FN1024 Principles of Banking and Finance Page 2 of 5
Section A
Answer ONE (1) question from this section and not more than further TWO (2)
questions.
1. (a) Discuss the main reasons for regulating banks and critically examine the role of the
safety net arrangements put in place in most banking systems.
(15 marks)
(b) Distinguish between micro- and macro-prudential regulation and give examples of
how macro-prudential regulation might work in practice.
(10 marks)
2. (a) Critically examine the role of conflicting requirements of lenders and borrowers
and transaction costs in explaining financial intermediation
(10 marks)
(b) Consider the role of delegated monitoring (Diamond model) in explaining financial
intermediation.
(15 marks)
3. (a) Explain the difference between valuation, informational and allocative efficiency.
(8 marks)
(b) Explain the joint-hypothesis problem encountered when testing for informational
efficiency of a market.
(7 marks)
(c) Explain the ‘January effect’ in stock markets and discuss the evidence for this effect.
(10 marks)
FN1024 Principles of Banking and Finance Page 3 of 5
4. (a) Discuss the risks arising from both the banking book (intermediation business) and
trading book of banks.
(8 marks)
(b) Explain how Value at Risk models can be used by a bank to manage its market risk
exposure. Discuss the problems with these models.
(10 marks)
(c) Explain how interest rate risk can impact a bank.
(7 marks)
Section B
Answer ONE (1) question from this section and not more than a further TWO (2)
questions.
5. (a) Distinguish between income gap and duration gap analysis in managing interest
rate risk. Critically examine the limitations of each.
(10 marks)
(b) Consider the following balance sheet of Unibank:
Assets (£) Duration Liabilities (£) Duration
Variable-rate Money market
mortgages 1400 8.1 deposits 1000 1.3
Fixed-rate
mortgages 1200 4.1 Savings deposits 3000 2.3
Commercial loans 4000 3.2 Variable-rate CD
(>1 year) 1000 1.2
Physical capital 1400 Equity 3000
Total 8000 Total 8000
Estimate the impact of an increase in interest rates from 3% to 4% on the equity of
Unibank.
(7 marks)
(c) Explain why the answer calculated in part (b) is an estimate.
(4 marks)
FN1024 Principles of Banking and Finance Page 4 of 5
(d) Explain what a duration gap of zero implies for a bank and discuss why banks
generally do not operate with duration gaps of zero.
(4 marks)
6. (a) Briefly explain each of the following terms:
(i) unsystematic (unique) risk
(ii) minimum risk portfolio
(iii) capital market line
(iv) borrowing (leveraged) portfolio
(8 marks)
(b) Explain why, under the CAPM framework, the standard deviation of an asset’s
returns is not a good measure of risk.
(4 marks)
(c) Derive, using two fund separation, the capital market line.
(8 marks)
(d) Explain whether a stock that sits above the security market line is undervalued or
overvalued. Explain how this under or over valuation is likely to be corrected.
(5 marks)
7. A firm is considering investing in the following two mutually exclusive projects:
Year A B
0 -260000 -350000
1 120000 100000
2 140000 130000
3 100000 200000
4 50000 50000
The firm has an opportunity cost of capital of 9%,
(a) Explain opportunity cost of capital.
(2 marks)
(b) Calculate the net present value (NPV) projects A and B.
(4 marks)
(c) Estimate the internal rate of return for projects A and B.
(5 marks)
FN1024 Principles of Banking and Finance Page 5 of 5
(d) Based on your results for (b) and (c) which investment project(s) should the
company invest in? Explain your decision.
(4 marks)
(d) Critically assess the usefulness of the internal rate of return criterion for investment
appraisal.
(6 marks)
(e) Explain why the additivity property of NPV is useful when selecting investment
projects where funds are limited.
(4 marks)
8. (a) You have been asked to explain Markowitz’s modern portfolio theory (MPT).
Outline the key features of MPT and explain the main benefits of MPT for an
investor (the use of diagrams in your answer is encouraged).
(12 marks)
(b) An investor is considering investing in the following two stocks, X and Y:
Expected return Variance
X 9% 15
Y 4% 7
The correlation between the returns on securities X and Y is - 0.4.
Calculate the expected return and standard deviation of the following four portfolios:
Portfolio Proportions (%)
Portfolio X Y
1 30 70
2 75 25
3 50 50
4 100 0
(6 marks)
(c) Discuss the limitations of the Capital Asset Pricing Model (CAPM).
(7 marks)
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