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Examiners’ commentaries 2020
Examiners’ commentaries 2020
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2019–20. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
di↵erent editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
Comments on specific questions
Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.
Section A
Candidates should answer ONE question and NO MORE THAN TWO further questions from
this section.
Question 1
(a) Discuss the main causes of illiquidity and insolvency in banking and discuss the
relationship between them.
(10 marks)
(b) Explain operational risk and market risk as it a↵ects banks. Give examples.
(5 marks)
(c) Explain credit risk as it a↵ects banks and discuss the techniques banks can use
to manage the moral hazard created by a credit risk exposure.
(10 marks)
Reading for this question
For (a), see subject guide, Chapter 6, pages 116–31.
For (b), see subject guide, Chapter 6, pages 118–20.
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FN1024 Principles of banking and finance
For (c), see subject guide, Chapter 6, pages 120–25.
Approaching the question
(a) Liquidity is a state where the bank is short of funds to meet cash needs. The main cash
need is deposit withdrawals (also the most uncertain). Large deposit withdrawals that
create illiquidity are typically caused by a loss of confidence in a bank leading to a ‘run’.
Another contributory factor is banks do not hold a large stock of liquid assets as a bu↵er to
meet unexpected cash needs (as liquid assets are a poor earning asset).
Insolvency is a state when the value of a bank’s assets falls below the value of liabilities
(principally deposits). This could be caused by defaults on loans (arising from credit risk),
reductions in trading asset values (arising from market risk) and losses generally (arising
from operational risk – for example, fraud etc.). A contributory factor to insolvency risk is
that banks do not hold a lot of capital (equity) – although this has increased with Basel 3.
A common issue in answering this part was to focus on the nature of illiquidity and
insolvency and not to explain the possible causes. Another problem was that some answers
did not consider the second element of this part, namely the link between the two concepts.
(b) Operational risk is the risk of loss arising from the banks operations, policies and people. It
includes risks such as IT failure, fraud and mismanagement. A classic example would be
that of the rogue trader Nick Leeson who in 1995 created extremely high trading losses for
Barings Bank which exceeded the capital of the bank causing it to fail. This illustrates poor
procedures at Barings as the trader did not have proper oversight.
Market risk is the risk of loss on the bank’s trading assets due to adverse changes in market
prices/interest rates. Trading assets are held for speculative purposes and include bonds,
currencies etc. Banks faced significant market risk in the period leading up to 2008 as they
held large positions in MBSs and CDOs – these su↵ered a large loss of value leading to
insolvency problems for the a↵ected banks – many of which had to be bailed out.
The main issue in answering this question was failure to provide example.
(c) Credit risk is related to non-performance of a debt contract – typically default.
Moral hazard refers to the risk of default increasing after the loan has been made due to
immoral actions by the borrower. These can be mitigated using:
i. restrictive covenants
ii. credit rationing
iii. taking security.
The way each of these impacts on moral hazard needs explaining.
The main issue with answering this part was to explain all the techniques for managing
credit risk rather than those that mitigated moral hazard.
Question 2
(a) Explain how banks are able to act as intermediaries by reconciling conflicting
requirements of lenders and borrowers and reducing costs.
(12 marks)
(b) Explain the Diamond theory of delegated monitoring and discuss its
contribution to our understanding of financial intermediation.
(13 marks)
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Examiners’ commentaries 2020
Reading for this question
For (a), see subject guide, Chapter 4, pages 69–72.
For (b), see subject guide, Chapter 4, page 81.
Approaching the question
(a) A bank engages in financial intermediation by issuing deposit contracts to raise funding and
then lending those funds using loan contracts. In the process of intermediation banks
transform the characteristics of the funds as they pass from lenders to borrowers.
This asset transformation occurs in order to reconcile the di↵erent requirements of lenders
and borrowers by using claims with characteristics that meet each of their needs.
The process of asset transformation creates liquidity risk (through liquidity transformation)
and credit risk (though risk transformation).
Banks can manage these risks more e↵ectively than other agents as they have advantages of
scale (allowing them to pool and diversify to reduce credit risk) – this allows them to o↵er
safe deposits to depositors thus reducing the potential for loss of confidence thus reducing
liquidity risk. Note that pooling and diversification of deposits also reduces liquidity risk.
Other advantages banks have, include, expertise.
Lending and borrowing incurs significant costs including search costs, verification costs,
monitoring costs and enforcement costs. Banks also use the advantages of economies of scale
and expertise to reduce costs for lenders and borrowers.
(b) The main idea of the delegated monitoring theory is that since monitoring borrowers is
costly, it is ecient for surplus units (lenders) to delegate the task of monitoring to
specialised agents such as banks. Banks have a comparative advantage relative to direct
lending in monitoring activities in the context of costly state verification. In fact, they have
a better ability to reduce monitoring costs because of their diversification.
Hypotheses required for delegated monitoring to work:
1. existence of scale economies in monitoring, that means that a typical bank finances many
(n) projects
2. small capacity of investors as compared to the size of investments, that means that each
project needs the funds of several investors (m)
3. low cost of delegation, that means that the cost of monitoring the financial intermediary
itself has to be less than the surplus gained from exploiting scale economies in
monitoring investment projects.
Direct lending implies that each of the m investors monitors the financed firm: the total cost
is n⇥m⇥K.
If a bank (financial intermediary) emerges, it can choose to monitor each firm (total cost
n⇥K): the bank is a delegated monitor, which monitors borrowers on behalf of lenders
(note that the bank is not monitored by its lenders – the depositors). As:
n⇥ k < N ⇥m⇥K
then lower cost to delegate.
Financial intermediation (delegated monitor) dominates direct lending as soon as n is large
enough: this means that diversification exists (i.e. a large number of loans are held by the
intermediary). Diversification is important because it increases the probability that the
intermediary has sucient loan proceeds to repay a fixed debt claim to depositors – this
reduces delegation cost to near zero.
The key issue with answering this part was to ignore the role played by diversification of
loans in reducing delegation cost.
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FN1024 Principles of banking and finance
Question 3
(a) With reference to examples, discuss the characteristics and consequences of
financial bubbles.
(12 marks)
(b) Discuss the empirical evidence on market under-reaction in the context of weak
and semi-strong form eciency.
(13 marks)
Reading for this question
For (a), see subject guide, Chapter 3, pages 59–61.
For (b), see subject guide, Chapter 5, pages 195–96.
Approaching the question
(a) Financial bubbles occur when the market price of an asset rises well above its fundamental
value. Better answers will discuss the problems associated with determining fundamental
value for assets with uncertain future returns.
Bubbles typically occur when there is a rising market and bullish sentiment. Often fuelled
by access to low cost easily available credit. Bubbles cannot exist permanently – at some
point a correction will occur and the price of the overvalued asset will fall. This can lead to
distress selling and defaults on borrowed funds.
Examples include Tulip Mania, Dot-com bubble, housing market bubbles.
Better answers will identify that bubbles are often associated with a rapid expansion in the
supply of credit.
(b) Evidence on market underreaction constitutes an anomaly related to earnings
announcements. Although empirical evidence generally confirms rapid adjustment to new
information (as shown in the evidence in favour of the semi-strong-form eciency), recent
evidence shows that stock prices do not instantaneously adjust. Two key anomalies are
identified: stock price overreaction and underreaction.
A definition of underreaction should be provided: underreaction to earnings announcements
means that stock prices do not fully incorporate the new information embodied in the
unexpected earnings announcement.
Answers should then examine the empirical evidence that shows that adjustment to extreme
bad news takes several months: there is a market overreaction and subsequent gradual
adjustment (see, for example, the evidence in Ball and Brown (1968), then confirmed by
Bernard and Thomas (1989)).
Better answers will describe the methodology and findings of the study by Bernard and
Thomas (1989) and show how the momentum strategy adopted is consistent with
semi-strong eciency.
Outstanding candidates are expected to make the link with the empirical evidence on
underreaction existing at a di↵erent level of informational eciency – the weak form
eciency (see results in Jegadeesh and Titman (1993)). This evidence suggests buying past
winner stocks and selling past losers to get excess returns. Once again, this evidence
suggests excess returns associated with a momentum strategy, but this evidence is
inconsistent with the weak-form eciency (not the semi-strong form) because the strategy is
based on historical prices only.
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Examiners’ commentaries 2020
Question 4
(a) Explain asymmetric information in lending/borrowing and discuss how adverse
selection influences the lending decision of banks.
(11 marks)
(b) Explain how moral hazard a↵ects equity contracts and discuss why moral
hazard is lower for debt contracts compared to equity contracts.
(9 marks)
(c) Explain why loan contracts su↵er less from free-riding problems compared to
bonds or other public financing.
(5 marks)
Reading for this question
For (a), see subject guide, Chapter 4, pages 73–76.
For (b), see subject guide, Chapter 4, pages 77–79.
For (c), see subject guide, Chapter 4, pages 79–80.
Approaching the question
(a) Asymmetric information occurs when one party to a transaction has less information than
the other party. In the case of lending/borrowing the lender will normally have less
information than the borrower. This creates two problems – adverse selection before the
loan is made and moral hazard after the loan is made.
Adverse selection is the problem created by asymmetric information before the transaction
occurs. It arises when the potential borrowers who are most likely to produce an undesirable
(adverse) outcome are the ones who most actively seek out loans. Thus, adverse selection
increases the probability that bad credit risks will get loans.
Following Akerlof (1970) in a market characterised by asymmetric information, lenders have
less information than borrowers. Lenders will therefore charge an interest rate reflecting the
average quality (risk) of borrowers in the market. This will be higher than good quality (low
risk) borrowers will be willing to pay and so mainly poor quality (high risk) borrowers will
seek a loan.
Better answers will explain how, in the presence of asymmetric information. Fewer potential
lenders will choose to engage in lending. However, banks will seek to mitigate adverse
selection through information production.
(b) Moral hazard in equity contracts qualifies as a special type known as the principal-agent
problem (Jensen and Meckling, 1976). Stockholders (called principals) own most of the
firm’s equity, but they are not the same people as the managers (agents) of the firm.
Managers have more information about their activities than stockholders so that there is
asymmetric information. The separation of ownership and control, together with the
asymmetric information, induce managers to act in their own interest rather than in the
interest of stockholder-owners (for example, managers will not take actions that maximise
firm value if the private costs borne by them for those actions are high).
Moral hazard in debt contracts is lower than in equity contracts but is still present. Debt
contracts require borrowers to pay fixed amounts and let them keep any profit above this
amount. Consequently, borrowers have incentives to take investments riskier than lenders
would like.
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FN1024 Principles of banking and finance
(c) Free-riding occurs when one party engages in an activity which incurs cost. However, others
can observe the activity and obtain benefits from without payment. So, the first party
incurs all the costs but does not get all the benefits.
A problem for tradable securities, such as bonds. Free-riding can reduce then benefits from
information production and from monitoring. For example, some bond-holders may decide
not to monitor restrictive covenants – i.e. free-ride on the monitoring of other investors. The
free-riders thus obtain benefits of monitoring without incurring cost.
Loan contracts created by a bank are not tradable. So a bank can incur costs to produce
information or monitor restrictive covenants without anyone free-riding. Hence the bank will
get all the benefits.
Section B
Candidates should answer ONE question and NO MORE THAN TWO further questions from
this section.
Question 5
(a) Plantfood paid an annual dividend of $3 on its common stock and promises that
the dividend will grow by 3% per year. If the stock’s marketprice is $30, what is
required rate of return for this stock?
(3 marks)
(b) Datasoft is currently paying dividends of $0.70 a share. These dividends are
expected to grow at a rate of 20% for the next two years and at a constant
growth rate of 3.5% thereafter. What would be the current price of Datasoft
shares given a required return of 15%?
(4 marks)
(c) Compare and contrast the risk and return for debt and equity securities from
the perspective of both lenders/investors and issuers.
(9 marks)
(d) Formally derive and discuss the dividend discount model used for the valuation
of common stocks.
(9 marks)
Reading for this question
For (a), see subject guide, Chapter 7, pages 154–5.
For (b), see subject guide, Chapter 7, pages 152–5.
For (c), see subject guide, Chapter 7, page 150.
For (d), see subject guide, Chapter 7, pages 152–4.
Approaching the question
(a) Using the Gordon growth model:
P0 =
D1
r g
where D1 = D0(1 + g). Hence:
30 =
3(1.03)
r 0.03 ) r 0.03 =
3(1.04)
30
) r 0.03 = 3.12
30
= 0.104
therefore:
r = 0.104 + 0.03 = 0.134 = 13.4%.
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Examiners’ commentaries 2020
(b) We have:
P0 =
D1
1 + r
+
D2
(1 + r)2
+
P2
(1 + r)2
where D1 = D0(1.2), D2 = D1(1.2), P2 = D3/(r g) and D3 = D2(1.035). Hence:
P0 =
0.84
1.15
+
1.008
(1.15)2
+
1.043/(0.15 0.035)
(1.15)2
= 8.35.
(c) Debt is low risk, low return for investors but high risk, low cost for issuers. Equity is high
risk, high return for investors but low risk, high cost for issuers
These relationships need explaining – particularly the high risk for debt issuers which arises
from the contractual nature of interest payments
(d) The subject sets out the key elements of the derivation of the dividend discount model.
Better answers discuss the steps involved.
Question 6
(a) Explain a factor model.
(6 marks)
(b) Consider two stocks (A and B), whose returns are determined by the following
two-factor model:
RA = 0.04 + 0.8F1 + 0.5F2 + "A
RB = 0.06 + 0.7F1 + 0.3F2 + "B.
What is the factor model for a portfolio made up of 30% in stock A and 70% in
stock B?
(4 marks)
(c) Outline the key features of Markowitz’s modern portfolio theory (MPT) and
hence explain the main lessons for an investor from MPT (the use of
appropriate diagrams is encouraged).
(15 marks)
Reading for this question
For (a) and (b), see subject guide, Chapter 8, page 178.
For (c), see subject guide, Chapter 8, pages 166–71.
Approaching the question
(a) The subject guide sets out the key elements of a factor model. Each of the elements should
be explained.
(b) The factor model for the portfolio will be a weighted average of the sensitivities of the two
factor models for A and B. We have:
Rp = (0.04⇥ 0.3 + 0.06⇥ 0.7) + (0.8⇥ 0.3 + 0.7⇥ 0.7)F1 + (0.5⇥ 0.3 + 0.3⇥ 0.7)F2 + "p
= 0.054 + 0.73F1 + 0.36F2 + "p.
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FN1024 Principles of banking and finance
(c) The key elements of Markowitz’s MPT are set out in the subject guide. To provide a good
answer to this question you need identify the lessons from MPT for an investor. Marks are
given for the use of appropriate diagrams to illustrate your answer.
Question 7
(a) Compare and contrast income gap and duration gap analysis as techniques for
management of interest rate risk by banks.
(12 marks)
(b) Consider the following balance sheet of Fairview Bank:
Assets (£) Duration Liabilities (£) Duration
Variable-rate 1,900 8.3 Money market 3,700 1.1
mortgages deposits
Fixed-rate 1,500 7.1 Savings 4,200 3.2
mortgages deposits
Commercial 6,500 5.0 Variable-rate 2,200 1.5
loans CDs
Physical capital 2,900 Equity 2,700
Total 12,800 Total 12,800
What will be the change in net interest income at the year-end if interest rates
decrease by 0.5 per cent, from 4 to 3.5 per cent? Explain using basic gap
analysis. (Use the following assumptions for runo↵ cash flows: fixed-rate
mortgages repaid during the year: 15 per cent; proportion of savings deposits
and variable-rate CDs that are rate-sensitive: 15 per cent).
(7 marks)
(c) Calculate the duration gap for Fairview Bank? Explain why a bank will
normally have a duration gap greater than zero.
(6 marks)
Reading for this question
For (a), see subject guide, Chapter 6, pages 125–30.
For (b), see subject guide, Chapter 6, pages 125–26.
For (c), see subject guide, Chapter 6, pages 127–30.
Approaching the question
(a) Using income gap analysis banks report the gap in each maturity bucket, calculated as the
di↵erence between rate-sensitive assets (RSA) and rate-sensitive liability (RSL) on their
balance sheets. The formula for the calculation of the gap:
GAP = RSA RSL.
Answers should clarify that a positive GAP implies sensitive assets > sensitive liabilities.
They should also illustrate the consequences of a change in interest rates in such a situation:
the rise in interest rates will cause a bank to have interest revenue rising faster than interest
costs; thus the net interest margin and income will increase. The decline in interest rates
will increase liabilities costs faster than assets returns; as a consequence the net interest
margin and income will decrease.
Answers should then make clear the link between the gap measure and the possibility to use
it in the management of interest rate risk. Banks’ managers can calculate the income
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Examiners’ commentaries 2020
exposure to changes in interest rates in di↵erent maturity buckets, by multiplying GAP
times the change in the interest rate:
I = GAP⇥i
where I = change in the banks’ income, and i = change in interest rate.
Duration gap analysis identifies the Duration gap for a bank which is essentially the
di↵erence between the duration of its assets and liabilities. This gap measures the
sensitivity of the banks equity to changes in interest rates.
The larger the gap the more sensitive the bank’s asset and liability values will be to changes
in interest rates. Hence these changes a↵ect equity.
To provide a good answer to this part you need to explain that each of the gap measures
relate to di↵erent types of interest rate risk: income gap measure the impact of a change in
interest rates on the bank’s net income whereas duration gap examines the impact on
market values of assets and liabilities and hence equity.
(b) Rate sensitive assets:
RSA = 1,900 + 1,500⇥ 0.15 + 6,500 = 8,625.
Rate sensitive liabilities:
RSL = 3,700 + 4,200⇥ 0.15 + 2,200⇥ 0.15 = 4,660.
Income Gap is:
8,625 4,660 = 3,965.
Change in net interest income equals:
Gap⇥ change in int. rate = 3,965⇥ (0.005) = 19.825
i.e. a decrease in net interest income of 19.825.
(c) Duration of assets is:
1,900
12,800
⇥ 8.3 + 1,500
12,800
⇥ 7.1 + 6,500
12,800
⇥ 5 = 4.603 years.
Duration of liabilities is:
3,700
10,100
⇥ 1.1 + 4,200
10,100
⇥ 3.2 + 2,200
10,100
⇥ 1.5 = 2.06 years.
Duration Gap is:
DurA L
A
⇥Dur L = 4.603 10,100
12,800
⇥ 1.878 = 2.978 years.
Duration gap analysis helps the Bank to identify the sensitivity of the Bank’s equity to
changes in interest rates. Duration Gap will always be positive for a bank as Dur A will
always be greater than Dur L as the bank is an intermediary. The higher the Dur Gap the
more sensitivity the equity of the bank is to changes in interest rates. Note that there is an
inverse relationship between changes in equity and changes in interest rates.
11
FN1024 Principles of banking and finance
Question 8
(a) Explain the concept of Macaulay duration and explain the relationship between
Macaulay duration and:
i. bond maturity
ii. interest rates
iii. bond coupon rate.
(7 marks)
(b) Calculate the price and Macaulay duration of a five-year 5% coupon bond where
the market interest rate is 5%. Assume the par value of the bond is $1,000 and
coupons are paid annually.
(6 marks)
(c) An investor decides to construct a bond portfolio made up of $20,000 in a bond
with a Macaulay duration of 5 years and $30,000 in a three-year zero-coupon
bond (par value = $1,000). What is the Macaulay duration of this bond
portfolio?
(4 marks)
(d) Estimate, using modified duration, the change in the price of the five-year 5%
coupon bond (described in part (b)) if the market interest rate decreases from
5% to 4%.
(4 marks)
(e) Explain why the modified duration measure only gives good estimates of price
changes when the change in the market interest rate being considered is small.
(4 marks)
Reading for this question
See subject guide, Chapter 6, pages 128–30.
Approaching the question
(a) Macauley duration measures the sensitivity of a bond price to changes in interest rates. It
can also be defined as a weighted average of the time to maturity of the cash flows of a bond
where the weights are the relative present values of the cash flows.
Macauley Duration is positively related to maturity.
Macauley Duration is negatively related to interest rates.
Macauley Duration is negatively related to coupon rates.
Each of these needs explaining.
(b) We have:
P =
50
1.05
+
50
(1.05)2
+
50
(1.05)3
+
50
(1.05)4
+
1,050
(1.05)5
= 1,000.
Better candidates will see that as coupon rate = interest rate then P = Par value.
t cf i/df cf⇥ 1/df t⇥ cf⇥ 1/df
1 50 1.05 47.6190476 47.6190476
2 50 1.1025 45.3514739 90.7029478
3 50 1.157625 43.1918799 129.57564
4 50 1.21550625 41.1351237 164.540495
5 1,050 1.27628156 822.702475 4,113.51237
1,000 4,545.9505
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Examiners’ commentaries 2020
Hence the duration is 4.5459505.
(c) Duration of portfolio is:
0.4⇥ 5 + 0.6⇥ 3 = 3.8 years.
Note that the duration of the zero-coupon bond equals the maturity of the bond. The
calculation is then a simple weighted average of the durations of the two bonds.
(d) Modified Duration is:
Change in P = D ⇥ change in i
i
= 4.55⇥ 0.01
1.05
= 0.0433
i.e. the bond price is estimated to increase by 4.33%.
(e) The relationship between bond price and the change in market interest rates in the modified
duration formula is linear. This is not correct as the relationship is non-linear (convex). So,
the modified duration formula provides an estimate and is generally a good estimate as long
as the change in interest rate considered is small.
A diagram to illustrate would be rewarded.
13
Examiners’ commentaries 2020
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2019–20. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
di↵erent editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.
Comments on specific questions
Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.
Section A
Candidates should answer ONE question and NO MORE THAN TWO further questions from
this section.
Question 1
(a) Discuss the main causes of illiquidity and insolvency in banking and discuss the
relationship between them.
(10 marks)
(b) Explain operational risk and market risk as it a↵ects banks. Give examples.
(5 marks)
(c) Explain credit risk as it a↵ects banks and discuss the techniques banks can use
to manage the moral hazard created by a credit risk exposure.
(10 marks)
Reading for this question
For (a), see subject guide, Chapter 6, pages 116–31.
For (b), see subject guide, Chapter 6, pages 118–20.
3
FN1024 Principles of banking and finance
For (c), see subject guide, Chapter 6, pages 120–25.
Approaching the question
(a) Liquidity is a state where the bank is short of funds to meet cash needs. The main cash
need is deposit withdrawals (also the most uncertain). Large deposit withdrawals that
create illiquidity are typically caused by a loss of confidence in a bank leading to a ‘run’.
Another contributory factor is banks do not hold a large stock of liquid assets as a bu↵er to
meet unexpected cash needs (as liquid assets are a poor earning asset).
Insolvency is a state when the value of a bank’s assets falls below the value of liabilities
(principally deposits). This could be caused by defaults on loans (arising from credit risk),
reductions in trading asset values (arising from market risk) and losses generally (arising
from operational risk – for example, fraud etc.). A contributory factor to insolvency risk is
that banks do not hold a lot of capital (equity) – although this has increased with Basel 3.
A common issue in answering this part was to focus on the nature of illiquidity and
insolvency and not to explain the possible causes. Another problem was that some answers
did not consider the second element of this part, namely the link between the two concepts.
(b) Operational risk is the risk of loss arising from the banks operations, policies and people. It
includes risks such as IT failure, fraud and mismanagement. A classic example would be
that of the rogue trader Nick Leeson who in 1995 created extremely high trading losses for
Barings Bank which exceeded the capital of the bank causing it to fail. This illustrates poor
procedures at Barings as the trader did not have proper oversight.
Market risk is the risk of loss on the bank’s trading assets due to adverse changes in market
prices/interest rates. Trading assets are held for speculative purposes and include bonds,
currencies etc. Banks faced significant market risk in the period leading up to 2008 as they
held large positions in MBSs and CDOs – these su↵ered a large loss of value leading to
insolvency problems for the a↵ected banks – many of which had to be bailed out.
The main issue in answering this question was failure to provide example.
(c) Credit risk is related to non-performance of a debt contract – typically default.
Moral hazard refers to the risk of default increasing after the loan has been made due to
immoral actions by the borrower. These can be mitigated using:
i. restrictive covenants
ii. credit rationing
iii. taking security.
The way each of these impacts on moral hazard needs explaining.
The main issue with answering this part was to explain all the techniques for managing
credit risk rather than those that mitigated moral hazard.
Question 2
(a) Explain how banks are able to act as intermediaries by reconciling conflicting
requirements of lenders and borrowers and reducing costs.
(12 marks)
(b) Explain the Diamond theory of delegated monitoring and discuss its
contribution to our understanding of financial intermediation.
(13 marks)
4
Examiners’ commentaries 2020
Reading for this question
For (a), see subject guide, Chapter 4, pages 69–72.
For (b), see subject guide, Chapter 4, page 81.
Approaching the question
(a) A bank engages in financial intermediation by issuing deposit contracts to raise funding and
then lending those funds using loan contracts. In the process of intermediation banks
transform the characteristics of the funds as they pass from lenders to borrowers.
This asset transformation occurs in order to reconcile the di↵erent requirements of lenders
and borrowers by using claims with characteristics that meet each of their needs.
The process of asset transformation creates liquidity risk (through liquidity transformation)
and credit risk (though risk transformation).
Banks can manage these risks more e↵ectively than other agents as they have advantages of
scale (allowing them to pool and diversify to reduce credit risk) – this allows them to o↵er
safe deposits to depositors thus reducing the potential for loss of confidence thus reducing
liquidity risk. Note that pooling and diversification of deposits also reduces liquidity risk.
Other advantages banks have, include, expertise.
Lending and borrowing incurs significant costs including search costs, verification costs,
monitoring costs and enforcement costs. Banks also use the advantages of economies of scale
and expertise to reduce costs for lenders and borrowers.
(b) The main idea of the delegated monitoring theory is that since monitoring borrowers is
costly, it is ecient for surplus units (lenders) to delegate the task of monitoring to
specialised agents such as banks. Banks have a comparative advantage relative to direct
lending in monitoring activities in the context of costly state verification. In fact, they have
a better ability to reduce monitoring costs because of their diversification.
Hypotheses required for delegated monitoring to work:
1. existence of scale economies in monitoring, that means that a typical bank finances many
(n) projects
2. small capacity of investors as compared to the size of investments, that means that each
project needs the funds of several investors (m)
3. low cost of delegation, that means that the cost of monitoring the financial intermediary
itself has to be less than the surplus gained from exploiting scale economies in
monitoring investment projects.
Direct lending implies that each of the m investors monitors the financed firm: the total cost
is n⇥m⇥K.
If a bank (financial intermediary) emerges, it can choose to monitor each firm (total cost
n⇥K): the bank is a delegated monitor, which monitors borrowers on behalf of lenders
(note that the bank is not monitored by its lenders – the depositors). As:
n⇥ k < N ⇥m⇥K
then lower cost to delegate.
Financial intermediation (delegated monitor) dominates direct lending as soon as n is large
enough: this means that diversification exists (i.e. a large number of loans are held by the
intermediary). Diversification is important because it increases the probability that the
intermediary has sucient loan proceeds to repay a fixed debt claim to depositors – this
reduces delegation cost to near zero.
The key issue with answering this part was to ignore the role played by diversification of
loans in reducing delegation cost.
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FN1024 Principles of banking and finance
Question 3
(a) With reference to examples, discuss the characteristics and consequences of
financial bubbles.
(12 marks)
(b) Discuss the empirical evidence on market under-reaction in the context of weak
and semi-strong form eciency.
(13 marks)
Reading for this question
For (a), see subject guide, Chapter 3, pages 59–61.
For (b), see subject guide, Chapter 5, pages 195–96.
Approaching the question
(a) Financial bubbles occur when the market price of an asset rises well above its fundamental
value. Better answers will discuss the problems associated with determining fundamental
value for assets with uncertain future returns.
Bubbles typically occur when there is a rising market and bullish sentiment. Often fuelled
by access to low cost easily available credit. Bubbles cannot exist permanently – at some
point a correction will occur and the price of the overvalued asset will fall. This can lead to
distress selling and defaults on borrowed funds.
Examples include Tulip Mania, Dot-com bubble, housing market bubbles.
Better answers will identify that bubbles are often associated with a rapid expansion in the
supply of credit.
(b) Evidence on market underreaction constitutes an anomaly related to earnings
announcements. Although empirical evidence generally confirms rapid adjustment to new
information (as shown in the evidence in favour of the semi-strong-form eciency), recent
evidence shows that stock prices do not instantaneously adjust. Two key anomalies are
identified: stock price overreaction and underreaction.
A definition of underreaction should be provided: underreaction to earnings announcements
means that stock prices do not fully incorporate the new information embodied in the
unexpected earnings announcement.
Answers should then examine the empirical evidence that shows that adjustment to extreme
bad news takes several months: there is a market overreaction and subsequent gradual
adjustment (see, for example, the evidence in Ball and Brown (1968), then confirmed by
Bernard and Thomas (1989)).
Better answers will describe the methodology and findings of the study by Bernard and
Thomas (1989) and show how the momentum strategy adopted is consistent with
semi-strong eciency.
Outstanding candidates are expected to make the link with the empirical evidence on
underreaction existing at a di↵erent level of informational eciency – the weak form
eciency (see results in Jegadeesh and Titman (1993)). This evidence suggests buying past
winner stocks and selling past losers to get excess returns. Once again, this evidence
suggests excess returns associated with a momentum strategy, but this evidence is
inconsistent with the weak-form eciency (not the semi-strong form) because the strategy is
based on historical prices only.
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Examiners’ commentaries 2020
Question 4
(a) Explain asymmetric information in lending/borrowing and discuss how adverse
selection influences the lending decision of banks.
(11 marks)
(b) Explain how moral hazard a↵ects equity contracts and discuss why moral
hazard is lower for debt contracts compared to equity contracts.
(9 marks)
(c) Explain why loan contracts su↵er less from free-riding problems compared to
bonds or other public financing.
(5 marks)
Reading for this question
For (a), see subject guide, Chapter 4, pages 73–76.
For (b), see subject guide, Chapter 4, pages 77–79.
For (c), see subject guide, Chapter 4, pages 79–80.
Approaching the question
(a) Asymmetric information occurs when one party to a transaction has less information than
the other party. In the case of lending/borrowing the lender will normally have less
information than the borrower. This creates two problems – adverse selection before the
loan is made and moral hazard after the loan is made.
Adverse selection is the problem created by asymmetric information before the transaction
occurs. It arises when the potential borrowers who are most likely to produce an undesirable
(adverse) outcome are the ones who most actively seek out loans. Thus, adverse selection
increases the probability that bad credit risks will get loans.
Following Akerlof (1970) in a market characterised by asymmetric information, lenders have
less information than borrowers. Lenders will therefore charge an interest rate reflecting the
average quality (risk) of borrowers in the market. This will be higher than good quality (low
risk) borrowers will be willing to pay and so mainly poor quality (high risk) borrowers will
seek a loan.
Better answers will explain how, in the presence of asymmetric information. Fewer potential
lenders will choose to engage in lending. However, banks will seek to mitigate adverse
selection through information production.
(b) Moral hazard in equity contracts qualifies as a special type known as the principal-agent
problem (Jensen and Meckling, 1976). Stockholders (called principals) own most of the
firm’s equity, but they are not the same people as the managers (agents) of the firm.
Managers have more information about their activities than stockholders so that there is
asymmetric information. The separation of ownership and control, together with the
asymmetric information, induce managers to act in their own interest rather than in the
interest of stockholder-owners (for example, managers will not take actions that maximise
firm value if the private costs borne by them for those actions are high).
Moral hazard in debt contracts is lower than in equity contracts but is still present. Debt
contracts require borrowers to pay fixed amounts and let them keep any profit above this
amount. Consequently, borrowers have incentives to take investments riskier than lenders
would like.
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FN1024 Principles of banking and finance
(c) Free-riding occurs when one party engages in an activity which incurs cost. However, others
can observe the activity and obtain benefits from without payment. So, the first party
incurs all the costs but does not get all the benefits.
A problem for tradable securities, such as bonds. Free-riding can reduce then benefits from
information production and from monitoring. For example, some bond-holders may decide
not to monitor restrictive covenants – i.e. free-ride on the monitoring of other investors. The
free-riders thus obtain benefits of monitoring without incurring cost.
Loan contracts created by a bank are not tradable. So a bank can incur costs to produce
information or monitor restrictive covenants without anyone free-riding. Hence the bank will
get all the benefits.
Section B
Candidates should answer ONE question and NO MORE THAN TWO further questions from
this section.
Question 5
(a) Plantfood paid an annual dividend of $3 on its common stock and promises that
the dividend will grow by 3% per year. If the stock’s marketprice is $30, what is
required rate of return for this stock?
(3 marks)
(b) Datasoft is currently paying dividends of $0.70 a share. These dividends are
expected to grow at a rate of 20% for the next two years and at a constant
growth rate of 3.5% thereafter. What would be the current price of Datasoft
shares given a required return of 15%?
(4 marks)
(c) Compare and contrast the risk and return for debt and equity securities from
the perspective of both lenders/investors and issuers.
(9 marks)
(d) Formally derive and discuss the dividend discount model used for the valuation
of common stocks.
(9 marks)
Reading for this question
For (a), see subject guide, Chapter 7, pages 154–5.
For (b), see subject guide, Chapter 7, pages 152–5.
For (c), see subject guide, Chapter 7, page 150.
For (d), see subject guide, Chapter 7, pages 152–4.
Approaching the question
(a) Using the Gordon growth model:
P0 =
D1
r g
where D1 = D0(1 + g). Hence:
30 =
3(1.03)
r 0.03 ) r 0.03 =
3(1.04)
30
) r 0.03 = 3.12
30
= 0.104
therefore:
r = 0.104 + 0.03 = 0.134 = 13.4%.
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Examiners’ commentaries 2020
(b) We have:
P0 =
D1
1 + r
+
D2
(1 + r)2
+
P2
(1 + r)2
where D1 = D0(1.2), D2 = D1(1.2), P2 = D3/(r g) and D3 = D2(1.035). Hence:
P0 =
0.84
1.15
+
1.008
(1.15)2
+
1.043/(0.15 0.035)
(1.15)2
= 8.35.
(c) Debt is low risk, low return for investors but high risk, low cost for issuers. Equity is high
risk, high return for investors but low risk, high cost for issuers
These relationships need explaining – particularly the high risk for debt issuers which arises
from the contractual nature of interest payments
(d) The subject sets out the key elements of the derivation of the dividend discount model.
Better answers discuss the steps involved.
Question 6
(a) Explain a factor model.
(6 marks)
(b) Consider two stocks (A and B), whose returns are determined by the following
two-factor model:
RA = 0.04 + 0.8F1 + 0.5F2 + "A
RB = 0.06 + 0.7F1 + 0.3F2 + "B.
What is the factor model for a portfolio made up of 30% in stock A and 70% in
stock B?
(4 marks)
(c) Outline the key features of Markowitz’s modern portfolio theory (MPT) and
hence explain the main lessons for an investor from MPT (the use of
appropriate diagrams is encouraged).
(15 marks)
Reading for this question
For (a) and (b), see subject guide, Chapter 8, page 178.
For (c), see subject guide, Chapter 8, pages 166–71.
Approaching the question
(a) The subject guide sets out the key elements of a factor model. Each of the elements should
be explained.
(b) The factor model for the portfolio will be a weighted average of the sensitivities of the two
factor models for A and B. We have:
Rp = (0.04⇥ 0.3 + 0.06⇥ 0.7) + (0.8⇥ 0.3 + 0.7⇥ 0.7)F1 + (0.5⇥ 0.3 + 0.3⇥ 0.7)F2 + "p
= 0.054 + 0.73F1 + 0.36F2 + "p.
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FN1024 Principles of banking and finance
(c) The key elements of Markowitz’s MPT are set out in the subject guide. To provide a good
answer to this question you need identify the lessons from MPT for an investor. Marks are
given for the use of appropriate diagrams to illustrate your answer.
Question 7
(a) Compare and contrast income gap and duration gap analysis as techniques for
management of interest rate risk by banks.
(12 marks)
(b) Consider the following balance sheet of Fairview Bank:
Assets (£) Duration Liabilities (£) Duration
Variable-rate 1,900 8.3 Money market 3,700 1.1
mortgages deposits
Fixed-rate 1,500 7.1 Savings 4,200 3.2
mortgages deposits
Commercial 6,500 5.0 Variable-rate 2,200 1.5
loans CDs
Physical capital 2,900 Equity 2,700
Total 12,800 Total 12,800
What will be the change in net interest income at the year-end if interest rates
decrease by 0.5 per cent, from 4 to 3.5 per cent? Explain using basic gap
analysis. (Use the following assumptions for runo↵ cash flows: fixed-rate
mortgages repaid during the year: 15 per cent; proportion of savings deposits
and variable-rate CDs that are rate-sensitive: 15 per cent).
(7 marks)
(c) Calculate the duration gap for Fairview Bank? Explain why a bank will
normally have a duration gap greater than zero.
(6 marks)
Reading for this question
For (a), see subject guide, Chapter 6, pages 125–30.
For (b), see subject guide, Chapter 6, pages 125–26.
For (c), see subject guide, Chapter 6, pages 127–30.
Approaching the question
(a) Using income gap analysis banks report the gap in each maturity bucket, calculated as the
di↵erence between rate-sensitive assets (RSA) and rate-sensitive liability (RSL) on their
balance sheets. The formula for the calculation of the gap:
GAP = RSA RSL.
Answers should clarify that a positive GAP implies sensitive assets > sensitive liabilities.
They should also illustrate the consequences of a change in interest rates in such a situation:
the rise in interest rates will cause a bank to have interest revenue rising faster than interest
costs; thus the net interest margin and income will increase. The decline in interest rates
will increase liabilities costs faster than assets returns; as a consequence the net interest
margin and income will decrease.
Answers should then make clear the link between the gap measure and the possibility to use
it in the management of interest rate risk. Banks’ managers can calculate the income
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Examiners’ commentaries 2020
exposure to changes in interest rates in di↵erent maturity buckets, by multiplying GAP
times the change in the interest rate:
I = GAP⇥i
where I = change in the banks’ income, and i = change in interest rate.
Duration gap analysis identifies the Duration gap for a bank which is essentially the
di↵erence between the duration of its assets and liabilities. This gap measures the
sensitivity of the banks equity to changes in interest rates.
The larger the gap the more sensitive the bank’s asset and liability values will be to changes
in interest rates. Hence these changes a↵ect equity.
To provide a good answer to this part you need to explain that each of the gap measures
relate to di↵erent types of interest rate risk: income gap measure the impact of a change in
interest rates on the bank’s net income whereas duration gap examines the impact on
market values of assets and liabilities and hence equity.
(b) Rate sensitive assets:
RSA = 1,900 + 1,500⇥ 0.15 + 6,500 = 8,625.
Rate sensitive liabilities:
RSL = 3,700 + 4,200⇥ 0.15 + 2,200⇥ 0.15 = 4,660.
Income Gap is:
8,625 4,660 = 3,965.
Change in net interest income equals:
Gap⇥ change in int. rate = 3,965⇥ (0.005) = 19.825
i.e. a decrease in net interest income of 19.825.
(c) Duration of assets is:
1,900
12,800
⇥ 8.3 + 1,500
12,800
⇥ 7.1 + 6,500
12,800
⇥ 5 = 4.603 years.
Duration of liabilities is:
3,700
10,100
⇥ 1.1 + 4,200
10,100
⇥ 3.2 + 2,200
10,100
⇥ 1.5 = 2.06 years.
Duration Gap is:
DurA L
A
⇥Dur L = 4.603 10,100
12,800
⇥ 1.878 = 2.978 years.
Duration gap analysis helps the Bank to identify the sensitivity of the Bank’s equity to
changes in interest rates. Duration Gap will always be positive for a bank as Dur A will
always be greater than Dur L as the bank is an intermediary. The higher the Dur Gap the
more sensitivity the equity of the bank is to changes in interest rates. Note that there is an
inverse relationship between changes in equity and changes in interest rates.
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FN1024 Principles of banking and finance
Question 8
(a) Explain the concept of Macaulay duration and explain the relationship between
Macaulay duration and:
i. bond maturity
ii. interest rates
iii. bond coupon rate.
(7 marks)
(b) Calculate the price and Macaulay duration of a five-year 5% coupon bond where
the market interest rate is 5%. Assume the par value of the bond is $1,000 and
coupons are paid annually.
(6 marks)
(c) An investor decides to construct a bond portfolio made up of $20,000 in a bond
with a Macaulay duration of 5 years and $30,000 in a three-year zero-coupon
bond (par value = $1,000). What is the Macaulay duration of this bond
portfolio?
(4 marks)
(d) Estimate, using modified duration, the change in the price of the five-year 5%
coupon bond (described in part (b)) if the market interest rate decreases from
5% to 4%.
(4 marks)
(e) Explain why the modified duration measure only gives good estimates of price
changes when the change in the market interest rate being considered is small.
(4 marks)
Reading for this question
See subject guide, Chapter 6, pages 128–30.
Approaching the question
(a) Macauley duration measures the sensitivity of a bond price to changes in interest rates. It
can also be defined as a weighted average of the time to maturity of the cash flows of a bond
where the weights are the relative present values of the cash flows.
Macauley Duration is positively related to maturity.
Macauley Duration is negatively related to interest rates.
Macauley Duration is negatively related to coupon rates.
Each of these needs explaining.
(b) We have:
P =
50
1.05
+
50
(1.05)2
+
50
(1.05)3
+
50
(1.05)4
+
1,050
(1.05)5
= 1,000.
Better candidates will see that as coupon rate = interest rate then P = Par value.
t cf i/df cf⇥ 1/df t⇥ cf⇥ 1/df
1 50 1.05 47.6190476 47.6190476
2 50 1.1025 45.3514739 90.7029478
3 50 1.157625 43.1918799 129.57564
4 50 1.21550625 41.1351237 164.540495
5 1,050 1.27628156 822.702475 4,113.51237
1,000 4,545.9505
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Examiners’ commentaries 2020
Hence the duration is 4.5459505.
(c) Duration of portfolio is:
0.4⇥ 5 + 0.6⇥ 3 = 3.8 years.
Note that the duration of the zero-coupon bond equals the maturity of the bond. The
calculation is then a simple weighted average of the durations of the two bonds.
(d) Modified Duration is:
Change in P = D ⇥ change in i
i
= 4.55⇥ 0.01
1.05
= 0.0433
i.e. the bond price is estimated to increase by 4.33%.
(e) The relationship between bond price and the change in market interest rates in the modified
duration formula is linear. This is not correct as the relationship is non-linear (convex). So,
the modified duration formula provides an estimate and is generally a good estimate as long
as the change in interest rate considered is small.
A diagram to illustrate would be rewarded.
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