds gap include relative cost of raising funds associated with each source, the risk of each funding
source, the maturity of the funds, the size of the institution and the regulations restricting the use of
various fund sources.
Q.4113 Which of the following types of Negotiable CDs is issued by foreign banks in the US?
A. Domestic CDs
B. Euro CDs
C. Yankee CDs
D. T hrift CDs
A Yankee CD is a foreign certificate of deposit usually denominated in the U.S dollars and is issued by
foreign banks in the US.
A i s i ncorrect: Domestic banks issue domestic CDs in the U.S.
B i s i ncorrect: EuroCDs are dollar-denominated CDs that are issued by banks outside the U.S
D i s i ncorrect: T hrift CDs are issued by substantial savings and loans and other non-banks in the
U.S.
205
Q.4114 A loan which is unwritten, often uncollateralized agreements usually negotiated over a
telephone and is payable in the next day is known as:
A. Term loan
B. Overnight loan
C. Continuing contract
Overnight loans are unwritten, often uncollateralized agreements usually negotiated over a telephone
and are payable in the next day.
A i s i ncorrect: Term loans are long-term contracts, usually accompanied by a written contract.
Term loans may take days, weeks, or even months.
C i s i ncorrect: Continuing contracts have daily renewals unless either the lender or borrower
decides to end the contract. T he agreements are commonly between smaller respondent institutions
and their more significant correspondents, where the latter automatically invests the smaller
institution’s deposits held with it in Fed funds loans until told to do otherwise.
206
Q.4115 KBC Bank is considering funding a package of new loans for $600 million. Money Bank has
projected that it must raise $800 million to have $600 million available to make the new loans. It
expects to raise $550 million of the total by selling time deposits at an average interest rate of 5%.
Noninterest costs from the time of sale deposits add an estimated 2% in operating expenses. KBC
Bank expects another $250 million to come from noninterest-bearing transaction deposits, whose
noninterest costs are expected to be 3% of the total amount of these deposits. What is the Bank’s
projected pooled-funds marginal cost?
Dollar Interest Non Total Total

Amount rate interest interest non-interest
($ millions) cost rate expenses expenses
T ime 550 5.00% 2.00% 27.50 11.00
deposits
T ransaction 250 0% 3.00% 0 7.50
deposits
Total 800 27.50 18.50
A. 5.75%
B. 6.25%
C. 2.31%
D. 3.44%
Projected pooled-funds marginal cost

All expected operating expenses27.50 + 18.50
= = = 5.75%
(All new funds expected) 800
207
Q.4116 T rust Bank purchases a 50-day negotiable CD with a $10 million denomination from Promise
Bank, bearing a 5% annual yield. What is the total amount that Promise Bank will have to pay back to
T rust Bank at the end of 50 days?
A. $10,000,000
B. $10,065,765
C. $10,069,444
D. $12,086,657
Amount due CD customer

Days to maturity
= Principal + Principal × × Annual interest rate
360 days
50
= $10, 000,000 + $10,000000 × × 5% = $10, 069, 444
360
208
Q.4117 KBC Bank is considering funding a package of new loans for $600 million. T he bank has
projected that it must raise $800 million to have $600 million available to make the new loans. It
expects to raise $550 million of the total by selling time deposits at an average interest rate of 5%.
Noninterest costs from the time of sale deposits add an estimated 2% in operating expenses. T he
bank expects another $250 million to come from noninterest-bearing transaction deposits, whose
noninterest costs are expected to be 3% of the total amount of these deposits. What hurdle rate
must the bank achieve in its earning assets?
A. 5.46%
B. 7.67%
C. 9.83%
D. 10.33%
T he hurdle rate of return is equivalent to:
All expected operating costs

Dollars available to place in earning assets
Dollar Interest Non Total Total

Amount rate interest interest non-interest
($ millions) cost rate expenses expenses
T ime 550 5.00% 2.00% 27.50 11.00
deposits
T ransaction 250 0% 3.00% 0 7.50
deposits
Total 800 27.50 18.50
(27.50 + 18.50)
= = 0.0767%
600
T his means that KCB Bank should earn 7.67% and above on average before taxation on all its new
funds invested in meeting the expected new funding cost.
209
Reading 136: Repurchase Agreements and Financing
Q.2239 Sover Bank needs short-term liquidity. It has high-quality US government bonds in its
portfolio. In order to fund its liquidity needs, Sover Bank has entered into a repurchase agreement
(repo) with GNR Bank. According to the repo agreement, Sover bank has to:
A. Sell US government bonds to third parties in order to repay any funds borrowed from
GNR bank.
B. Buy US government bonds from GNR Bank.
C. Pledge US government bonds to receive a loan from GNR Bank.
D. Sell government bonds to GNR Bank with an obligation to repurchase those bonds.
A repurchase agreement or repo is a contract in which a security is traded at some initial price with
the understanding that the trade will be reversed at some future date at some fixed price.
Q.2240 Bolny Bank has entered into a repo agreement with Kovit Bank. In the first part of the
transaction, it receives US government bonds from Kovit Bank. In the second part of the transaction
Bolny bank has to:
A. Return the bonds, which it received as collateral, to Kovit.
B. Receive money from Kovit.
C. Sell bonds back to Kovitat at their market price on the settlement date.
D. Sell bonds to Kovit at the fixed price agreed upon in advance.
A repurchase agreement or repo is a contract in which a security is traded at some initial price with
the understanding that the trade will be reversed at some future date at some fi xed pri ce.
210
Q.2241 Sokolov Bank is going to enter into a repurchase agreement with Branitzky Bank. Sokolov
Bank will sell high-quality securities to Branitzky bank in the first part of the transaction. At what
price will Branitzkybank sell the aforementioned securities back to Sokolov Bank?
A. A fixed price agreed upon at the time of entering into the repo agreement.
B. At the market price of the securities at the time of entering into the repo agreement.
C. At the market price of the securities at the time of the second transaction.
D. At the price that should have been agreed upon at the time of the second transaction.
T he price at which the trade will be reversed must be agreed upon at the onset, i.e., at the beginning
of the contract.
211
Q.2242 Ludska Bank entered into a repo agreement with SKA Bank. Under the agreement, Ludska
Bank sold government bonds to SKA Bank as per the following details:
Face amount: USD 1,000,000,
Invoice price: USD 1,100,000,
Repo rate: 4% p.a.,
Settlement date: 90 days after the conclusion of the agreement
What is going to happen on the date of the settlement, assuming the 360-day convention applies?
A. Ludska Bank will repurchase the bonds from SKA Bank for USD 1,100,000.
B. Ludska Bank will repurchase the bonds from SKA Bank for USD 1,000,000.
C. Ludska Bank will repurchase bonds from SKA Bank for USD 1,101,466.66.
D. Ludska Bank will repurchase bonds from SKA Bank for USD 1,111,000.
T he formula for calculation of the repurchase price is as follows:
(Repo rate ∗ Repo term in days)

Repurchase price = Invoice price (1 + )
360
T herefore,
(4% ∗ 90)
Repurchase price = 1, 100, 000 (1 + ) = 1, 111, 000
360
212
Q.2243 Which of the following statements is correct about repurchase agreements?
A. T hey can be traded on secondary markets.
B. T hey are unsecured.
C. T hey are classified as money market instruments.
D. T hey can have a maturity period of up to 20 years.
Repo agreements are short-term, money market instruments. T hus, they are typically traded
overnight, but can also have a maturity period of up to three months. T hey cannot be traded on
secondary markets. T hey are also secured by the underlying high-quality bonds.
Q.2246 For a particular high-quality security transaction, the agreement is ‘repo’ from the point of
view of:
A. T he security buyer
B. T he security seller
C. T he clearinghouse
D. T he Federal Reserve
In the eyes of the party selling the security and agreeing to repurchase it in the future, it’s a repo. In
the eyes of the party that buys the security hoping to sell it back to the original seller, it’s a reverse
repurchase agreement.
213
Q.2247 Briggs Bank buys US treasury bonds from Roland Bank under a repo agreement. Sometime
before the settlement date agreed upon in advance, the market value of the bonds significantly
reduces. Which of the following actions would most likely be taken by Briggs bank in response to the
declining market value? T he bank will:
A. Terminate the agreement.
B. Demand immediate maturity of the contract so as to avoid further losses that may arise
from the bonds losing more of their value.
C. Do nothing, except hope that the bonds regain their value as the settlement date
approaches.
D. Demand more collateral.
Repo agreements are normally subject to margin calls, through which the borrower of cash supplies
extra collateral in declining markets. T he borrower may also withdraw collateral in advancing
markets.
In case of a decrease in the price of the underlying security, the buyer may request for provision of
additional securities in an attempt to maintain the overall value of collateral.
214
Q.2248 Voynet Bank buys a security from Bornet bBank under a repo agreement. In the period
leading up to the settlement date, the market value of the security significantly increases. Assuming a
margin call forms part of the agreement, Bornet Bank will most likely:
A. Terminate the agreement.
B. Request that the contract matures immediately so that it can sell the mortgage to third
parties at a profit.
C. Request that the amount of collateral be reduced to reflect the increased value.
D. Do nothing, except wait for maturity of the agreement as scheduled.
Repo agreements are normally subject to margin calls, through which the borrower of cash supplies
extra collateral in declining markets. T he borrower may also withdraw collateral in advancing
markets.
Since the agreement is subject to margin calls, the borrower may withdraw collateral in case the
value of the securities increases.
Q.2249 After modeling daily cash flows at BBB Bank, its managers strongly believe that the bank will
be unable to meet day-to-day funding requirements in about 1 years’ time. As such, the bank has to
secure long-term funding to avert a possible cash crunch. BBB Bank has high-quality US treasury
bonds in its portfolio. Should the bank sell the bonds under a repo agreement so as to secure the
required funds?
A. Yes, because US treasury bonds are highly marketable.
B. No, because repo financing is usually short-term.
C. Yes, because the repo market is highly illiquid.
D. No, because repo borrowing has to be backed up by collateral of a similar value.
In the spectrum of financing choices, repo markets are relatively liquid and repo borrowing rates
relatively low. On the other hand, repo agreements have very short maturities. T he bank would have
to buy back the bonds just a few days or months after selling them, and therefore such a move would
do little to avert a long-term cash crunch. In fact, a repo in such circumstances would only aggravate
the situation because besides returning the amount borrowed, the bank would also have to pay
accrued interest.
215
Q.2250 During the financial crisis of 2007/2008, repo transactions were partly to blame for the
failure of quite a number of firms. T his is because:
A. T he repo market was largely unregulated.
B. Firms borrowed money at relatively high-interest rates using low-quality financial

instruments as collateral.
C. Firms borrowed money at relatively low-interest rates using low-quality financial

instruments as collateral.
D. T he US government defaulted on most treasury bonds.
In the run-up to the financial crisis of 2007/2008, borrowers financed lower-quality collateral, like
lower-quality corporate bonds and lower-quality mortgage-backed securities, at the relatively low
rates and haircuts available in the repo market. Lenders, on their part, accepted this collateral in
exchange for rates somewhat higher than those available when lending on higher-quality collateral.
T herefore, in case of counterparty default in a repo agreement, the other party would struggle to
sell the securities in the market. T hose lucky enough to find a buyer would still incur heavy losses
due to decreased market value.
Q.2251 Bank Aluvia has an excess liquidity and it has decided to finance another bank under a repo
agreement. Why would Aluvia Bank prefer a repo transaction to other market products such as the
purchase of stocks?
A. A repo transaction would guarantee a quick return.
B. A repo transaction would be faster and easier to execute.
C. A repo transaction would be risk-free.
D. A repo-transaction would be more secure.
Repo transactions are usually less risky because (I) they have short maturities and (II) the seller has
to provide high-quality collateral.
216
Q.2252 Boulogne Bank sells securities to Betis Bank as part of a repo agreement. Which of the
following statements would not be consistent with best market practice under such agreements?
A. T he “buy back” price would be fixed.
B. T he contract would be settled overnight.
C. Betis Bank would be free to sell the securities back to Boulogne Bank at any time.
D. T he agreement would be legally binding.
A repurchase agreement normally has a fixed settlement date.
Q.2253 Alameda Bank is looking to buy bonds which are “trading special”. Which type of bonds is the
bank looking for?
A. General collateral bonds.
B. Zero-collateral bonds.
C. Bonds issued by the government.
D. Bonds most in demand.
Repo trades can be divided into those using general collateral (GC) and those using special collateral
or "specials." In the former, the lender of cash is willing to take any particular security, although the
broad categories of acceptable securities might be specified with some precision. In specials trading,
the lender of cash initiates the repo in order to take possession of a particular security. Bonds most
in demand to be borrowed are said to be tradi ng speci al , although any request for specific
collateral is a specials trade.
217
Q.2732 Calculate the financing value per $100 market value of an on-the-run bond if it was issued on
March 31st and trades at a special spread of 0.30%. T he bond is expected to trade at GC rates after
September 30th. Use the actual/360 day convention.
A. $0.100
B. $0.187
C. $0.125
D. $0.153
T he financing value of the bond can be determined by finding its value for the period that it trades at
the special spread.
Number of days it is traded at the special spread = 183 days
183
Financing value = 100 × × 0.30% = $0.153 per $100
360
218
Q.2972 Assuming that a counterparty X sells a €250 million face amount of DBR 4’s of December
9th, 2014, to a counterparty Y , for settlement on April 1st, 2013, at an invoice price of €280.131
million. At the same time, counterparty X decides to rebuy the €250 million face amount five months
later, for settlement on September 1st 2013 at a purchase rate equivalent to the invoice price
including interest at a repo rate of 0.31%. Compute the repurchase price.
A. €250.166 million
B. €259.187 million
C. €281.129 million
D. €280.500 million
By applying the actual/360 convention popular for most money market instruments, and using 153
days between April 1st and September 1st.
T herefore:
(0.0031 × 153)
€280, 131, 000(1 + ) =€280, 500, 072
360
≈€280.5 Million
Note: Repurchase agreements use the actual/360 day count convention.
T hey are classified as money market instruments in the same category as T-bills.
219
Q.2973 Which of the following is the value of lending $1,000 of cash at a spread of 0.31% for 133
days?
A. $1.145 per $1,000
B. $2.982 per $1,000
C. $1.675 per $1,000
D. $2.442 per $1,000
T he value of lending $1,000 of cash at a spread of 0.31% for 133 days is computed as:
(133×; 0.0031)
$1, 000 × = $1.145
360
⇒ $1.145 per $1,000 market value of the bond
Q.2974 Supposing that DBR 4s of face value $120 million of January 14th, 2030, are to be sold by HJK
Bank to a counterparty for settlement for $159 million. HJK Bank selling the DBR 4s then decides to
buy the $120 million face amount some 122 days later for settlement at a buying price equal to that
of the invoice price with a repo rate of 0.26%. At what price can HJK Bank repurchase the bond?
A. $159.14 million
B. $121.65 million
C. $150.11 million
D. $121.33 million
T he repurchase price is:
122
$159 (1 + (0.0026 × )) = $159.14 million
360
220
Q.4118 A counterparty K sells a €300 million face amount of DBR 4’s of June 10th, 2016, to a
counterparty W, for settlement on January 1st, 2015, at an invoice price of €350.25 million. At the
same time, counterparty X decides to rebuy the €300 million face amount six months later, for
settlement on July 1st, 2015, at a purchase rate equal to the invoice price with interest at a repo
rate of 0.26%. Compute the repurchase price.
A. 350.16 million
B. 350.56 million
C. 350.71 million
D. 350.85 million
We apply the actual/360 convention popular for most money market instruments. T here are using
181 days between January 1st and July 1st.
Repurchase Price
Repo Term in Days
= Principal + (Principal × Repo Rate × )
360 days
Repurchase Price
181
= $350.25 + (350.25 × 0.26% × ) = $350.71 Million
360
Note: Repurchase agreements use the actual/360 day count convention. T hey are classified as
money market instruments in the same category as T-bills.
221
Q.4119 Prime Bank sells DBR 4s of face value $200 million of September 1st, 2040, to a
counterparty for settlement for 250 million. Prime Bank then decides to buy the $200 million face
amount after 183 days for settlement at a buying price equal to that of the invoice price with a repo
rate of 0.34%. At what price can Prime Bank repurchase the bond?
A. $250.43 million
B. $250.57 million
C. $200.68 million
D. $200.97 million
Repurchase Price
Repo Term in Days
= Principal (1 + (Repo Rate × ))
360 days
Repurchase Price
183
= $250 (1 + (0.34% × )) = $250.43 Million
360
Q.4120 Bright Bank lends $10,000 of cash at a spread of 0.26% for 150 days. Calculate the Bank’s
lending value.
A. $1.034 per $10,000
B. $5.45 per $10,000
C. $10.83 per $10,000
D. $10.68 per $10,000
T he value of lending $100 of cash at a spread of 0.26% for 150 days is calculated as:
150 × 0.26%
$10, 000 × = $10.83
360
i.e., $10.83 per $10,000 market value of the bond.
222
Q.4121 Calculate the financing value per $1,000 market value of an on-the-run bond if it was issued
on July 1st 2019and trades at a special spread of 0.50%. T he bond is expected to trade at GC rates
after October 31st 2019. Use the actual/360 day convention.
A. $1.57
B. $1.60
C. $1.67
D. $1.69
T he financing value of the bond can be determined by finding its value for the period that it trades at
the special spread.
Number of days it is traded at the special spread = 122 days
122
Financing value = 1, 000 × × 0.50% = $1.69 per $1, 000
360
223
Q.4122 Which of the given options is a reason for carrying out a repo?
A. Availing an efficient source of short-term funding
B. Providing a flexible and secure home for short-term investment
C. Facilitating central bank operations
D. All of the above
Opti on A i s correct: Repos aims to provide more in-depth and cheaper funding for financial
intermediaries (security dealers). It aims to give deposits secured by the legal title to high-quality
liquid assets. Repo is used to meet temporary liquidity requirements without having to liquidate long-
term strategic investments.
B i s correct: Repo allows investors to reduce their exposure to commercial banks and diversify
counterparty credit threat through transferring cash out of bank accounts. It is almost certainly the
most secure short-term asset available to many investors since they are ineligible for deposit
protection techniques.
C i s correct: Repo is commonly utilized for the operations of the central bank open market. T he
fact that it is collateralized minimizes the credit threat of the central banks.
Q.4123 Calculate the value of lending $200 cash at a spread of 0.25% for 150 days.
A. $0.208
B. $0.304
C. $0.308
D. $0.205
150
Lending value (financial advantage) = $200 × 0.25% × = $0.208
360
224
Q.4162 T he following are characteristics of a Repurchase Agreement. Which one is NOT?
A. It has a specified price
B. It usually takes a short duration
C. It is generally considered a safe investment.
D. It usually takes a long duration.
A repurchase agreement typically lasts for a short term, from overnight to 21 days.
A i s i ncorrect: T he repo price of the securities is agreed upon in the agreement that is signed
between the lender and borrower. T he repo price must be higher than the current price since it has
to cater to a profit for the lender. As such, the repo price does not rely on the future expected
amount of the securities; instead, it relies on the market interest rates raining at a particular time.
Option C is incorrect: Repos are generally regarded as secure investments since the underlying
security is used as collateral.
225
Reading 137: Liquidity Transfer Pricing: A Guide to Better Practice
Q.4201 Calculate the rate charged for contingent liquidity risk of a line of credit assumed to have a
limit of $56million where $22 million has already been drawn. Further, suppose there is a 38%
chance that the customer will draw on the remaining credit and that the cost of term funding assets
in the liquidity cushion is 7.5 bps.
A. 1.73 bps
B. 2.85bps
C. 4.40 bps
D. 2.71 bps
Limit-Drawn Amount
Rate charged = × Likelihood of Drawdown
Limit
× Cost of Funding Liquidity Cushion
Hence,
($56m − $22m)
× 0.38 × 0.00075 = 0.000173 ≅1.73bps
$56m
226
Q.4202 A line of credit has a limit of $120 million, in which $56 million has already been drawn. An
assumption is made that customer K will draw on the remaining credit with a 75% probability and the
cost of term funding assets in the liquidity cushion at 32bps. Calculate the rate charged for the
contingent liquidity risk of the line of credit.
A. 5.14 bps
B. 1.12 bps
C. 12.8 bps
D. 1.28 bps
Formula.
Limit-Drawn Amount
× Likelihood of Drawdown × Cost of Funding Liquidity Cushion
Limit
Hence,
($120m − $56m)
× 0.75 × 0.0032 = 0.00128 ≅12.8bps
$120m
227
Q.4203 Which of the given options most accuratel y highlights poorly designed trading book
policies?
A. Banks having trading book funding policies where some assume that assets are held for a
short-term consisting of at least 180 days.
B. Large banks with a considerably vast trading business having their investment and trading
banking activities financed as per the total net funding need in all related business units
C. Large trading businesses using inadequate haircuts on most of the assets they owe.
D. All of the above
A study carried out by the Financial Stability Institute, which analyzed 38 large banks from nine
countries, established that most of the banks had poorly designed trading book policies. Notably, the
institute found out that:
Most of the banks included in the survey did have trading book funding policies, but nearly all these
policies assumed that assets were only held short-term (i.e., for 180 days or less). One problem with
this approach is that irrespective of whether assets are likely to be held for more than the 180-day
threshold, long-term funding charges only apply when assets roll from the trading book to the banking
book.
Many of the larger banks included in the survey, particularly those with substantial trading
businesses, lacked a line of sight to individual business balance sheets, and thus could not identify the
funding requirements of individual trading desks. As a result, trading and investment banking activities
were funded based on the total net funding requirement across all related business units.
Finally, banks with significant trading businesses that participated in the survey also applied
insufficient haircuts to many of the traded assets they held.
T herefore, D is the most accurate answer.
228
Q.4204 Given that a six-year amortizing loan in recent times has the following annual liquidity
premiums: 6, 14, 18,24, 27, 32. Use the matched-maturity marginal cost of funds approach to
calculate the charge of funding liquidity risk of this loan.
A. 32.00 bps
B. 42.33 bps
C. 33.43 bps
D. 24.33 bps
(Term in year 1 × Term liquidity premium) + (Term in year 2 × Term liquidity premium)
+ ⋯ (Term in year n × Term liquidity premium)
Term in year (1 + 2 + 3+. . . +n)
T hus, the charge of funding liquidity risk of this loan is
(1 × 6) + (2 × 14) + (3 × 18) + (4 × 24) + (5 × 27) + (6 × 32)

= 24.3bps
(1 + 2 + 3 + 4 + 5 + 6)
Q.4205 Calculate the monthly payment required to amortize a loan whose principal is $225,000 at an
annual interest rate of 3.25% compounded monthly for a term of 30 years.
A. 739.23
B. 799.21
C. 979.21
D. 2700.21
(P × i)
R=
1 − (1 + i)
Note:
229
A loan of P dollars at interest rate i per period may be amortized in an equal periodic payments of R
dollars made at the end of each period.
Where:
i
r=
m
i is the interest rate per period
r is the interest rate on loan (periodic payment)
m is the number of compounding periods per year.
n=m×t
t is the term of the loan
P= 225,000
r =3.25% (0.0325)
m = 12
But,
0.0325
i=
12
n = 12 × 30 = 360
Hence,
0.0325
225, 000 ×
12
R= = $979.21
0.0325 −360
1 − (1 + )
12
230
Q.4206 Assume the following term liquidity premiums and the average cost of funds were recorded
by a bank at a point before the crisis (Pre-GFC), and more recently.
Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds
Term in years 1 2 3 4 5
Pre-Global Financial Crisis
Term liquidity premium 1 3 5 7 10
Average cost of funds 3 3 3 3 3
Current
Using the matched-maturity marginal cost of funds approach, calculate the amount of charge that a
one-year non-amortizing bullet loan will be charged for funding liquidity risk if it originated pre-crisis
and more recently, respectively.
A. $1 and $3
B. $1 and $5
C. $3 and $5
D. $10 and $35
From the table, we can see that a one-year non-amortizing bullet loan should have received a charge
of 1 bp if originated pre-crisis, and 5 bps if arisen more recently.
231
Q.4207 Suppose the following term liquidity premiums and the average cost of funds were recorded
Current
Assume that the principal of the loan was $5 million. Using the matched-maturity marginal cost of
funds approach, calculate the charge that a one-year loan translated to the business unit(s) writing
the loans if it originated pre-crisis and more recently, respectively.
A. $100 and $500
B. $500 and $2,500
C. $1,000 and $2,000
D. $2,000 and $2,500
From the table, a one-year non-amortizing bullet loan should have received a charge of 1 bp if
originated pre-crisis, and 5 bps if arisen more recently. Given the principal of the loan as $5 million.
T his should have translated to charges of $500 (0.0001×5,000,000) and $2,500 (0.0005×5,000,000),
respectively, to the business unit(s) writing the loans.
232
Q.4208 Suppose the following term liquidity premiums and the average cost of funds were recorded
Current
Prime Bank decides to use the average cost of funds approach to calculate the amount to charge for
funding liquidity risk of five-year non-amortizing loans. How much will the bank charge for funding
liquidity risk of these loans if they arose pre-crisis and more recently, respectively?
A. $1 and $5
B. $3 and $5
C. $3 and $10
D. $10 and $35
Using the average cost of funds technique, the bank will charge 3bps if originated pre-crisis, and 10
bps if arisen more recently.
233
Q.4209 A five-year linearly amortizing bullet loan has a principal amount of $2 million. T hink of these
as five separate annual loans, each of $400,000, using a matched-maturity marginal cost of funds
approach, calculate the charge that this loan receives using the information provided in the following
table:
Difference −2 2 4 5 8
A. 3.93bps
B. 8.93bps
C. 9.83bps
D. 398.00bps
Term in year (1 + 2 + 3+? + n)
(1 × 2) + (2 × 6) + (3 × 8) + (4 × 9) + (5 × 12)
= 8.93bps
(1 + 2 + 3 + 4 + 5)
234
Q.4210 T he following are problems with bank liquidity unveiled by the Great Financial Crisis (GFC).
Which is NOT?
A. Most banks failed to use the outcomes of stress-testing in determining their liquidity
cushion size
B. T he banks assumed that the assets they had had liquidity cushions believed to be highly
liquid and highly correlated.
C. Most banks preferred liquidity cushions on short-term funding, i.e., overnight on the
assumption that funds would be easy to access, and in case of any market disruptions, the
impact will be short-lived.
D. Banks accounted for the costs, benefits, and risks of liquidity in all or some aspects of
their business activities.
The correct answer i s D:According to a recent survey conducted by the Financial Stability
Institute, and it was also noted that the most striking example of poor practices was the failure of
banks to account for the costs, benefits, and risks of liquidity in all or some aspects of their business
activities. T hese banks looked at liquidity as being free and thus seeing zero liquidity risk. T herefore,
this attributed zero charges to some assets for the cost of using funding liquidity and conversely
attributed no credit to some liabilities for the benefit of providing funding liquidity
A i s i ncorrect: Banks failed to regard or had minimal factoring of the possibility of prolonged
market-wholesome instability, meaning they had deficiently sized cushions for protecting the banks
from severe unforeseen (contingent) large-scale outflows. Most of the banks’ processes of stress-
testing utilized measures that were narrow and inadequate enough as they based on historical
information. T he method utterly ignored events that occurred on current basis.
B i s i ncorrect: T he banks assumed that the assets they had had liquidity cushions believed to be
highly liquid and highly correlated. In some, they had assets that consisted of stand-by liquidity,
referring to the lack of legal claim over the asset, or they were completely free from debts.
C i s i ncorrect: Most banks preferred liquidity cushions on short-term funding, i.e., overnight on
the assumption that funds would be easy to access, and in case of any market disruptions, the impact
will be short-lived. T he technique barred negative carry costs while availing minimal motivation to
ascribe the required cost back to the businesses that brought about carry additional liquidity needs.
235
Q.4211 T here is an $80 million limit on a line of credit and $24 million already drawn. Jack is
expected to draw the remaining with a 45% probability at the cost of term funding assets in the
liquidity cushion at 24bps. Calculate the rate charged for contingent liquidity risk.
A. 0.756 bps
B. 7.56 bps
C. 0.60 bps
D. 75.6 bps
Formula.
Limit-Drawn Amount
Rate charged = × Likelihood of Drawdown
Limit
× Cost of Funding Liquidity Cushion
Hence,
($80m − $24m)
× 0.45 × 0.0024 = 0.000756 ≅7.56bps
$80m
236
Q.4212 Which of the given options is the most accurate reason why banks choose to use pooled
average costs approach to LT P?
A. It is a more straightforward method
B. It is simple, thus makes it easier for banks to understand and comply with the LT P
process.
C. T he average cost of funds approach is vulnerable to transitional changes in banks’ real

market cost of funding, therefore, minimizing net interest income deviation across all
businesses.
D. All of the above
Banks choose the pooled “average” cost of funds approach because of the following reasons:
It is simple to find the mean of the funding costs across all assets relative to charging specific assets,
transactions, or products as per their contractual maturities.
It is simple, thus makes it easier for banks to understand and comply with the LT P process.
T he approach makes it easy to apply the LMIS basics for efficient management of LT P.
T he average cost of funds approach is vulnerable to transitional changes in banks’ real market cost
of funding, therefore, minimizing net interest income deviation across all businesses.
T herefore, the most accurate answer is D:
237
Q.4213 Use the matched-maturity marginal cost of funds approach to calculate the cost of funding
liquidity risk given that a four-year amortizing bullet loan has annual liquidity premiums of 12, 17, 24,
30, respectively.
A. 23.8bps
B. 32.8bps
C. 238bps
D. 832bps
Term in year (1 + 2 + 3+? + n)
(1 × 12) + (2 × 17) + (3 × 24) + (4 × 30)

= 23.8bps
(1 + 2 + 3 + 4)
238
Q.4214 Most banks are moving towards better Liquidity T ransfer Pricing policies. Which of the
given options is the most accurate about some of the following steps banks are taking in the
actualization of improved LT P practices?
A. Banks operating with decentralized funding centers are changing towards wholesale
funding controlled centrally via a treasury function.
B. Banks are coming up with trading book procedures and policies
C. Banks with small trading book exposures in their business activities want to do away with
over-trading behaviors by applying higher funding rates on net funding needs upon breaching
certain funding limits.
D. All of the above
A towards better LTP consi sts of:
Banks operating with decentralized funding centers are changing towards wholesale funding
controlled centrally via a treasury function. T he aim is to bar arbitrage between treasury and
business units as well as between the business themselves.
Banks are coming up with trading book procedures and policies. To actualize this change, they are
developing risk limits and controls for trading activities for proper measuring, monitoring, and
assessment of liquidity threat attached in business units and products.
Banks with small trading book exposures in their business activities want to do away with over-
trading behaviors by applying higher funding rates on net funding needs upon breaching certain
funding limits.
239
Q.4215 T he following are the cost components of liquidity transfer pricing (LT P). Which of the
following is NOT?
A. Liquidity risk costs
B. Costs of the liquidity cushion
C. Costs of the liquidity reserves
D. Expense costs
Expense cost is not a component of LT P.
A i s i ncorrect: Liquidity risk costs are defined as transfer prices covering liquidity risks. T hese
costs can be split into the cost of the liquidity cushion and the cost of the liquidity reserve.
B i s i ncorrect: T he cost of the liquidity cushion refers to the cost of providing a liquidity cushion
for unanticipated cash flows obtained from product models, which are based on individual
parameters.
C i s i ncorrect: T he liquidity reserve has two primary purposes: Coverage of additional stress
scenarios (on top of the already modeled variety) as well as the assurance of regulatory compliance
(such as reaching, for example, LCR or NSFR targets). T herefore, the cost of liquidity reserves is
an integral part of LT P.
240
Reading 138: The US Dollar Shortage in Global Banking and the

International Policy Response
Q.4164 T he stretch to which banks invest in one currency and fund in another via F.X. swaps is
known as:
A. Cross currency funding
B. Funding gap
C. Carry trading
D. Hedging
Cross currency funding refers to the extent to which banks invest in one currency and fund in
another via F.X. swaps. For example, Europe and Japan banking systems mainly engaged in cross-
currency funding since 2000, taking enormous amounts of the net on-balance-sheet positions in
foreign currencies, especially in U.S. dollars.
B i s i ncorrect: A funding gap refers to the amount of money required to finance the ongoing
operations of a project or future business development that is not currently financed with debt,
equity, or cash.
C i s i ncorrect: A carry trade involves an investor holding a high-yielding currency asset (target
asset), which is financed with a low-yielding currency liability (funding liability).
D i s i ncorrect: Hedging is a strategy that is aimed at decreasing or transferring risk.
241
Q.4165 T he international policy response came into place due to the severe U.S. dollar shortage
among banks outside the United States. It brought about the following success. Which of the
following choices is the most accurate?
A. It increased the appetite for foreign currency assets
B. It led to the U.S. dollar funding gap
C. It contributed to the reversal of carry trades
D. It mitigated upward pressure and interbank rate volatility on the U.S. dollar.
T he international policy response came with the following succeeded in mitigating upward pressure
and interbank rate volatility on the U.S. dollar.
A i s i ncorrect: Increased appetite for foreign currency assets is one of the causes of the U.S
Dollar shortage during the great financial crisis.
B i s i ncorrect: Similar to A above, the U.S. dollar funding gap is one of the reasons for the U.S.
Dollar shortage during the great financial crisis.
C i s i ncorrect: During the great financial crisis, the dollar profited from the unwinding of carry
trades. T his contributed to the U.S. Dollar shortage.
242
Q.4166 In a discussion panel on mitigating the recurrence of the great financial crisis, a delegate
mentioned the following causes of the U.S Dollar shortage during the great financial crisis.
I. Increased appetite for foreign currency assets by non-US investors

II. Cross currency funding
III. U.S. dollar funding gap
Which of the above causes are correct?
A. I and II
B. I and III
C. II and III
D. All of the above
Investors had an increased thirst for foreign currency assets, notably the U.S. denominated claims on
non-bank entities. T he funding difficulty during the GFC had a direct relation to the considerable
bank's global balance sheets expansion over the past decade before the crisis.
Moreover, banks engaged in cross-currency funding. Europe and Japan banking systems mainly
engaged in investing in one currency and funding in another via F.X. swaps. Since 2000, the two
banking systems took enormous amounts of the net on-balance-sheet positions in foreign currencies,
especially in U.S. dollars. T he associated currencies exposures were left hedged off-balance-sheet
since the accumulation of net foreign currency position led to a situation where the banks were on a
foreign currency funding risk. In other words, these banks were exposed to the risk that their
funding positions could not be rolled over.
Finally, unlike domestic banks, non-US banks had limited access to a stable base of dollar deposits.
T his made them rely on short-term and potentially more volatile sources of funding, such as
commercial paper and loans from other banks, leading to the U.S. dollar funding gap.
243
Q.4167 T he banks' international balance sheet expansions since 2000 are highly associated with the
U.S. dollar shortage. T he stock on banks' foreign claims significantly grew from $10 trillion at the
start of 2000 to $34 trillion by the end of 2007. By 2001, international claims were at 10% while at
the end of 2007, it approached 30%. T hese significant improvements occurred mainly during the
financial innovation period. T his innovation period included the following, EXCEPT :
A. Expansion growth in the hedge fund industry
B. T he introduction of financial structures
C. T he spreading of universal banking
D. Auctioning of the U.S dollar.
Auctioning of the U.S dollar was an international policy response, which minimized the level of
volatile swap spread during the great financial crisis.
A, B, and C are i ncorrect: T he financial innovation period included the expansion growth in the
hedge fund industry, the introduction of financial structures, and the spreading of universal banking,
which combined proprietary trading, investment, and commercial banking activities.
244
Q.4168 You are a student in a Risk Management class. Your lecturer asks you to explain maturity
transformation across banks’ balance sheets. Which of the following is correct about maturity
transformation across banks’ balance sheets?
A. A maturity mismatch needed to facilitate long term investment projects should allow banks
to earn a spread in a negative sloping yield curve surrounding.
B. Banks do not transfer funds from agents in surplus, demanding short-term deposits to
agents in deficit with long-term financing needs.
C. Banks might be motivated to increase their maturity mismatch excessively and thus,
making themselves vulnerable to funding risks related to short-term liabilities roll-over.
D. It mitigates upward pressure and interbank rate volatility on the U.S dollar
Banks are likely to get the incentive of making increments to their maturity mismatch. T his creates
room for vulnerability to the funding risks attached to the essence of rolling-over short-term
liabilities.
A i s i ncorrect: T he maturity mismatch needed to facilitate long-term investment projects while
serving investors’ liquidity needs should allow banks to earn a spread in an environment where the
yield curve is positively sloped but not negatively sloped as the option suggests.
B i s i ncorrect: Maturity transformation remains to be one of the crucial functions of banking.
Banks are still called to transfer funds from agents in surplus demanding short-term deposits to agents
in deficit with long-term financing needs despite the notable evolution of banks’ activity through the
years
D i s i ncorrect: Mitigating upward pressure and the interbank volatility on the U.S. dollar is a
success that was achieved by the international policy response during the great financial crisis.
245
Q.4169 In a class discussion, each student was asked to mention something about the U.S dollar
shortage during the great financial crisis. T he following statements were recorded from the students’
responses.
I. T he dollar shortage refers to a situation where a country has an inadequate supply of the
dollar to manage international trade effectively.
II. During the U.S. dollar shortage, countries had to pay more U.S dollars for imports relative to
the U.S dollars received from exports.
III. T he U.S. dollar shortage refers to the mismatches between the maturity, currency, and
counterparty of assets and liabilities.
Which of the following alternatives is correct?
A. I and II
B. II and III
C. I, II, and III
Statements I and II are correct: A dollar shortage creates a situation where a country lacks a
sufficient supply of the U.S. dollar for effective management of international trade. It mainly occurs
in cases where a country has to make additional U.S dollar payments for its imports as compared to
the U.S dollar received from exports. A dollar shortage has an immense impact on global trade since
the U.S dollar acts as a 'safe haven' for other country's currencies.
Statement III is incorrect: T his statement refers to funding risk, but not the U.S. dollar shortage.
Funding risk is inherently tied to stresses across the global balance sheet mismatches between the
maturity, currency, and counterparty of assets and liabilities.
246
Q.4170 Malcolm was asked to identify two main challenges related to international lending of last
resort solved by international swap arrangements. He gave four responses as follows:
I. T he Federal Reserve and its foreign counterparts were now accorded power of creating
whatever amounts of money they choose as compared to global financial institutions
administering resources in limited nature.
II. T he auctioning of the U.S dollar led to a minimized level of volatile swap spread.
III. T he swap network does not consist of information issues that can lead to moral dangers.
IV. It mitigated upward pressure and interbank rate volatility on the U.S. dollar.
Which of the responses correctly identifies the two main challenges?
A. I and III
B. II and IV
C. I and IV
International swap arrangement mitigates two main challenges, mainly related to international lending
of last resort. T hese include:
T he Federal Reserve and its foreign counterparts are accorded the power of creating
whatever amounts of money they choose to as compared to global financial institutions
administering resources in limited nature.
T he swap network does not consist of information issues that can lead to moral dangers.
B i s i ncorrect: II and IV show the success of international policy response which include:
T he Auctioning of the U.S. dollar led to a minimized level of volatile swap spread.
It assisted in averting more large-scale distress-selling of assets with dollar denomination.
It mitigated upward pressure and interbank rate volatility on the U.S. dollar.
T his makes responses I and III correct.
247
Q.4171 T he following statements are about the structure of bank operations in long and short of the
banks’ global balance sheets. Which one is most definitely T RUE?
A. Banks management of maturity and currencies are based on a consolidated global entity
instead of per office.
B. Banks actively operating across the world have numerous offices in various countries.
C. Significant mismatches measured on an office’s balanced sheet located in a different office

may be offset/hedged off-balance sheet through an on-balance sheet position booked by other
offices elsewhere
D. All of the above
T he structure of banks’ operation requires that banks are actively operating across the world must
have numerous offices in various countries. T heir management of maturity and currencies are based
on a consolidated global entity instead of per office.
T his implies that significant mismatches measured on an office’s balanced sheet located in a different
office may be offset/hedged off-balance sheet through an on-balance sheet position booked by other
offices elsewhere.
T he result is a matched book for the bank as a whole. T hus, choice A, B, and C are true statements
about the structure of bank operations in long and short of the banks’ global balance sheets. In that
case, D is the most accurate answer.
248
Q.4172 Which of the following entails an investor holding a high-yielding currency asset (target
asset), which is financed with a low-yielding currency liability (funding liability)?
A. Carry trade
B. Cross currency funding
C. Hedging
D. Funding gap
A carry trade involves an investor holding a high-yielding currency asset (target asset), which is
financed with a low-yielding currency liability (funding liability).
B i s i ncorrect: Cross-currency funding refers to the extent to which banks invest in one currency
and fund it another via F.X swaps.
C i s i ncorrect: Hedging refers to a strategy that aims at decreasing or transferring risk.
D i s i ncorrect: Funding gap refers to the amount of money required to finance the ongoing
operations of a project or future business development that is not currently financed with debt,
equity, or cash.
249
Q.4173 Why is the U.S. dollar is referred to as a “safe haven”?
A. It acts as a peg for other countries due to its liquidity.
B. It has less value relative to other currencies.
C. It is highly illiquid
D. T he U.S. has weak political systems
Some features make a currency a “safe haven” for other currencies. One of them is acting as a peg
for other countries since it is highly liquid. Moreover, it is of high value, as compared to other
currencies. Finally, the United States has a stable political system. T hese make the U.S. dollar be
known as a safe haven.
B i s i ncorrect: T he U.S. dollar is considered to have the most substantial value as compared to
other currencies.
C i s i ncorrect: T he U.S. dollar has high liquidity. In other words, it is easy to buy or sell.
D i s i ncorrect: T he United States has a stable political system; thus, making the U.S. dollar a stable
currency against other currencies.
250
Q.4174 Bank Y wants to investigate whether there is a disconnect between its short-term assets and
short-term liabilities, commonly known as maturity/currency mismatch. T he bank’s manager decided
to employ a team that assesses the maturity mismatch across its balance sheet. Upon establishing a
maturity mismatch in the bank’s balance sheet, the team outlines the following reasons that imply a
maturity mismatch:
I. When the bank has more liabilities than assets.

II. When a hedging instrument and the underlying asset's maturities are misaligned
III. When the bank has more assets than liabilities
Which of the following options given by the team is correct?
A. I and II
B. I and III
C. I, II, and III
D. III
Maturity mismatch occurs where the liabilities exceed the assets. Additionally, a misalignment of the
underlying assets and hedging instruments’ maturities results in a maturity mismatch.
Options B, C, and D are wrong since III shows efficient use of the company's assets thus, the reason
for more assets than liabilities
251
Q.4175 T he federal reserve may extend a loan using nominal figure collateral of foreign currencies
to foreign central banks. Moreover, a bank can access the funds through U.S. dollar auction in the
bank's respective jurisdiction/country. Which of the following best describes this?
A. International lending of last resort
B. Maturity transformation across banks' balance sheets
C. Cross-currency funding
D. Balance sheet expansion
T he Federal Reserve participates in international lending of last resort when issuing U.S. dollars on a
universal scale. A swap network is a method used by Federal Reserve to extend loans with foreign
currencies collaterals to other countries' central banks. T his makes the funds available via
auctioning of the U.S. dollar in their respective states/ jurisdiction. T he outcome is that commercial
banks across the world can access U.S. dollar liquidity, without excluding those that lacked sufficient
eligible collateral and subsidiaries as they can directly borrow from the Federal Reserve system.
B i s i ncorrect: Maturity mismatch is a situation where there is a disconnect between a bank’s
short-term assets and its short-term liabilities. T he occurrences during the GFC highly disrupted
bank's sources of short-term funding. T he seizure of interbank and F.X. swap market dislocation led
to the high accessibility of U.S. dollars via swaps. For adequate maturation of the U.S. dollar, funding
was shortened while the assets increased, resulting in market stresses. T hus, the U.S. dollar
shortage was highly caused by maturity mismatches and difficulties to hedge ante.
C i s i ncorrect: Cross-currency funding refers to the extent to which banks invest in one currency
and fund in another.
D i s i ncorrect: T he banks' international balance sheet expansions since 2000 are highly associated
with the U.S. dollar shortage. T he stock on banks' foreign claims significantly grew from $10 trillion
at the start of 2000 to $34 trillion by the end of 2007. By 2001, international claims were at 10%
while at the end of 2007, it approached 30%. T hese significant improvements occurred mainly during
the financial innovation period. It included expansion growth in the hedge fund industry, the
introduction of financial structures, and the spreading of universal banking, which combined
proprietary trading, investment, and commercial banking activities.
252
Q.4176 Which of the following correctly defines the U.S. dollar funding gap?
A. T he amount of U.S. dollars invested in longer-term assets which are not supported by
longer-term U.S. dollar liabilities.
B. An offshore investment fund, typically formed as a private limited partnership that engages
in speculation using a credit or borrowed capital.
C. A scenario where a country lacks a sufficient supply of the U.S. dollar for effective
management of international trade.
D. A situation that involves an investor holding a high-yielding currency asset (target asset),
which is financed with a low-yielding currency liability (funding liability).
T he U.S. dollar funding gap refers to the amount’s banks are required to have it rolled over before
the maturity of their investments. In other words, it refers to the amount of U.S. dollars invested in
longer-term assets lacking the support from longer-term U.S. dollar liabilities.
B i s i ncorrect: T his option defines a hedge fund. It is a fund that operates as an offshore
investment fund, formed as a private limited partnership that engages in speculation by utilizing
borrowed and credit.
C i s i ncorrect: It refers to a dollar shortage, a situation where a country lacks a sufficient supply
of the U.S. dollar for effective management of international trade. It occurs when a country is
required to pay more U.S. dollars for its imports as compared to the U.S. dollars received from
exports.
D i s correct: It refers to carry trade. A carry trade involves an investor holding a high-yielding
currency asset (target asset), which is financed with a low-yielding currency liability (funding
liability). By the time when financial markets became volatile, the target currencies with the most
lucrative yields significantly depreciate, and the funding currencies appreciate. T his was the case
during the GFC. T he dollar interest rates decline by mid-2008 had already recommended the dollar to
carry traders as a funding currency alongside the yen.
253
Q.4177 A maturity mismatch commonly involves a firm's balance sheet. Which of the following is
correct about a maturity mismatch?
A. It is not visible on a firm’s balance sheet and masks its liquidity.
B. Involves short-term borrowers funding long-term assets
C. It cannot occur in hedging
D. T he maturity mismatch needed for the facilitation of long-term investment projects and
for serving the liquidity needs of the investor should allow banks to earn a spread in a
negatively sloped yield curve surrounding.
When there are maturity mismatches in a firm’s balance sheet, it means that the firm is funding a
longer-term asset using a shorter-term liability.
A i s i ncorrect: Maturity mismatches are visible in a firm’s balance sheets and can bring to light
liquidity issues associated with the institution. It sheds light on how the maturity of its liabilities and
assets are organized in the firm.
C i s i ncorrect: Mismatches can also take place in hedging. T his occurs when an underlying asset’s
maturity does not match the hedging instrument, therefore resulting in an imperfect hedge.
D i s i ncorrect: T he maturity mismatch needed for the facilitation of long-term investment projects
and for serving the liquidity needs of the investor should allow banks to earn a spread in a positively
sloped yield curve surrounding.
254
Reading 139: Covered Interest Rate Parity Lost: Understanding the

Cross-Currency Basis
Q.4178 Bright Ltd., a US-based corporation, enters a currency basis swap with Gamble, a British
company, in which the original principal amounts are $300 million and £240 million. T hat is: At
inception, there is an initial principal exchange in which Bright Ltd. pays Gamble $300 million and
receives £240 million. Subsequently, at each interest payment date, Bright Ltd pays Gamble the GBP-
Libor rate on £240million and receives the USD-Libor rate on $300 million. Finally, at maturity, a re-
exchange of principals occurs in which Bright Ltd pays £240million in exchange for $300 million.
Suppose the spot exchange rate is $1.25 = £1 at the time of entering the swap. Assuming Bright Ltd.
And Gamble both have AA credit ratings at this time and can access funds at Libor flat, the value of
the swap at inception to Bright Ltd is?
A. Positive
B. Negative
C. Zero
D. Cannot be determined from the above information
A cross-currency swap does not involve an initial capital outlay since its initial market value is zero.
255
Q.4180 Suppose the market USD/EUR spot exchange rate is 1.3536 EUR with a one-year forward
rate of 1.3280 EUR. T he market consists of a risk-free rate of 4% USD and 6% EUR per annum,
respectively. Calculate the ratio of returns.
A. 0.1097
B. 0.9811
C. 12.4500
D. 109.7000
Covered interest rate parity is checked using the formula:
F 1 +r
=
S 1 + r∗
1+r
T he ratio of returns =
1 + r∗
Where:
r is the US dollar interest rate
r* is the foreign currency interest rate.
1 + 4%
= = 0.9811
1 + 6%
256
Q.4181 Suppose the market USD/EUR spot exchange rate is 1.3536 EUR with a one-year forward
rate of 1.3280 EUR. T he market consists of a risk-free rate of 4% USD and 6% EUR, respectively.
Calculate the ratio of forward rate to spot rate.
A. 0.9811
B. 1.0193
C. 0.0189
D. 1.5467
F 1.3280
T he ratio of forward to spot rate = = = 0.9811
S 1.3536
257
Q.4183 Walter runs a business in the United States. He wants to purchase some materials for his
warehouse from France. Walter decides to purchase the warehouse on a mortgage that needs him to
make the payments in euros. However, since his company is in the United States, the main currency
he will receive when conducting business is dollars. T hus, he is required to have the U.S dollars
converted to Euros so that he can make payments to his mortgage in France. Unfortunately, the
dollar’s value is weakening against the euro. T his means that Walter will have to pay expensively for
the mortgage payments. What should Walter do so that he does not end up paying a mortgage that
keeps getting more expensive?
A. He should adopt a cross-currency swap.
B. He should adopt a carry trade
C. He should avoid entering any swaps
D. He should wait until when the foreign exchange market has stabilized
For Walter’s situation, adopting a cross-currency swap will assist him because he will borrow dollars
and have them converted to Euros at a fixed rate. As such, Walter will take out a loan and make
interest payments in dollars in his home currency instead of in Euros.
B i s i ncorrect: A carry trade does not apply to Walter’s case since it involves an investor holding a
high-yielding currency asset (target asset), which is financed with a low-yielding currency liability
(funding liability).
C i s i ncorrect: Avoiding entering any swaps at all is the same as raising the USD funds for exchange
and leaving it unhedged. T hus, not a good option for Walter.
D i s i ncorrect: T he foreign exchange market cannot stabilize because it is susceptible to
numerous risks. T he least that banks, institutions, and governments wishing to participate in
international trading can do is to apply cross-currency swaps in their transactions.
258
Q.4184 Counterparty A wants to carry out a cross-currency swap where it will exchange the
sterling pound for the U.S. dollar with counterparty B. Today, the U.S Libor rate is 1.0% while the
sterling pound Libor rate is -2.6%. A dollar shortage occurs, and counterparty B quotes a basis of -40
bps. Compute the cost of the swap for counterparty A. (Assume that both parties pay interest on the
currency they receive.)
A. 4.0%
B. 2.0%
C. 2.6%
D. 3.2%
Cost of the swap = 1.0% + 2.6% + 0.4% = 4.0%
Note: T he Sterling pound Libor is negative (-2.6%); thus, counterparty B will also have to pay for it,
hence the reason why we add it.
Detai l ed Expl anati on
Counterparty A is exchanging pounds for dollars. In other words, it's giving out pounds to receive
dollars. Both parties pay interest on the currency they receive (because they have technically
borrowed that currency). In our case, A should pay the dollar LIBOR (1%) plus the cross-currency
basis (-0.4%). Because B has "borrowed" the pound from A, it should pay the pound LIBOR (-2.6%) to
A. But here's the problem: this rate is negative, and just like in any other scenario where the interest
rate is negative, i t woul d be the l ender and not the borrower, who pays the i nterest.
Counterparty A would have to pay pound interest to B.
At the end of the day, therefore, the total theoretical cost of the Pound/USD currency swap to A is
1% +0.4% + 2.6% = 4.0%
If the pound LIBOR was +2.6%, party A would have actually received interest on the pound. A's cost
would have been 1% +0.4% - 2.6% = -1.2%; it would receive a net rate of interest of 1.2% from B.
259
Q.4185 Company A wants to transform $60 million floating rate debt into a fixed rate GBP loan. On
trade date, Company A exchanges $60 million with Company B in return for 48 million GBP. Calculate
the GBP/USD exchange rate if their agreement is set to expire in 10 years.
A. 0.50
B. 0.86
C. 0.80
D. 1.25
60
GBP/USD = = 1.25
48
Note that,
T he way Foreign exchange is quoted is always interpreted as; you exchange many units of the
denominator currency for 1 unit of the given numerator currency. T he rates are different when you
quote GBP/USD or USD/GBP.
For example, in this case, USD/GBP=0.8.
However, the general idea here is to quote GBP/USD instead of USD/GBP.
260
Q.4186 Assume that two parties enter a five -year FX currency swap for 100 million. Party, A is a
US firm, while the other, B, is a European firm. T he EUR/USD exchange rate is $1.25 by the time
the swap is arranged. In other words, the dollar is EUR 0.8. T he start of the swap is December 31st,
2019. On this date, A pays B $100m, while B pays A EUR 80m. Assume that the agreed dollar interest
rate is 6%, while the euro interest rate is 3.5%. Calculate the amount that company A pays annually
to company B.
A. €800,000
B. €900,000
C. €1,900,000
D. €2,800,000
Every year, company A pays €80,000,000×3.5% = €2,800,000 to Company B.
Q.4187 Assume that a U.S. firm A wants to acquire Japanese yen while a Japanese firm, B, is aiming
to borrow U.S. dollars (USD). Suppose that A wants to borrow ¥100 million. T he Japanese firm needs
$50 million. T he two firms enter a USD/JPY swap with an exchange rate of 2. Calculate the quarterly
interest amount that A pays to B, given that A pays 4% on ¥100 million annually, and the interest
rates remain unchanged.
A. ¥250,000
B. ¥500,000
C. ¥1,000,000
D. ¥1,500,000
4 1
× 100, 000, 000 × = ¥1, 000, 000
100 4
261
Q.4188 An investor borrows $2,000 and converts the funds into British pounds, allowing him to
purchase a British bond. If the purchased bond has a yield of 8% while the equivalent U.S. bond yield
is 5%, calculate the interest rate differential if the exchange rate between dollars and pounds
remains constant.
A. 3.0%
B. 5.0%
C. 6.5%
D. 13.0%
An interest rate differential is simply the difference in the interest rate between two currencies.
T his differential in the cash money markets should equal the differential between the forward and
spot exchange rates. Otherwise, arbitrageurs could make a seemingly riskless profit.
In this case, the interest rate differential = 8% - 5%. = 3%
Q.4189 Calculate the 1-year Euro interest rate that will satisfy the covered interest rate parity if the
EUR/USD spot rate is $1.32 and the U.S dollar has a 1-year interest rate of 6% and the EUR/USD
forward rate is 1.22.
A. 10.24%
B. 29.32%
C. 12.42%
D. 14.69%
(1 + R U SD )
FEUR/USD = S
(1 + R E UR )
(1.06)
1.22 = 1.32
(1 + R EU R)
1.22
⇒ R EUR = −1
1.32 × 1.06
= 0.14688
T hus, the one-year Euro interest rate is 14.69%
262
Q.4190 A Japanese company X wants to compute the one-year forward USD/JPY rate, with a spot
yen selling at 132 USD/JPY. T he JPY per annum interest rate is equal to 4%, and the annual interest
rate for USD is 11%. Calculate the one-year forward exchange rate USD/JPY.
A. 0.14
B. 123.68
C. 136.87
D. 140.88
According to covered interest rate parity, the interest rate differential between two countries is
equal to the differential between the forward exchange rate and the spot exchange rate.
T he forward exchange rate is given by:
T
1 + R JP Y
F = S ×( )
1 + R U SD
1.04 1
= 132 × ( )
1.11
= 123.6758
263
Q.4191 FX swaps and Currency Swaps are derivative instruments utilized in the hedging of foreign
currency exposures. Which of the following correctly points out the similarities between the two?
A. T hey entail the exchange of two different currencies at the start of the contract and the
reversal at the same currencies back to their original currencies at the end of the contract.
B. T hey are applied when hedging against fluctuations in the foreign exchange rate.
C. T hey are both agreements that need no starting outlay since they both consist of an initial
market value of zero
FX swaps and cross-currency swaps are two derivative instruments used in hedging. FX swaps and
cross-currency swaps entail the exchange of two different currencies at the start and the reversal at
the same currencies at the end of the contract. Moreover, both agreements do not need a starting
outlay since they both consist of an initial market value of zero. Finally, they are used in hedging
against fluctuations in the foreign exchange rate.
Q.4192 A hypothetical condition where the correlation between interest rates, spot and forwards
currency value of two countries are equal is referred to as:
A. FX swaps
B. Cross-currency swaps
C. Covered Interest Rate Parity
D. Mark-to-market
CIP is a textbook no-arbitrage condition according to which interest rates on two otherwise identical
assets in two different currencies should be equal once the foreign currency risk is hedged:
F 1 +r
=
S 1 + r∗
Where:
S is the spot exchange rate in US dollar per foreign currency
264
F is the corresponding forward exchange rate
r is the US dollar interest rate
r* is the foreign currency interest rate.
A i s i ncorrect: In an FX swap agreement, one party borrows one currency from and, at the same
time, lends another to a second party. Each party utilizes the repayment obligation as the collateral.
Moreover, the repayment amount is fixed at the FX forward rate as of the beginning of the contract.
B i s i ncorrect: A Cross currency swap is an over the counter (OT C) derivative in the form of a
contract between two parties who purpose to exchange interest payments and principal in different
denominated currencies.
D i s i ncorrect: Mark-to-market refers to a contract where two parties exchange foreign currency
contracts to some assumed amounts of the loan, meaning as the exchange rates shift/change, there
are small amounts of cash that are transferred between the two companies for compensation. T hus,
the loan’s value is maintained the same based on marked-to-market.
Q.4193 Assume that the GBP/USD spot exchange rate is 1.500 (i.e., 1 GBP = 1.500 USD). Further
assume that the 180-day USD LIBOR rate stands at 1.2%, and the 180-day GBP LIBOR rate is 2.0%.
Compute the 180-day forward GBP/USD exchange rate.
A. 1.4882
B. 1.4292
C. 1.4276
D. 1.4941
(1 + r × T )
F = S×
(1 + r∗ × T )
180
⎛ 1 + 0.012 × 360⎞
= 1.500
⎝ 1 + 0.02 × 180 ⎠
360
= 1.49405
265
Q.4194 Assuming a forward rate of $0.40/JPY, a one-year interest rate for the U.S. currency of 5%,
and a spot rate of $0.5/JPY, calculate the current one-year JPY interest rate that will satisfy the
covered interest rate parity.
A. 14.35%
B. 16.53%
C. 31.25%
D. 41.53%
F 1 +r
=
S 1 + r∗
S
r∗ = (1 + r) −1
F
0.50
= ((1 + 0.05) × ) − 1 = 0.3125
0.40
JPY i nterest rate 31.25%
266
Q.4195 A currency swap bears counterparty risk unlike an interest-rate swap because:
A. Counterparties are in different countries, making the currency swap vulnerable to

different legal systems, unlike an interest rate swap.
B. T he currency swap involves an exchange and re-exchange of principal amounts, unlike an

interest rate swap, making the swap susceptible to movements in exchange rates.
C. FX markets have more credit risk than interest rate markets.
D. Each counterparty is having a lower probability of defaulting in its home currency than in
a foreign currency.
A currency swap is a contract in which two parties exchange the notional amount of a loan and the
interest in one currency for the principal and interest in another currency.
At the start of the swap, equivalent principal amounts are swapped at the spot rate. During the term
of the swap, each party pays the interest on the swapped principal loan amount. T he principal
amounts are exchanged back at r the spot rate prevailing or pre-agreed rate at the end of the
contract. T hese transactions face movement in exchange rates. However, using the initial rate
would remove transaction risk on the swap. T hus, B is the most valid answer.
A, C and D are incorrect.
267
Reading 140: Risk Management for Changing Interest Rates: Asset-

Liability Management and Duration Techniques
Q.4228 Bright Bank posted the following financial entries:
Interest revenues $83

Interest costs $72
Total earning assets $942
Calculate the bank’s net interest margin.
A. 1.17%
B. 1.56%
C. 2.25%
D. 4.78%
Net interest income

Net interest margin (NIM) =
Total earning assets
$83 − $72
Net Interest Margin = = 0.011677 ≈ 1.17%
$942
268
Q.4229 National Bank has a cumulative gap for the coming year of +$128 million. T he interest rates
are expected to decrease by one and a half percentage points. Calculate the expected change in the
Bank’s net interest income.
A. -1.23
B. -1.92
C. 1.89
D. 128
Change in net interest income

= Total change in interest rate (Percentage points)
× Size of cumulative gap in dollars.
T hus,
Expected change in net interest income = $128 × (−0.015) = −1.92
Q.4230 Mutual Friends Bank has interest-sensitive assets worth $470 million and interest-sensitive
liabilities of $876 million. Calculate its dollar interest-sensitive gap.
A. -$406m
B. -$470m
C. -$876m
D. -$1,346m
Dollar interest sensitive gap(IS GAP) = Interest sensitive assets (IS GAP)
− Interest sensitive liabilities (ISL)
= $470 − $876 = −$406m
269
Q.4231 Mutual Friends Bank has interest-sensitive assets worth $470 million and interest-sensitive
liabilities of $876 million and the total value of assets is $1000 million.
Calculate its relative interest-sensitive gap ratio.
A. -30.00%
B. -40.87%
C. -40.60%
D. -50.32%
ISGap
Relative Gap =
Total Assets
($470 − $876)
≈ −0.406 or − 40.60%
$1000
Q.4232 Davidson Bank registered a net interest margin of 2.45% in its previous financial report, with
total interest revenues of $100 million and total interest expenses worth $64 million. Compute the
volume of the earning assets held by the bank.
A. $845.67 million
B. $1,045.23 million
C. $1,236.87 million
D. $1,469.39 million
Net interest income

Net interest margin =
(100 − 64) million
0.0245 =
(100 − 64) million
⇒ Total earning assets =
0.0245
= $1,469.39 million
270
Q.4233 Banks find it challenging to forecast interest rate changes on an individual level. Which of the
following correctly identifies factors as to why this happens?
A. Interest rates are determined by the numerous investors trading in the credit market. A
group of banks or an individual cannot set the interest rates.
B. Each market rate of interest has various components – the risk-free interest rate plus
different risk premia. A change in any of these rate components can cause interest rates to
change.
C. Bankers need to have perfect timing to be able to identify the changes in interest rates.
T hat is, to maximize their predictions, they must have an insight into when the changes will
take place.
Generally, it is hard for interest rates to be set by only one bank or a group of banks; instead,
thousands of investors in the credit market take part in determining the interest rates. More so, in
each interest rate market, various components impact interest rates making it fluctuate. For
consistent and correct forecasting of the interest rates, banks need to look out for changes in the
interest rates components. Also, bankers need to have perfect timing to be able to identify the
changes in interest rates. T hat is, to maximize their predictions, they must have an insight into when
the changes will take place.
271
Q.4234 T he purchase price of a government bond is $750. It pays $150 per year in interest for 4
years when it matures. If the redemption value of this bond is $1,000, calculate its yield to maturity
if it is purchased today for $750.
A. 12.00%
B. 13.23%
C. 24.87%
D. 25.73%
$150 $150 $150 $150 $1000

$750 = + + + +
1 2 3 4
(1 + YT M) (1 + YT M) (1 + YT M) (1 + YT M) (1 + YT M)4
At YT M of 26%, the bond’s price is $744.78, while at 25%, its bond price is 763.84. T herefore, the
actual YT M is between 25% and 26%.
By linear interpolation, we calculate YT M as follows:
763.84 − 750
YT M = 0.25 + × 0.01 = 0.2573 ≈ 25.73%
763.84 − 744.78
272
Q.4235 Suppose that Millennial National bank consists of an average asset duration of 2.53 years and
an average liability duration of 0.65years. Its assets size is a total of $367 million, and the volume of
its liabilities is $219 million. Suppose that its original interest rates were 5% before rising to 8.5%.
Compute Millennial National Bank’s estimated leverage adjusted the duration gap and the change in its
net worth as a result of the rise in interest rates.
A. +1.34 years, -$10.34million
B. +2.14 years, -D10$12.56million
C. +1.34 years, -$13.10million
D. +2.14 years, -$26.21million
Leverage Adjusted Duration Gap

Total Liabilities
= Dollar-weighted duration of Assets Portfolio − Dollar-weighted Duration of Liability Portfolio ×
Total Assets
Millennial National Bank’s duration gap is:
219
2.53 − 0.65 × = +2.14 years
367
T he change in net worth:
Δr Δr
Change in value of net worth = −DA × × A − [−DL × × L]
(1 + r) (1 + r)
+0.035 +0.035
− 2.53 × × 367 − [−0.65 × × 219] = −$26.21 million
(1 + 0.05) (1 + 0.05)
T his means that Millennial National Bank’s net worth will drop by approximately $26.21 million if the
interest increases by 3.5%.
273
Q.4236 A financial firm is seeking to have itself hedged against interest rate fluctuations by the use of
duration-gap analysis. How can the firm management get to know when it is fully hedged through this
approach?
A. When fully hedged, it will have a zero-duration gap position.
B. When it can track the variations between the interest earned on loans and the interest
paid on deposits
C. When it can get a clear comparison of the amount of liabilities and assets in each period in
the interest rate sensitivity gap table, enabling it to get an estimated perspective of the
interest rates risk of the firm’s balance sheet being assessed.
D. When it has higher interest-rate sensitive liabilities relative to its interest-rate sensitive
assets.
Financial Firm W can know when it is fully hedged if its dollar-weighted duration of the asset’s
portfolio is equivalent to the dollar-weighted duration of the liability portfolio. T his implies that it has
a zero duration-gap position.
B i s i ncorrect: It refers to the application of asset-liability management in aiding banks to hedge
against interest rate risks. ALM supports banks in tracking the variations between the interest
earned on loans and the interest paid on deposits, which is generally referred to as interest rate
margins.
C i s i ncorrect: It refers to an interest-sensitive gap management application in which the interest
rate sensitivity gap is used in comparing the amount of liabilities and assets in each period in the
interest rate sensitivity gap table. T hus, through the comparison, an estimated perspective of the
interest rate risk of the balance sheet undergoing analysis is achieved.
D i s i ncorrect: It refers to a negative gap where the ratio is less than one and is as a result of a
bank’s interest-rate sensitive liabilities being more than interest-sensitive assets.
274
Q.4237 Suppose that a hypothetical bank has an average yield on rate-sensitive and fixed assets of 5%
and 10%, respectively. Additionally, the bank has rate-sensitive and non-rate-sensitive liabilities cost
of 4% and 6%, respectively. During the coming week, the bank holds $542 million in rate-sensitive
assets and $156 million in rate-sensitive liabilities. Assume that the asset total is $1,212. Further,
suppose that these annualized interest rates remain steady. Assuming that equity is zero, calculate
the firm’s net interest income on an annualized basis.
A. 20.0 million
B. 23.4 million
C. 24.5 million
D. 30.0 million
Net interest income = Total interest income − Total interest cost

= [Average interest yield on rate-sensitive assets × Volume of rate-sensitive assets
+ Average interest yield on fixed (non-rate-sensitive) assets × Volume of fixed assets]
− [Average interest cost on rate-sensitive liabilities × Volume of interest-sensitive liabilities
− Average interest cost on fixed (non-rate-sensitive) liabilities × Volume of fixed
(non-rate-sensitive) liabilities]
= 0.05 × $542 + 0.10 × [$1, 212 − $542] − 0.04 × $156 − 0.06 × [$1, 212 − $156]
= $24.5 million
Note:
T he balance sheet is based on the fundamental equation:
Assets = Li abi l i ti es + Equi ty
In this case, we've been told there's no equity, which means that:
Assets = Li abi l i ti es
275
Q.4238 T he interest-sensitive gap approach is not enough to fully hedge a financial firm from interest
rates risks, thus the need for duration-gap management. T he information below identifies some of the
disadvantages of duration-gap management, which one is NOT ?
A. Duration matching (immunization) can be costly and time-consuming
B. Immunization is a dynamic problem such that the duration of liabilities and assets changes
as they near their maturity
C. T he interest-sensitive gap fails to put into consideration the implications of interest rate
fluctuations on the positions of equity
D. Duration is not accurate for significant interest rate changes unless convexity is taken
into account
It is a disadvantage of using the interest-sensitive GAP approach. T he duration gap management

approach takes into account the effects of interest rate fluctuations on equity positions.
A, B and D are i ncorrect: T hey provide the correct limitations of using duration-gap management,
where they generally include:
It is hard to find liabilities and assets of the same duration.
Some liabilities and assets may fail to have well a defined pattern of cash flows, thus,
making it difficult to calculate the duration.
Customer prepayments of loans might distort the anticipated cash inflows in a particular
duration.
Also, the expected cash inflows in duration can be disrupted by the customers defaulting
payments (credit risk).
T he duration gap approach assumes that there is the existence of a linear relationship
between the market value of liabilities and assets and interest rates, which is not entirely
true.
276
Q.4239 Suppose that a treasury bill has a face value of $100 set for payment at maturity. Its purchase
price is $88. If the security is to mature in 120 days, calculate the interest rate measured using the
bank discount rate.
A. 18%
B. 20%
C. 24%
D. 36%
(100 − 88) 360

DR = × = 0.36 = 36%
100 120
Q.4240 Assume that a treasury bill has a face value of $100 set for payment at maturity. Its purchase
price is $88. If the security is to mature in 120 days, calculate the YT M equivalent yield of this bill.
A. 36.00%
B. 41.48%
C. 50.86%
D. 56.24%
(100 − Purchase Price) 365

YT M equivalent yield = ×
Purchase Price Days of maturity
(100 − 88) 365
= × = 41.48%
88 120
277
Q.4241 Pride Bank’s interest-sensitive assets have a value of $500, and its interest-sensitive
liabilities are worth $300. Calculate the interest-sensitive ratio of the bank.
A. 1.67
B. 2.54
C. 2.67
D. 3.84
ISA
Interest Sensitive Ratio (ISR) =
ISL
$500
= = 1.67
$300
Q.4242 Barnhill Bank holds $24 million in government bonds with a duration of 8 years. Suppose that
there is a sudden rise in the interest rates from 7% to 9.5%. Compute the percentage change that
should take place in the bond’s market price.
A. -18.69%
B. -4.56%
C. 7.00%
D. 9.50%
ΔP Δi
= −D [ ]
P (1 + i)
ΔP +0.025
= −8 years × [ ] = −0.1869 or − 18.69%
P (1 + 0.07)
T he market price will decrease by 18.69%
278
Q.4243 Assuming that Green House National bank holds liabilities and assets with the following
average duration and dollar amount as given below:
Asset Avg. Dollar Liability Avg. Dollar

Composition Duration Amount Composition Duration Amount
(Years) (M) (Years) (M)
Investment- 7.5 80 Deposits 2.3 $376
grade bonds
Commercial 4.23 423 Non-deposit 0.12 $25
loans borrowings
Consumer 3.2 $145
loans
Total Assets $648 Total $401
Liabilities
Calculate the dollar-weighted duration of the bank’s liability portfolio and asset portfolio; thus,
calculate the leverage-adjusted duration gap, respectively.
A. 2.16 years, 4.40 years, 3.06 years
B. 3.06 years, 4.40 years, 2.16 years
C. 4.40 years, 2.16 years, 3.06 years
D. 0.12 years, 3.2 years, 4.23 years
80 423 145
DA = 7.5 × + 4.23 × + 3.2 × = 4.40 years
648 648 648
376 25
DL = 2.3 × + 0.12 × = 2.16 years
401 401
T hus, the leverage-adjusted duration gap is
Total Liabilities
DA – DL ×
Total Assets
Leverage-adjusted duration Gap
401
4.40 − 2.16 × = 3.06 years
648
279
Q.4244 A Canadian T reasury bill is available for purchase this week with a price of $89.84 based on a
par value of $100, with its maturity indicated as 124 days. Calculate the discounted rate of this
treasury bill.
A. 2.950 %
B. 29.500%
C. 32.950%
D. 295.000%
100 − Purchase price on loan or security

DR = ( )
100
360
×
Number of days to maturity
100 − 89.84 360
=( )× = 0.2949 ≈ 29.5%
100 124
280
Reading 141: Illiquid Assets
Q.2426 Jude Wang, a portfolio manager, works at an investment management firm. She has been
recently asked to manage the endowment fund of a large university. She meets the head of the
university to discuss finer details about the fund, including the composition of the endowment fund.
T he university head informs her that the university plans to withdraw a substantial amount of the
fund in next two years and use the money to establish a state-of-the-art financial laboratory. He also
adds that the university board desires to keep the transaction cost as low as possible. After the
discussion, Wang meets her colleague, Jane Jones, with whom she explores the asset classes that can
possibly be included in the endowment fund. According to Jones, Wang should consider including
private equity and real estate in the endowment fund as these asset classes have low correlation
with stocks and bonds and can provide a better diversification effect to the overall portfolio. Jones
goes further to opine that private equity and real estate would make it easier for Wang to generate an
excess return compared to stocks and bonds.
Which of the following does not support the idea of including private equity and real estate in the
portfolio?
A. It would provide a better diversification effect to the portfolio.
B. It would help Wang to generate an excess return.
C. T he university needs a substantial amount of funds in next two years for the laboratory.
D. It would improve the portfolio because of the assets’ low correlation with stocks and
bonds.
Private equity and real estate fall under the category of illiquid assets. Large trades of illiquid assets
results in substantial market movement which may in turn trigger adverse price movements. T hus,
an investor trying to cash in on illiquid assets in a short time period may have to suffer significant
losses due to adverse price movement. Barring a change of plans by the university, a substantial
amount of money is needed in next two years – and that’s where the problem lies. If the fund invests
in illiquid assets, divesting such assets may force the institution to accept a lower market price or
incur substantial transaction costs. T herefore, investment in illiquid assets must be avoided.
281
Q.2427 Jude Wang, a portfolio manager, works at an investment management firm. She has been
recently asked to manage the endowment fund of a large university. She meets the head of the
university to discuss finer details about the fund, including the composition of the endowment fund.
T he university head informs her that the university plans to withdraw a substantial amount of the
fund in next two years and use the money to establish a state-of-the-art financial laboratory. He also
adds that the university board desires to keep the transaction cost as low as possible. After the
discussion, Wang meets her colleague, Jane Jones, with whom she explores the asset classes that can
possibly be included in the endowment fund. According to Jones, Wang should consider including
private equity and real estate in the endowment fund as these asset classes have low correlation
with stocks and bonds and can provide a better diversification effect to the overall portfolio. Jones
goes further to opine that private equity and real estate would make it easier for Wang to generate an
excess return compared to stocks and bonds.
Which of the following statements is correct?
A. Jones may include private equity and real estate since they will reduce transaction costs.
B. Jones must not include private equity and real estate because they may increase
transaction costs.
C. T he inclusion of private equity and real estate in the portfolio will have no effect on
transaction costs.
D. Private equity and real estate will make the portfolio more diversified and reduce
transaction costs.
Illiquid assets are characterized by information asymmetry. As the information regarding illiquid
assets is not readily available, the cost of obtaining information on such assets is very high.
T herefore, this increases transaction costs.
282
Q.2428 T he bias associated with returns being observed only when the underlying asset values are
high is best known as:
A. Selection bias
B. Survivorship bias
C. Infrequent trading
Selection bias results from the tendency of returns only to be observed when underlying asset
values are high. For example, buildings are sold only when property has a high value and companies
are made public only when stock values are high in buyout funds etc.
B is incorrect: Survivorship bias or survivor bias occurs when funds stop reporting low returns
C is incorrect: Reported returns under infrequent trading underestimate risks (volatilities,

correlations, and betas).
Q.2429 Illiquid assets can generate excess return because:
A. T hey allow the transfer of idiosyncratic risk from liquid markets.
B. T hey reduce transaction costs.
C. T hey generate arbitrage opportunities.
D. T hey require huge investments.
Liquid asset markets are information efficient. Information regarding the assets is freely available
and every participant has equal access. T his makes the generation of alpha (excess return) in such
markets a challenging task. However, the market for illiquid assets markets is fraught with
information asymmetry. T his information asymmetry can be exploited to generate excess return.
T hus, the idiosyncratic risk of liquid assets can be transferred to illiquid assets and help generate
excess returns.
283
Q.2430 Sam Kesler, a portfolio manager, is trying to select stocks for his portfolio. T he investment
policy statement of the fund indicates that the portfolio must consist of only liquid stocks. Kesler has
the following investment options:
Category Stock Information

Mid Cap X Going by the latest trading information available, the stock could
be sold at $12.30 and purchased at $12.32.
Mid Cap Y T he majority shareholding of the company rests with a family. T he
daily turnover of the shares equals 100 stocks only.
Large Cap Z T he stock was last traded 2 days ago.
Small Cap A Going by the latest trading information available, the stock could
Which of the following statements is correct?
A. Stock Y must not be selected due to its large family holding.
B. Stock Y must be selected due to its daily turnover.
C. Stock Y must be selected due to its large family holding.
D. Stock Y must not be selected as it belongs to the Mid Cap category.
Due to Stock Y’s large family shareholding, the shares available for trading are significantly less. Less
number of shares for trading makes the stock illiquid. T he stock must, therefore, not be selected.
284

T he stock(s) which must be included in the portfolio is (are):
A. X and Y
B. X only
C. Y only
D. X and A
Stock X: T he difference between the purchase and sell price (bid-ask spread) of the stock is very
small which indicates high liquidity. T he smaller the bid-ask spread, the more liquid a stock is.
Stock Y: Due to Stock Y’s large family shareholding, there are very few shares freely available for
trading.
Stock Z: T hat the stock was last traded 2 days ago is indicative of high illiquidity.
Stock A: T he bid-ask spread of the stock is very large, indicating illiquidity.
T herefore, only Stock X must be selected.
285

T he majority shareholding of Y decreases the:
A. Profitability of the company.
B. Number of shares available for trading.
C. T ransaction costs.
D. Both the number of shares available for trading and the transaction costs.
Due to Stock Y’s large family shareholding, the shares available for trading are significantly less. If
only a small number of shares are available for trading, the stock is quite illiquid.
286
Q.2433 Avery Mason, a financial analyst, is investigating the performance of a mutual fund based on
the information on returns provided in the following table:
Fund Historical Return Fund Status

1 6% Active
2 −12% Closed due to acquisition
3 8% Active
4 −8% Closed due to poor performance
5 10% Active
Mason only considers the funds that are still active for the analysis. T he results of his analysis are
exposed to:
A. Selection bias
B. Survivorship bias
C. Infrequent sampling
Survivorship bias entails the exclusion of information that relates to financial vehicles that are no
longer existent, during sampling.
In this case, the average return of funds that are still active is 8%. By contrast, if Mason includes the
returns of all the funds, the calculated average returns would be only 1% – seven eighths less than
the return calculated under survivorship bias.
T hus, analyzing only the “surviving” funds have overestimated the average mutual fund earnings.
287
Q.2434 A fund manager has quarterly and daily returns of stocks A and B. In order to calculate the
volatility of the two stocks, the fund manager utilizes the quarterly return of A and the daily return
of B. T he computed volatility values are given below:
Stock A Stock B
Return frequency Quarterly Daily
Volatility 0.33 0.43
Based on the above result, the fund manager argues that stock A is less risker than stock B.Which of
the following statements is accurate?
A. T he fund manager is incorrect.
B. T he fund manager is incorrect as the volatility is not a true measure of riskiness.
C. T he fund manager is correct.
D. T he fund manager is incorrect as the daily return of stock B makes its volatility lower
than that of A.
T he frequency of return reporting is different for the two stocks. T his is usually the effect of
infrequent trading. T he quarterly reporting frequency of stock A makes its volatility appear lower
compared to stock B.
Q.2435 Which of the following is one of the processes usually employed to account for infrequent
trading?
A. Unsmoothing
B. Noise reduction
C. Autocorrelation
D. Filtering
To account for the infrequent trading bias, we need to unsmoothing the returns. In the process, the
noise is added back to the reported returns to uncover the true return.
288
Q.2436 Alco Bank is contemplating creating an index to value artistic work. As art works are not
actively traded, the bank decides to create an index from data reported by its members. T he
members include the major auction firms and art advisors situated in the city.
Sam Park is looking to invest in the art work space to diversify his portfolio. In order to make an
informed decision, he decides to use the index created by the bank to calculate the expected return.
T he returns as indicated by the bank’s index exhibit:
A. Autocorrelation
B. Unsmoothing
C. Auto regression
D. Filtering
Autocorrelation describes a situation where current values are a function of previously recorded
values.
An illiquid asset has very little trading data. As such, managers tend to use the most recent and most
comparable sales data to estimate the current value of such an asset. T hey may also use past
appraised values (estimated or perceived). In these circumstances, the final value attached to the
asset will show strong autocorrelation with the past values used. T hese values will constitute the
index. T hat means the asset's returns computed on basis of the index will also show autocorrelation
with previous returns.
289
Q.2437 Alco Bank is contemplating creating an index to value artistic work. As art works are not
actively traded, the bank decides to create an index from data reported by its members. T he
members include major auction firms and art advisors situated in the city.
Sam Park is looking to invest in the artworks space to diversify his portfolio. In order to make an
informed decision, he decides to use the index created by the bank to calculate the expected return.
T he index created by Alco Bank is an example of a (an):
A. T rue index
B. Appraisal index
C. Equal-weighted index
D. T ransaction index
An index developed by the returns reported by the members and not the actual transactions is known
as an appraisal index.
Q.2438 Michael Bay is thinking to include real estate in his portfolio to generate excess returns and
to diversify his portfolio. He studies a report prepared by a big consultancy firm on the real estate
sector. T he report outlines the future prospects of the sector and also contains the list of recent
transactions carried out and the return generated.
Date Return
Building A 12/2/2016 12.00%
Building B 13/06/2016 11.60%
Building C 12/1/2016 13.00%
Building D 4/9/2016 11.00%
Building E 9/10/2016 14.00%
T he report also mentions that there has been an increase in real estate transactions in recent times
due to increases in land prices. Furthermore, it adds that the number of transactions increased from
3 in 2015 to 28 in 2016, indicating the changing fortunes of real estate.Based on the returns contained
in the report and by computing the corresponding market return, Bay tries to calculate the beta (β)
and alpha (α – also known as excess return) of the real estate sector. β turns out to be 0.65 while α
stands at 3.45%. T hus, Bay concludes that the real estate sector is less risky than the market, and an
excess return of 3.45% can be easily generated by investing in real estate.T he report on real estate
exhibits a:
A. Survivorship bias
290
B. Selection bias
C. Infrequent sampling bias
D. Both selection bias and infrequent sampling bias
T he report contains the returns observed in the year 2016, the year in which the real estate sector
started performing well. Furthermore, the report also mentions that the number of transactions
increased from 3 in 2015 to 28 in 2016. T herefore, the returns were only observed when the values
of the underlying assets were high, which indicates a selection bias.
Infrequent sampling (trading) bias occurs when a sample statistic such as industry alpha, does not
accurately reflect the true value of the parameter in the target industry. It concerns itself with
situations where the trading of an asset is too infrequent and only summary data spanning a relatively
long period is present.
In this question, there's infrequent sampling bias because beta has been underestimated and alpha has
been overestimated
291
Date Return
Building A 12/2/2016 12.00%
Building B 13/06/2016 11.60%
Building C 12/1/2016 13.00%
Building D 4/9/2016 11.00%
Building E 9/10/2016 14.00%
T he report also mentions that there has been an increase in real estate transactions in the recent
times due to increases in land prices. Furthermore, it adds that the number of transactions increased
from 3 in 2015 to 28 in 2016, indicating the changing fortunes of real estate.
Based on the returns contained in the report and by computing the corresponding market return, Bay
tries to calculate the beta (β) and alpha (α – also known as excess return) of the real estate sector. β
turns out to be 0.65 while α stands at 3.45%. T hus, Bay concludes that the real estate sector is less
risky than the market, and an excess return of 3.45% can be easily generated by investing in real
estate.Which of the following statements is accurate?
A. Bay has overestimated the values of α and β.
B. Bay has overestimated the value of α but the value of β is correctly estimated.
C. Bay has overestimated the value of β but the value of α is correctly estimated.
D. Bay has overestimated the value of α and understated the value of β.
Due to selection bias, the returns were observed when the underlying asset values were high.
T herefore, the selection bias overestimates the value of α (excess return). T he higher observed
returns result in an underestimation of β. T he security market line, when plotted, gives a flatter line
instead of a steeper one.
292
Date Return
Building A 12/2/2016 12.00%
Building B 13/06/2016 11.60%
Building C 12/1/2016 13.00%
Building D 4/9/2016 11.00%
Building E 9/10/2016 14.00%
T he report also mentions that there has been an increase in real estate transactions in the recent
times due to increases in land prices. Furthermore, it adds that the number of transactions increased
from 3 in 2015 to 28 in 2016, indicating the changing fortunes of real estate. Based on the returns
contained in the report and by computing the corresponding market return, Bay tries to calculate the
beta (β) and alpha (α – also known as excess return) of the real estate sector. β turns out to be 0.65
while α stands at 3.45%. T hus, Bay concludes that the real estate sector is less risky than the
market, and an excess return of 3.45% can be easily generated by investing in real estate.T he
estimates of α and β can be made more robust by:
A. Decreasing the number of observations.
B. Using a multifactor risk model.
C. Using daily returns.
D. None of the above.
T he effect of the selection bias can be mitigated by using a multifactor risk model rather than just
using a market portfolio as the sole risk factor.
293
Q.2758 People tend to overstate expected returns and understate the risk of illiquid assets. T his is
due to certain biases that affect their judgment. T hese biases include all of the following, except the:
A. Survivorship bias
B. Infrequent sampling bias
C. Selection bias
D. Availability bias
T he biases that cause people to overstate the expected returns and understate the risk of illiquid
assets include:
Survivorship bias: poor performance and failures are not reported
Infrequent sampling bias: due to infrequent trading the estimates of risk are too low when computed
using reported returns.
Selection bias: results from the tendency of returns only to be observed when underlying asset
values are high.
Q.2759 Which of these statements about illiquid markets is most likely to be true?
A. Very few asset classes are illiquid.
B. T he market for illiquid assets is very small and limited.
C. In a liquid market, the liquidity will never dry up.
D. Illiquid assets form a major part of most investor’s portfolios.
T he majority of assets available to an investor are illiquid in nature. As a result, the market for
illiquid assets is a very large one and illiquid assets dominate most investor’s portfolios. Liquid asset
markets can also experience times of illiquidity as almost all assets have a degree of illiquidity
associated with them.
294
Q.3024 In 2012, a taxonomy of how illiquidity comes about in the market was given by Vayanos and
Wang. Which of the following is not a source of market illiquidity according to Vayanos and Wang
(2012)?
A. Costs of transaction
B. Symmetric information
C. T he effect of prices
D. Search frictions
Asymmetric information rather than symmetric information leads to market illiquidity. T his is due to
the fact that an investor may have superior knowledge as compared to other investors. T he other
investors will, therefore, become reluctant to trade, since they may fear to be fleeced.
Q.3025 Expected returns can be overstated and the risk of illiquid assets understated due to some
key biases. Survivorship bias is one of these biases. How does survivorship bias arise?
A. T he survivorship bias is is the result of infrequent trading where risk estimates like
volatility, correlations and betas get too low when calculated using past data.
B. T he survivorship bias results from the tendency of returns to be only observed as the
underlying values of the asset get high as compared to other assets.
C. T he survivorship bias results from the tendency of poorly performing funds to stop their
activities.
D. All the above.
T he tendency of poorly performing funds to stop reporting leads to the survivorship bias. Ultimately,
most of these funds will fail, although their failures are rarely counted. T herefore, as compared to
the reported data, the true illiquid asset returns are worse due to this fact.
295

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FRM Part II Exam

Questions with Answers - Liquidity and Treasury Risk

Last Updated: Mar 13, 2023

prohibited. Infringers will be prosecuted in their local jurisdictions. ”

123 - Liquidity Risk 3

Reading 123: Liquidity Risk

Q.2255 Liquidity risk is best defined as:

D. Inability to meet short-term debt obligations without giving up capital or income.

A. T he bid-ask spread is exogenous to the bank.

B. T he bid-ask spread is endogenous to the bank.

C. T he bank is in a position to influence market price of T reasury bonds.

D. T he bank has too big an investment in gilts.

A. T he bid-ask spread is limited to 1%.

B. T he bid-ask spread is limited to 0.5%.

D. T he bid-ask spread is not limited.

LVaR = V aR + Exogenous Liquidity Cost (ELC)

LVaR = (-expected return + standard deviation of asset∗z-score)

VaR = (-expected return + standard deviation of asset∗ z-score)

LVaR (0.03 × 1.645) + 0.5(0.025 + 0.03 × 1.645)

Using the constant spread approach,

LVAR = (V × Zα × σ) + (0.5 × V × spread)

V = asset (or portfolio) value

Zα = confidence parameter (Normal distribution)

σ = standard deviation of returns

LV AR = (40 × 1.65 × 0.01) + 0.5 × 40 × 0.02 = $1.06

LVaR =(-expected return + standard deviation of asset∗z-score)

5% = (-expected return + 5% ∗1.65) + 0.5∗ (0.83% + 2% ∗1.65)

Q.3214 T im Lauren is an analyst at a large commercial bank. He plans to invest in Grantson

T he mid-market value of the position of the shares is equivalent to:

25 × 91.6 = $2, 290 million

T he mid-market of the position in the commodity is:

25.1 × 35 = $878.5 million

T he proportional bid-offer spread for the position of the shares is:

Offer price-Bid price

Similarly, the proportional bid-offer spread for the commodity;

Hence the cost of liquidation in a normal market is;

(0.5 × 0.017467 × 2, 290) + (0.5 × 0.087649 × 878.5) = $58.49 million

T he mid-market price for shares is 80.6 ×50=$4,030

0.004963 × 4, 030 (x × 614)

X=0.0065066, which is the proportional bid-offer price for the commodity

Mean Standard Deviation

standard deviation for the propositional bid-offer spread.

1, 426 × (0.0467 + 2.326 × w) 814 × (0.006857 + 2.326 × 0.006857)

W × (0.0721 + 2.326 × 0.0675)413 × (0.00524 + 2.326 × 0.00463)

0.001879 × 801 0.002488 × 413

A. 35million and $47.699

B. 37million and $42.076

C. 20 million and $65.000

D. 17 million and $34.985

T he mid-market value of the position in the commodity =46.9×19=$891.1million

offer spread for the share is;

T hen the cost of liquidation in a normal market;

0.03352 × 2, 506 0.01279 × 891.1

T he bank holds 1 million units in each of the two positions.

$72,000, 000 × (0.0181 + 2.326 × 0.0143)

A. Liquidation of trading book positions

B. Holdings of cash and treasury securities

C. Increasing investments in real estate

D. Ability to borrow money at short notice

D i s i ncorrect: the ability to borrow money at short notice is a source of liquidity

A. Partial loss of deposits and decreased haircuts

B. Drawdowns on lines of credit and partial loss of deposits

C. Drawdowns on lines of deposits and decreased haircuts