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© University of London 2018
UL18/0194 Page 1 of 4 D0
~~FN1024_ZA_2016_d0
This paper is not to be removed from the Examination Hall
UNIVERSITY OF LONDON FN1024 ZA
BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences
Principles of Banking and Finance
Wednesday, 9 May 2018 : 10:00 to 13:00
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.
A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.
PLEASE TURN OVER
© University of London 2018
UL18/0194 Page 2 of 4 D0
SECTION A
Answer ONE question and NO MORE THAN TWO further questions from this section.
1. (a) Explain how a bank can become (i) insolvent and (ii) illiquid. Discuss the role of capital in
preventing a bank becoming insolvent and illiquid. (12 marks)
(b) Explain liquidity risk in banking and critically evaluate the methods a bank can use to
manage liquidity risk. (13 marks)
2. (a) Briefly outline the moral hazard problem as it affects financial contracts. (3 marks)
(b) Compare the moral hazard problem in equity and debt contracts and explain why moral
hazard is generally lower for debt contracts. (9 marks)
(c) Outline the Diamond model of delegated monitoring. (13 marks)
3. (a) Distinguish between weak-form, semi-strong form and strong-form levels of market
efficiency. Discuss the implications of weak, semi-strong and strong form efficient equity
markets for investors. (6 marks)
(b) Explain the joint-hypothesis problem encountered when testing for informational
efficiency of a market. (7 marks)
(c) Discuss the evidence relating to weak-form efficiency of equity markets. (12 marks)
4. (a) Discuss the advantages and disadvantages of unregulated banking. (12 marks)
(b) Explain the causes, consequences and solutions for the problem of banks being ‘too big
to fail’. (13 marks)
© University of London 2018
UL18/0194 Page 3 of 4 D0
SECTION B
Answer ONE question and NO MORE THAN TWO further questions from this section.
5. A firm is considering two investment projects, Yana and Zeta. These projects are NOT
mutually exclusive. Assume the firm is not capital constrained. The initial costs and
cashflows for these projects are:
Year Yana Zeta
0 -50,000 -45,000
1 19,000 10,000
2 17,000 20,000
3 25,000 25,000
(a) Using a discount rate of 10% calculate the net present value for each project. What
decision would you make based on your calculations? (4 marks)
(b) How would your decision change if the discount rate used for calculating the net present
value is 12%? (4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%. What
decision would you make based on your calculations? (6 marks)
(d) Calculate the payback period for each project. The company looks to select investment
projects paying back in 2 years. What decision would you make based on your
calculations? (2 marks)
(e) Discuss the advantages and disadvantages of the payback rule of investment appraisal.
(4 marks)
(f) Discuss the limitations of the internal rate of return method of investment appraisal
(5 marks)
6. (a) Discuss the advantages and limits to diversification when constructing a portfolio of risky
assets. (6 marks)
(b) Explain the following concepts:
(i) risk free asset
(ii) unsystematic risk
(iii) the efficient frontier
(iv) the security market line
(8 marks)
(c) You are given the following information:
(i) A stock with a beta of 0 has an expected return of 4%.
(ii) A portfolio made up of 30% invested at the risk free rate and 70% invested in the
market portfolio has an expected return of 15%
What is the market risk premium? (4 marks)
Question continues on next page.
© University of London 2018
UL18/0194 Page 4 of 4 D0
(d) Discuss the problems associated with empirically testing the Capital Asset Pricing
Model. (7 marks)
7. (a) Distinguish between re-financing risk and re-investment risk. Give examples of each and
explain which of these risks a bank is more likely to face. (8 marks)
(b) Consider the following extracts from the balance sheet of Radobank (values in £millions
and duration in years):
Value Duration
Loans (short term) 1700 0.9
Loans (long term) 3000 3.9
Mortgages 4400 8.4
T-bonds 1200 3.2
Deposits 8500 1.7
Calculate the duration gap for Radobank (5 marks)
(c) Explain the relationship between the market value of equity and a change in interest
rates. (4 marks)
(d) What is the change in the market value of equity of Radobank, as a percentage of
assets, if interest rates increase from 4.5% to 5.0%? (3 marks)
(e) Critically discuss the main problems associated with duration gap analysis.
(5 marks)
8. (a) Discuss the problems of valuing common stocks compared to bonds. (6 marks)
(b) Formally derive and explain the dividend discount model used for the valuation of
common stocks. (9 marks)
(c) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)
(d) Consider the following stocks:
Stock A is expected to pay a dividend of £4 next year and then an annual dividend of £5
from the following year, forever.
Stock B is expected to pay a dividend of £4 next year (t=1) with dividend growth
expected to be 10% per annum for the next three years (t=2, 3, 4) before settling down
to 4% a year thereafter (t=5 …).
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)
END OF PAPER
© University of London 2018
UL18/0195 Page 1 of 4 D0
~~FN1024_ZA_2016_d0
This paper is not to be removed from the Examination Hall
UNIVERSITY OF LONDON FN1024 ZB
BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences
Principles of Banking and Finance
Wednesday, 9 May 2018 : 10:00 to 13:00
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.
A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.
PLEASE TURN OVER
© University of London 2018
UL18/0195 Page 2 of 4 D0
SECTION A
Answer ONE question and NO MORE THAN TWO further questions from this section.
1. (a) Distinguish between liquidity and solvency in relation to a bank. Explain how a bank could
become insolvent and explain the role of capital and liquidity in preventing insolvency.
(12 marks)
(b) Explain market risk and how it affects banks and critically evaluate how banks manage
this risk. (13 marks)
2. (a) Discuss the role of asymmetric information in explaining the existence of banks.
(15 marks)
(b) Briefly outline Leland and Pyle’s informational economies of scale theory.
(10 marks)
3. (a) Distinguish between weak-form, semi-strong form and strong-form levels of market
efficiency. Discuss the implications of weak, semi-strong and strong form efficient equity
markets for investors. (6 marks)
(b) Explain the joint-hypothesis problem encountered when testing for informational efficiency
of a market. (7 marks)
(c) Discuss the evidence relating to semi-strong efficiency of equity markets.
(12 marks)
4. (a) Discuss the reasons for the regulation of banks. (12 marks)
(b) Discuss how Basel 3 improves on Basel 1 and 2 in terms of improving the ability of banks
to withstand shocks. (13 marks)
© University of London 2018
UL18/0195 Page 3 of 4 D0
SECTION B
Answer ONE question and NO MORE THAN TWO further questions from this section.
5. A firm is considering two investment projects, A and B. These projects are NOT mutually
exclusive. Assume the firm is not capital constrained. The initial costs and cashflows for
these projects are:
Year A B
0 -48,00 -42,000
1 19,000 10,000
2 17,000 35,000
3 25,000 8,000
(a) Using a discount rate of 10% calculate the net present value for each project. What
decision would you make based on your calculations? (4 marks)
(b) How would your decision change if the discount rate used for calculating the net present
value is 12.5%? (4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%. What
decision would you make based on your calculations? (6 marks)
(d) Calculate the payback period for each project. The company looks to select investment
projects paying back in 2 years. What decision would you make based on your
calculations? (2 marks)
(e) Discuss the advantages and disadvantages of the payback rule of investment appraisal.
(4 marks)
(f) Discuss the limitations of the internal rate of return method of investment appraisal
(5 marks)
6. (a) Outline the key features of Markowitz’s modern portfolio theory (MPT) and discuss the
implications of MPT for an investor in risky securities (the use of diagrams in your answer is
encouraged). (13 marks)
(b) You are given the following information:
(i) A stock with a beta of 0 has an expected return of 5%.
(ii) A portfolio made up of 20% invested at the risk free rate and 80% invested in the
market portfolio has an expected return of 14%
What is the market risk premium? (4 marks)
(c) Discuss the limitations of the Capital Asset Pricing Model. (8 marks)
© University of London 2018
UL18/0195 Page 4 of 4 D0
7. (a) Distinguish between re-financing risk and re-investment risk. Give examples of each and
explain which of these risks a bank is more likely to face. (8 marks)
(b) Consider the following extracts from the balance sheet of Exxobank (values in £millions
and duration in years):
Value Duration
Loans (short term) 1800 0.9
Loans (long term) 3000 3.6
Mortgages 4000 8.4
T-bonds 1200 3.2
Deposits 9000 1.6
Calculate the duration gap for Exxobank (5 marks)
(c) What is the change in the market value of equity of Exxobank, as a percentage of assets,
if interest rates increase from 4.5% to 5.0%? (3 marks)
(d) Explain the respective roles and limitations of liquidity gap and duration gap analysis in
helping banks manage interest rate risk. (9 marks)
8. (a) Briefly discuss the problems of valuing common stocks, preferred stocks and corporate
bonds. (6 marks)
(b) Formally derive and explain the dividend discount model used for the valuation of
common stocks. (9 marks)
(c) Discuss the usefulness of the Gordon Growth model for the valuation of stocks.
(4 marks)
(d) Consider the following stocks:
Stock A is expected to pay a dividend of £3 next year and then an annual dividend of £4
from the following year, forever.
Stock B is expected to pay a dividend of £4 next year (t=1) with dividend growth
expected to be 10% per annum for the next first three years before settling down to 4%
a year thereafter (t=5 …).
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)
END OF PAPER
Examiners’ commentaries 2018
Examiners’ commentaries 2018
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2017–18. 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.
General remarks
Learning outcomes
At the end of the course and having completed the Essential reading and activities you should:
• discuss why financial systems exist, and how they are structured
• explain why the relative importance of financial intermediaries and financial markets is
di↵erent around the world, and how bank-based systems di↵er from market-based systems
• understand why financial intermediaries exist, and discuss the role of transaction costs and
information asymmetry theories in providing an economic justification
• explain why banks need regulation, and illustrate the key reasons for and against the
regulation of banking systems
• discuss the main types of risks faced by banks, and use the main techniques employed by
banks to manage their risks
• explain how to value real assets and financial assets, and use the key capital budgeting
techniques (Net Present Value and Internal Rate of Return)
• explain how to value financial assets (bonds and stocks)
• understand how risk a↵ects the return of a risky asset, and hence how risk a↵ects the value
of the asset in equilibrium under the fundamental asset pricing paradigms (Capital Asset
Pricing Model and Asset Pricing Theory)
• discuss whether stock prices reflect all available information, and evaluate the empirical
evidence on informational eciency in financial markets.
1
FN1024 Principles of banking and finance
Planning your time in the examination
From the allocation of marks, you should be able to identify the importance and weighting of each
part of the question. Therefore, you should devote an appropriate amount of time to each part
related to the marks awarded.
What are the topics under examination?
The FN1024 Principles of banking and finance examination paper tests your understanding of
a wide range of concepts and techniques in the banking and finance areas. Therefore, you are
expected to demonstrate numerical competence as well as a thoughtful and clear writing style in the
discursive parts of each question.
All the questions asked in the examination are designed to test topics covered in the syllabus as
presented in the Regulations; the subject guide provides a framework for covering the syllabus and
directs you to the Essential reading. You are reminded that the examination for this course may test
any aspect of the syllabus.
What are the examiners looking for?
This is a foundation course and you are expected to demonstrate your knowledge and understanding
of key concepts/terms in banking and finance.
Moreover, you are expected to demonstrate your knowledge of the relevant technical terminology.
Finally, you are encouraged to demonstrate your ability to identify links between concepts presented
in di↵erent chapters of the syllabus/subject guide. In essay questions, in addition to depth of
knowledge of the subject matter, the examiners are looking for your ability to discuss and evaluate
arguments and to relate knowledge to the question asked, as opposed to simple repetition of factual
information on a particular topic. One way of helping to ensure that you have a clear,
well-structured and relevant argument is to spend a few minutes organising your answer before you
begin writing, and by trying not to fit a standard answer to the question.
Please note that since 2010 examination marks have not generally been allocated to individual
points made in the answer. This is particularly relevant to Section A questions but also to the parts
of Section B questions where you have to explain a concept. Instead, the examiners will be looking
at the answer as a whole when allocating a mark. The examiners will be looking for evidence of an
overall understanding of the concept/issue being examined. Demonstrating your understanding can
come from providing relevant factual information, relevant examples and showing how the concept
relates to other concepts in the syllabus. This change in the approach to marking will reinforce the
point made in the paragraph above that simple repetition of material from the subject guide is
unlikely to be rewarded with a high mark.
Key steps to improvement
While some of the questions might appear to be technical, most of the marks are awarded for
providing the economic reasoning and explanations. The examiners therefore recommend focusing
on both the economic reasoning and some of the techniques/tools as you work with the subject
guide. Note that in numerical questions alternative hypotheses are equally acceptable if you have
been consistent in the di↵erent parts of the question: in these cases the examiners are flexible in the
allocation of marks.
2
Examiners’ commentaries 2018
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sucient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in diculties
when you sit the examination. We strongly advise you not to adopt this strategy.
3
FN1024 Principles of banking and finance
Examiners’ commentaries 2018
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2017–18. 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 – Zone A
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
Answer one question and no more than two further questions from this section.
Question 1
(a) Explain how a bank can become (i) insolvent and (ii) illiquid. Discuss the role
of capital in preventing a bank becoming insolvent and illiquid.
(12 marks)
Reading for this question
See subject guide, Chapter 5, pages 101–08.
Approaching the question
Insolvency is a situation where the value of a bank’s assets falls below the value of its
deposit liabilities. The di↵erence between assets and deposits is the bank’s capital. A bank
can become insolvent due to losses in the value of assets through, for example, loan defaults.
Illiquidity is a situation where a bank has insucient cash to meet depositor withdrawals.
Better answers would explain that banks are liquidity insurers and, therefore, only hold a
small proportion of assets in liquid form. Banking relies on depositor confidence. Loss of
confidence leads to a run causing extreme illiquidity problems.
4
Examiners’ commentaries 2018
Capital acts as a bu↵er, soaking up losses on assets. Having adequate capital protects
depositors from loss and thus prevents insolvency. Holding capital does not directly help
with liquidity but can help to increase confidence thus preventing a run (extreme illiquidity).
(b) Explain liquidity risk in banking and critically evaluate the methods a bank can
use to manage liquidity risk.
(13 marks)
Reading for this question
See subject guide, Chapter 6, pages 119 and 130–32.
Approaching the question
Liquidity risk is essentially the risk of running out of cash to meet deposit withdrawals. An
extreme situation of illiquidity is a run.
Managed by: holding stocks of liquid assets, borrowing from other banks, borrowing from
the central bank, securitisation of illiquid assets. Each of these techniques should be
explained with better answers identifying which techniques work best.
Question 2
(a) Briefly outline the moral hazard problem as it a↵ects financial contracts.
(3 marks)
Reading for this question
See subject guide, Chapter 4, page 74.
Approaching the question
Moral hazard is a problem caused by asymmetric information where the borrower/insured
may engage in immoral activities after borrowing/becoming insured. These immoral
activities increase the risk of default/insurance claim.
(b) Compare the moral hazard problem in equity and debt contracts and explain
why moral hazard is generally lower for debt contracts.
(9 marks)
Reading for this question
See subject guide, Chapter 4, pages 77–80.
Approaching the question
Moral hazard in equity contracts manifests itself as a principal–agent problem. Stockholders
are principals and they delegate management of the firm to managers (agents). This,
combined with asymmetric information, can lead managers to run the firm in their own
interest, rather than maximise stockholder wealth. Debt contracts require borrowers to pay
fixed amounts irrespective of profits made. This can lead borrowers to take more risk than
lenders would like.
The reason why moral hazard is less for debt contracts compared to equity contracts is that
for equity contracts they are claims on profits in all situations, whether the firm makes or
loses money. A debt contract is one that pays a contractual amount of money without
reference to whether the firm makes a profit or not. This reduces the need to monitor
managers. Consequently, debt contracts have lower moral hazard than equity contracts.
A good answer would cover both parts of this question. A satisfactory answer would be one
that only compared the moral hazard problem for debt and equity contracts.
5
FN1024 Principles of banking and finance
(c) Outline the Diamond model of delegated monitoring.
(13 marks)
Reading for this question
See subject guide, Chapter 4, page 81.
Approaching the question
The Diamond model provides an explanation of why lenders delegate the monitoring of
ultimate borrowers to a specialist lender. A good answer would be one that sets out the
model and the conditions under which such a model works – for example, many lenders to
one borrower and the delegated bank has a pooled and diversified portfolio of loans and,
therefore, reduces risk for the ultimate lender. Essentially, the model demonstrates that it is
less costly for the bank to monitor borrowers than many ultimate lenders. The need for
lenders to monitor the bank is reduced by the bank being able to diversify and pool its
default risks so that the risk of the bank failing is very small.
Question 3
(a) Distinguish between weak-form, semi-strong form and strong-form levels of
market eciency. Discuss the implications of weak, semi-strong and strong form
ecient equity markets for investors.
(6 marks)
Reading for this question
See subject guide, Chapter 9, pages 189–90.
Approaching the question
Weak-form – prices fully reflect all historical information.
Semi-strong form – prices reflect all public information.
Strong-form – prices reflect all public and private information.
Better answers would define what each of these information sets is and explain that the
wider information sets nest the less-wide sets (for example, the semi-strong information set
nests the weak set).
The implications of weak-form eciency for investors are that investors cannot use
models/technical analysis based on past data to predict future prices.
The implications of semi-strong eciency are that investors cannot use fundamental analysis
to try to pick undervalued securities.
The implications of strong-form eciency are that excess returns cannot be obtained by
using private information – for example, superior forecasting ability.
(b) Explain the joint-hypothesis problem encountered when testing for
informational eciency of a market.
(7 marks)
Reading for this question
See subject guide, Chapter 9, page 188.
Approaching the question
Testing for ineciency typically involves identifying whether excess returns can be made.
The choice of the model (for example, CAPM) used to adjust actual returns in the excess
return calculation may be wrong. This implies that excess returns may be incorrectly
quantified, and then used in the test of the ecient market hypothesis. This implies that
the same ecient market hypothesis would become untestable because of the joint
hypothesis problem. The test of whether a market is ecient becomes a joint test of:
6
Examiners’ commentaries 2018
i. informational eciency
ii. accuracy of the equilibrium expected returns
It is not possible to test just i. – the hypothesis of interest.
(c) Discuss the evidence relating to weak-form eciency of equity markets.
(12 marks)
Reading for this question
See subject guide, Chapter 9, page 190–96.
Approaching the question
The answer to this question requires a discussion of both the evidence in favour of and
against weak-form eciency. The evidence in favour relates to evidence supporting random
walks in stock prices and evidence showing that technical trading rules do not consistently
generate excess returns. Evidence against relates to evidence that small firm stocks may
consistently generate excess returns as well as calendar e↵ects such as the January e↵ect and
evidence of mean reversion. All the evidence against weak-form eciency suggests that
there is some predictability in prices/returns which is inconsistent with the hypothesis.
Better answers would discuss the evidence rather that just describing it.
Question 4
(a) Discuss the advantages and disadvantages of unregulated banking.
(12 marks)
Reading for this question
See subject guide, Chapter 5, pages 90–96.
Approaching the question
Unregulated or ‘free’ banking essentially refers to banking where there is no regulatory
oversight of a bank’s activities. This has a number of advantages such as lower cost, lower
moral hazard, greater eciency. However, there is a major disadvantage with unregulated
banking that is related to the fragility of banks. That is, banks are prone to runs that can
spread throughout the system. This is known as systemic risk.
Better answers would argue that as most countries regulate banks we can conclude that
systemic risk ranks more highly than moral hazard/cost etc.
(b) Explain the causes, consequences and solutions for the problem of banks being
‘too big to fail’.
(13 marks)
Reading for this question
See subject guide, Chapter 5, pages 100–01.
Approaching the question
Better answers will cover all three parts of the question – causes, consequences and
solutions. Excellent answers would relate discussion of these parts together.
Banks have grown large as growth was encouraged by the regulator – increase in size was
seen as reducing risk. This belief lay behind the repeal of the Glass–Steagall Act which led
to many mergers of investment and commercial banks leading to very large banks in the US.
The main consequences are moral hazard and state bail-outs.
The three main solutions are: i. reduce size, ii. increase resilience (Basel 3), iii. living wills.
Better answers would explain that regulators are using all three solutions.
7
FN1024 Principles of banking and finance
Section B
Answer one question and no more than two further questions from this section.
Question 5
A firm is considering two investment projects, Yana and Zeta. These projects are
NOT mutually exclusive. Assume the firm is not capital constrained. The initial
costs and cashflows for these projects are:
Year Yana Zeta
0 50,000 45,000
1 19,000 10,000
2 17,000 20,000
3 25,000 25,000
(a) Using a discount rate of 10% calculate the net present value for each project.
What decision would you make based on your calculations?
(4 marks)
(b) How would your decision change if the discount rate used for calculating the net
present value is 12%?
(4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%.
What decision would you make based on your calculations?
(6 marks)
(d) Calculate the payback period for each project. The company looks to select
investment projects paying back in 2 years. What decision would you make
based on your calculations?
(2 marks)
(e) Discuss the advantages and disadvantages of the payback rule of investment
appraisal. (4 marks)
(f) Discuss the limitations of the internal rate of return method of investment
appraisal (5 marks)
Reading for this question
See subject guide, Chapter 7, pages 142–49.
Approaching the question
(a) We have:
Yana Zeta
50000.00 45000.00
17272.72 9090.90
14049.58 16528.92
18782.87 18782.87
NPV = 105.18 NPV= 597.29
Accept Yana and reject Zeta.
8
Examiners’ commentaries 2018
(b) We have:
Yana Zeta
50000.00 45000.00
16964.29 8928.57
13552.30 15943.88
17794.51 17794.51
NPV = 1688.91 NPV = 2333.04
Reject both projects at 12%.
(c) Using linear interpolation: IRR = 10% for Yana and 9% for Zeta.
Therefore, marginally accept Yana and reject Zeta.
(d) Payback = just under 3 years for Yana and just under 3 years for Zeta hence both projects
rejected on the basis of a two-year payback criteria.
(e) Advantages – simple, good when capital constrained, some allowance for risk (as it is based
on earlier cash flows which are more certain).
Disadvantages – does not take into account time value of money, no allowance for cashflows
after the payback point.
(f) The three main limitations of the IRR method are:
• may not give the same ranking as NPV as it is based on % return rather than scale of
return
• may give multiple solutions
• may give no solution.
Question 6
(a) Discuss the advantages and limits to diversification when constructing a
portfolio of risky assets.
(6 marks)
Reading for this question
See subject guide, Chapter 8, pages 166–71.
(b) Explain the following concepts:
(i) risk free asset
(ii) unsystematic risk
(iii) the ecient frontier
(iv) the security market line
(8 marks)
Reading for this question
See subject guide, Chapter 8, pages 90–96.
Approaching the question
All that is required here is a brief explanation of each concept. To get the full two marks for
each part it is useful to identify two points in the explanation.
(i) Risk free asset – an asset with no uncertainty of return. An example would be a
government issued bill.
(ii) Unsystematic risk – risk that is unique to the security. Can be diversified away.
9
FN1024 Principles of banking and finance
(iii) The ecient frontier – the outer edge of the feasible region. Contains portfolios that
have the highest return for a given risk.
(iv) The security market line – the line of the CAPM. Intercept at the risk free return and is
upward sloping indicating an increasing return for risk.
(c) You are given the following information:
(i) A stock with a beta of 0 has an expected return of 4%.
(ii) A portfolio made up of 30% invested at the risk free rate and 70% invested
in the market portfolio has an expected return of 15%.
What is the market risk premium?
(4 marks)
Reading for this question
See subject guide, Chapter 8, pages 172–73.
Approaching the question
From (i), Rf = 4%.
From (ii), 0.3⇥ 4% + 0.7⇥Rm = 15%. Hence Rm = (15 1.2)/0.7 = 19.71%.
Therefore, market risk premium = 19.71 4 = 15.71%.
(d) Discuss the problems associated with empirically testing the Capital Asset
Pricing Model. (7 marks)
Reading for this question
See subject guide, Chapter 8, pages 176–77.
Approaching the question
The imitations can be split into empirical and theoretical.
• Theoretical – the market portfolio is unobservable, therefore it is not possible to test the
EMH – joint hypothesis problem.
• Empirical – the evidence from testing the CAPM has found that it is not a good model
in terms of explaining expected returns. Other models are better – for example, Fama
and French etc.
Question 7
(a) Distinguish between re-financing risk and re-investment risk. Give examples of
each and explain which of these risks a bank is more likely to face.
(8 marks)
Reading for this question
See subject guide, Chapter 6, pages 117–18.
Approaching the question
Re-financing risk is the risk that the cost of re-borrowing funds will be higher than the
returns earned on asset investments, in the presence of longer-term assets relative to
liabilities.
Re-investment risk is the risk that returns on funds to be reinvested will be lower than the
cost of funds, when the bank holds shorter-term assets relative to liabilities.
Examples of each required.
Better answers would demonstrate that banks are more likely to face re-financing risk as
liabilities are shorter term than assets (as they are intermediaries).
10
Examiners’ commentaries 2018
(b) Consider the following extracts from the balance sheet of Radobank (values in
£millions and duration in years):
Value Duration
Loans (short term) 1700 0.9
Loans (long term) 3000 3.9
Mortgages 4400 8.4
T-bonds 1200 3.2
Deposits 8500 1.7
Calculate the duration gap for Radobank
(5 marks)
(c) Explain the relationship between the market value of equity and a change in
interest rates.
(4 marks)
(d) What is the change in the market value of equity of Radobank, as a percentage
of assets, if interest rates increase from 4.5% to 5.0%?
(3 marks)
(e) Critically discuss the main problems associated with duration gap analysis.
(5 marks)
Reading for this question
See subject guide, Chapter 6, pages 129–30.
Approaching the question
(b) Weighted average duration of assets:
=
1700
10300
⇥ 0.9 + 3000
10300
⇥ 3.9 + 4400
10300
⇥ 8.4 + 1200
10300
⇥ 3.2 = 5.246 years.
Duration of liabilities = 1.7 years.
Duration gap = Dur A L
Assets
⇥Dur L = 5.246 8500
10300
⇥ 1.7 = 3.843 years.
(c) There is an inverse relationship because when interest rates increase then the market value
of assets and liabilities falls but falls more for assets (as banks have a positive duration gap).
As NW = A L, then NW falls.
(d) Change in NW/A = Duration gap⇥ Change in i/(1 + i).
Change in NW/A:
= 3.843⇥ 0.01
1.04
= 0.0370
or 3.70%.
(e) Duration gap analysis assumes a linear relationship between the change in i and the change
in NW. However, the actual relationship is convex so the calculation using modified
duration only gives an approximation.
Question 8
(a) Discuss the problems of valuing common stocks compared to bonds.
(6 marks)
(b) Formally derive and explain the dividend discount model used for the valuation
of common stocks.
(9 marks)
11
FN1024 Principles of banking and finance
(c) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)
(d) Consider the following stocks:
Stock A is expected to pay a dividend of £4 next year and then an annual
dividend of £5 from the following year, forever.
Stock B is expected to pay a dividend of £4 next year (t = 1) with dividend
growth expected to be 10% per annum for the next three years (t = 2, 3, 4)
before settling down to 4% a year thereafter (t = 5, . . .).
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)
Reading for this question
See subject guide, Chapter 7, pages 150–55.
Approaching the question
(a) All securities are valued by discounting future cashflows to present value then summing all
the present values.
Common stocks – uncertain cashflows (dividend uncertain), therefore dicult to value.
Bonds – fixed cashflows (fixed interest rate) with certain timing so can obtain a certain
value – only element of uncertainty comes from potential default risk.
Hence stocks more dicult to value.
(b) An answer to this question involves starting with the price of the stock assuming a
one-period investment horizon. The value of the stock at the end of period one is then
substituted for the present value of the dividend in period 2 plus the price at the end of
period 2. The terminal value is then repeatedly substituted until infinity. This gives the
price of the stock as the sum of the present value of each period’s dividend plus the price of
the present value of the stock at infinity. As the PV of the terminal value of the stock is
close to zero we can ignore it.
(c) The model assumes a constant growth rate for dividends. This is not realistic for stocks in
the early stage of the life cycle (rapid growth phase) with slower growth rate in future.
More realistic for mature company stocks with steady cashflows – for example, utility
companies.
(d) Value of A:
=
4
1.08
+
5/0.08
1.08
= 3.70 + 57.87 = £61.57.
Value of B:
=
4
1.08
+
4⇥ 1.1
(1.08)2
+
4⇥ (1.1)2
(1.08)3
+
4⇥ (1.1)3
(1.08)4
+
[4⇥ (1.1)3 ⇥ (1.04))/(0.08 0.04)
(1.08)4
= 3.70 + 3.7729 + 3.8421 + 3.9133 + 101.74
= £116.96.
12
Examiners’ commentaries 2018
Examiners’ commentaries 2018
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2016–17. 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 – Zone B
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
Answer one question and no more than two further questions from this section.
Question 1
(a) Distinguish between liquidity and solvency in relation to a bank. Explain how a
bank could become insolvent and explain the role of capital and liquidity in
preventing insolvency.
(12 marks)
Reading for this question
See subject guide, Chapter 5, pages 101–08.
Approaching the question
Insolvency is a situation where the value of a bank’s assets falls below the value of its
deposit liabilities. The di↵erence between assets and deposits is the bank’s capital. A bank
can become insolvent due to losses in the value of assets through, for example, loan defaults.
Illiquidity is a situation where a bank has insucient cash to meet depositor withdrawals.
Better answers would explain that banks are liquidity insurers and, therefore, only hold a
small proportion of assets in liquid form. Banking relies on depositor confidence. Loss of
confidence leads to a run causing extreme illiquidity problems.
13
FN1024 Principles of banking and finance
Capital acts as a bu↵er, soaking up losses on assets. Having adequate capital protects
depositors from loss and thus prevents insolvency. Holding capital does not directly help
with liquidity but can help to increase confidence thus preventing a run (extreme illiquidity).
(b) Explain market risk and how it a↵ects banks and critically evaluate how banks
manage this risk.
(13 marks)
Reading for this question
See subject guide, Chapter 6, pages 118–19.
Approaching the question
Market risk is the risk arising from assets held in the trading book whose value can fluctuate
due to changes in market-related prices, interest rates etc. Examples needed.
Managed using Value at Risk – this technique needs explaining. Better answers will identify
limitations of VaR.
Question 2
(a) Discuss the role of asymmetric information in explaining the existence of banks.
(15 marks)
Reading for this question
See subject guide, Chapter 4, pages 73–4.
Approaching the question
Asymmetric information is the problem of one party to a transaction having less
information than the other party. In lending and borrowing it is the lender who has less
information than the borrower. Asymmetric information gives rise to adverse selection and
moral hazard. Both these problems need to be explained in the context of
lending/borrowing. Answers need to show that banks are better able to solve these
problems compared to traded debt as banks do not face free-rider problems
(b) Briefly outline Leland and Pyle’s informational economies of scale theory.
(10 marks)
Reading for this question
See subject guide, Chapter 4, pages 77–8.
Approaching the question
In the presence of adverse selection, there are scale economies in the lending–borrowing
activity. In such a context, financial intermediaries can be seen as ‘information sharing
coalitions’ as argued by Leland and Pyle (1977) in the informational economies of scale
theory.
The main details of this theory need explaining.
Question 3
(a) Distinguish between weak-form, semi-strong form and strong-form levels of
market eciency. Discuss the implications of weak, semi-strong and strong form
ecient equity markets for investors.
(6 marks)
14
Examiners’ commentaries 2018
Reading for this question
See subject guide, Chapter 9, pages 189–90.
Approaching the question
Weak-form – prices fully reflect all historical information.
Semi-strong form – prices reflect all public information.
Strong-form – prices reflect all public and private information.
Better answers would define what each of these information sets is and explain that the
wider information sets nest the less-wide sets (for example, the semi-strong information set
nests the weak set).
The implications of weak-form eciency for investors are that investors cannot use
models/technical analysis based on past data to predict future prices.
The implications of semi-strong eciency are that investors cannot use fundamental analysis
to try to pick undervalued securities.
The implications of strong-form eciency are that excess returns cannot be obtained by
using private information – for example, superior forecasting ability.
(b) Explain the joint-hypothesis problem encountered when testing for
informational eciency of a market.
(7 marks)
Reading for this question
See subject guide, Chapter 9, page 188.
Approaching the question
Testing for ineciency typically involves identifying whether excess returns can be made.
The choice of the model (for example, CAPM) used to adjust actual returns in the excess
return calculation may be wrong. This implies that excess returns may be incorrectly
quantified, and then used in the test of the ecient market hypothesis. This implies that
the same ecient market hypothesis would become untestable because of the joint
hypothesis problem. The test of whether a market is ecient becomes a joint test of:
i. informational eciency
ii. accuracy of the equilibrium expected returns
It is not possible to test just i. – the hypothesis of interest.
(c) Discuss the evidence relating to semi-strong eciency of equity markets.
(12 marks)
Reading for this question
See subject guide, Chapter 9, page 192 and 195–6.
Approaching the question
The answer to this question requires a discussion of both the evidence in favour of and
against semi-strong form eciency. The evidence in favour relates mainly to the studies on
earnings announcements. The evidence against relates mainly to evidence of under- and
over-reaction to announcements.
Better answers will note that given the evidence on both under- and over-reaction then as it
is not possible to predict whether an under- or over-reaction will occur then this actually
supports semi-strong form eciency.
Question 4
(a) Discuss the reasons for the regulation of banks.
(12 marks)
15
FN1024 Principles of banking and finance
Reading for this question
See subject guide, Chapter 5, pages 92–6.
Approaching the question
The main arguments in favour of regulation are:
• fragility of banks
• contagion – systemic risk
• depositor protection
• high social cost of bank failure.
The main arguments against are:
• cost
• moral hazard
• restrictions on innovation/entry into the system
• ineciency.
Better answers will argue that given that most countries regulate then the main factor is
systemic risk.
(b) Discuss how Basel 3 improves on Basel 1 and 2 in terms of improving the ability
of banks to withstand shocks.
(13 marks)
Reading for this question
See subject guide, Chapter 5, pages 104–06.
Approaching the question
Better answers will explain the philosophy of Basel framework – risk related capital
adequacy.
Basel 3 improves on Basel 1 and 2 by:
• improving quality of capital – focus on common equity
• increase quantity of capital
• additional bu↵er to address pro-cyclicality of Basel 1 and 2
• additional bu↵er to address systemic risk issues
• additional bu↵er for systemically important banks
• a new Leverage ratio
• new liquidity ratios.
Section B
Answer one question and no more than two further questions from this section.
Question 5
A firm is considering two investment projects, A and B. These projects are NOT
mutually exclusive. Assume the firm is not capital constrained. The initial costs and
cashflows for these projects are:
Year A B
0 48,000 42,000
1 19,000 10,000
2 17,000 35,000
3 25,000 8,000
16
Examiners’ commentaries 2018
(a) Using a discount rate of 10% calculate the net present value for each project.
What decision would you make based on your calculations?
(4 marks)
(b) How would your decision change if the discount rate used for calculating the net
present value is 12.5%?
(4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%.
What decision would you make based on your calculations?
(6 marks)
(d) Calculate the payback period for each project. The company looks to select
investment projects paying back in 2 years. What decision would you make
based on your calculations?
(2 marks)
(e) Discuss the advantages and disadvantages of the payback rule of investment
appraisal. (4 marks)
(f) Discuss the limitations of the internal rate of return method of investment
appraisal (5 marks)
Reading for this question
See subject guide, Chapter 7, pages 142–49.
Approaching the question
(a) We have:
A B
48000 45000
17272.73 9090.91
14049.59 28925.62
18782.87 6010.52
NPV = 2105.18 NPV= 2027.05
Decision : Select both projects as the projects are not mutually exclusive and the NPV of
each is > 0.
(b) We have:
A B
48000 42000
16888.89 8888.89
13432.10 27654.32
17558.30 5618.66
NPV = 120.71 NPV = 161.87
Decision : Reject A but accept B.
(c) Using linear interpolation: IRR ⇡ 12% for A and 13% for B.
Therefore, accept both A and B.
(d) Payback period for A is between 2 and 3 years, therefore reject. Payback period for B is
under 2 years, therefore accept.
(e) Advantages – simple, good when capital constrained, some allowance for risk (as it is based
on earlier cash flows which are more certain).
Disadvantages – does not take into account time value of money, no allowance for cashflows
after the payback point.
17
FN1024 Principles of banking and finance
(f) The three main limitations of the IRR method are:
• may not give the same ranking as NPV as it is based on % return rather than scale of
return
• may give multiple solutions
• may give no solution.
Question 6
(a) Outline the key features of Markowitz’s modern portfolio theory (MPT) and
discuss the implications of MPT for an investor in risky securities (the use of
diagrams in your answer is encouraged).
(13 marks)
Reading for this question
See subject guide, Chapter 8, pages 166–70.
Approaching the question
Main features include:
• investors look at return and risk when deciding which investments to invest in
• diversification reduces risk (unless assets are perfectly positively correlated)
• special characteristics of the investor should be reflected in the composition of the
investor’s portfolio
• the riskiness of an asset can only be judged in terms of the overall portfolio
• the only way to increase expected return on a well-run portfolio is by increasing risk.
Better answers would use diagrams to show (i) mean variance frontier/ecient frontier, and
(ii) e↵ects of changing correlation on risk of the portfolio.
(b) You are given the following information:
(i) A stock with a beta of 0 has an expected return of 5%.
(ii) A portfolio made up of 20% invested at the risk free rate and 80% invested
in the market portfolio has an expected return of 14%.
What is the market risk premium?
(4 marks)
Reading for this question
See subject guide, Chapter 8, pages 172–73.
Approaching the question
From (i), Rf = 5%.
From (ii), 0.2⇥ 5% + 0.8⇥Rm = 14%. Hence Rm = (14 1)/0.8 = 16.25%.
Therefore, market risk premium = 16.25 5 = 11.25%.
(c) Discuss the limitations of the Capital Asset Pricing Model.
(8 marks)
Reading for this question
See subject guide, Chapter 8, pages 176–7.
Approaching the question
The imitations can be split into empirical and theoretical.
18
Examiners’ commentaries 2018
• Theoretical – the market portfolio is unobservable therefore it is not possible to test the
validity of the model without jointly testing the validity of the proxy – joint hypothesis
problem.
• Empirical – the evidence from testing the CAPM has found that it is not a good model
in terms of explaining expected returns. Other models are better – for example, Fama
and French etc.
Question 7
(a) Distinguish between re-financing risk and re-investment risk. Give examples of
each and explain which of these risks a bank is more likely to face.
(8 marks)
Reading for this question
See subject guide, Chapter 6, pages 117–18.
Approaching the question
Re-financing risk is the risk that the cost of re-borrowing funds will be higher than the
returns earned on asset investments, in the presence of longer-term assets relative to
liabilities.
Re-investment risk is the risk that returns on funds to be reinvested will be lower than the
cost of funds, when the bank holds shorter-term assets relative to liabilities.
Examples of each required.
Better answers would demonstrate that banks are more likely to face re-financing risk as
liabilities are shorter term than assets (as they are intermediaries).
(b) Consider the following extracts from the balance sheet of Exxobank (values in
£millions and duration in years):
Value Duration
Loans (short term) 1800 0.9
Loans (long term) 3000 3.6
Mortgages 4000 8.4
T-bonds 1200 3.2
Deposits 9000 1.6
Calculate the duration gap for Exxobank
(5 marks)
(c) What is the change in the market value of equity of Exxobank, as a percentage
of assets, if interest rates increase from 4.5% to 5.0%?
(3 marks)
(d) Explain the respective roles and limitations of liquidity gap and duration gap
analysis in helping banks manage interest rate risk.
(9 marks)
Reading for this question
See subject guide, Chapter 6, pages 125–30.
19
FN1024 Principles of banking and finance
Approaching the question
(b) Weighted average duration of assets:
=
1800
10000
⇥ 0.9 + 3000
10000
⇥ 3.6 + 4000
10000
⇥ 8.4 + 1200
10000
⇥ 3.2 = 4.986 years.
Duration of liabilities = 1.6 years.
Duration gap = Dur A L
Assets
⇥Dur L = 4.986 9000
10000
⇥ 1.6 = 3.546 years.
(c) Change in NW/A = Duration gap⇥ Change in i/(1 + i).
Change in NW/A:
= 3.546⇥ 0.005
1.045
= 0.01697
or 1.697%.
(d) Liquidity gap analysis focuses on cashflows and identifies the impact of a change in interest
rates on rate-sensitive assets rate-sensitive liabilities
Duration gap focuses on the impact of interest rate changes on market values of assets and
liabilities and hence on net worth or capital of the bank.
They are both useful with liquidity gap being an indicator of liquidity issues and duration
gap being an indicator of solvency (capital) issues.
Better answers will look at limitations of each analysis.
Question 8
(a) Briefly discuss the problems of valuing common stocks, preferred stocks and
corporate bonds.
(6 marks)
(b) Formally derive and explain the dividend discount model used for the valuation
of common stocks.
(9 marks)
(c) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)
(d) Consider the following stocks:
Stock A is expected to pay a dividend of £3 next year and then an annual
dividend of £4 from the following year, forever.
Stock B is expected to pay a dividend of £4 next year (t = 1) with dividend
growth expected to be 10% per annum for the next three years (t = 2, 3, 4)
before settling down to 4% a year thereafter (t = 5, . . .).
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)
Reading for this question
See subject guide, Chapter 7, pages 150–55.
20
Examiners’ commentaries 2018
Approaching the question
(a) All securities are valued by discounting future cashflows to present value then summing all
the present values.
Common stocks – uncertain cashflows (dividend uncertain), therefore dicult to value.
Preferred stocks – more certain cashflows but still uncertainty about whether they are paid.
Corporate bonds – fixed cashflows but risk of issuer defaulting.
(b) An answer to this question involves starting with the price of the stock assuming a
one-period investment horizon. The value of the stock at the end of period one is then
substituted for the present value of the dividend in period 2 plus the price at the end of
period 2. The terminal value is then repeatedly substituted until infinity. This gives the
price of the stock as the sum of the present value of each period’s dividend plus the price of
the present value of the stock at infinity. As the PV of the terminal value of the stock is
close to zero we can ignore it.
(c) The model assumes a constant growth rate for dividends. This is not realistic for stocks in
the early stage of the life cycle (rapid growth phase) with slower growth rate in future.
More realistic for mature company stocks with steady cashflows – for example, utility
companies.
(d) Value of A:
=
3
1.08
+
4/0.08
1.08
= 2.78 + 46.30 = £49.08.
Value of B:
=
4
1.08
+
4⇥ 1.1
(1.08)2
+
4⇥ (1.1)2
(1.08)3
+
4⇥ (1.1)3
(1.08)4
+
[4⇥ (1.1)3 ⇥ (1.04))/(0.08 0.04)
(1.08)4
= 3.70 + 3.7729 + 3.8421 + 3.9133 + 101.74
= £116.96.
21
UL18/0194 Page 1 of 4 D0
~~FN1024_ZA_2016_d0
This paper is not to be removed from the Examination Hall
UNIVERSITY OF LONDON FN1024 ZA
BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences
Principles of Banking and Finance
Wednesday, 9 May 2018 : 10:00 to 13:00
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.
A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.
PLEASE TURN OVER
© University of London 2018
UL18/0194 Page 2 of 4 D0
SECTION A
Answer ONE question and NO MORE THAN TWO further questions from this section.
1. (a) Explain how a bank can become (i) insolvent and (ii) illiquid. Discuss the role of capital in
preventing a bank becoming insolvent and illiquid. (12 marks)
(b) Explain liquidity risk in banking and critically evaluate the methods a bank can use to
manage liquidity risk. (13 marks)
2. (a) Briefly outline the moral hazard problem as it affects financial contracts. (3 marks)
(b) Compare the moral hazard problem in equity and debt contracts and explain why moral
hazard is generally lower for debt contracts. (9 marks)
(c) Outline the Diamond model of delegated monitoring. (13 marks)
3. (a) Distinguish between weak-form, semi-strong form and strong-form levels of market
efficiency. Discuss the implications of weak, semi-strong and strong form efficient equity
markets for investors. (6 marks)
(b) Explain the joint-hypothesis problem encountered when testing for informational
efficiency of a market. (7 marks)
(c) Discuss the evidence relating to weak-form efficiency of equity markets. (12 marks)
4. (a) Discuss the advantages and disadvantages of unregulated banking. (12 marks)
(b) Explain the causes, consequences and solutions for the problem of banks being ‘too big
to fail’. (13 marks)
© University of London 2018
UL18/0194 Page 3 of 4 D0
SECTION B
Answer ONE question and NO MORE THAN TWO further questions from this section.
5. A firm is considering two investment projects, Yana and Zeta. These projects are NOT
mutually exclusive. Assume the firm is not capital constrained. The initial costs and
cashflows for these projects are:
Year Yana Zeta
0 -50,000 -45,000
1 19,000 10,000
2 17,000 20,000
3 25,000 25,000
(a) Using a discount rate of 10% calculate the net present value for each project. What
decision would you make based on your calculations? (4 marks)
(b) How would your decision change if the discount rate used for calculating the net present
value is 12%? (4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%. What
decision would you make based on your calculations? (6 marks)
(d) Calculate the payback period for each project. The company looks to select investment
projects paying back in 2 years. What decision would you make based on your
calculations? (2 marks)
(e) Discuss the advantages and disadvantages of the payback rule of investment appraisal.
(4 marks)
(f) Discuss the limitations of the internal rate of return method of investment appraisal
(5 marks)
6. (a) Discuss the advantages and limits to diversification when constructing a portfolio of risky
assets. (6 marks)
(b) Explain the following concepts:
(i) risk free asset
(ii) unsystematic risk
(iii) the efficient frontier
(iv) the security market line
(8 marks)
(c) You are given the following information:
(i) A stock with a beta of 0 has an expected return of 4%.
(ii) A portfolio made up of 30% invested at the risk free rate and 70% invested in the
market portfolio has an expected return of 15%
What is the market risk premium? (4 marks)
Question continues on next page.
© University of London 2018
UL18/0194 Page 4 of 4 D0
(d) Discuss the problems associated with empirically testing the Capital Asset Pricing
Model. (7 marks)
7. (a) Distinguish between re-financing risk and re-investment risk. Give examples of each and
explain which of these risks a bank is more likely to face. (8 marks)
(b) Consider the following extracts from the balance sheet of Radobank (values in £millions
and duration in years):
Value Duration
Loans (short term) 1700 0.9
Loans (long term) 3000 3.9
Mortgages 4400 8.4
T-bonds 1200 3.2
Deposits 8500 1.7
Calculate the duration gap for Radobank (5 marks)
(c) Explain the relationship between the market value of equity and a change in interest
rates. (4 marks)
(d) What is the change in the market value of equity of Radobank, as a percentage of
assets, if interest rates increase from 4.5% to 5.0%? (3 marks)
(e) Critically discuss the main problems associated with duration gap analysis.
(5 marks)
8. (a) Discuss the problems of valuing common stocks compared to bonds. (6 marks)
(b) Formally derive and explain the dividend discount model used for the valuation of
common stocks. (9 marks)
(c) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)
(d) Consider the following stocks:
Stock A is expected to pay a dividend of £4 next year and then an annual dividend of £5
from the following year, forever.
Stock B is expected to pay a dividend of £4 next year (t=1) with dividend growth
expected to be 10% per annum for the next three years (t=2, 3, 4) before settling down
to 4% a year thereafter (t=5 …).
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)
END OF PAPER
© University of London 2018
UL18/0195 Page 1 of 4 D0
~~FN1024_ZA_2016_d0
This paper is not to be removed from the Examination Hall
UNIVERSITY OF LONDON FN1024 ZB
BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences
Principles of Banking and Finance
Wednesday, 9 May 2018 : 10:00 to 13:00
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.
A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.
PLEASE TURN OVER
© University of London 2018
UL18/0195 Page 2 of 4 D0
SECTION A
Answer ONE question and NO MORE THAN TWO further questions from this section.
1. (a) Distinguish between liquidity and solvency in relation to a bank. Explain how a bank could
become insolvent and explain the role of capital and liquidity in preventing insolvency.
(12 marks)
(b) Explain market risk and how it affects banks and critically evaluate how banks manage
this risk. (13 marks)
2. (a) Discuss the role of asymmetric information in explaining the existence of banks.
(15 marks)
(b) Briefly outline Leland and Pyle’s informational economies of scale theory.
(10 marks)
3. (a) Distinguish between weak-form, semi-strong form and strong-form levels of market
efficiency. Discuss the implications of weak, semi-strong and strong form efficient equity
markets for investors. (6 marks)
(b) Explain the joint-hypothesis problem encountered when testing for informational efficiency
of a market. (7 marks)
(c) Discuss the evidence relating to semi-strong efficiency of equity markets.
(12 marks)
4. (a) Discuss the reasons for the regulation of banks. (12 marks)
(b) Discuss how Basel 3 improves on Basel 1 and 2 in terms of improving the ability of banks
to withstand shocks. (13 marks)
© University of London 2018
UL18/0195 Page 3 of 4 D0
SECTION B
Answer ONE question and NO MORE THAN TWO further questions from this section.
5. A firm is considering two investment projects, A and B. These projects are NOT mutually
exclusive. Assume the firm is not capital constrained. The initial costs and cashflows for
these projects are:
Year A B
0 -48,00 -42,000
1 19,000 10,000
2 17,000 35,000
3 25,000 8,000
(a) Using a discount rate of 10% calculate the net present value for each project. What
decision would you make based on your calculations? (4 marks)
(b) How would your decision change if the discount rate used for calculating the net present
value is 12.5%? (4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%. What
decision would you make based on your calculations? (6 marks)
(d) Calculate the payback period for each project. The company looks to select investment
projects paying back in 2 years. What decision would you make based on your
calculations? (2 marks)
(e) Discuss the advantages and disadvantages of the payback rule of investment appraisal.
(4 marks)
(f) Discuss the limitations of the internal rate of return method of investment appraisal
(5 marks)
6. (a) Outline the key features of Markowitz’s modern portfolio theory (MPT) and discuss the
implications of MPT for an investor in risky securities (the use of diagrams in your answer is
encouraged). (13 marks)
(b) You are given the following information:
(i) A stock with a beta of 0 has an expected return of 5%.
(ii) A portfolio made up of 20% invested at the risk free rate and 80% invested in the
market portfolio has an expected return of 14%
What is the market risk premium? (4 marks)
(c) Discuss the limitations of the Capital Asset Pricing Model. (8 marks)
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UL18/0195 Page 4 of 4 D0
7. (a) Distinguish between re-financing risk and re-investment risk. Give examples of each and
explain which of these risks a bank is more likely to face. (8 marks)
(b) Consider the following extracts from the balance sheet of Exxobank (values in £millions
and duration in years):
Value Duration
Loans (short term) 1800 0.9
Loans (long term) 3000 3.6
Mortgages 4000 8.4
T-bonds 1200 3.2
Deposits 9000 1.6
Calculate the duration gap for Exxobank (5 marks)
(c) What is the change in the market value of equity of Exxobank, as a percentage of assets,
if interest rates increase from 4.5% to 5.0%? (3 marks)
(d) Explain the respective roles and limitations of liquidity gap and duration gap analysis in
helping banks manage interest rate risk. (9 marks)
8. (a) Briefly discuss the problems of valuing common stocks, preferred stocks and corporate
bonds. (6 marks)
(b) Formally derive and explain the dividend discount model used for the valuation of
common stocks. (9 marks)
(c) Discuss the usefulness of the Gordon Growth model for the valuation of stocks.
(4 marks)
(d) Consider the following stocks:
Stock A is expected to pay a dividend of £3 next year and then an annual dividend of £4
from the following year, forever.
Stock B is expected to pay a dividend of £4 next year (t=1) with dividend growth
expected to be 10% per annum for the next first three years before settling down to 4%
a year thereafter (t=5 …).
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)
END OF PAPER
Examiners’ commentaries 2018
Examiners’ commentaries 2018
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2017–18. 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.
General remarks
Learning outcomes
At the end of the course and having completed the Essential reading and activities you should:
• discuss why financial systems exist, and how they are structured
• explain why the relative importance of financial intermediaries and financial markets is
di↵erent around the world, and how bank-based systems di↵er from market-based systems
• understand why financial intermediaries exist, and discuss the role of transaction costs and
information asymmetry theories in providing an economic justification
• explain why banks need regulation, and illustrate the key reasons for and against the
regulation of banking systems
• discuss the main types of risks faced by banks, and use the main techniques employed by
banks to manage their risks
• explain how to value real assets and financial assets, and use the key capital budgeting
techniques (Net Present Value and Internal Rate of Return)
• explain how to value financial assets (bonds and stocks)
• understand how risk a↵ects the return of a risky asset, and hence how risk a↵ects the value
of the asset in equilibrium under the fundamental asset pricing paradigms (Capital Asset
Pricing Model and Asset Pricing Theory)
• discuss whether stock prices reflect all available information, and evaluate the empirical
evidence on informational eciency in financial markets.
1
FN1024 Principles of banking and finance
Planning your time in the examination
From the allocation of marks, you should be able to identify the importance and weighting of each
part of the question. Therefore, you should devote an appropriate amount of time to each part
related to the marks awarded.
What are the topics under examination?
The FN1024 Principles of banking and finance examination paper tests your understanding of
a wide range of concepts and techniques in the banking and finance areas. Therefore, you are
expected to demonstrate numerical competence as well as a thoughtful and clear writing style in the
discursive parts of each question.
All the questions asked in the examination are designed to test topics covered in the syllabus as
presented in the Regulations; the subject guide provides a framework for covering the syllabus and
directs you to the Essential reading. You are reminded that the examination for this course may test
any aspect of the syllabus.
What are the examiners looking for?
This is a foundation course and you are expected to demonstrate your knowledge and understanding
of key concepts/terms in banking and finance.
Moreover, you are expected to demonstrate your knowledge of the relevant technical terminology.
Finally, you are encouraged to demonstrate your ability to identify links between concepts presented
in di↵erent chapters of the syllabus/subject guide. In essay questions, in addition to depth of
knowledge of the subject matter, the examiners are looking for your ability to discuss and evaluate
arguments and to relate knowledge to the question asked, as opposed to simple repetition of factual
information on a particular topic. One way of helping to ensure that you have a clear,
well-structured and relevant argument is to spend a few minutes organising your answer before you
begin writing, and by trying not to fit a standard answer to the question.
Please note that since 2010 examination marks have not generally been allocated to individual
points made in the answer. This is particularly relevant to Section A questions but also to the parts
of Section B questions where you have to explain a concept. Instead, the examiners will be looking
at the answer as a whole when allocating a mark. The examiners will be looking for evidence of an
overall understanding of the concept/issue being examined. Demonstrating your understanding can
come from providing relevant factual information, relevant examples and showing how the concept
relates to other concepts in the syllabus. This change in the approach to marking will reinforce the
point made in the paragraph above that simple repetition of material from the subject guide is
unlikely to be rewarded with a high mark.
Key steps to improvement
While some of the questions might appear to be technical, most of the marks are awarded for
providing the economic reasoning and explanations. The examiners therefore recommend focusing
on both the economic reasoning and some of the techniques/tools as you work with the subject
guide. Note that in numerical questions alternative hypotheses are equally acceptable if you have
been consistent in the di↵erent parts of the question: in these cases the examiners are flexible in the
allocation of marks.
2
Examiners’ commentaries 2018
Examination revision strategy
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sucient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in diculties
when you sit the examination. We strongly advise you not to adopt this strategy.
3
FN1024 Principles of banking and finance
Examiners’ commentaries 2018
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2017–18. 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 – Zone A
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
Answer one question and no more than two further questions from this section.
Question 1
(a) Explain how a bank can become (i) insolvent and (ii) illiquid. Discuss the role
of capital in preventing a bank becoming insolvent and illiquid.
(12 marks)
Reading for this question
See subject guide, Chapter 5, pages 101–08.
Approaching the question
Insolvency is a situation where the value of a bank’s assets falls below the value of its
deposit liabilities. The di↵erence between assets and deposits is the bank’s capital. A bank
can become insolvent due to losses in the value of assets through, for example, loan defaults.
Illiquidity is a situation where a bank has insucient cash to meet depositor withdrawals.
Better answers would explain that banks are liquidity insurers and, therefore, only hold a
small proportion of assets in liquid form. Banking relies on depositor confidence. Loss of
confidence leads to a run causing extreme illiquidity problems.
4
Examiners’ commentaries 2018
Capital acts as a bu↵er, soaking up losses on assets. Having adequate capital protects
depositors from loss and thus prevents insolvency. Holding capital does not directly help
with liquidity but can help to increase confidence thus preventing a run (extreme illiquidity).
(b) Explain liquidity risk in banking and critically evaluate the methods a bank can
use to manage liquidity risk.
(13 marks)
Reading for this question
See subject guide, Chapter 6, pages 119 and 130–32.
Approaching the question
Liquidity risk is essentially the risk of running out of cash to meet deposit withdrawals. An
extreme situation of illiquidity is a run.
Managed by: holding stocks of liquid assets, borrowing from other banks, borrowing from
the central bank, securitisation of illiquid assets. Each of these techniques should be
explained with better answers identifying which techniques work best.
Question 2
(a) Briefly outline the moral hazard problem as it a↵ects financial contracts.
(3 marks)
Reading for this question
See subject guide, Chapter 4, page 74.
Approaching the question
Moral hazard is a problem caused by asymmetric information where the borrower/insured
may engage in immoral activities after borrowing/becoming insured. These immoral
activities increase the risk of default/insurance claim.
(b) Compare the moral hazard problem in equity and debt contracts and explain
why moral hazard is generally lower for debt contracts.
(9 marks)
Reading for this question
See subject guide, Chapter 4, pages 77–80.
Approaching the question
Moral hazard in equity contracts manifests itself as a principal–agent problem. Stockholders
are principals and they delegate management of the firm to managers (agents). This,
combined with asymmetric information, can lead managers to run the firm in their own
interest, rather than maximise stockholder wealth. Debt contracts require borrowers to pay
fixed amounts irrespective of profits made. This can lead borrowers to take more risk than
lenders would like.
The reason why moral hazard is less for debt contracts compared to equity contracts is that
for equity contracts they are claims on profits in all situations, whether the firm makes or
loses money. A debt contract is one that pays a contractual amount of money without
reference to whether the firm makes a profit or not. This reduces the need to monitor
managers. Consequently, debt contracts have lower moral hazard than equity contracts.
A good answer would cover both parts of this question. A satisfactory answer would be one
that only compared the moral hazard problem for debt and equity contracts.
5
FN1024 Principles of banking and finance
(c) Outline the Diamond model of delegated monitoring.
(13 marks)
Reading for this question
See subject guide, Chapter 4, page 81.
Approaching the question
The Diamond model provides an explanation of why lenders delegate the monitoring of
ultimate borrowers to a specialist lender. A good answer would be one that sets out the
model and the conditions under which such a model works – for example, many lenders to
one borrower and the delegated bank has a pooled and diversified portfolio of loans and,
therefore, reduces risk for the ultimate lender. Essentially, the model demonstrates that it is
less costly for the bank to monitor borrowers than many ultimate lenders. The need for
lenders to monitor the bank is reduced by the bank being able to diversify and pool its
default risks so that the risk of the bank failing is very small.
Question 3
(a) Distinguish between weak-form, semi-strong form and strong-form levels of
market eciency. Discuss the implications of weak, semi-strong and strong form
ecient equity markets for investors.
(6 marks)
Reading for this question
See subject guide, Chapter 9, pages 189–90.
Approaching the question
Weak-form – prices fully reflect all historical information.
Semi-strong form – prices reflect all public information.
Strong-form – prices reflect all public and private information.
Better answers would define what each of these information sets is and explain that the
wider information sets nest the less-wide sets (for example, the semi-strong information set
nests the weak set).
The implications of weak-form eciency for investors are that investors cannot use
models/technical analysis based on past data to predict future prices.
The implications of semi-strong eciency are that investors cannot use fundamental analysis
to try to pick undervalued securities.
The implications of strong-form eciency are that excess returns cannot be obtained by
using private information – for example, superior forecasting ability.
(b) Explain the joint-hypothesis problem encountered when testing for
informational eciency of a market.
(7 marks)
Reading for this question
See subject guide, Chapter 9, page 188.
Approaching the question
Testing for ineciency typically involves identifying whether excess returns can be made.
The choice of the model (for example, CAPM) used to adjust actual returns in the excess
return calculation may be wrong. This implies that excess returns may be incorrectly
quantified, and then used in the test of the ecient market hypothesis. This implies that
the same ecient market hypothesis would become untestable because of the joint
hypothesis problem. The test of whether a market is ecient becomes a joint test of:
6
Examiners’ commentaries 2018
i. informational eciency
ii. accuracy of the equilibrium expected returns
It is not possible to test just i. – the hypothesis of interest.
(c) Discuss the evidence relating to weak-form eciency of equity markets.
(12 marks)
Reading for this question
See subject guide, Chapter 9, page 190–96.
Approaching the question
The answer to this question requires a discussion of both the evidence in favour of and
against weak-form eciency. The evidence in favour relates to evidence supporting random
walks in stock prices and evidence showing that technical trading rules do not consistently
generate excess returns. Evidence against relates to evidence that small firm stocks may
consistently generate excess returns as well as calendar e↵ects such as the January e↵ect and
evidence of mean reversion. All the evidence against weak-form eciency suggests that
there is some predictability in prices/returns which is inconsistent with the hypothesis.
Better answers would discuss the evidence rather that just describing it.
Question 4
(a) Discuss the advantages and disadvantages of unregulated banking.
(12 marks)
Reading for this question
See subject guide, Chapter 5, pages 90–96.
Approaching the question
Unregulated or ‘free’ banking essentially refers to banking where there is no regulatory
oversight of a bank’s activities. This has a number of advantages such as lower cost, lower
moral hazard, greater eciency. However, there is a major disadvantage with unregulated
banking that is related to the fragility of banks. That is, banks are prone to runs that can
spread throughout the system. This is known as systemic risk.
Better answers would argue that as most countries regulate banks we can conclude that
systemic risk ranks more highly than moral hazard/cost etc.
(b) Explain the causes, consequences and solutions for the problem of banks being
‘too big to fail’.
(13 marks)
Reading for this question
See subject guide, Chapter 5, pages 100–01.
Approaching the question
Better answers will cover all three parts of the question – causes, consequences and
solutions. Excellent answers would relate discussion of these parts together.
Banks have grown large as growth was encouraged by the regulator – increase in size was
seen as reducing risk. This belief lay behind the repeal of the Glass–Steagall Act which led
to many mergers of investment and commercial banks leading to very large banks in the US.
The main consequences are moral hazard and state bail-outs.
The three main solutions are: i. reduce size, ii. increase resilience (Basel 3), iii. living wills.
Better answers would explain that regulators are using all three solutions.
7
FN1024 Principles of banking and finance
Section B
Answer one question and no more than two further questions from this section.
Question 5
A firm is considering two investment projects, Yana and Zeta. These projects are
NOT mutually exclusive. Assume the firm is not capital constrained. The initial
costs and cashflows for these projects are:
Year Yana Zeta
0 50,000 45,000
1 19,000 10,000
2 17,000 20,000
3 25,000 25,000
(a) Using a discount rate of 10% calculate the net present value for each project.
What decision would you make based on your calculations?
(4 marks)
(b) How would your decision change if the discount rate used for calculating the net
present value is 12%?
(4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%.
What decision would you make based on your calculations?
(6 marks)
(d) Calculate the payback period for each project. The company looks to select
investment projects paying back in 2 years. What decision would you make
based on your calculations?
(2 marks)
(e) Discuss the advantages and disadvantages of the payback rule of investment
appraisal. (4 marks)
(f) Discuss the limitations of the internal rate of return method of investment
appraisal (5 marks)
Reading for this question
See subject guide, Chapter 7, pages 142–49.
Approaching the question
(a) We have:
Yana Zeta
50000.00 45000.00
17272.72 9090.90
14049.58 16528.92
18782.87 18782.87
NPV = 105.18 NPV= 597.29
Accept Yana and reject Zeta.
8
Examiners’ commentaries 2018
(b) We have:
Yana Zeta
50000.00 45000.00
16964.29 8928.57
13552.30 15943.88
17794.51 17794.51
NPV = 1688.91 NPV = 2333.04
Reject both projects at 12%.
(c) Using linear interpolation: IRR = 10% for Yana and 9% for Zeta.
Therefore, marginally accept Yana and reject Zeta.
(d) Payback = just under 3 years for Yana and just under 3 years for Zeta hence both projects
rejected on the basis of a two-year payback criteria.
(e) Advantages – simple, good when capital constrained, some allowance for risk (as it is based
on earlier cash flows which are more certain).
Disadvantages – does not take into account time value of money, no allowance for cashflows
after the payback point.
(f) The three main limitations of the IRR method are:
• may not give the same ranking as NPV as it is based on % return rather than scale of
return
• may give multiple solutions
• may give no solution.
Question 6
(a) Discuss the advantages and limits to diversification when constructing a
portfolio of risky assets.
(6 marks)
Reading for this question
See subject guide, Chapter 8, pages 166–71.
(b) Explain the following concepts:
(i) risk free asset
(ii) unsystematic risk
(iii) the ecient frontier
(iv) the security market line
(8 marks)
Reading for this question
See subject guide, Chapter 8, pages 90–96.
Approaching the question
All that is required here is a brief explanation of each concept. To get the full two marks for
each part it is useful to identify two points in the explanation.
(i) Risk free asset – an asset with no uncertainty of return. An example would be a
government issued bill.
(ii) Unsystematic risk – risk that is unique to the security. Can be diversified away.
9
FN1024 Principles of banking and finance
(iii) The ecient frontier – the outer edge of the feasible region. Contains portfolios that
have the highest return for a given risk.
(iv) The security market line – the line of the CAPM. Intercept at the risk free return and is
upward sloping indicating an increasing return for risk.
(c) You are given the following information:
(i) A stock with a beta of 0 has an expected return of 4%.
(ii) A portfolio made up of 30% invested at the risk free rate and 70% invested
in the market portfolio has an expected return of 15%.
What is the market risk premium?
(4 marks)
Reading for this question
See subject guide, Chapter 8, pages 172–73.
Approaching the question
From (i), Rf = 4%.
From (ii), 0.3⇥ 4% + 0.7⇥Rm = 15%. Hence Rm = (15 1.2)/0.7 = 19.71%.
Therefore, market risk premium = 19.71 4 = 15.71%.
(d) Discuss the problems associated with empirically testing the Capital Asset
Pricing Model. (7 marks)
Reading for this question
See subject guide, Chapter 8, pages 176–77.
Approaching the question
The imitations can be split into empirical and theoretical.
• Theoretical – the market portfolio is unobservable, therefore it is not possible to test the
EMH – joint hypothesis problem.
• Empirical – the evidence from testing the CAPM has found that it is not a good model
in terms of explaining expected returns. Other models are better – for example, Fama
and French etc.
Question 7
(a) Distinguish between re-financing risk and re-investment risk. Give examples of
each and explain which of these risks a bank is more likely to face.
(8 marks)
Reading for this question
See subject guide, Chapter 6, pages 117–18.
Approaching the question
Re-financing risk is the risk that the cost of re-borrowing funds will be higher than the
returns earned on asset investments, in the presence of longer-term assets relative to
liabilities.
Re-investment risk is the risk that returns on funds to be reinvested will be lower than the
cost of funds, when the bank holds shorter-term assets relative to liabilities.
Examples of each required.
Better answers would demonstrate that banks are more likely to face re-financing risk as
liabilities are shorter term than assets (as they are intermediaries).
10
Examiners’ commentaries 2018
(b) Consider the following extracts from the balance sheet of Radobank (values in
£millions and duration in years):
Value Duration
Loans (short term) 1700 0.9
Loans (long term) 3000 3.9
Mortgages 4400 8.4
T-bonds 1200 3.2
Deposits 8500 1.7
Calculate the duration gap for Radobank
(5 marks)
(c) Explain the relationship between the market value of equity and a change in
interest rates.
(4 marks)
(d) What is the change in the market value of equity of Radobank, as a percentage
of assets, if interest rates increase from 4.5% to 5.0%?
(3 marks)
(e) Critically discuss the main problems associated with duration gap analysis.
(5 marks)
Reading for this question
See subject guide, Chapter 6, pages 129–30.
Approaching the question
(b) Weighted average duration of assets:
=
1700
10300
⇥ 0.9 + 3000
10300
⇥ 3.9 + 4400
10300
⇥ 8.4 + 1200
10300
⇥ 3.2 = 5.246 years.
Duration of liabilities = 1.7 years.
Duration gap = Dur A L
Assets
⇥Dur L = 5.246 8500
10300
⇥ 1.7 = 3.843 years.
(c) There is an inverse relationship because when interest rates increase then the market value
of assets and liabilities falls but falls more for assets (as banks have a positive duration gap).
As NW = A L, then NW falls.
(d) Change in NW/A = Duration gap⇥ Change in i/(1 + i).
Change in NW/A:
= 3.843⇥ 0.01
1.04
= 0.0370
or 3.70%.
(e) Duration gap analysis assumes a linear relationship between the change in i and the change
in NW. However, the actual relationship is convex so the calculation using modified
duration only gives an approximation.
Question 8
(a) Discuss the problems of valuing common stocks compared to bonds.
(6 marks)
(b) Formally derive and explain the dividend discount model used for the valuation
of common stocks.
(9 marks)
11
FN1024 Principles of banking and finance
(c) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)
(d) Consider the following stocks:
Stock A is expected to pay a dividend of £4 next year and then an annual
dividend of £5 from the following year, forever.
Stock B is expected to pay a dividend of £4 next year (t = 1) with dividend
growth expected to be 10% per annum for the next three years (t = 2, 3, 4)
before settling down to 4% a year thereafter (t = 5, . . .).
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)
Reading for this question
See subject guide, Chapter 7, pages 150–55.
Approaching the question
(a) All securities are valued by discounting future cashflows to present value then summing all
the present values.
Common stocks – uncertain cashflows (dividend uncertain), therefore dicult to value.
Bonds – fixed cashflows (fixed interest rate) with certain timing so can obtain a certain
value – only element of uncertainty comes from potential default risk.
Hence stocks more dicult to value.
(b) An answer to this question involves starting with the price of the stock assuming a
one-period investment horizon. The value of the stock at the end of period one is then
substituted for the present value of the dividend in period 2 plus the price at the end of
period 2. The terminal value is then repeatedly substituted until infinity. This gives the
price of the stock as the sum of the present value of each period’s dividend plus the price of
the present value of the stock at infinity. As the PV of the terminal value of the stock is
close to zero we can ignore it.
(c) The model assumes a constant growth rate for dividends. This is not realistic for stocks in
the early stage of the life cycle (rapid growth phase) with slower growth rate in future.
More realistic for mature company stocks with steady cashflows – for example, utility
companies.
(d) Value of A:
=
4
1.08
+
5/0.08
1.08
= 3.70 + 57.87 = £61.57.
Value of B:
=
4
1.08
+
4⇥ 1.1
(1.08)2
+
4⇥ (1.1)2
(1.08)3
+
4⇥ (1.1)3
(1.08)4
+
[4⇥ (1.1)3 ⇥ (1.04))/(0.08 0.04)
(1.08)4
= 3.70 + 3.7729 + 3.8421 + 3.9133 + 101.74
= £116.96.
12
Examiners’ commentaries 2018
Examiners’ commentaries 2018
FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 2016–17. 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 – Zone B
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
Answer one question and no more than two further questions from this section.
Question 1
(a) Distinguish between liquidity and solvency in relation to a bank. Explain how a
bank could become insolvent and explain the role of capital and liquidity in
preventing insolvency.
(12 marks)
Reading for this question
See subject guide, Chapter 5, pages 101–08.
Approaching the question
Insolvency is a situation where the value of a bank’s assets falls below the value of its
deposit liabilities. The di↵erence between assets and deposits is the bank’s capital. A bank
can become insolvent due to losses in the value of assets through, for example, loan defaults.
Illiquidity is a situation where a bank has insucient cash to meet depositor withdrawals.
Better answers would explain that banks are liquidity insurers and, therefore, only hold a
small proportion of assets in liquid form. Banking relies on depositor confidence. Loss of
confidence leads to a run causing extreme illiquidity problems.
13
FN1024 Principles of banking and finance
Capital acts as a bu↵er, soaking up losses on assets. Having adequate capital protects
depositors from loss and thus prevents insolvency. Holding capital does not directly help
with liquidity but can help to increase confidence thus preventing a run (extreme illiquidity).
(b) Explain market risk and how it a↵ects banks and critically evaluate how banks
manage this risk.
(13 marks)
Reading for this question
See subject guide, Chapter 6, pages 118–19.
Approaching the question
Market risk is the risk arising from assets held in the trading book whose value can fluctuate
due to changes in market-related prices, interest rates etc. Examples needed.
Managed using Value at Risk – this technique needs explaining. Better answers will identify
limitations of VaR.
Question 2
(a) Discuss the role of asymmetric information in explaining the existence of banks.
(15 marks)
Reading for this question
See subject guide, Chapter 4, pages 73–4.
Approaching the question
Asymmetric information is the problem of one party to a transaction having less
information than the other party. In lending and borrowing it is the lender who has less
information than the borrower. Asymmetric information gives rise to adverse selection and
moral hazard. Both these problems need to be explained in the context of
lending/borrowing. Answers need to show that banks are better able to solve these
problems compared to traded debt as banks do not face free-rider problems
(b) Briefly outline Leland and Pyle’s informational economies of scale theory.
(10 marks)
Reading for this question
See subject guide, Chapter 4, pages 77–8.
Approaching the question
In the presence of adverse selection, there are scale economies in the lending–borrowing
activity. In such a context, financial intermediaries can be seen as ‘information sharing
coalitions’ as argued by Leland and Pyle (1977) in the informational economies of scale
theory.
The main details of this theory need explaining.
Question 3
(a) Distinguish between weak-form, semi-strong form and strong-form levels of
market eciency. Discuss the implications of weak, semi-strong and strong form
ecient equity markets for investors.
(6 marks)
14
Examiners’ commentaries 2018
Reading for this question
See subject guide, Chapter 9, pages 189–90.
Approaching the question
Weak-form – prices fully reflect all historical information.
Semi-strong form – prices reflect all public information.
Strong-form – prices reflect all public and private information.
Better answers would define what each of these information sets is and explain that the
wider information sets nest the less-wide sets (for example, the semi-strong information set
nests the weak set).
The implications of weak-form eciency for investors are that investors cannot use
models/technical analysis based on past data to predict future prices.
The implications of semi-strong eciency are that investors cannot use fundamental analysis
to try to pick undervalued securities.
The implications of strong-form eciency are that excess returns cannot be obtained by
using private information – for example, superior forecasting ability.
(b) Explain the joint-hypothesis problem encountered when testing for
informational eciency of a market.
(7 marks)
Reading for this question
See subject guide, Chapter 9, page 188.
Approaching the question
Testing for ineciency typically involves identifying whether excess returns can be made.
The choice of the model (for example, CAPM) used to adjust actual returns in the excess
return calculation may be wrong. This implies that excess returns may be incorrectly
quantified, and then used in the test of the ecient market hypothesis. This implies that
the same ecient market hypothesis would become untestable because of the joint
hypothesis problem. The test of whether a market is ecient becomes a joint test of:
i. informational eciency
ii. accuracy of the equilibrium expected returns
It is not possible to test just i. – the hypothesis of interest.
(c) Discuss the evidence relating to semi-strong eciency of equity markets.
(12 marks)
Reading for this question
See subject guide, Chapter 9, page 192 and 195–6.
Approaching the question
The answer to this question requires a discussion of both the evidence in favour of and
against semi-strong form eciency. The evidence in favour relates mainly to the studies on
earnings announcements. The evidence against relates mainly to evidence of under- and
over-reaction to announcements.
Better answers will note that given the evidence on both under- and over-reaction then as it
is not possible to predict whether an under- or over-reaction will occur then this actually
supports semi-strong form eciency.
Question 4
(a) Discuss the reasons for the regulation of banks.
(12 marks)
15
FN1024 Principles of banking and finance
Reading for this question
See subject guide, Chapter 5, pages 92–6.
Approaching the question
The main arguments in favour of regulation are:
• fragility of banks
• contagion – systemic risk
• depositor protection
• high social cost of bank failure.
The main arguments against are:
• cost
• moral hazard
• restrictions on innovation/entry into the system
• ineciency.
Better answers will argue that given that most countries regulate then the main factor is
systemic risk.
(b) Discuss how Basel 3 improves on Basel 1 and 2 in terms of improving the ability
of banks to withstand shocks.
(13 marks)
Reading for this question
See subject guide, Chapter 5, pages 104–06.
Approaching the question
Better answers will explain the philosophy of Basel framework – risk related capital
adequacy.
Basel 3 improves on Basel 1 and 2 by:
• improving quality of capital – focus on common equity
• increase quantity of capital
• additional bu↵er to address pro-cyclicality of Basel 1 and 2
• additional bu↵er to address systemic risk issues
• additional bu↵er for systemically important banks
• a new Leverage ratio
• new liquidity ratios.
Section B
Answer one question and no more than two further questions from this section.
Question 5
A firm is considering two investment projects, A and B. These projects are NOT
mutually exclusive. Assume the firm is not capital constrained. The initial costs and
cashflows for these projects are:
Year A B
0 48,000 42,000
1 19,000 10,000
2 17,000 35,000
3 25,000 8,000
16
Examiners’ commentaries 2018
(a) Using a discount rate of 10% calculate the net present value for each project.
What decision would you make based on your calculations?
(4 marks)
(b) How would your decision change if the discount rate used for calculating the net
present value is 12.5%?
(4 marks)
(c) Calculate an approximate IRR for each project. Assume the hurdle rate is 10%.
What decision would you make based on your calculations?
(6 marks)
(d) Calculate the payback period for each project. The company looks to select
investment projects paying back in 2 years. What decision would you make
based on your calculations?
(2 marks)
(e) Discuss the advantages and disadvantages of the payback rule of investment
appraisal. (4 marks)
(f) Discuss the limitations of the internal rate of return method of investment
appraisal (5 marks)
Reading for this question
See subject guide, Chapter 7, pages 142–49.
Approaching the question
(a) We have:
A B
48000 45000
17272.73 9090.91
14049.59 28925.62
18782.87 6010.52
NPV = 2105.18 NPV= 2027.05
Decision : Select both projects as the projects are not mutually exclusive and the NPV of
each is > 0.
(b) We have:
A B
48000 42000
16888.89 8888.89
13432.10 27654.32
17558.30 5618.66
NPV = 120.71 NPV = 161.87
Decision : Reject A but accept B.
(c) Using linear interpolation: IRR ⇡ 12% for A and 13% for B.
Therefore, accept both A and B.
(d) Payback period for A is between 2 and 3 years, therefore reject. Payback period for B is
under 2 years, therefore accept.
(e) Advantages – simple, good when capital constrained, some allowance for risk (as it is based
on earlier cash flows which are more certain).
Disadvantages – does not take into account time value of money, no allowance for cashflows
after the payback point.
17
FN1024 Principles of banking and finance
(f) The three main limitations of the IRR method are:
• may not give the same ranking as NPV as it is based on % return rather than scale of
return
• may give multiple solutions
• may give no solution.
Question 6
(a) Outline the key features of Markowitz’s modern portfolio theory (MPT) and
discuss the implications of MPT for an investor in risky securities (the use of
diagrams in your answer is encouraged).
(13 marks)
Reading for this question
See subject guide, Chapter 8, pages 166–70.
Approaching the question
Main features include:
• investors look at return and risk when deciding which investments to invest in
• diversification reduces risk (unless assets are perfectly positively correlated)
• special characteristics of the investor should be reflected in the composition of the
investor’s portfolio
• the riskiness of an asset can only be judged in terms of the overall portfolio
• the only way to increase expected return on a well-run portfolio is by increasing risk.
Better answers would use diagrams to show (i) mean variance frontier/ecient frontier, and
(ii) e↵ects of changing correlation on risk of the portfolio.
(b) You are given the following information:
(i) A stock with a beta of 0 has an expected return of 5%.
(ii) A portfolio made up of 20% invested at the risk free rate and 80% invested
in the market portfolio has an expected return of 14%.
What is the market risk premium?
(4 marks)
Reading for this question
See subject guide, Chapter 8, pages 172–73.
Approaching the question
From (i), Rf = 5%.
From (ii), 0.2⇥ 5% + 0.8⇥Rm = 14%. Hence Rm = (14 1)/0.8 = 16.25%.
Therefore, market risk premium = 16.25 5 = 11.25%.
(c) Discuss the limitations of the Capital Asset Pricing Model.
(8 marks)
Reading for this question
See subject guide, Chapter 8, pages 176–7.
Approaching the question
The imitations can be split into empirical and theoretical.
18
Examiners’ commentaries 2018
• Theoretical – the market portfolio is unobservable therefore it is not possible to test the
validity of the model without jointly testing the validity of the proxy – joint hypothesis
problem.
• Empirical – the evidence from testing the CAPM has found that it is not a good model
in terms of explaining expected returns. Other models are better – for example, Fama
and French etc.
Question 7
(a) Distinguish between re-financing risk and re-investment risk. Give examples of
each and explain which of these risks a bank is more likely to face.
(8 marks)
Reading for this question
See subject guide, Chapter 6, pages 117–18.
Approaching the question
Re-financing risk is the risk that the cost of re-borrowing funds will be higher than the
returns earned on asset investments, in the presence of longer-term assets relative to
liabilities.
Re-investment risk is the risk that returns on funds to be reinvested will be lower than the
cost of funds, when the bank holds shorter-term assets relative to liabilities.
Examples of each required.
Better answers would demonstrate that banks are more likely to face re-financing risk as
liabilities are shorter term than assets (as they are intermediaries).
(b) Consider the following extracts from the balance sheet of Exxobank (values in
£millions and duration in years):
Value Duration
Loans (short term) 1800 0.9
Loans (long term) 3000 3.6
Mortgages 4000 8.4
T-bonds 1200 3.2
Deposits 9000 1.6
Calculate the duration gap for Exxobank
(5 marks)
(c) What is the change in the market value of equity of Exxobank, as a percentage
of assets, if interest rates increase from 4.5% to 5.0%?
(3 marks)
(d) Explain the respective roles and limitations of liquidity gap and duration gap
analysis in helping banks manage interest rate risk.
(9 marks)
Reading for this question
See subject guide, Chapter 6, pages 125–30.
19
FN1024 Principles of banking and finance
Approaching the question
(b) Weighted average duration of assets:
=
1800
10000
⇥ 0.9 + 3000
10000
⇥ 3.6 + 4000
10000
⇥ 8.4 + 1200
10000
⇥ 3.2 = 4.986 years.
Duration of liabilities = 1.6 years.
Duration gap = Dur A L
Assets
⇥Dur L = 4.986 9000
10000
⇥ 1.6 = 3.546 years.
(c) Change in NW/A = Duration gap⇥ Change in i/(1 + i).
Change in NW/A:
= 3.546⇥ 0.005
1.045
= 0.01697
or 1.697%.
(d) Liquidity gap analysis focuses on cashflows and identifies the impact of a change in interest
rates on rate-sensitive assets rate-sensitive liabilities
Duration gap focuses on the impact of interest rate changes on market values of assets and
liabilities and hence on net worth or capital of the bank.
They are both useful with liquidity gap being an indicator of liquidity issues and duration
gap being an indicator of solvency (capital) issues.
Better answers will look at limitations of each analysis.
Question 8
(a) Briefly discuss the problems of valuing common stocks, preferred stocks and
corporate bonds.
(6 marks)
(b) Formally derive and explain the dividend discount model used for the valuation
of common stocks.
(9 marks)
(c) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)
(d) Consider the following stocks:
Stock A is expected to pay a dividend of £3 next year and then an annual
dividend of £4 from the following year, forever.
Stock B is expected to pay a dividend of £4 next year (t = 1) with dividend
growth expected to be 10% per annum for the next three years (t = 2, 3, 4)
before settling down to 4% a year thereafter (t = 5, . . .).
If the required return on similar equities is 8%, calculate the price of each stock.
(6 marks)
Reading for this question
See subject guide, Chapter 7, pages 150–55.
20
Examiners’ commentaries 2018
Approaching the question
(a) All securities are valued by discounting future cashflows to present value then summing all
the present values.
Common stocks – uncertain cashflows (dividend uncertain), therefore dicult to value.
Preferred stocks – more certain cashflows but still uncertainty about whether they are paid.
Corporate bonds – fixed cashflows but risk of issuer defaulting.
(b) An answer to this question involves starting with the price of the stock assuming a
one-period investment horizon. The value of the stock at the end of period one is then
substituted for the present value of the dividend in period 2 plus the price at the end of
period 2. The terminal value is then repeatedly substituted until infinity. This gives the
price of the stock as the sum of the present value of each period’s dividend plus the price of
the present value of the stock at infinity. As the PV of the terminal value of the stock is
close to zero we can ignore it.
(c) The model assumes a constant growth rate for dividends. This is not realistic for stocks in
the early stage of the life cycle (rapid growth phase) with slower growth rate in future.
More realistic for mature company stocks with steady cashflows – for example, utility
companies.
(d) Value of A:
=
3
1.08
+
4/0.08
1.08
= 2.78 + 46.30 = £49.08.
Value of B:
=
4
1.08
+
4⇥ 1.1
(1.08)2
+
4⇥ (1.1)2
(1.08)3
+
4⇥ (1.1)3
(1.08)4
+
[4⇥ (1.1)3 ⇥ (1.04))/(0.08 0.04)
(1.08)4
= 3.70 + 3.7729 + 3.8421 + 3.9133 + 101.74
= £116.96.
21
