MARKS: PART A:

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_______ ____________________________________________________________________________ SUPPLEMENTARY MID-SESSION EXAM WITH ANSWERS THE UNIVERSITY OF NEW SOUTH WALES SCHOOL OF BANKING AND FINANCE

FINS3630 BANK FINANCIAL MANAGEMENT SUPPLEMENTARY MID-SESSION EXAM - SESSION 2, 2007

INSTRUCTIONS 1. This paper has only ONE PART the Multiple Choice Paper which is worth 75 marks. Total Marks possible: Each question is worth ONE mark.. 2. Write your name and student I.D. number the right hand side of this paper above and then sign your name in your usual signature. You are signing that this is all your own work. 3. Also enter your name and your S.I.D.number in the numbered spaces provided on the separate marking sheet. 4. Answer all questions on the marking sheet for Part A in pencil (2B or darker). 5. Time Allowed: 1 hours 45 minutes plus 10 minutes reading time. 6. Calculators may be used. (Non-programmable types) 75 marks

THIS PAPER MAY NOT BE TAKEN OUT OF THE EXAMINATION ROOM.

The Changing Bank Environment

1. Historically, a commercial bank was defined as a firm that: a. accepted NOW accounts and made consumer loans. b. accepted demand deposits and made commercial loans. c. accepted government deposits and made public loans. d. accepted demand deposits and made consumer loans. e. is regulated by the Federal Reserve. Answer: b 2. Which of the following is not a purpose of bank regulation? a. Guarantee minimal profitability of the banking system. b. Provide monetary stability. c. Ensure safety and soundness of banks. d. Provide a competitive financial system. e. Protect consumers from abuses by banks. Answer: a 3. a. b. c. Moral hazard occurs when: Regulatory supervision is lax. Bank management behaves in an antisocial or unethical manner. The actions and consequences of bank management's decisions can be separated. d. Regulators and regulatees have a vested interest in circumventing regulations. e. None of the above. Answer: c 4. Commercial banks mostly specialize in: a. mortgages. b. mutual loans. c. short-term business credit. d. savings accounts. e. share draft accounts. Answer: c 5. Savings and loans have historically specialized in: a. commercial loans. b. auto loans. c. mutual loan. d. real estate loans. e. demand deposit accounts. Answer: d 6. a. b. c. d. Bank regulations: can prevent bank failures. can eliminate economic risk for banks. Serve as guidelines for sound operating policies. guarantee bankers will make sound management decisions.

e. guarantee bankers act in an ethical manner. Answer: c 7. Historically, why have banks been among the safest businesses? a. Banks invest heavily in risk management technologies. b. Banking is one of the most regulated businesses. c. The government has never allowed a bank to fail. d. The products of a bank, loans and deposits, are always in strong demand. e. Banking has traditionally employed conservative risk-averse managers. Answer: b 8. Regulatory dialectic can be described as: a. the consolidation of the banking industry. b. the process by which banks respond to regulations and the imposition of new regulations. c. the investment banking process. d. the securitization of bank assets. e. the facilitating of corporate mergers. Answer: b 9. General purpose finance companies often make all of the following types of loans except: a. commercial loans. b. home improvement loans. c. first mortgage loans. d. second mortgage loans. e. automobile loans. Answer: c 10. The payment method with the smallest transaction size is: a. cash. b. check. c. debit card. d. credit card. e. ACH. Answer: a 11. Why do banks consider investment banking so attractive? a. Investment banks already provide banking services to prime commercial customers. b. Investment banks can compete in any geographic location without regulation. c. Commercial bank returns are negatively correlated with investment bank returns. d. Investment banks have a higher return on assets than commercial banks. e. All of the above. Answer: e

12. Which of the following is not a function of investment banking? a. Underwriting public offerings of new securities. b. Accepting demand deposits from customers. c. Trading securities in the secondary market. d. Advising and financing mergers and acquisitions e. All of the above are investment banking functions. Answer: b 13. Which of the following is incorrect about Australian banking? a. The Payments System is regulated by APRA. b. Banks dominate the Australian Financial Services Industry. c. Deregulation has led to a large increase in the volume of OBS transactions. d. Deregulation has led to a reduction in the number of building societies. e. None of the above. Answer: a 14. Securitization is the process of: a. increasing security at banks. b. underwriting municipal securities. c. converting bank deposits to Treasury securities. d. converting bank assets into marketable securities. e. converting bank liabilities into marketable securities. Answer: a

Analyzing Bank Performance

15. Bank assets fall into each of the following categories except: a. loans. b. investment securities. c. demand deposits. d. noninterest cash and due from banks. e. other assets. Answer: c 16. Banks generate their largest portion of income from: a. loans. b. short-term investment. c. demand deposits. d. long-term investments. e. certificates of deposit. Answer: a 17. Which of the following would a bank generally classify as a short-term investment? a. Demand deposits b. Deposits at the Federal Reserve c. Repurchase agreements d. Fed Funds purchased e. Vault cash Answer: c

18. The volume of net deferred credit is commonly referred to as: a. the burden. b. NOW balances. c. reserve requirements. d. equity. e. float. Answer: e 19. A banks core deposits are: a. vault cash. b. stable deposits that are not typically withdrawn over short periods of time. c. the banks deposits at the Federal Reserve. d. the most interest rate sensitive liabilities of a bank. e. deposits held in foreign offices. Answer: b 20. A banks burden is defined as: a. net interest income minus non-interest income. b. non-interest income minus non-interest expense. c. non-interest expense minus non-interest income. d. net interest income plus non-interest income. e. interest expense plus non-interest expense. Answer: c 21. Interest income includes: a. interest earned on all of the banks assets. b. fees earned on all of the banks assets. c. fees earned on all of the banks deposit accounts. d. all of the above. e. a. and b. only Answer: e 22. Non-interest expenses includes all of the following except: a. occupancy expenses. b. goodwill impairment. c. insufficient funds service charges. d. personnel expenses. e. all of the above are considered non-interest expense. Answer: c 23. Net income is defined as: a. Net interest income burden + provision for loan loss + securities gains or losses taxes. b. Net interest income + burden + provision for loan loss + securities gains or losses taxes. c. Net interest income burden provision for loan loss + securities gains or losses taxes. d. Net interest income burden provision for loan loss + securities gains or losses + taxes.

e. Net interest income + burden provision for loan loss + securities gains or losses taxes. Answer: c 24. What is the return on equity for a bank that has an equity multiplier of 12, an interest expense ratio of 5%, and a return on assets of 1.1%? a. 5.0% b. 13.2% c. 8.2% d. 26.4% e. 0.66% Answer: b ROE = ROA * EM = 1.1% * 12 = 13.2% Use the following information for questions 25 29 Bigger Mac Bank(BMB) Balance Sheet Assets Cash & Due from Banks Investments Com & State Govt Funds Loans Premises Average Total Assets Liabilities & Equity Demand Deposits Time Deposits Com & State Govt Funds Equity Average Total Liabilities & Equity Income Statement Interest Income Interest Expense Non-Interest Income Non-Interest Expense Net Income 25. What is BMBs return on equity? a. 0.6% b. 3.8% c. 5.0% d. 8.2% e. 9.8% Answer: c ROE = Net Income/Total Equity ROE = $5/$100 = 5% $ 50 300 10 350 90 800 $ 100 300 300 100 800 $ 100 75 5 25 5

26. What is BMBs net interest margin? a. 0.6% b. 3.8% c. 5.0% d. 8.2% e. 9.8% Answer: b Net Interest Margin = Net Interest Income/Earning Assets Net Interest Income = Interest Income Interest Expense Net Interest Income = $100 - $75 = $25 Earning Assets = Investments + Federal Funds + Loans Earning Assets = $300 + $10 + $350 = $660 Net Interest Margin = $25/$660 = 3.8% 27. What is the earnings base at BMB? a. 12.5% b. 17.5% c. 58.5% d. 75.5% e. 82.5% Answer: e Earnings Base = Earning Assets/Total Assets Earning Assets = Investments + Federal Funds + Loans Earning Assets = $300 + $10 + $350 = $660 Earnings Base = $660/$800 = 82.5% 28. What is BMBs burden? a. 2.5% b. 17.5% c. 25.0% d. 75.5% e. 82.5% Answer: a Burden = (Non-Interest Expense Non-Interest Income)/Average Total Assets Burden = ($25 - $5)/$800 = 2.50% 29. What is BMBs efficiency ratio? a. 2.53% b. 17.51% c. 0.83% d. 0.45% e. 83.3% Answer: e Efficiency Ratio = Non-Interest Expense/(Net Interest Income + Non-Interest Income) Net Interest Income = Interest Income Interest Expense Net Interest Income = $100 - $75= $25 Efficiency Ratio = $25/($25 + $5) =83.3%

30. Which type of risk is the most difficult to quantify? a. Credit risk b. Liquidity risk c. Legal risk d. Operating risk e. Market risk Answer: c

Managing Non-Interest Income and Non-Interest Expense

31. Which type of non-interest cheque account incurs a monthly fee regardless of the balance, as well as a possible per-check fee? a. single-balance, single-fee b. multiple-balance, single fee c. account fee-only d. free e. multiple-balance, multiple-fee Answer: c 32. Which type of non-interest cheque account imposes no fee of any kind? a. single-balance, single-fee b. multiple-balance, single fee c. account fee-only d. free e. multiple-balance, multiple-fee Answer: d 33. If a bank pays 62 cents in non-interest expense per dollar of net operating revenue, its _______ is equal to 0.62. a. burden b. net non-interest margin c. efficiency ratio d. overhead ratio e. non-interest expense ratio Answer: c 34. __________ is not a measure of bank productivity? a. Assets per employee b. Average personnel expense c. Loans per employee d. Net income per employee e. Number of customers per employee Answer: e

35. ______________ transactions are the highest-cost type of transaction for a bank. a. Web-based b. ATM c. Work station d. Live teller e. After-hours Answer: d 36. Profitable bank customers: a. make up a small fraction of all bank customers. b. generally shop for the bank with the lowest price c. have small loan balances. d. always avoid service charges e. are the most sensitive to changes in price. Answer: a 37. Banks can increase their operating efficiencies by: a. reducing costs and maintaining the existing level of products and services. b. reducing costs and reducing the existing level of products and services. c. decreasing the level of output while maintaining the current level of expenses. d. increasing the level of output while increasing the level of expenses. e. decreasing workflow. Answer: a

Pricing Fixed-Income Securities

38. If a bond is selling at par value, then: a. the yield to maturity is less than the coupon rate. b. the yield to maturity is greater than the coupon rate. c. the yield to maturity is equal to the coupon rate. d. its duration must be greater than its maturity. e. its duration must be equal to its maturity. Answer: c 39. To the nearest dollar, what is the value today of an investment that pays $15,000 in seven years, assuming an annual opportunity cost of 9%? a. $7,473 b. $27,421 c. $8,206 d. $7,130 e. None of the above Answer: c Financial calculator solution FV = 15,000 I=9 N=7 PV = ? = 8,205.51

40. If you invested $200 today, another $400 in one year, and another $600 in two years, how much will your investment be worth in five years, assuming a 7% annual compound return? (To the nearest dollar.) a. $1,540 b. $600 c. $720 d. $770 e. None of the above Answer: a Financial calculator solution Step 1 CF0 = 200 CF1 = 400 CF2 = 600 I=7 NPV = ? = 1,097.90 Step 2 PV = 1,097.90 I=7 N=5 FV = ? = 1,539.86 41. At what annual interest rate will you double your money if you invest for 8 years? a. 10.11% b. 9.05% c. 8.19% d. 7.91% e. 6.73% Answer: b Financial calculator solution PV = 1 FV = -2 N=8 I = ? = 9.05 42. What is the effective annual cost of a credit card that charges 18%, compounded monthly? a. 16.63% b. 18.00% c. 18.81% d. 19.56% e. 19.61% Answer: d Financial calculator solution P/Y = 12 NOM = 18

EFF = ? = 19.56 Or Effective Rate = (1 + .18/12)12 1 = .1956 43. A bond with a par value of $1,000 and a 13% semi-annual coupon rate has 20 years to maturity. Assuming it is priced to yield 10%, compounded semiannually, what is the market value of the bond, to the nearest dollar? a. $1,187 b. $1,107 c. $1,257 d. $2,373 e. None of the above Answer: c Financial calculator solution P/Y = 2 FV = 1,000 PMT = 13%/2 * 1,000 = 65 I = 10 N = 20 * 2 = 40 PV = ? = 1,257.39 44. Duration: a. is always greater than maturity. b. rises as the coupon payment rises. c. measures how bond prices change with changes in maturity. d. is a measure of total return. e. is a measure of how price sensitive a bond is to a change in interest rates. Answer: e 45. What is the Macaulays duration of a 10 year zero-coupon bond with a face value of $1,000 and a market rate of 8%, compounded annually is: a. 10 years b. 11 years c. 12 years d. 13 years e. None of the above Answer: a 46. A bond that has an annual coupon rate of 15% has two years to maturity. If the current discount rate is 8%, what is the bonds Macaulays duration? a. 2.00 years b. 1.99 years c. 1.88 years d. 1.77 years e. 1.66 years Answer: c

Discount Rate Cash Flows t*CF PV(t*CF) PV(t*CF) Price Macaulay's Duration = PV(t*CF)/Price

8.00% 0

1 2 $ 150 $ 1,150 $ 150.00 $ 2,300.00 $138.89 $1,971.88

$2,110.77 $1,124.83 1.88 Years

47. Which of the following is false? a. As interest rates rise, bond prices rise, everything else the same. b. Given an absolute change in interest rates, the percentage increase in a bonds price will be greater than the percentage decrease, everything else the same. c. Long-term bonds change proportionately more in price than short-term bonds for a given rate change, everything else the same. d. A bond with a lower coupon will change more in price than a bond with a higher coupon, everything else the same. e. A bonds duration is a measure of its price elasticity. Answer: a 48. A bonds Macaulay duration is 7.95 years. If the current annual interest rate is 7%, what is the modified duration of this bond? a. 7.00 years b. 7.88 years c. 7.43 years d. 7.95 years e. 8.51 years Answer: b Modified Duration = Macaulays Duration/(1+i) = 7.95/1.07 = 7.43 49. A stripped security: a. pays no interest. b. has no par value. c. is easier to value than a traditional bond. d. should sell as a package of zero coupon bonds. e. None of the above Answer: d 50. A bank buys a $10,000 Treasury bill with a maturity of 1 year. Current market rates are 8%. If interest rates rise to 8.25%, what is the approximate change in the price of the T-bill? a. -0.02% b. -0.23% c. -2.31% d. -23.15% e. -231.15% Answer: b P/P = -[Duration/(1+i)]*i = [1/(1+.08)]*.0025 = -.00231

51. Which of the following are sources of a bonds total return? a. Coupon interest b. Reinvestment income c. Capital gains or losses realize at maturity d. All of the above are sources of a bonds total return e. a. and c. only Answer: d

Managing Interest Rate Risk: GAP and Earnings Sensitivity

52. When is interest rate risk for a bank greatest? a. When interest rates are volatile. b. When interest rates are stable. c. When inflation is high. d. When inflation is low. e. When loan defaults are high. Answer: a 53. A banks GAP is defined as: a. the dollar amount of rate-sensitive assets divided by the dollar amount of rate-sensitive liabilities. b. the dollar amount of earning assets divided by the dollar amount of total liabilities. c. the dollar amount of rate-sensitive assets minus the dollar amount of ratesensitive liabilities. d. the dollar amount of rate-sensitive liabilities minus the dollar amount of rate-sensitive assets. e. the dollar amount of earning assets times the average liability interest rate. Answer: c 54. Keeping all other factors constant, banks can reduce the volatility of net interest income by: a. adjusting the dollar amount of rate-sensitive assets. b. adjusting the dollar amount of fixed-rate liabilities. c. using interest rate swaps. d. Bank can reduce volatility of net interest income by doing all of the above. e. a. and c. only Answer: e 55. If a bank has a positive GAP, a decrease in interest rates will cause interest income to __________, interest expense to__________, and net interest income to __________. a. increase, increase, increase b. increase, decrease, increase c. increase, increase, decrease d. decrease, decrease, decrease e. decrease, increase, increase Answer: d

56. If rate-sensitive assets equal $500 million and rate-sensitive liabilities equals $400 million, what is the expected change in net interest income if rates increase by 1%? a. Net interest income will increase by $1 million. b. Net interest income will fall by $1 million. c. Net interest income will increase by $10 million. d. Net interest income will fall by $10 million. e. Net interest income will be unchanged. Answer: a ($500 million - $400 million) * 1% = $1,000,000 57. A banks cumulative GAP will always be: a. greater than the periodic GAP. b. less than the periodic GAP. c. positive. d. negative. e. the sum of the interim periodic GAPs. Answer: e 58. Which of the following does not have an embedded option? a. A callable Wizard Home Loans bond. b. Demand deposit accounts. c. A home mortgage loan. d. An auto loan. e. All of the above have embedded options. Answer: e 59. To increase asset sensitivity, a bank can: a. buy longer-term securities. b. pay premiums on subordinated debt. c. shorten loan maturities. d. make more fixed rate loans. e. All of the above. Answer: c 60. If a bank expects interest rates to decrease in the coming year, it should: a. increase its GAP. b. issue long-term subordinated debt today. c. increase the rates paid on long-term deposits. d. issue more variable rate loans. e. become more liability sensitive. Answer: e

Managing Interest Rate Risk: Duration Gap and Economic Value of Equity
61. Duration gap analysis: a. applies he the concept of duration to the banks entire balance sheet. b. applies he the concept of duration to the banks entire income statement. c. applies he the concept of duration to the banks retained earnings.

d. e. Answer: a

indicates the difference in the GAP in the time it takes to collect on loan payments versus the time to attract deposits. estimates when embedded options will be exercised.

62. Macaulay's duration: a. is a weighted average of the time until cash flows are received. b. is always greater than maturity. c. is never equal to maturity. d. directly indicates how much the price of a security will change given a change in interest rates. e. estimates when embedded options will be used. Answer: a 63. Modified duration: a. estimates when embedded options will be used. b. directly indicates how much the price of a security will change given a change in interest rates. c. is always greater than maturity. d. All of the above e. a. and b. Answer: b 64. Effective duration: a. estimates when embedded options will be used. b. directly indicates how much the price of a security will change given a change in interest rates. c. is always greater than maturity. d. is a weighted average of the time until cash flows are received. e. All of the above Answer: a 65. A bond has a Macaulay's duration of 10.7 years. If rates fall from 7% to 6%, the bonds price will: a. increase by approximately 1%. b. decrease by approximately 1%. c. increase by approximately 10%. d. decrease by approximately 10%. e. Not enough information is given to answer the question. Answer: c Modified Duration = Macaulay's duration/(1+i) = 10.7/1.07 = 10 % Change in Price = -Modified duration * Change in interest rates = 10 * 1% = 10% 66. Which of the following is likely to have a negative effective duration? a. A high coupon, interest only mortgage-backed security that is pre-paying at a high rate. b. A low coupon Commonwealth Treasury bond. c. Commonwealth Government Securities purchased. d. Demand deposits e. None of the above can have a negative effective duration.

Answer: a 67. What does a bank's duration gap measure? a. The duration of short-term buckets minus the duration of long-term buckets. b. The duration of the bank's assets minus the duration of its liabilities. c. The duration of all rate-sensitive assets minus the duration of rate-sensitive liabilities. d. The duration of the bank's liabilities minus the duration of its assets. e. The duration of all rate-sensitive liabilities minus the duration of ratesensitive assets. Answer: b 68. Which of the following allows a security's cash flows to change when interest rates change? a. Modified duration b. Macaulay's duration c. Effective duration d. Balance sheet duration e. Income statement duration Answer: c Use the following bank information for questions 69 73.
Market Value $ 200 $ 800 $ 250 $ 1,250 Duration (Years) Liabilities and Market Equity Value Time Deposits $ 600 3.750 CDs $ 500 7.250 Equity $ 150 $ 1,250 Duration (Years) 1.500 3.125

Assets Cash Loans T-Bonds Total

Rate

Rate 2.0% 4.5%

8.0% 4.0%

69. What is the weighted average duration of assets? a. 2.56 years b. 3.85 years c. 4.85 years d. 5.00 years e. 7.5 years Answer: b (800/1,250)*3.75 years + (250/1,250)*7.25 years = 3.85 years 70. What is the banks duration gap? a. 0.53 b. 0.73 c. 0.91 d. 1.88 e. 4.58 Answer: d Step 1

Weighted Average Duration of Liabilities = (600/1,100)*1.5 years + (500/1,100)*3.125 years = 2.24 years Step 2 Duration Gap = Weighted Avg Duration of Assets (Liabilities/Total Assets)Weighted Avg Duration of Liabilities Duration Gap = 3.85 years (1,100/1,250)*2.24 years = 1.88 years 71. What is the banks weighted average cost of liabilities? a. $24.9 b. $34.5 c. $80.0 d. $94.3 e. $102.1 Answer: b (600* 2%) + (500*4.5%) = 34.5 72. What is the banks expected economic net interest income? a. $34.5 b. $32.3 c. $39.5 d. $44.0 e. $120.5 Answer: c (8%*$800) + (4%*$250) (2%*$600) (4.5%*$500) = $39.5 73. If interest rates rise 1% for all assets and liabilities, what is the approximate expected change in the economic value of equity? a. $2.56 b. $5.84 c. $5.84 d. $22.19 e. -$22.19 Answer: d Step 1 Calculate Weighted Average Return of Assets (8%*$800/$1,250) + (4%*$250/$1,250) = 5.92% Step 2 EVE = -DGAP[y/(1+y)]MVA = -1.88*[-.01/1.0592]*$1,250 = 22.19 74. What are the weaknesses of using static GAP analysis versus duration gap analysis? a. Static GAP ignores the time value of money. b. Static GAP ignores the cumulative impact of interest rate changes on a banks risk profile. c. Static GAP does not proscribe the treatment of demand deposits. d. All of the above are weaknesses of using static GAP analysis versus duration gap analysis. e. a.and b.

Answer: d 75. If the yield curve is inverted, a portfolio manager can take advantage of this by: a. pricing more deposits on a fixed-rate basis. b. buying more long-term securities c. making variable-rate, callable loans. d. increasing the number of rate-sensitive assets. e. All of the above. Answer: b