Reference no: EM131061174

Part 1: MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.

1) The demand for an asset rises if ________ falls.

A) risk relative to other assets B) wealth C) expected return relative to other assets D) liquidity relative to other assets

2) Banks' attempts to solve adverse selection and moral hazard problems help explain loan management principles such as

A) credit rationing.
B) collateral and compensating balances.
C) screening and monitoring of loan applicants.
D) all of the above.
E) only A and B of the above.

3) When a lender refuses to make a loan, although borrowers are willing to pay the stated interest rate or even a higher rate, it is said to engage in ________.

A) credit rationing B) constrained lending C) strategic refusal D) collusive behavior

4) If a bank has more rate- sensitive liabilities than rate- sensitive assets, then a(n) ________ in interest rates will ________ bank profits.

A) increase; increase B) increase; reduce
C) decline; not affect D) decline; reduce

	First National Bank
	Assets	Liabilities
Rate-sensitive	$20 million	$ 50 million
Fixed-rate	$80 million	$40 million

Table 23.1

5) Referring to Table 23.1, if interest rates rise by 5 percentage points, then bank profits (measured using gap analysis) will

A) increase by $1.5 million. B) decline by $0.5 million.
C) decline by $2.5 million. D) decline by $1.5 million.

	First National Bank
	Assets	Liabilities
Rate-sensitive	$40 million	$ 50 million
Fixed-rate	$60 million	$40 million

Table 23.2

6) Refer to Table 23.2. Assuming that the average duration of the bank's assets is four years, while the average duration of its liabilities is three years, a rise in interest rates from 5 percent to 10 percent will cause the net worth of First National to ________ by ________ of the total original asset value.

A) decline; 6.2% B) increase; 5% C) decline; 5% D) decline; 1.3%

7) Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap for several maturity subintervals by the change in the interest rate is called

A) basic gap analysis.
B) the maturity bucket approach to gap analysis.
C) the segmented maturity approach to interest- exposure analysis.
D) the segmented maturity approach to gap analysis.
E) none of the above.

8) If a decline in interest rates causes the market value of a bank's net worth to rise, then the bank must have a ________.

A) positive duration gap B) positive gap
C) negative duration gap D) negative gap

9) One problem with duration gap analysis is that it

A) applies only to financial institutions.
B) does not measure the sensitivity of net worth to interest rate changes.
C) does not measure the sensitivity of income to interest rate changes.
D) is calculated assuming that the yield curve is flat.
E) is calculated assuming that the yield curve does not change.

10) One problem with basic gap analysis is that it

A) is calculated assuming interest rates on all maturities are equal.
B) does not measure the sensitivity of income to interest rate changes.
C) is calculated assuming interest rates on all maturities change by equal amounts.
D) applies only to financial institutions.
E) measures the sensitivity of net worth to interest rate changes.

11) A bank manager concerned about interest income who expects interest rates to fall and who knows the bank currently has a positive gap should ________ rate- sensitive assets and ________ rate- sensitive liabilities.

A) decrease; decrease B) decrease; increase
C) increase; increase D) increase; decrease

12) The number of contracts outstanding in a particular financial future is the ________.

A) open interest B) outstanding balance
C) index level D) demand coefficient

13) The advantage of forward contracts over futures contracts is that forward contracts

A) have lower default risk. B) are standardized.
C) are more liquid. D) are none of the above.

14) When a financial institution hedges the interest- rate risk for a specific asset, the hedge is called a ________.

A) macro hedge B) futures hedge C) micro hedge D) cross hedge

15) An increase in the volatility of the underlying asset, all other things held constant, will ________ the option premium.

A) not affect B) increase C) decrease D) Not enough information is given.

16) A financial contract that obligates one party to exchange a set of payments it owns for another set of payments owned by another party is called a ________.

A) cross put option B) swap
C) cross call option D) cross hedge

17) If Second National Bank has more rate- sensitive assets than rate- sensitive liabilities, it can reduce interest- rate risk with a swap which requires Second National to

A) receive a fixed rate while paying a floating rate.
B) both receive and pay a floating rate.
C) both receive and pay a fixed rate.
D) pay a fixed rate while receiving a floating rate.

18) The use of financial derivatives by financial institutions to hedge can decrease risk. However, they can also increase risk. Which of the following examples illustrates this?

A) Some institutions such huge amounts of derivatives that the amounts exceed capital.
B) Financial derivatives allow financial institutions to increase their leverage.
C) All of the above are valid examples.
D) None of the above are valid examples.

19) Factors that cause the demand curve for bonds to shift to the left include

A) an increase in the liquidity of stocks.
B) an increase in the inflation rate.
C) a decrease in the volatility of stock prices.
D) all of the above.
E) none of the above.

20) According to the expectations theory of the term structure,

A) buyers of bonds prefer short- term to long- term bonds.
B) interest rates on bonds of different maturities move together over time.
C) the interest rate on long- term bonds will exceed the average of expected future short- term interest rates.
D) all of the above.
E) only A and B of the above.

21) If bad credit risks are the ones who most actively seek loans and, therefore, receive them from financial intermediaries, then financial intermediaries face the problem of

A) adverse selection. B) costly state verification.
C) free- riding. D) moral hazard.

22) The problem created by asymmetric information before the transaction occurs is called ________, while the problem created after the transaction occurs is called ________.

A) free- riding; costly state verification B) adverse selection; moral hazard
C) moral hazard; adverse selection D) costly state verification; free- riding

23) The process of deleveraging refers to

A) a reduction in debt owed by banks.
B) cutbacks in lending by financial institutions.
C) both A and B.
D) none of the above.

24) When we refer to the shadow banking system, what are we talking about?

A) the subsidiaries of depository institutions
B) the "underground" banking system used for illegal activities
C) hedge funds, investment banks, and other nonbank financial firms that supply liquidity
D) none of the above

25) Federal Reserve independence is thought to

A) introduce longer- run considerations to monetary policymaking.
B) introduce a short- term bias to monetary policymaking.
C) lead to better fiscal and monetary policy coordination.
D) do both A and B of the above.

26) The theory of bureaucratic behavior suggests that the objective of a bureaucracy is to maximize

A) its own welfare.
B) the public's welfare.
C) profits.
D) conflict between the executive and legislative branches of government.

27) Instrument independence means the central bank is free from

A) political pressure regarding the goals it pursues.
B) political pressure regarding how it uses the tools of monetary policy.
C) both A and B of the above.
D) neither A nor B of the above.

28) The federal funds rate is

A) the price the Fed pays for government securities.
B) the interest rate on loans of reserves from one bank to another.
C) the price banks pay the Fed for government securities.
D) the interest rate on loans from a bank to the federal government.
E) the interest rate on loans from the Fed to a bank.

29) Which of the following statements is true?

A) Bubbles driven solely by irrational exuberance lead to a failure of financial institutions.
B) Credit- driven asset bubbles are particularly dangerous. When asset prices fall, the deleveraging of credit markets reduces economic activity.
C) Both A and B are correct.
D) Neither A nor B is correct.

30) Bankers' concern regarding the optimal mix of excess reserves, secondary reserves, borrowings from the Fed, and borrowings from other banks to deal with deposit outflows is an example of

A) managing interest- rate risk. B) liquidity management.
C) liability management. D) none of the above.

31) Holding everything else constant, if the federal funds rate rises, then the demand for

A) reserves will not change because the Fed sets the level of required reserves.
B) required reserves rises because the cost of borrowing from the Fed is relatively lower.
C) excess reserves rises because they have a higher return.
D) required reserves falls because the cost of borrowing from the Fed is relatively higher.
E) excess reserves falls because they have a higher cost.

32) If a bank has $100,000 of deposits, a required reserve ratio of 20 percent, and $40,000 in reserves, then the maximum deposit outflow it can sustain without altering its balance sheet is

A) $25,000. B) $10,000. C) $30,000. D) $20,000.

33) A bank can reduce its total amount of loans outstanding by

A) "calling in" loans; that is, by not renewing some loans when they come due.
B) selling loans to other banks.
C) selling loans to the Federal Reserve.
D) doing all of the above.
E) doing only A and B of the above.

34) Deposit insurance

A) encourages bank managers to take on greater risks than they otherwise would.
B) attracts risk- prone entrepreneurs to the banking industry.
C) reduces the incentives of depositors to monitor the riskiness of their banks' asset portfolios.
D) does all of the above.
E) does only A and B of the above.

35) The primary difference between the "payoff" and the "purchase and assumption" methods of handling failed banks is that the FDIC

A) guarantees all deposits, not just those under the $250,000 limit, when it uses the "payoff" method.
B) is more likely to use the "payoff" method when the bank is large and it fears that depositor losses may spur business bankruptcies and other bank failures.
C) guarantees all deposits, not just those under the $250,000 limit, when it uses the "purchase and assumption" method.
D) does both A and B of the above.
E) does both B and C of the above.

36) The legislation that separated commercial banking from the securities industry is known as the ________.

A) Glass- Steagall Act B) McFadden Act C) National Bank Act D) Federal Reserve Act

37) Adjustable rate mortgages

A) reduce financial institutions' interest- rate risk.
B) benefit homeowners when interest rates are falling.
C) reduce households' risk of having to pay higher mortgage payments when interest rates rise.
D) do only A and B of the above.

38) The bundling of mortgages into a saleable security (usually for large institutional investors) is called ________.

A) hedge optioning
B) disintermediation
C) securitization
D) quasi- intermediation
E) futures bundling

39) When disintermediation occurs, the banking system ________ deposits and bank lending ________.

A) loses; increases B) gains; increases
C) loses; decreases D) gains; decreases

40) In a ________ banking system, commercial banks engage in securities underwriting, but separate subsidiaries conduct the different activities. Also, banking and insurance are not typically undertaken together in this system.

A) universal B) divided
C) British- style universal
D) compartmentalized
E) severable.

Part 2:

Amounts are in millions

Assets		Duration
Reserves and Cash Items	$ 6	0
Securities
< 1 year	$ 5	0.75
1 to 2 years	$ 5	1.5
> 2 years	$ 10	5
Residential Mortgages
Variable Rate	$ 8	0.5
Fixed Rate	$ 10	8
Commercial Loans
< 1 year	$ 15	0.5
1 to 2 years	$ 13	1.3
> 2 years	$ 25	8
Physical Capital	$ 3	0
Total Assets	$ 100

Liabilities		Duration
Checkable Deposits	15	2
Money Market Accounts	8	0.1
Savings Deposits	10	1
Certificates of Deposits
Variable Rate	5	0.5
< 1 year	15	0.5
1­2 years	10	1.5
> 2 years	5	4
Fed Funds	7	0
Borrowings
< 1 year	10	0.5
1­2 years	5	1.5
> 2 years	5	3
Equity	5
Liabilities + Equity	100

1. What is the impact to this year's net income if interest rates increase from 5% to 6%?

2. What is the impact to equity if interest rates increase from 5% to 6%?

3. A semiannual bond with 4 years to maturity has a coupon rate of 5%. The face value of the bond is $1,000 and trades at $1,074.86. Calculate Macaulay duration, modified duration, and effective duration for this bond.

Using the information from the previous question, how much would the bondholder gain/lose if interest rates decreased by 50 bps?