University of London 2017 UL17/0190 Page 1 of 4 D0 ~~FN1024_ZA_2016_d0 This paper is not to be removed from the Examination Halls 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 Tuesday, 9 May 2017 : 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 2017 UL17/0190 Page 2 of 4 D0 SECTION A Answer one question and no more than two further questions from this section. 1. (a) Explain the process of securitisation and identify the advantages to a financial institution in securitising its assets. (10 marks) (b) Explain the main characteristics of the 2007/8 sub-prime mortgage crisis. (15 marks) 2. (a) How does adverse selection influence the lending decisions of banks (7 marks) (b) Discuss how to reduce/solve the problems arising from moral hazard in lending. (13 marks) (c) Explain why loan contracts do not suffer from problems of free-riding on information compared to bonds. (5 marks) 3. (a) Discuss the arguments for and against bank regulation. (13 marks) (b) Explain the differences between market-based and bank-based financial systems. (12 marks) 4. (a) Distinguish between valuation, allocative and informational efficiency in relation to financial markets. Explain why allocative efficiency depends upon the existence of valuation and informational efficiency. (10 marks) (b) Explain the empirical evidence on market underreaction in the context of weak and semi- strong form efficiency. (15 marks) University of London 2017 UL17/0190 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 investing in the following two mutually exclusive projects: Year Alpine Beeline 0 -252000 -372000 1 125000 100000 2 140000 140000 3 -100000 125000 4 170000 125000 (a) If the opportunity cost of capital is 9%, calculate the net present value (NPV) for each project. (4 marks) (b) Calculate the net present value for each project for discount rates of 12% and 14%. Draw a diagram of NPV against discount rates of 9%, 12% and 14% and identify the approximate internal rate of return (IRR) for each project (you may give your answer as a range e.g. 5% to 5.5%). (7 marks) (c) Based on your results for (a) and (b) which investment project(s) should the company invest in Explain your decision. (5 marks) (d) Explain the payback method of investment appraisal and discuss its advantages and disadvantages. (5 marks) (e) Explain why the NPV decision rule is consistent with the objective of the firm to maximise shareholder wealth. (4 marks) 6. (a) Explain the differences between reinvestment and refinancing risk giving examples and identify which is likely to be more common for a bank. (5 marks) (b) Explain how a bank can use income gap analysis to manage interest rate risk. Critically discuss the problems associated with income gap analysis. (8 marks) (c) Consider the following balance sheet of Bank Gamma: Assets (￡) Duration Liabilities (￡) Duration Variable-rate mortgages 260 8.1 Money market deposits 350 1.9 Fixed-rate mortgages 140 5.1 Savings deposits 280 2.3 Commercial loans 560 3.5 Variable-rate CD (> 1 year) 210 3.1 Physical capital 230 Equity 350 Total 1190 Total 1190 What will be the change in net interest income at the year-end if interest rates fall by 1 per cent, from 5 to 4 per cent Explain using income gap analysis. Question continues on next page University of London 2017 UL17/0190 Page 4 of 4 D0 (Use the following assumptions on the runoff of cash flows: fixed-rate mortgages repaid during the year: 20 per cent; proportion of savings deposits and variable rate CD that are rate- sensitive: 20 per cent). (4 marks) (d) Calculate the duration gap for Bank Gamma (4 marks) (e) Explain why duration gap is likely to be positive for a bank. (4 marks) 7. (a) Consider the following stocks: Stock X is expected to pay a dividend of ￡3 for the next two years and then ￡4 forever; Stock Y is expected to pay a dividend of ￡0.8, followed by ￡1.20 in year 2 then ￡1.40 in year 3 with dividend growth expected to be 3% per annum thereafter. If the required return on similar equities is 7%, calculate the price of each stock. (6 marks) (b) Discuss the issues with estimating future cash flows for a stock, government bond and corporate bond. (6 marks) (c) Formally derive and discuss the dividend discount model used for the valuation of common stocks. (9 marks) (d) Describe the Gordon growth model and identify the types of stocks it is best used to value. (4 marks) 8. (a) Briefly explain each of the following terms: (i) efficient frontier (ii) feasible region (iii) security market line (iv) market risk premium (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) Demonstrate how the capital market line can be identified by the introduction of a risk-free asset. (8 marks) (d) Discuss the problems with empirically testing the Capital Asset Pricing Model. (5 marks) END OF PAPER University of London 2017 UL17/0191 Page 1 of 4 D0 ~~FN1024_ZB_2016_d0 This paper is not to be removed from the Examination Halls 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 Tuesday, 9 May 2017 : 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 2017 UL17/0191 Page 2 of 4 D0 SECTION A Answer one question and no more than two further questions from this section. 1. (a) Explain the process of securitisation and identify the advantages to a financial institution in securitising its assets. (10 marks) (b) With reference to examples, discuss the characteristics and consequences of financial bubbles in markets. (15 marks) 2. (a) How does moral hazard influence the lending decisions of banks (7 marks) (b) Discuss how to reduce/solve the problems arising from adverse selection in the lending process. (13 marks) (c) Explain why loan contracts do not suffer from free-riding problems in information production compared to bonds. (5 marks) 3. (a) Discuss the main changes to capital regulation introduced by Basel 3. (15 marks) (b) Explain the key features of the safety net in the regulatory system for banks. Discuss the problems caused by this safety net and the solutions to these problems. (10 marks) 4. (a) Distinguish between valuation, allocative and informational efficiency in relation to financial markets. Explain why allocative efficiency depends upon the existence of valuation and informational efficiency. (10 marks) (b) Explain the empirical evidence on market over-reaction in the context of weak and semi- strong form efficiency. (15 marks) University of London 2017 UL17/0191 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 investing in the following two mutually exclusive projects: Year Yeti Zylo 0 -260000 -350000 1 120000 100000 2 140000 130000 3 -100000 125000 4 170000 125000 (a) If the opportunity cost of capital is 9%, calculate the net present value (NPV) for each projects. (4 marks) (b) Calculate the net present value for each project for discount rates of 12% and 14%. Draw a diagram of NPV against discount rates of 9%, 12% and 14% and identify the approximate internal rate of return (IRR) for each project (you may give your answer as a range e.g. 5% to 5.5%). (7 marks) (c) Based on your results for (a) and (b) 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) 6. (a) Compare income gap analysis with duration gap analysis as techniques for managing interest rate risk for a bank. (9 marks) (b) Consider the following balance sheet of Bank Leppa: Assets ($) Duration Liabilities ($) Duration Variable-rate mortgages 250 7.5 Money market deposits 300 1.9 Fixed-rate mortgages 120 4.1 Savings deposits 250 2.2 Commercial loans 500 4.5 Variable-rate CD (> 1 year) 210 3.0 Physical capital 200 Equity 310 Total 1070 Total 1070 What will be the change in net interest income at the year-end if interest rates rise by 1 per cent, from 3 to 4 per cent Explain using income gap analysis. Question continues on next page University of London 2017 UL17/0191 Page 4 of 4 D0 (Use the following assumptions on the runoff of cash flows: fixed-rate mortgages repaid during the year: 20 per cent; proportion of savings deposits and variable rate CD that are rate- sensitive: 20 per cent). (4 marks) (c) Calculate the duration gap for Bank Leppa (4 marks) (d) What is the estimated change in the value of equity (in $s) for Bank Leppa if interest rates increase by 1% from 3 to 4% (4 marks) (e) Explain why duration gap is likely to be positive for a bank. (4 marks) 7. (a) Consider the following stocks: Stock A is expected to pay a dividend of $2.50 for the next two years and then $4 forever; Stock B is expected to pay a dividend of $0.9, followed by $1.20 in year 2 then $1.50 in year 3 with dividend growth expected to be 4% per annum thereafter. If the required return on similar equities is 6%, calculate the price of each stock. (6 marks) (b) Discuss the issues with estimating future cash flows for a stock, government bond and corporate bond. (6 marks) (c) Explain why capital gains is not included in the dividend discount formula for the valuation of a stock. (5 marks) (d) Explain Macaulay duration and describe the main characteristics of Macaulay duration in relation to bonds. (8 marks) 8. (a) Briefly explain each of the following terms: (i) unsystematic (unique) risk (ii) minimum risk portfolio (iii) capital market line (iv) market risk premium (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) END OF PAPER Examiners’ commentaries 2017 Examiners’ commentaries 2017 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. 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 d
emonstrate 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 2017 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 2017 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 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 the process of securitisation and identify the advantages to a financial institution in securitising its assets. (10 marks) Reading for this question See subject guide, Chapter 3, pages 56–7. Approaching the question This question part requires two things: an explanation of the process of securitisation and the identification of reasons why a financial institution such as a bank securitises its assets. Many answers simply focused on an explanation of the process and did not cover advantages. Securitisation is the process of transforming illiquid financial assets (such as loans and mortgages) into marketable securities. Typically, this involves packaging illiquid loans into bundles and then passing these on to a third party (special purpose vehicle (SPV)). The SPV then manages the securitisation by issuing new (loan backed) securities to investors. The original loans continue to earn interest which is typically passed through to the SPV to 4 Examiners’ commentaries 2017 pay the interest/capital on the issued securities. The SPV will pass the proceeds from the sale of the securities back to the bank as cash. In engaging in this process, the bank has therefore transformed illiquid loans into cash. This allows it to manage liquidity risk over the medium/long term. It can also be used to remove assets that have a high-risk weighting into assets with a lower risk weighting to help manage its capital requirement. Better answers would also identify the risks with securitisation. (b) Explain the main characteristics of the 2007/8 sub-prime mortgage crisis. (15 marks) Reading for this question See subject guide, Chapter 3, pages 56–7. Approaching the question One way to begin answering this question part is to explain that over the period prior to 2007 structured credit markets experienced a rapid growth under benign conditions. Investors showed a high-risk appetite that stimulated further development by financial institutions of techniques for unbundling and distributing risks through financial markets. This led to a marked expansion of the so-called sub-prime mortgage market. In 2005 and 2006, the competition among the sub-prime originators intensified. To maintain volumes and/or increase market share, originators introduced product innovations such as teaser rates. At the same time, there was an apparent weakening of lending standards. Loans were made with increasingly high loan-to-value ratios and often without full documentation. Most originators sold the loans to larger banks, who in turn securitised them and sold them to end-investors. As interest rates increased and house prices fell rapidly in the U.S. in 2006 there was an increase in mortgage defaults, particularly among sub-prime borrowers (especially for those who moved o teaser interest rates to higher rates). These mortgage defaults led to a decline in the quality of securitised debt leading to a fall in value of this debt leading to spread of the problem outside of sub-prime originating banks. Better answers would tell a coherent ‘story’ of the causes of the crisis relating the di erent elements together. Weaker answers will simply list the characteristics of the crisis. Question 2 (a) How does adverse selection influence the lending decisions of banks (7 marks) Reading for this question See subject guide, Chapter 4, pages 73–4. Approaching the question Adverse selection is a problem created by asymmetric information. The existence of asymmetric information means that lenders will lend at a rate of interest reflecting average risk (as they cannot distinguish between good and bad risks). This drives many good-risk borrowers out of the market leaving mainly poor risks. Hence the borrowers who are more likely to want to borrow are poor risks. As a consequence, lenders may decide not to lend. Better answers will give more detail on how the decision to lend at rates of interest reflecting average risk will lead to adverse selection. However, the discussion should be in the context of lending decisions and not second-hand car purchase decisions. 5 FN1024 Principles of banking and finance (b) Discuss how to reduce/solve the problems arising from moral hazard in lending. (13 marks) Reading for this question See subject guide, Chapter 4, pages 79–80. Approaching the question A good answer would first define moral hazard, i.e. the risk created after the loan is made because the borrower may use the loan for a riskier proposition than promised, thus increasing the risk of default. It is a consequence of asymmetric information. Solutions include: 1. Making debt contract incentive-compatible (i.e. align the incentives of borrowers and lenders). 2. Monitoring and enforcement of restrictive covenants. Discussion of the types of possible covenants and relevant examples needed. 3. Financial intermediaries. Problems arising from the use of covenants. Mechanisms used by financial intermediaries to solve the incentive problem and the free-rider problem. 4. Use of screening and monitoring, favoured by the existence of established long-term relationships to overcome moral hazard. Better answers would explain in more detail how these solutions impact on moral hazard. (c) Explain why loan contracts do not su er from problems of free-riding on information compared to bonds. (5 marks) Reading for this question See subject guide, Chapter 4, page 80. Approaching the question A good answer would refer to the fact that bank loans are private securities, not traded in the open financial market. Therefore, investors are not able to observe the bank and bid up the price of the loan to the point where the bank makes no profit on the production of information. Bonds in contrast are tradeable therefore bonds su er from free-riding. Better answers would explain that as a consequence of lending through non-traded loans banks have the incentive to devote sucient resources to solving adverse selection/moral hazard problems because no other investors can extract benefits from this. Hence the bank gets all the benefits. Question 3 (a) Discuss the arguments for and against bank regulation. (13 marks) Reading for this question See subject guide, Chapter 5, pages 92–6. 6 Examiners’ commentaries 2017 Approaching the question The key arguments in favour include: 1. The fragility of banks – mainly due to their provision of liquidity to the financial system (i.e. vulnerability to runs). A source of mitigation of fragility is the role of banks in screening and monitoring borrowers who cannot obtain direct finance from financial markets. 2. Systemic risk – the contagion e ect exacerbated by asymmetric information. 3. Depositor protection. The main arguments against are: 1. Cost. 2. Complexity – creates opportunities for arbitrage which can lead to unintended consequences. 3. Moral hazard. 4. Increases barriers to entry – less competition. Better answers would identify that systemic risk is the most important reason to justify prudential regulation of banks. So regulators are willing to accept the costs cited above in order to get the main benefit of reduced systemic risk. (b) Explain the di erences between market-based and bank-based financial systems. (12 marks) Reading for this question See subject guide, Chapter 3, pages 50–3. Approaching the question A good answer would explain that essentially, in market-based systems (U.S. and U.K.) in contrast to bank-based financial systems (Germany and Japan), the financial markets play a greater role in providing finance to firms – the relationship between banks and firms is not close and there is a lower level of integration between bank and non-bank financial services. A better answer to this question would explain the following points in their discussion of the di erences between the two types of system. 1. The proportion of gross financial assets owned by pension funds is higher in market-based systems. 2. Equity is a more important component of households’ asset portfolios in market-based systems. 3. Moral hazard should be lower in bank-based financial systems. 4. There is a trend towards market-based systems suggesting their superiority in terms of capital allocation. Question 4 (a) Distinguish between valuation, allocative and informational eciency in relation to financial markets. Explain why allocative eciency depends upon the existence of valuation and informational eciency. (10 marks) Reading for this question See subject guide, Chapter 9, pages 184–5. 7 FN1024 Principles of banking and finance Approaching the question Note this question part has two elements: first, distinguishing between di erent kinds of eciency in financial markets and, second, explaining why allocative eciency depends upon the existence of the other two types. Better answers will cover both elements. A financial market is referred to as informational ecient when security prices fully reflect all available information. Informational eciency is a more specific form of the general valuation eciency, which refers to whether the prices of the securities traded on a market reflect the true fundamental (also termed intrinsic, or fair) value of the securities. Under valuation eciency, all prices are always correct, and reflect market fundamentals. Therefore, the market price of a security is the fair price, and has to be equal to the expected cash-flows from the security using all relevant information. Informational eciency is a more specific form of eciency than valuation eciency, because it assumes that expectations are optimal forecasts using all available information, but not that market prices reflect the fair value. Valuation eciency and informational eciency are conditions for the achievement of the most general eciency condition of financial markets: allocative eciency. This refers to whether a market allocates productive resources to the most productive investments in performing its main function of channelling funds from saver–lenders to spender–borrowers. This requires asset prices to reflect accurately the discounted stream of future cash-flows the asset is expected to generate over its existence. The price of an asset then acts as a signal directing resources from savers into the firm securities yielding the highest returns and from firms into the real assets yielding the highest returns. (b) Explain the empirical evidence on market under-reaction in the context of weak and semi-strong form eciency. (15 marks) Reading for this question See subject guide, Chapter 9, page 195. Approaching the question Evidence on market under-reaction constitutes an anomaly related to earnings announcements. Although empirical evidence generally confirms rapid adjustment to new information (as shown in the evidence in favour of the semi-strong form eciency), recent evidence shows that stock prices do not instantaneously adjust. A definition of under-reaction should be provided: under-reaction to earnings announcements means that stock prices do not fully incorporate the new information embodied in the unexpected earnings announcement. Answers should then examine the empirical evidence that shows that adjustment to extreme bad news takes several months: there is a market over-reaction and subsequent gradual adjustment (see for example the evidence in Ball and Brown (1968), then confirmed by Bernard and Thomas (1989)). Better answers will describe the methodology and findings of the study by Bernard and Thomas (1989). T