Paper Code: ACFI 342 Page 1 of 5

Paper Code: ACFI 342 Department: ULMS
Examiner: Davide Avino Tel. No: 49485


MOCK PAPER

Financial Risk Management



TIME ALLOWED: 2 Hours plus 30 Minutes administrative time

INSTRUCTIONS TO CANDIDATES

Student declaration:
I confirm that I have read and understood the University’s Academic Integrity policy. I confirm that
I have acted honestly, ethically and professionally in conduct leading to assessment for the
programme of study. I confirm that I have not copied material from another source nor committed
plagiarism nor fabricated data when completing the attached piece of work. I confirm that I have
not previously presented the work or part thereof for assessment for another University of
Liverpool module. I confirm that I have not colluded with any other student in the preparation and
production of this work. I confirm that I have not incorporated into this assignment material that
has been submitted by me or any other person in support of a successful application for a degree
of this or any other University or degree awarding body. Students who require sympathetic marking
should ensure that they attach the Sympathetic Marking Indicator to the first page of the document
prior to submission


PLEASE ANSWER ALL QUESTIONS
















Paper Code: ACFI 342 Page 2 of 5

QUESTION 1
a) Consider the coefficients of Altman’s Z-score. Comment on the size of the coefficients and
explain which ratios appear to be the most important in assessing the creditworthiness of a loan
applicant. Also, comment upon the key limitation of this method.
[8 marks]
b) ABC Bank has the following balance sheet:



Suppose interest rates rise such that the average yield on rate sensitive assets increases by 45 basis
points and the average yield on rate sensitive liabilities increases by 35 basis points.

Required
(i) Calculate the repricing gap for ABC Bank
(ii) Assuming the bank does not change the composition of its balance sheet, calculate the
net interest income for the bank before and after the interest rate changes. What is the
resulting change in net interest income?

[10 marks]

c) A U.S. bank is raising all of its $20 million liabilities in dollars (one-year CDs) but investing 50
percent in U.S. dollar assets (one-year maturity loans) and 50 percent in U.K. pound sterling assets
(one-year maturity loans). Suppose the promised one-year U.S. CD rate is 9 percent, to be paid in
dollars at the end of the year, and that one-year, credit risk-free loans in the United States are
yielding only 10 percent. Credit risk-free one-year loans are yielding 16 percent in the United
Kingdom. What amount, in sterling, will the bank have to repatriate back to the U.S. after one year
if the exchange rate remains constant at £1/$1.60?
[10 marks]

d) Using appropriate models, discuss the three factors that affect changes in the net worth of a
financial institution when interest rates change. Assume that only duration is used for portfolio
immunization purposes.
[10 marks]

e) ABC Bank has the following balance sheet (in millions), with the risk weights in parentheses.
Assets Liabilities and Equity
Cash (0%) $21 Deposits $176
OECD interbank deposits (20%) 25 Subordinated debt (5 years) 2
Paper Code: ACFI 342 Page 3 of 5

Mortgage loans (50%) 70 Cumulative preferred stock 2
Consumer loans (100%) 70 Equity 5
Reserve for loan losses (1)
Total Assets $185 Total liabilities and equity $185

The cumulative preferred stock is qualifying and perpetual. In addition, the bank has $30
million in performance-related standby letters of credit (SLCs) to a BBB-rated corporation,
$40 million in two-year forward FX contracts that are currently in the money by $1 million,
and $300 million in six-year interest rate swaps that are currently out of the money by $2
million. The counterparty of the derivatives contracts is also BBB-rated.

Credit conversion factors follow:

Performance-related standby LCs 50%
1- to 5-year foreign exchange contracts 5%
1- to 5-year interest rate swaps 0.5%
5- to 10-year interest rate swaps 1.5%

Required
(i) What are the risk-adjusted on-balance-sheet assets of the bank as defined under the
Basel Accord?
(ii) Disregarding any capital conservation buffer, what are the core Tier I capital, the total
Tier I capital, and the total capital required for both off- and on-balance-sheet assets?


[12 marks]
TOTAL: 50 marks


QUESTION 2
a) Discuss the JP Morgan RiskMetrics Model for measuring market risk and explain how it can
be applied for FX, equity and bond portfolios.
[14 marks]

b) John Orange, Vice President of operations of ABC Bank, is estimating the aggregate DEAR of
the bank’s portfolio of assets consisting of loans (L), foreign currencies (FX), and common stock
(EQ). The individual DEARs are £25,310, £23,155, and £67,328 respectively. If the correlation
coefficients ρij between L and FX, L and EQ, and FX and EQ are -0.2, 0.5, and 0.8, respectively,
what is the DEAR of the aggregate portfolio?
[12 marks]


c) Calculate the term structure of default probabilities over three years using the following spot
rates from the Treasury and corporate bond (pure discount) yield curves. Be sure to calculate both
the annual marginal and the cumulative default probabilities.

Paper Code: ACFI 342 Page 4 of 5









[16 marks]
d) What are the two reasons that liquidity risk arises? How does liquidity risk arising from the
liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance
sheet?
[8 marks]

TOTAL: 50 marks
























Paper Code: ACFI 342 Page 5 of 5