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FRM Part II Exam

By AnalystPrep

Questions with Answers - Liquidity and Treasury Risk

Measurement and Management

Last Updated: Feb 24, 2024

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Table of Contents

127 - Liquidity Risk 3

128 - Liquidity and Leverage 24
129 - Early Warning Indicators 51
130 - The Investment Function in Financial Services Management 60
131 - Liquidity and Reserves Management: Strategies and Policies 71
132 - Intraday Liquidity Risk Management 90
133 - Monitoring Liquidity 103
134 - The Failure Mechanics of Dealer Banks 119
135 - Liquidity Stress Testing 128
136 - Liquidity Risk Reporting and Stress Testing 146
137 - Contingency Funding Planning 162
138 - Managing and Pricing Deposit Services 176
139 - Managing Nondeposit Liabilities 191
140 - Repurchase Agreements and Financing 208
141 - Liquidity Transfer Pricing: A Guide to Better Practice 224
The US Dollar Shortage in Global Banking and the
142 - 239
International Policy Response
Covered Interest Rate Parity Lost: Understanding the Cross-
143 - 253
Currency Basis
Risk Management for Changing Interest Rates: Asset-Liability
144 - 267
Management and Duration Techniques
145 - Illiquid Assets 280

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Reading 127: Liquidity Risk

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Q.2255 Liquidity risk is best defined as:

A. The risk that a counterparty in a transaction will delay meeting their financial
obligation, thereby subjecting an institution to a shortage of funds.

B. The risk that an institution will not be able to meet its financial needs at some future
date.

C. The risk that the amount of money in circulation within an economy is too low.

D. Inability to meet short-term debt obligations without giving up capital or income.

The correct answer is D.

Liquidity risk is indeed the inability of a financial institution to meet its short-term debt

obligations without sacrificing capital or income. This risk arises when an institution is unable to

convert its assets into cash without incurring a significant loss. This inability could be due to

various factors such as market conditions, the nature of the assets, or the institution's financial

health. In a situation where the institution cannot liquidate its assets quickly enough to meet its

obligations, it faces liquidity risk. This risk is a critical aspect of financial risk management as it

directly impacts the institution's solvency and financial stability. Therefore, financial institutions

employ various strategies and tools to manage and mitigate liquidity risk, such as maintaining a

diversified portfolio, having adequate cash reserves, and using financial instruments that can be

easily liquidated.

Choice A is incorrect. While it does involve a delay in meeting financial obligations, this

definition more accurately describes counterparty or credit risk, not liquidity risk. Liquidity risk

pertains to the institution's own ability to meet its short-term obligations.

Choice B is incorrect. This choice is too vague and could apply to several types of risks.

Liquidity risk specifically refers to the inability of an institution to meet short-term debt

obligations without sacrificing capital or income.

Choice C is incorrect. This choice describes a macroeconomic condition rather than a specific

institutional risk. The amount of money in circulation within an economy can affect many

aspects, but it doesn't directly define liquidity risk for a financial institution.

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Q.2257 Joseph Bradley, FRM, works at I&M bank. As per the results of his intensive research, the
US Treasury has issued bonds with a nominal value of approximately 800 billion dollars. I&M
holds bonds worth 20 million dollars. This implies that:

A. The bid-ask spread is exogenous to the bank.

B. The bid-ask spread is endogenous to the bank.

C. The bank is in a position to influence market price of Treasury bonds.

D. The bank has too big an investment in gilts.

The correct answer is A.

The bid-ask spread is exogenous to the bank. The term 'exogenous' refers to factors or variables

that are determined outside the system being studied and are often considered as given or

constant. In this context, the bid-ask spread is determined by the larger bond market, not by

I&M Bank's activities. Given the size of the bond market ($800 billion) and the bank's relatively

small position ($20 million), the bank's trading activities would have an insignificant effect on the

market price of bonds. Therefore, the bid-ask spread, which is the difference between the

highest price that a buyer is willing to pay for an asset and the lowest price that a seller is

willing to accept, is exogenous to the bank. It is determined by market forces beyond the bank's

control.

Choice B is incorrect. The bid-ask spread is not endogenous to the bank. Endogenous variables

are those that are influenced by other factors within the system. In this case, the bid-ask spread

of Treasury bonds is determined by market forces and not directly controlled or influenced by

I&M Bank's actions or decisions.

Choice C is incorrect. The bank does not have a position to influence market price of Treasury

bonds. Given that the total face value of US Treasury bonds issued is approximately $800 billion,

I&M Bank's holding of $20 million represents a very small fraction (0.0025%) of the total

issuance, which would be insufficient to exert any significant influence on market prices.

Choice D is incorrect. It cannot be concluded that the bank has too big an investment in gilts

based on given information alone. Whether an investment size in gilts (UK government

securities) or any other security for that matter, is 'too big' depends on various factors such as

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risk tolerance, investment strategy and portfolio diversification among others - none of which are

provided in this question.

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Q.2258 Which of the following statements is correct regarding the bid-ask spread of a financial
instrument?

A. The bid-ask spread is limited to 1%.

B. The bid-ask spread is limited to 0.5%.

C. The bid-ask spread ranges between 0.5% and 1%, depending on the type of security
being traded.

D. The bid-ask spread is not limited.

The correct answer is D.

The bid-ask spread is not limited. It is a dynamic variable that can fluctuate based on a variety of

market factors. The bid-ask spread is essentially the difference between the highest price a

buyer is willing to pay for an asset (the bid) and the lowest price a seller is willing to sell that

asset for (the ask). This spread can vary widely depending on the liquidity of the asset, the

volatility of the market, and the overall economic conditions. For instance, in a highly liquid

market with many buyers and sellers, the bid-ask spread may be quite narrow. Conversely, in a

less liquid market or during times of high market volatility, the bid-ask spread may widen

significantly. Therefore, it is not accurate to state that the bid-ask spread is limited to a specific

percentage or range. It is a variable that is influenced by market conditions and the

characteristics of the specific asset being traded.

Choice A is incorrect. The bid-ask spread is not limited to 1%. The spread can be wider or

narrower depending on various factors such as the liquidity of the asset, market volatility, and

information asymmetry among market participants.

Choice B is incorrect. Similarly to Choice A, the bid-ask spread is not limited to 0.5%. It can

vary widely based on a multitude of factors including but not limited to the ones mentioned

above.

Choice C is incorrect. While it's true that the bid-ask spread can range between different

percentages depending on the type of security being traded, it's misleading to suggest that this

range is strictly between 0.5% and 1%. The actual range can be much broader or narrower

depending on specific market conditions and characteristics of individual securities.

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Q.2262 Bilco Bank has implemented the LaR (liquidity at risk) method based on a 95%
probability and a 1-day holding period. Suppose its calculations for the next day result in a figure
of USD 15 million. What would that imply?

A. The maximum loss over the next day is $15 million with a probability of 95%.

B. The maximum profit over the next day is $15 million with a probability of 95%.

C. The worst outcome over the next day is an inflow of cash of $15 million with a
probability of 95%.

D. The worst outcome over the next day is an outflow of cash of $15 million with a
probability of 95%.

The correct answer is D.

The Liquidity at Risk (LaR) method is a risk management tool used by financial institutions to

estimate the potential cash outflows or inflows that could occur over a specified holding period,

given a certain level of confidence (in this case, 95%). In the context of this question, a LaR value

of USD 15 million implies that the worst-case scenario for Bilco Bank over the next day is a cash

outflow of USD 15 million. This means that, with a 95% level of confidence, the bank could

experience a cash outflow of up to USD 15 million. This is considered the 'worst' outcome as it

represents a decrease in the bank's liquidity, which could potentially impact its ability to meet its

short-term obligations. Therefore, the bank needs to ensure that it has sufficient liquidity buffers

in place to cover such a scenario.

Choice A is incorrect because it incorrectly interprets the LaR value as a potential loss. While a

cash outflow could indeed lead to a decrease in the bank's liquidity, it is not the same as a loss. A

loss would imply that the bank has incurred a negative return on its investments or operations,

which is not what the LaR value represents. The LaR value is a measure of potential cash flows

(either inflows or outflows), not profits or losses. Therefore, the statement that the maximum loss

over the next day is USD 15 million with a probability of 95% is incorrect.

Choice B is incorrect because it incorrectly interprets the LaR value as a potential profit. The

LaR method is not used to estimate potential profits; rather, it is used to estimate potential cash

flows (either inflows or outflows) over a specified holding period, given a certain level of

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confidence. Therefore, the statement that the maximum profit over the next day is USD 15

million with a probability of 95% is incorrect. It is important to note that a cash inflow is not

necessarily a profit, as it could be due to various factors such as the receipt of loan repayments

or the sale of assets, which do not represent a return on investment.

Choice C is incorrect because it incorrectly interprets the LaR value as a potential cash inflow.

In the context of this question, a positive LaR value represents a potential cash outflow, not an

inflow. Therefore, the statement that the worst outcome over the next day is an inflow of cash of

USD 15 million with a probability of 95% is incorrect. It is important to note that a cash inflow is

not necessarily a 'worst' outcome, as it could increase the bank's liquidity and improve its ability

to meet its short-term obligations.

Q.2266 Redding bank is in process of implementing a LaR framework. In the process, risk
analysts realize that the bank has very similar hedging positions, albeit with different
counterparties, in different sectors. In this scenario, which type of risk would be paramount?

A. Credit risk

B. Market risk

C. Compliance risk

D. Reputation risk

The correct answer is A.

Credit risk is the risk of loss that may occur from the failure of any party to abide by the terms

and conditions of any financial contract, principally, the failure to make required payments on

loans due to an inability to pay. In the given scenario, Redding bank has similar hedging

positions with different counterparties in different sectors. This means that the bank is exposed

to the risk that these counterparties may default on their obligations. This is a classic example of

credit risk. The bank's exposure to credit risk is paramount in this scenario, as similar positions

with different counterparties do not offset each other and increase the risk of simultaneous

defaults. Therefore, the bank needs to manage this risk effectively to prevent potential losses.

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Choice B is incorrect. Market risk refers to the potential for financial loss due to changes in

the market conditions such as interest rates, exchange rates, equity prices or commodity prices.

In this scenario, the bank has taken similar hedging positions across different sectors which does

not necessarily increase its exposure to market risk. The main concern here is credit risk

because of dealing with different counterparties.

Choice C is incorrect. Compliance risk pertains to the potential for legal penalties, financial

forfeiture and material loss an organization faces when it fails to act in accordance with industry

laws and regulations, internal policies or prescribed best practices. While compliance is always a

concern for any bank, it's not specifically highlighted as a major issue in this scenario.

Choice D is incorrect. Reputation risk refers to the potential damage to a firm's reputation

from any association, action or inaction which could be perceived negatively by others. Although

reputation risk can have significant impacts on a bank's business operations and profitability, it

isn't directly related to taking similar hedging positions across different sectors with various

counterparties.

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Q.2727 Given a stressed market scenario with the following parameters:

Mean (μ) = 0

Stressed standard deviation = 0.03

Stressed standard deviation of the proportional bid-offer spread = 0.03

Spread = 0.025

Confidence interval = 95%

Assuming that spreads are normally distributed, what is the ratio of LVaR to VaR?

A. 1.19

B. 1.10

C. 0.76

D. 1.75

The correct answer is D.

Liquidity-adjusted VaR (LVaR) incorporates exogenous liquidity risk into Value at Risk (VaR). It

can be defined as:

LV aR = V aR + Exogenous Liquidity Cost (ELC)

Exogenous liquidity cost is defined as the worst expected half spread at a particular confidence

level. Thus:

LVaR = (-expected return + standard deviation of asset∗z-score)

+ 0.5∗ (spread + standard deviation of spread ∗z-score)

And

VaR = (-expected return + standard deviation of asset∗ z-score)

LVaR (0.03 × 1.645) + 0.5(0.025 + 0.03 × 1.645)

= = 1.7533
VaR (0.03 ∗ 1.645)

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Q.2977 Suppose that XYZ Company has a current stock price of $40 and a daily standard
deviation of 1%. The current bid-ask spread is 2%. Calculate LVaR at the 95% confidence level.
Assume a constant spread.

A. 0.2452

B. 1.3526

C. 1.0981

D. 1.06

The correct answer is D.

Using the constant spread approach,

LV AR = (V × Zα × σ) + (0.5 × V × spread)

Where:

V = asset (or portfolio) value

Zα = confidence parameter (Normal distribution)

σ = standard deviation of returns

LV AR = (40 × 1.65 × 0.01) + 0.5 × 40 × 0.02 = $1.06

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Q.3132 Quadruple Funds only wants to invest in equity instruments which have 30-day liquidity
adjusted VaR of 5% at 95% confidence in a stressed market.
Suppose an instrument has a 30-day standard deviation of 5% and its bid-ask spread is 83 basis
points with a volatility of 2%. What should be its expected return to fulfill the entity’s criteria?

A. 0.05315

B. 0.04217

C. 0.05

D. 0.06975

The correct answer is A.

When both spread and asset are normally distributed, the LVaR can be computed as follows:

LVaR =(-expected return + standard deviation of asset∗ z-score)

+ 0.5∗ (spread + standard deviation of spread∗ z-score)

5% = (-expected return + 5%∗1.65) + 0.5∗ (0.83% + 2%∗ 1.65)

⇒ 5% − 0.5∗ (0.83% + 2% ∗1.65) − 5% ∗1.65
⇒ expected return = − (5% ∗ − 2.065% − 8.25%) = 5.315%

Q.3214 Tim Lauren is an analyst at a large commercial bank. He plans to invest in Grantson
Automobile stock with bid and ask prices equal to $53.70 and $54.10, respectively. Given this
information, the proportional bid-ask spread for Grantson Automobile stock is closest to?

A. 0.74%.

B. 1.48%.

C. 2.35%.

D. 1.45%.

The correct answer is A.

(ask-price − bid-price)
Proportional Bid-ask spread =
[(ask-price + bid-price) × 0.5]
($54.10 − $53.70)
=
[($54.10 + $53.70) × 0.5]
= 0.0074 or 0.74%

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Q.3873 Suppose that the liquidity division in QPR bank has bought 25 million shares of one
company and 35 million ounces of a commodity. Assume that the shares are bid $90.8, offer
$92.4, and the commodity is bid $24, offer $ 26.2. Calculate its liquidation cost in a normal
market.

A. $45.67million

B. $58.49 million

C. $23.56million

D. $32.08million

The correct answer is B.

The mid-market value of the position of the shares is equivalent to:

25 × 91.6 = $2, 290 million

Note that the mid-market price is halfway between the offer price and the bid price.

The mid-market of the position in the commodity is:

25.1 × 35 = $878.5 million

The proportional bid-offer spread for the position of the shares is:

Offer price-Bid price

s=
Mid-market price
(92.4 − 90.8)
= = $0.017467
91.6

Similarly, the proportional bid-offer spread for the commodity;

(26.2 − 24)
= $0.087649
25.1

Hence the cost of liquidation in a normal market is;

(0.5 × 0.017467 × 2, 290) + (0.5 × 0.087649 × 878.5) = $58.49 million

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Q.3940 Cathleen Wilson is the liquidity manager for CPR bank. She decides to invest in 50
million shares of one company and 20 million ounces of a commodity. Assume that the shares’ bid
price is $80.4, offer price $80.8, and the commodity’s bid is $30.6. However, she is not able to
remember the commodity’s offer price. Given the cost of liquidation for the portfolio to be $12.0
million and the mid-market position in the commodity to be $614 million, calculate the offer price
for the commodities in a normal market.

A. 30.8

B. 31.6

C. 34.6

D. 28.9

The correct answer is A.

The mid-market price for shares is 80.6 × 50 = $4, 030

0.4
The proportional bid-offer spread for the share is = 0.004963
80.6

We let the proportional bid-offer for the share be x, and the offer price be w

Then

0.004963 × 4, 030 (x × 614)

+ = 12.00
2 2
= 1.99754 = 307x

X=0.0065066, which is the proportional bid-offer price for the commodity

(w − 30.6)
⇒ = 0.0065066
0.5 × (w + 30.6)
(2w − 61.2)
= 0.0065066
(w + 30.6)

Thus

w = 30.8

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Q.3941 Suppose that a bank invests in shares and a commodity whose mid-market position is
$1,400 million, and $840 million respectively. You are also provided with the following
information:

Mean Standard Deviation

Bid-offer spread for the shares $1.0 million $1.1 million
Bid-offer spread of the commodity $0.1 million $0.1 million
Proportional bid-offer spread for the shares 0.034 0.018
Proportional bid-offer spread for the commodity 0.0044 0.0044

Assuming the distribution of the spreads is normal, calculate the cost of liquidation in a stressed
market at a 95% confidence level.

A. $40.10million

B. $50.23million

C. $49.42million

D. $107.93million

The correct answer is C.

n (μ j + λσj )α j
Cost of liquidation (stressed market) = ∑
j =1 2
1, 400 × (0.034 + 1.645 × 0.018)
2
840 × (0.0044 + 1.645 × 0.0044)
+
2
= $49.415 million

In this question, we are considering the mean and standard deviation for the proportional bid-

offer spread for both shares and the commodity, bearing in mind that n=2.

Additionally, α j is the mid-market position, μJ represents the mean for the proportional bid-offer,

λ represents the constant factor given as 1.645 at 95% confidence level, and the σ represents the

standard deviation for the propositional bid-offer spread.

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Q.3942 Fatou James, the liquidity manager for CPQ bank, invests in shares and a commodity
whose mid-market value of the positions are1,426, and 814 respectively. The mean and standard
deviation of the position in shares are $1.12 and $1.45, respectively. Suppose that the mean and
standard deviation for the commodity are both $0.63, and the mean for the proportional bid-offer
spread for the shares is 0.0467, while the standard deviation for the proportional bid-offer
spread for the shares is unknown. Given that the mean and standard deviation for the
proportional bid-offer spread for the commodity are both 0.006857. Assume that the distribution
of the spreads is normal. Further, the cost of liquidation under a stressed market condition at a
99% confidence level is 82.264. Calculate the standard deviation for the proportional bid-offer
spread for shares.

A. $0.0630

B. $0.0480

C. $0.0560

D. $0.0239

The correct answer is D.

Let the value of the standard deviation for the proportional bid-offer spread for shares be w.

Then,

1 , 426 × (0.0467 + 2.326 × w)814 × (0.006857 + 2.326 × 0.006857)

+ = $82.264m
2 2
33.2971 + 1, 658.438w + 9.2822 = $82.264
1, 658.438w = $39.6847

Thus

w = 0.02393

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Q.3943 A liquidity division for HTC bank invests in shares and a commodity. The mid-market
value of the position in shares is $W while the mid-market value of the position in the commodity
is $413. The mean and standard deviation of the bid-offer spread for the shares are $1.24 and
$1.02, respectively. On the other hand, the mean and standard deviation of the bid-offer spread
for the commodity are $0.67 and $0.34. Further, the mean and standard deviation of the
proportional bid-offer spread for the shares is 0.0721 and 0.0675, respectively, while the mean
and standard deviation of the proportional bid-offer spread for the commodity is 0.00524 and
0.00463, respectively. Assuming that the distribution of the spreads is normal, and the cost of
liquidation at the 99% confidence level in a stressed market condition is $95.062, calculate W,
the mid-market value of the position in shares.

A. $905

B. $809

C. $801

D. $1,579

The correct answer is C.

W × (0.0721 + 2.326 × 0.0675)413 × (0.00524 + 2.326 × 0.00463)

+ = $95.062m
2 2
0.5W(0.229105) + 3.3059 = $95.062m
$91.75606
W=
0.1145525
= $801

Note that 2.326 is the z-value at 99% confidence from the standard normal table.

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Q.3944 A liquidity division for HTC bank invests in shares and a commodity whose mid-market
position is $801, and $413, respectively. If the proportional bid-offer spread for the shares is
0.001879, and that for the commodity is 0.002488, What is the cost of liquidation in a normal
market.

A. 2.0982

B. $1.2663

C. $1.8990

D. $2.7660

The correct answer is B.

0.001879 × 801 0.002488 × 413

+ = $1.2663 million
2 2

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Q.3945 Richard Watson, the liquidity manager of RTC bank, has been finding ways of boosting
the liquidity for the bank. He decides to invest in W shares of one company and 19 million ounces
of a commodity. Assume that the shares are bid $70.4, offer $72.8, and the commodity is bid is
$46.6, offer $47.2. The mid-market value of the position in shares is $2,506 million. Calculate, W,
the number of shares, and the cost of liquidation in a normal market.

A. 35million and $47.699

B. 37million and $42.076

C. 20 million and $65.000

D. 17 million and $34.985

The correct answer is A.

Since the mid-market value of the position in shares is $2,506 million, W, the number of shares,
can be calculated as follows:

70.4 + 72.8
$2, 506m = ×W
2

Thus

W = 35 million

The mid-market value of the position in the commodity =46.9×19=$891.1million

47.2−46.6
The proportional offer spread for the commodity is = 0.01279 , while the proportional bid-
46.9

offer spread for the share is;

72.8 − 70.4
= 0.03352
71.6

Then the cost of liquidation in a normal market;

0.03352 × 2 , 506 0.01279 × 891.1

+ = $47.699 million
2 2

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Q.3946 JCT bank has a position in two assets - shares of company X and a separate commodity Y.
The following data has been extracted from the bank's liquidity division:

The mid-market price of the shares is $72, and the mid-market price of the commodity

is $47.

The mean and standard deviation for the bid-offer spread for the shares are $1.30 and

$1.03, respectively.

The mean and standard deviation for the bid-offer spread for the commodity are $1.32

and $0.88, respectively.

The bank holds 1 million units in each of the two positions.

Calculate the cost of liquidation at a 99% confidence level, assuming the spread distribution is
approximately normal in a stressed market.

A. $2,500,000

B. $3,500,650

C. $3,531,536

D. $7,063,072

The correct answer is C.

Shares

$1.3
Mean, proportional bid-offer spread: = 0.0181
$72

$1.03
Standard deviation, proportional bid-offer spread: = 0.0143
$72

Commodity

$1.32
Mean, proportional bid-offer spread: = 0.0281
$47

$0.88
Standard deviation, proportional bid-offer spread: = 0.0187
$47

$72, 000,000 × (0.0181 + 2.326 × 0.0143)

$47,000, 000 × (0.0281 + 2.326 × 0.0187
Cost of liquidation = +
2 2
= $3, 531, 536

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Q.3947 James Farouk, the liquidity manager of CRP financial institution, has been struggling
with boosting liquidity in his institution. Farouk consults Richard Taylor, one of the staff in RCP
seeking help on how he can source liquidity for the institution. Which of the following choices is
not likely to be one of the choices offered by Taylor, assuming he was right?

A. Liquidation of trading book positions

B. Holdings of cash and treasury securities

C. Increasing investments in real estate

D. Ability to borrow money at short notice

The correct answer is C.

Increasing investments in real estate is not a viable strategy for boosting liquidity in a financial

institution. While such investments may enhance the solvency status of the bank, they do not

directly contribute to its liquidity. Liquidity refers to the ability of an institution to meet its short-

term obligations, which requires readily available funds. Real estate investments, on the other

hand, are typically long-term and illiquid, meaning they cannot be quickly converted into cash

without potentially incurring a significant loss. Therefore, increasing investments in real estate

would not effectively address the liquidity concerns of the institution.

Choice A is incorrect. Liquidation of trading book positions can indeed enhance the liquidity of

a financial institution. Trading book positions are typically composed of financial instruments

that can be easily sold or bought in the market, thus providing immediate liquidity.

Choice B is incorrect. Holding cash and treasury securities is another effective strategy for

enhancing an institution's liquidity. Cash is the most liquid asset, and treasury securities are

highly liquid due to their strong demand in the market.

Choice D is incorrect. The ability to borrow money at short notice also contributes to an

institution's liquidity position. This strategy ensures that even if there are unexpected cash

outflows, the institution can quickly secure funds to meet its obligations.

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Q.3948 A credit downgrade of three notches (e.g., from AA+ to A+) is one of the acute stresses
incorporated in the 30-day period considered in the calculation of the liquidity coverage ratio
(LCR). Which of the following most accurately states the other stress events?

A. Partial loss of deposits and decreased haircuts

B. Drawdowns on lines of credit and partial loss of deposits

C. Drawdowns on lines of deposits and decreased haircuts

D. Reduced haircuts

The correct answer is B.

The Liquidity Coverage Ratio (LCR) is a regulatory requirement designed to ensure that a bank

has an adequate stock of unencumbered high-quality liquid assets (HQLAs) that can be

converted into cash to meet its liquidity needs for a 30 calendar day liquidity stress scenario. The

LCR is calculated as the ratio of the stock of HQLAs to total net cash outflows over the next 30

calendar days. The stress scenario incorporated in the calculation of the LCR includes a credit

downgrade of three notches (e.g., from AA+ to A+), drawdowns on lines of credit, and a partial

loss of deposits. Drawdowns on lines of credit refer to the situation where a bank's customers,

who have been granted a line of credit, decide to draw down on this facility, thereby increasing

the bank's cash outflows. A partial loss of deposits refers to a situation where a bank's depositors

decide to withdraw a portion of their deposits, thereby reducing the bank's available liquidity.

These are realistic scenarios that could occur during a period of financial stress and are

therefore included in the calculation of the LCR.

Choice A is incorrect. While partial loss of deposits is a stress event considered in the LCR,

decreased haircuts are not. Haircuts refer to the difference between the market value of an asset

and its collateral value; a decrease would imply an increase in liquidity, which contradicts the

concept of a stress scenario.

Choice C is incorrect. The phrase "drawdowns on lines of deposits" seems to be a

misinterpretation or typo as it doesn't make sense in this context. Banks do not draw down on

deposits; instead, they face potential drawdowns on lines of credit extended to their customers.

Choice D is incorrect. Reduced haircuts alone do not constitute a comprehensive stress

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scenario for LCR calculation purposes. As mentioned earlier, reduced haircuts would imply

increased liquidity rather than financial stress.

Q.3949 Thomas Wong, one of the traders in the security market, has been a positive feedback
trader. In his interview with a business analyst, Wong stated the factors that cause him to be a
positive trader. Which choice among the following accurately states the reason as to why Wong
practices positive trading?

A. Urgent need for cash

B. Need for liquidity

C. Competition

D. Predatory trading

The correct answer is D.

Predatory trading is a strategy where a trader anticipates that a stock's value will either increase

or decrease and places trades accordingly. This strategy aligns with the concept of a 'positive

feedback' strategy, where a trader buys more of a stock as its price increases and sells it as its

price decreases. Thomas Wong, being a positive feedback trader, would likely engage in

predatory trading as it aligns with his strategy of capitalizing on price movements. Therefore,

predatory trading is the most accurate reason for Wong's positive feedback trading strategy.

Choice A is incorrect. An urgent need for cash does not necessarily dictate a positive feedback

trading strategy. This strategy involves buying securities when prices are rising and selling when

they are falling, which may not be the best approach if immediate liquidity is required.

Choice B is incorrect. The need for liquidity also does not directly influence the adoption of a

positive feedback trading strategy. While this strategy can potentially provide liquidity through

frequent trades, it's not specifically designed to enhance liquidity.

Choice C is incorrect. Competition in the market might influence a trader's overall approach

but it doesn't specifically lead to the adoption of a positive feedback trading strategy. This type of

strategy is more about capitalizing on price trends rather than outperforming competitors.

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Q.3950 The following statistics extracted from RTC bank’s balance sheet reflect some of the
underlying transactions conducted by the bank. The balance sheet has distinguished short-term
and long-term liabilities and assets, according to Basel III. Use the data with the weighted
factors to calculate the net stable funding ratio (NSFR) for the bank.

Assets Short Long NSFR LCR Liabilities Short Long NSFR LCR
Term Term Term Term
Cash 950 90% Owners 90 100%
Equity
Loans 4, 200 3, 000 100% Deposits 500 100%
Corporates
Mortgages 3, 200 100% 25% Unsecured 250 2, 500 75% 45%
Debt
Issuance
Corporates 950 1, 400 85% 15% Deposits 540 5, 000 10% 100%
Financial
Institution
Expenses 230 6, 600 100%
Notes Payable 700 0 0 50%

A. 1.27

B. 1.33

C. 1.08

D. 0.75

The correct answer is D.

NSFR is defined as the ratio of the amount of available stable funding to the amount of required
stable funding. Available stable funding represents the capital and liabilities that are expected to
remain reliable over a 1-year horizon. On the other hand, required stable funding comprises the
portion of assets and off-balance sheet exposures that need to be funded over the same 1-year
horizon.

Amount of stable funding

≥ 100%
Required amount of stable funding
500 + 250 × 0.75 + 540 × 0.10 + 230 + 2, 500 × 0.75 + 5, 000 × 0.10 + 6, 600
=
950 × 0.9 + 3, 000 + 3, 200 + 1, 400 × 0.85 + 4, 200 + 950 × 0.85
9, 946.5
= ≈ 0.75
13, 252.5

Q.3951 Suppose that the following statistics extracted from the RTC bank’s balance sheet refers
to its trade. The balance sheet has distinguished short-term and long-term liabilities and assets,

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according to the Basel III. Use the data with the weighted factors to calculate the Liquidity
Coverage Ratio (LCR) for the bank.

Assets Short Long NSFR LCR Liabilities Short Long NSFR LCR
Term Term Term Term
Cash 90 100% Owners 950 90%
Equity
T-notes 500 100%
Loans 250 2, 500 75% 45% Deposits 4, 200 3, 000 100% 25%
corporates
Mortgages 540 5, 000 10% 100% Unsecured 3, 200 100%
debt
issuance
corporates 230 6600 100% Depossits 950 1, 400 85% 15%
financial
institution
loans 700 0 0 50%
financial
institution

A. 49%

B. 85%

C. 50%

D. 43%

The correct answer is C.

High-quality liquid assets (HQLA) are categorized into two;

- Level 1 Assets, which are included without a limit (For example, cash at hand) and,
- Level 2 Assets.
Assets to be included in each of the Levels 1 and 2 are those that the bank is holding on the first
day of the stress period. The maximum amount of the adjusted Level 2 assets in the stock of
high-quality liquid assets is equivalent to two-thirds of the adjusted amount of Level 1 assets
after haircuts have been applied. This is in line with Basel III Requirements.

Stock of high quality liquid assets

LCR =
Total Net Cash Outflows

Stock of high quality liquid assets = Level 1 Assets

+ Maximum amount of adjusted Level 2 Assets
2
= Level 1 Assets + × Level 1 Assets
3
2
= (90 + (90 × )) = 150
3

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Consistent with Basel III principles, the term total net cash outflows is the total expected cash

outflows less the total expected cash inflows in the particular stress scenario for the subsequent

30 calendar days.

Total expected cash outflows are equivalent to the sum of the product of the outstanding

balances of several types of liabilities and off-balance sheet commitments by their respective

weights.

In other words,

Total net cash outflows = Total expected cash outflows

− Min{total expected cash inflows;
75% of total expected cash outflows }
= (4200 × 0.25) + (950 × 0.15)
3
− Min [⟨(250 × 0.45) + 540 + (700 × 0.50)⟩ , ⟨ × (4200 × 0.25) + (950 × 0.15
4
= 298.125

150
LCR = = 0.503 ≈ 50%
298.125

This is equivalent to;

(90 + (90 × 23 )) 600

4× = = 0.503 ≈ 50%
((4200 × 0.25) + (950 × 0.15))1192.5

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Q.3952 The following table represents a section extracted from ABC bank’s balance sheet. Use
the provided data to determine the Liquidity Coverage Ratio of the bank for 2018 and 2019,
respectively.

Description 2018 2019

High Liquid assets 2100 1458
Average monthly withdrawals 1200 2458
Expected monthly outflows in a stressed scenario 1600 1700

A. 126% and 145 %

B. 131% and 86%

C. 80% and 124%

D. 129% and 134%

The correct answer is B.

The Liquidity Coverage ratio is equivalent to;

High-quality liquid asset

≥ 100%
Net cash outflows in a 30-day period

2100
LCR for 2018 = = 1.312 = 131%
1600
1458
The LCR for 2019 = = 0.857 = 86%
1700

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Q.5383 While delivering a training session on liquidity risk to newly recruited individuals, Jane
Doe, a risk manager at the national regulator, discusses the insights gained from the collapse of
Metallgesellschaft. Which of the following lessons regarding liquidity risk failures would be most
effectively exemplified by the case of Metallgesellschaft in 1993?

A. Cash flow mismatches may occur when hedging liabilities by rolling forward futures
contracts.

B. Compared to forwards, futures offer a more effective hedge for mitigating

commodities exposure.

C. A bank run can be triggered by a negative public perception of emergency borrowing

from the central bank.

D. Excessive losses can arise from positive feedback trading in illiquid instruments.

The correct answer is A.

Hedging liabilities involves using futures contracts to protect against potential adverse

movements in prices or interest rates. Rolling forward futures contracts refers to the practice of

closing out existing contracts and simultaneously opening new contracts with extended maturity

dates. It introduces the risk of cash flow mismatches. This occurs because the cash flows

associated with the futures contracts may not align perfectly with the cash flows of the

underlying liabilities being hedged.

B is incorrect. Both forwards and futures can serve as hedging tools for managing commodities

exposure, but they can introduce liquidity risk when there is a cash flow mismatch.

C and D are incorrect. These were not issues in the case of Metallgesellschaft.

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Reading 128: Liquidity and Leverage

Q.2274 Balasz Bank’s risk management team is developing the bank’s liquidity risk policy. In
order to implement a sound liquidity risk management system, all sources or elements of
liquidity risk must be defined. What are the main elements that should be mentioned in the
policy?

A. Liquidity credit risk, liquidity counterparty risk, and market liquidity risk.

B. Liquidity credit risk, transaction liquidity risk, and systemic risk.

C. Systemic risk, liquidity credit risk, and transaction liquidity risk.

D. Systemic risk, transaction liquidity risk, and funding liquidity risk.

The correct answer is D.

Systemic risk, transaction liquidity risk, and funding liquidity risk are the main elements of

liquidity risk that should be included in a sound liquidity risk management policy. Systemic risk

refers to the risk that the failure of one part of the financial system could lead to the collapse of

the entire system. Transaction liquidity risk is the risk that an entity might not be able to execute

a transaction at the prevailing market price because the size of the transaction could influence

the market price. Funding liquidity risk, also known as balance sheet risk, is the risk that an

entity might not be able to meet its obligations as they come due without incurring unacceptable

losses. These three elements are critical in the management of liquidity risk and should be

clearly defined in the policy.

Choice A is incorrect. While liquidity credit risk and market liquidity risk are elements of

liquidity risk, there is no such thing as "liquidity counterparty risk". Counterparty risk refers to

the likelihood that the other party in a financial transaction will default on their obligations, but

it's not specifically related to liquidity.

Choice B is incorrect. Although transaction liquidity risk and systemic risks are components of

a comprehensive liquidity policy, "liquidity credit risk" isn't a recognized term in this context.

Credit risks can influence an institution's overall financial stability, but they're not directly tied to

its ability to meet short-term obligations.

Choice C is incorrect. Systemic risks and transactional liquidity risks are indeed part of the

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policy framework for managing liquidity risks; however, similar to choice B, "liquidity credit risk"

isn't a standard term used in this context.

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Q.2275 CRG Bank has a large portfolio of securities that could be quickly sold without significant
price fluctuations. Such securities are said to be:

A. Liquid

B. Perfectly liquid

C. Illiquid

D. Perfectly illiquid

The correct answer is A.

Liquidity refers to the ease with which an asset, or security, can be converted into ready cash

without affecting its market price. High liquidity is a desirable attribute for any asset or security

because it means that the asset can be quickly sold without causing a significant change in its

price and without incurring substantial transaction costs. In the context of the question, the

securities in CRG Bank's portfolio are described as being able to be quickly sold without

significant price fluctuations. This characteristic is indicative of high liquidity, hence, the term

'liquid' is the most appropriate description for such securities.

Choice B is incorrect. While "perfectly liquid" might seem like a stronger version of "liquid",

it's not the term typically used in financial markets to describe securities that can be sold

without significantly impacting their prices. Perfect liquidity is a theoretical concept where

transactions do not affect the price and there are no transaction costs, which is rarely observed

in real-world markets.

Choice C is incorrect. Illiquid securities are those that cannot be easily sold or exchanged for

cash without a substantial loss in value. This description contradicts the scenario presented in

the question, where CRG Bank's securities can be readily sold without causing significant

changes in their prices.

Choice D is incorrect. Similar to choice C, "perfectly illiquid" refers to assets that cannot be

converted into cash quickly or without significant loss of value. This does not align with the

characteristics of CRG Bank's portfolio as described in the question.

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Q.2276 Transaction liquidity risk can be best defined as:

A. The risk of reducing the demand for an asset by increasing the number of
transactions.

B. The risk of moving the price of an asset adversely in the act of buying or selling it.

C. The risk of moving the supply of an asset adversely in the act of buying or selling it.

D. The risk that too many transactions on the trading floor could render the firm unable
to meet its day-to-day operation costs.

The correct answer is B.

Transaction liquidity risk is indeed the risk of moving the price of an asset adversely in the act of

buying or selling it. This risk arises when the market's liquidity is not sufficient to absorb the

quantity being traded without impacting the price. In other words, if a large quantity of an asset

is bought or sold, it could significantly move the price in an unfavorable direction. This is

particularly relevant in illiquid markets where the lack of buyers or sellers at any given time can

cause significant price movements. Therefore, managing transaction liquidity risk is crucial for

financial institutions and traders to prevent substantial losses.

Choice A is incorrect. Transaction liquidity risk does not pertain to the reduction in demand

for an asset due to an increase in the number of transactions. Rather, it refers to the potential

adverse impact on the price of an asset during its buying or selling process.

Choice C is incorrect. This choice incorrectly defines transaction liquidity risk as a movement

in supply of an asset during buying or selling activities. While supply and demand dynamics can

influence prices, transaction liquidity risk specifically relates to how those transactions might

negatively affect the price of that particular asset.

Choice D is incorrect. The statement describes operational risk rather than transaction

liquidity risk. Operational risks are associated with failures in systems, processes, or controls,

including those related to managing day-to-day operations and trading floor activities.

Q.2277 Nathan James, a trader for Nathan Capital, works on the short-term funding desk at his
firm. Over the past few months, markets have been highly volatile but Nathan Capital still enjoys

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a large capital base and is financially stable. In his monthly report to the liquidity subcommittee
of the board of directors, James reports that in the last month, Nathan Capital's chief lender has
been steadily increasing collateral requirements to roll over repo contracts. From the
perspective of Nathan Capital, this represents:

A. Transactions liquidity risk

B. Balance sheet risk

C. Systematic risk

D. Maturity transformation risk

The correct answer is B.

Balance sheet risk, also known as funding liquidity risk, is the risk that creditors either withdraw

credit or change the terms on which it is granted in such a way that the positions have to be

unwound and/or are no longer profitable. This risk can arise due to perceived or actual

deterioration in the borrower’s credit quality, or due to overall deteriorating financial conditions.

In the case of Nathan Capital, the lender is increasing the collateral requirements, thus changing

the terms of credit. This is happening despite Nathan Capital being financially sound and

showing no signs of financial deterioration. Therefore, this situation represents a balance sheet

risk for Nathan Capital.

Choice A is incorrect. Transaction liquidity risk refers to the risk that a firm may not be able to

execute a transaction at the prevailing market price because of the size of the transaction

relative to normal market size. In this case, Nathan Capital is not facing any issues with

executing transactions at prevailing market prices, but rather it's experiencing an increase in

collateral requirements from its chief lender.

Choice C is incorrect. Systematic risk refers to the overall impact of financial system or market

and cannot be eliminated through diversification. It includes factors such as interest rates,

inflation rates, and economic recessions that affect all participants in a market equally. The

situation described for Nathan Capital does not indicate any systematic risks affecting all firms

equally.

Choice D is incorrect. Maturity transformation risk arises when financial institutions borrow

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short-term while lending long-term, creating a mismatch between their assets and liabilities'

maturities. This scenario doesn't mention anything about Nathan Capital's borrowing or lending

practices related to different maturities.

Q.2278 Yemi Bank was recently ordered to pay a hefty fine as punishment for engaging in certain
illegal trades. Following this event, creditors have expressed fears over their investment and
would want to introduce more conditions governing the use of funds lent to the bank. This
scenario gives an example of:

A. Liquidity credit risk

B. Strategic risk

C. Systemic risk

D. Balance sheet risk

The correct answer is D.

Balance sheet risk, also known as funding liquidity risk, is a type of financial risk that arises

when a firm's creditors either withdraw their credit or alter the terms of credit in such a way

that the firm's positions have to be unwound or are no longer profitable. In the given scenario,

Yemi Bank has been involved in illegal trading activities, which has led to a significant fine. This

has caused concern among the bank's creditors, who are now considering introducing more

conditions on the use of the funds they have lent to the bank. This situation is a clear example of

balance sheet risk, as the bank may face difficulties in meeting its financial obligations due to the

potential withdrawal or alteration of credit terms by its creditors.

Choice A is incorrect. Liquidity credit risk refers to the risk that a party may not be able to

meet its financial obligations due to an inability to convert assets into cash quickly. In this case,

Yemi Bank's situation does not involve any issues with liquidity or converting assets into cash.

Choice B is incorrect. Strategic risk refers to the potential for loss due to poor business

decisions, improper implementation of strategies, or inadequate response to changes in the

business environment. While Yemi Bank's unlawful trading activities could be seen as a poor

business decision, the question specifically relates more closely with balance sheet risk as it

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involves creditors considering additional conditions on their loans due to concerns about the

bank's activities.

Choice C is incorrect. Systemic risk refers to the possibility that an event at company level

could trigger severe instability or collapse an entire industry or economy. The situation described

in this question pertains only Yemi Bank and its creditors and does not suggest a threat of

widespread economic impact.

Q.2279 Elipsa Bank has witnessed a dramatic deterioration of the credit quality of its borrowers
in its loan portfolio. As a result, the bank's balance sheet position has worsened. The bank will
most likely have to contend with:

A. Systemic risk

B. Funding liquidity risk

C. Reputation risk

D. Strategic risk

The correct answer is B.

Funding liquidity risk, also known as balance sheet risk, arises when a borrower's credit position

is deteriorating or is perceived by market participants to be deteriorating. In the case of Elipsa

Bank, the credit quality of its borrowers has significantly declined, which has negatively

impacted its loan portfolio and overall balance sheet position. This situation makes it difficult for

the bank to negotiate new credit terms for its own funding needs. Potential lenders and investors

may be hesitant to lend to the bank under the same terms as before due to the increased risk. As

a result, any new funding for the bank may come with stricter credit terms, such as higher

interest rates. This scenario exemplifies funding liquidity risk, as the bank's ability to meet its

funding needs is compromised due to the deteriorating credit quality of its borrowers.

Choice A is incorrect. Systemic risk refers to the potential for a major disruption in the

function of an entire market or financial system due to the failure of a single entity or group of

entities. While Elipsa Bank's situation is concerning, it does not necessarily imply a systemic risk

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unless the bank's failure could cause significant disruption to the broader financial system.

Choice C is incorrect. Reputation risk involves damage to an organization's reputation which

can lead to loss of revenue or legal, regulatory, or financial costs. In this scenario, there is no

mention of any reputational damage suffered by Elipsa Bank due to its declining loan portfolio

and balance sheet position.

Choice D is incorrect. Strategic risk arises from poor business decisions, improper

implementation of decisions, inadequate resource allocation, or failure to respond well to

changes in the business environment. The scenario does not provide any information suggesting

that Elipsa Bank has made poor strategic decisions leading up its current predicament.

Q.2280 Egda Bank has had a rough year in which its financial health and performance
substantially deteriorated. An intensive study of the market by its risk management department
has attributed the deterioration to bad market conditions. The study also found out that a
majority of players in the banking sector have had almost identical problems. This scenario gives
an example of:

A. Maturity transformation risk

B. Balance sheet risk

C. Systemic risk

D. Banking sector liquidity risk

The correct answer is C.

Systemic risk refers to the risk that could cause a widespread or major disruption in the financial

system, potentially leading to severe financial stress or even a financial crisis. It is the risk that

the failure of one financial institution could cause other financial institutions to fail, leading to a

domino effect that could potentially destabilize the entire financial system. In the given scenario,

Egda Bank and other banks in the sector are facing similar challenges due to unfavorable market

conditions. This indicates that the risk is not specific to Egda Bank but is affecting the entire

banking sector, which is a characteristic of systemic risk. Therefore, the situation described in

the scenario is an example of systemic risk.

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Choice A is incorrect. Maturity transformation risk refers to the risk that arises when financial

institutions borrow short-term and lend long-term, creating a mismatch in the maturity of their

assets and liabilities. This is not the case described in the scenario, where unfavorable market

conditions are affecting all banks in the sector.

Choice B is incorrect. Balance sheet risk pertains to risks associated with assets, liabilities,

and equity on a bank's balance sheet. While it's possible that Egda Bank may have balance sheet

risks due to its declining financial performance, this does not explain why other banks in the

sector are also facing challenges.

Choice D is incorrect. Banking sector liquidity risk refers to a situation where most or all

banks within a specific banking system lack sufficient liquid assets to meet their obligations. The

scenario does not provide any information suggesting that there's an industry-wide issue with

liquidity.

Q.2281 Aruba Commercial Bank's risk management team has recently expressed concerns about
an escalating exposure to funding liquidity risk. This risk is associated with the bank's ability to
meet its obligations without incurring unacceptable losses. Which of the following scenarios
could potentially be the reason for this heightened exposure to funding liquidity risk?

A. Financing short-term loans mostly with short-term deposits.

B. Financing long-term loans mostly with long-term deposits.

C. Financing long-term loans mostly with short-term deposits.

D. Financing short-term loans mostly with long-term deposits.

The correct answer is C.

Many banks are largely short-term borrowers (via deposits), so their capacity to maintain long-
term positions and their flexibility when circumstances or expectations change is limited. If the
bank uses deposits to fund long-term loans, there’s a big possibility that it will not have cash
readily available as and when the depositor comes calling.

Q.2282 What do you understand by matched funding as used in the context of lending?

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A. Financing long-term loans with borrowed funds.

B. Financing loans with reserve cash saved over a period of time.

C. Financing long-term assets with long-term debt.

D. Giving a particular facility to the beneficiary who qualifies for it, taking into
consideration their full credit profile.

The correct answer is C.

Matched funding refers to the practice of financing long-term assets with long-term debt. This is

an ideal scenario as it aligns the maturity of the assets (loans given out by the bank) with the

maturity of the liabilities (debt taken on by the bank). This reduces the risk of a liquidity crunch,

where the bank might have to pay off its liabilities before its assets have matured. However, in

practice, this is not always possible due to the nature of banking operations. Banks often engage

in maturity transformation, where they use short-term deposits to finance long-term loans. This

can lead to a mismatch in the maturity of assets and liabilities, increasing the risk of a liquidity

crisis. However, banks manage this risk through various risk management practices and

regulatory requirements.

Choice A is incorrect. While it is true that financial institutions often finance long-term loans

with borrowed funds, this does not accurately define the concept of 'matched funding'. Matched

funding specifically refers to the practice of financing assets with debt that has a similar

maturity or due date. Therefore, simply financing long-term loans with borrowed funds, without

considering the matching of maturities, does not constitute matched funding.

Choice B is incorrect. Financing loans with reserve cash saved over a period of time can be

part of an institution's overall financial strategy but it doesn't represent 'matched funding'. In

matched funding, the focus is on aligning the maturities of assets and liabilities to mitigate risks

associated with interest rate fluctuations and liquidity concerns.

Choice D is incorrect. Giving a particular facility to a beneficiary who qualifies for it based on

their full credit profile pertains more to credit risk management and underwriting practices

rather than matched funding. It doesn't involve matching the duration or maturity dates between

assets and liabilities which is central to matched funding.

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Q.2283 Which of the following best explains why a bank may be incentivized to finance long-
term loans with short-term deposits, despite the grave liquidity issues this could create?

A. It is much easier to find long-term deposits than short-term deposits.

B. Interest rates on long-term loans are usually higher than those on short-term loans.

C. It is much easier to find clients for long-term financing.

D. Long-term facilities are less risky than short-term ones.

The correct answer is B.

The primary reason why banks may be incentivized to finance long-term loans with short-term

deposits is the difference in interest rates. Typically, interest rates on long-term loans are higher

than those on short-term loans. This is primarily due to the yield curve, which is generally

upward sloping. This means that the longer the maturity of a loan, the higher the interest rate

that can be charged. Therefore, by financing long-term loans with short-term deposits, banks can

earn a higher return on their investments. This practice, however, exposes the banks to rollover

risk. Rollover risk is the risk that the short-term debt cannot be refinanced, or can be refinanced

only on highly disadvantageous terms. Despite this risk, the potential for higher returns often

incentivizes banks to engage in this practice.

Choice A is incorrect. It is not necessarily easier to find long-term deposits than short-term

deposits. In fact, the opposite may be true as short-term deposits offer more flexibility and are

therefore often more attractive to depositors.

Choice C is incorrect. The ease of finding clients for long-term financing does not directly

relate to the decision of banks to finance long-term loans with short-term deposits. This choice

does not address the risk-return trade-off that banks consider when making such decisions.

Choice D is incorrect. Long term facilities are not inherently less risky than short term ones.

The risk associated with a loan or facility depends on a variety of factors including the

creditworthiness of the borrower, interest rate fluctuations, and market conditions among others.

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Q.2284 In a recent discussion between two senior risk managers at a Chinese bank, the topic of
rollover risk was brought up as a growing concern for their institution. What does the term
"rollover risk" most likely refer to?

A. The bank was increasingly lending money to high-risk individuals, thereby increasing
its exposure to credit risk.

B. The amount recovered from non-performing loans was gradually declining, thereby
increasing the bank’s losses.

C. The bank was increasingly financing long-term loans with short-term deposits, thereby
making it hard to repay its own short-term debt.

D. The bank’s portfolio at risk was growing at a relatively higher rate.

The correct answer is C.

Funding long-term assets with short-term debt exposes an intermediary to rollover risk, the risk
that the short-term debt cannot be refinanced, or can be refinanced only on highly
disadvantageous terms.

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Q.2285 A certain bank has a portfolio of CDOs (Collateralized Debt Obligations). In order to
improve its liquidity position, its finance department has proposed an entry to secondary markets
by selling the CDOs under a repo agreement. Is the proposal viable?

A. No, because CDOs are ineligible for repo agreements.

B. No, because liquidity positions can only be improved via direct sale of assets.

C. Yes, because CDOs are always eligible for repo transactions regardless of their credit
quality.

D. Yes, because CDOs can be used as collateral in repo agreements provided their credit
quality is high.

The correct answer is D.

Collateralized Debt Obligations (CDOs) can indeed be used as collateral in repurchase

agreements, provided their credit quality is high. A repurchase agreement, or 'repo', is

essentially a short-term loan where the borrower sells an asset to the lender with a promise to

repurchase it at a later date at a predetermined price. The asset sold is considered as 'collateral'

for the loan. In this context, the bank's CDOs can serve as the collateral. However, the key factor

here is the 'credit quality' of the CDOs. High credit quality implies that the CDOs are less risky

and more likely to meet their debt obligations. This makes them more acceptable as collateral in

a repo agreement. Therefore, if the bank's CDOs have high credit quality, they can be used in a

repo agreement to improve the bank's liquidity position.

Choice A is incorrect. CDOs are not ineligible for repo agreements. The eligibility of a CDO for

a repo agreement depends on its credit quality and the specific terms of the agreement.

Choice B is incorrect. Improving liquidity positions does not solely depend on direct sale of

assets. Other financial strategies, such as entering into repo agreements, can also be used to

enhance liquidity.

Choice C is incorrect. It's not accurate to say that CDOs are always eligible for repo

transactions regardless of their credit quality. The eligibility largely depends on the credit quality

and other factors like market conditions.

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Q.2286 Baraba bank is in the process of calculating its leverage. An extract of its balance sheet
is as follows:
Assets: $50 million
Equity: $20 million
Deposits: $30 million

What is the level of leverage?

A. 1

B. 2.5

C. 1.67

D. 1.5

The correct answer is B.

Leverage should be calculated as (all $ amounts in million):

Total Assets 50
= = 2.5
Equity 20

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Q.2288 Barakuda is considering borrowing additional funds to in order to finance an ambitious

expansion plan. In what circumstances would it be appropriate for the bank to borrow funds and
go ahead with its plan?

A. If its return on assets is equal to expenses of additional borrowing.

B. If the cost of borrowing equals the expenses of the existing borrowing.

C. If the cost of borrowing is less than the return on assets.

D. If the total value of existing assets is less than the total value of existing debt.

The correct answer is C.

If the cost of borrowing is less than the return on assets, it is financially viable for the bank to

borrow additional funds and proceed with its expansion plan. This is because the return on

assets (ROA) is a measure of how efficiently a bank is using its assets to generate earnings. If the

ROA is higher than the cost of borrowing, it means that the bank is earning more from its assets

than it is paying in interest on the borrowed funds. This would result in a net gain for the bank,

making the borrowing and expansion plan financially justifiable. The bank would be able to repay

the borrowed capital while still making a profit. This is a fundamental principle in finance known

as the cost of capital, which states that a company should only invest in projects or expansions

that are expected to generate a return that is higher than the cost of the capital used to finance

them.

Choice A is incorrect. If the return on assets is equal to the expenses of additional borrowing,

it means that all the returns generated by the assets are used to cover borrowing costs. This

leaves no room for profit, which makes this option unviable for expansion.

Choice B is incorrect. The cost of new borrowing being equal to the expenses of existing

borrowing does not necessarily justify an expansion plan. It's important that the return on assets

exceeds both these costs in order to generate a profit and justify expansion.

Choice D is incorrect. If the total value of existing assets is less than total value of existing

debt, it indicates a negative net worth for Barakuda which would make further borrowing risky

and potentially unsustainable.

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Q.2730 You have been given the following information about a Cima Tech:

Total assets $2 million

Return on assets 6%
Cost of debt 5%
Hurdle rate/Return on equity 9%

Which of the following leverage ratios is Cima Tech most likely to choose?

A. 3

B. 4

C. 2

D. 5

The correct answer is B.

rE = LrA − (L − 1)rD
⇒ 9% = L × 6% − (L − 1)5%
⇒ 0.09 = L × 0.06 − (L − 1)0.05
⇒ 0.09 = 0.01L + 0.05
⇒L=4

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Q.2731 The shares of a company currently trade at a bid/ask rate of $20.20 and $20.35. If the
sample standard deviation of the spread is $0.0003, what will be the expected transaction cost
assuming a 99% confidence interval on transaction cost?

A. $0.321

B. $0.065

C. $0.082

D. $0.820

The correct answer is C.

1
Transaction costs = ±P × (s + 2.33σ)
2

Where

P = midprice

S = expected bid-ask spread

Bid price + Ask price 20.2 + 20.35

P = = = $20.275
2 2

Ask price– Bid price 20.35– 20.20

S= = = $0.0074
Midprice 20.275

Thus,

1
Transaction costs = ±20.275 × (0.0074 + 2.33(0.0003))
2
1
= ±20.275 × (0.0074 + 2.33(0.0003))
2
= $0.082

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Q.2980 To understand the causes of illiquidity, we focus primarily on asset liquidity under a
standard set of characteristics of market liquidity. What does tightness mean in this context?

A. It describes how large an order it takes to adversely move the market.

B. It is the length of time for which the market is moved away from the equilibrium price
by a lumpy order.

C. It refers to the cost of a round-trip transaction and measured typically by the bid-ask
spread and the commissions of the broker.

D. It is the condition that makes markets to be closely related to the rate at which
transactions can be executed by participants in the market.

The correct answer is C.

Tightness is the cost of a round-trip transaction that is typically measured by the commissions of
the broker and the bid-ask spread.

Q.2982 In the period of the global financial turmoil, the collapse of the financial institutions can
largely be attributed to both illiquidity and insolvency. Which of the following does NOT describe
the sequence of events in the collapse of an intermediary?

A. Issues about the solvency of the company were raised by the reports of losses at the
intermediary, or at other institutions.

B. All companies, financial intermediaries, and non-financial companies are still willing to
lend to the intermediary.

C. To raise funds, the intermediary is forced to liquidate assets, which might lead to
losses in a distressed market.

D. Being aware that the challenges faced by the intermediary are now being compounded
by the realized mark-to-market losses, the lenders become more and more reluctant to
extend credit to the intermediary.

The correct answer is B.

This choice states that all companies, financial intermediaries, and non-financial companies are

still willing to lend to the intermediary. However, this is not accurate. In the context of a financial

crisis, firms, financial intermediaries, and non-financial companies would typically be very

reluctant to lend to an intermediary that is facing solvency issues. This reluctance is often

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reflected in high credit spreads and a decrease in the volume of loan proceeds that the affected

company can acquire. Therefore, this choice does not accurately describe a step in the sequence

of events leading to the collapse of a financial intermediary during a financial crisis.

Choice A is incorrect. This statement accurately represents a step in the sequence leading to

the collapse of a financial intermediary. During a financial crisis, reports of losses at an

institution can indeed raise concerns about its solvency, which can trigger further negative

events.

Choice C is incorrect. This statement accurately represents a step in the sequence leading to

the collapse of a financial intermediary. When faced with liquidity issues and unable to secure

loans from other institutions, an intermediary may be forced into liquidating assets at potentially

unfavorable prices.

Choice D is incorrect. This statement also accurately represents part of this sequence; lenders

often become more reluctant to extend credit as they realize that their risks are increasing due

to mark-to-market losses at the borrowing institution.

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Q.3135 A firm has a return on asset of 2.5% and a value at risk of 2.45% at 95% confidence. Its
cost of debt is 2%.
What should be its debt equity ratio if its desired return on equity is twice its 95% VaR.

A. 2.4

B. 3.4

C. 5.8

D. 4.8

The correct answer is D.

An entity’s return on equity can be computed using the following formulas:

rE = LrA − (L − 1)rD

Where:

rA = return on assets

rE = return on equity

rD = cost of debt

(Equity+Debt) Debt
L = leverage ratio = = 1 + Equity
Equity

You may also want to express this in words as:

ROE = (leverage ratio × ROA) − [(leverage ratio − 1) × cost of debt]

ROE = 2 × V aR = 2 × 0.0245 = 0.049

Thus,

0.049 = L × 0.025 − (L − 1)0.02

0.049 = 0.025L − 0.02L + 0.02
0.049 = 0.005L + 0.02
0.029
L= = 5.8
0.005
D
L = 1+
E
D
= 5.8 − 1 = 4.8
E

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Q.3225 Mark Sanders is a chief investment officer at Kremlin Pension Fund managing defined
benefit plan for state employees. His fund manager has calculated the 1-day value at risk (V aR)
of the position at $62 million. However, given the magnitude of the position it is most likely that
any liquidation will take place over four trading days. In this scenario, what will be the liquidity-
adjusted V aR for Kremlin?

A. $116,250,000

B. $84,897,000

C. $22,897,000

D. $54,250,000

The correct answer is B.

1 (1 + T ) (1 + 2T )
V aRi (α , ) (X) × √
252 6T

(1 + 4 × 1 + 8)
liquidity-adjusted VaR = $62, 000, 000 × ⎷[ ] = $84 , 897, 000.
6× 4

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Q.3226 Samar Sarkar Brokerage specializes in providing margin loans to U.S. hedge funds that
intend to buy securities on margin. One of the brokerage's clients, Xenon Hedge Fund, wants to
take a $3,000,000 equity position while putting up the minimum equity amount required by the
Federal Reserve. Determine the margin loan amount and the leverage ratio of this position.

A. Margin Loan $3,000,000; Leverage Ratio 1.0

B. Margin Loan $1,500,000; Leverage Ratio 1.0

C. Margin Loan $1,500,000; Leverage Ratio 2.0

D. Margin Loan $3,000,000; Leverage Ratio 0.0

The correct answer is C.

According to Regulation T of the Federal Reserve Board, one may borrow up to 50 percent of the

purchase price of securities that can be purchased on margin. Therefore, the margin loan will be

$1 , 500, 000(= $3, 000, 000 × 50%). The remaining $1,500,000 has to be financed by equity. The

leverage ratio is calculated as total assets divided by equity. Therefore, the hedge fund’s
$3,000 ,000
leverage ratio is 2.0 (= ).
$1,500 ,000

Note: By buying on margin, you borrow money from a broker. Margin accounts increase an

investor's purchasing power and allow them to use other people's money to increase financial

leverage.

Q.3227 Bob Woolmer is a fund manager at Fortune Investment. He is analyzing shares of Bell
Aviation which currently have a bid price of $32.45 and an ask price of $32.90. The sample
standard deviation of this bid-ask spread is 0.004. Given this information, determine the 99
percent confidence interval on the transactions cost, in dollars per unit of the asset, and the 99%
spread risk factor for a transaction involving Bell Aviation.

A. Transactions Cost: $0.759; Spread Risk Factor: 0.0232

B. Transactions Cost: $0.759; Spread Risk Factor: 0.0139

C. Transactions Cost: $0.378; Spread Risk Factor: 0.0116

D. Transactions Cost: $0.379; Spread Risk Factor: 0.0139

The correct answer is C.

Ask price − Bid priceAsk price − Bid price

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Ask price − Bid priceAsk price − Bid price

S=2 =
Ask price + Bid price Mid Price

S is an estimate of the expected or typical bid-ask spread,and P is the asset's mid-price.

¯¯¯¯
Under zero-mean normality, the hypothesis is that S = S .

1 ¯¯¯¯
± ¯P¯¯¯ (S + 2.33σS)
2
1
Expected transactions cost = P × [S + 2.33 (0.004)]
2

($32.90 + 32.45)
Midprice P = = $32.68
2

($32.90 − 32.45)
Expected bid-ask spread (S ) = = 0.0138
$32.68

1
Expected transactions cost = $32.68 × [0.0138 + 2.33 (0.004)] = $0.378
2

¯¯¯¯
Where P is an estimate of the next day asset mid-price,and since P = P , the 99 percent risk

factor is referred to as:

1 ¯¯¯¯
(S + 2.33σS )
2
1
99% spread risk factor = [0.0138 + 2.33 (0.004)] = 0.01156
2

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Q.3228 Tom Daniel is a portfolio manager at XinWin pension fund investing in common stocks.
XinWin has a policy around liquidity risk measure to limit each of its holdings to a maximum of
45% of its 30-day average value traded. If the fund size is $7 billion, what is the maximum
allocation that the fund can hold in a stock with a 30-day average value traded of $390 million?

A. 17.56%

B. 2.25%

C. 2.51%

D. 5.57%

The correct answer is C.

390 × 0.45 = $175.5 million

175.5
% of allocation in fund = = 0.0251 or 2.51%
7000

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Q.3230 Abraham Maslow is an equity strategist at FinteeseCapital. He intends to use leverage to

increase the returns on a convertible arbitrage strategy. The expected return on assets of the
strategy is 11%. The fund has $16 million invested in the strategy and will finance the
investment with 60% borrowed funds. The cost of borrowing is 7%. Using this information, the
return on equity (ROE ) is closest to:

A. 17%

B. 13.66%

C. 10.66%

D. 11%

The correct answer is A.

Debt = $16 × 0.60 = $9.6 million

total assets
Leverage ratio =
equity
16
leverage ratio = Leverage ratio = = 2.5 times
(16 − 9.6)
re = Lra − (L − 1) rd

Where:

ra = return on assets

re = return on equity

rd = cost of debt

L = leverage ratio

Return on equity = 2.5 × 11% − [(2.5 − 1) (7%)] = 27.5% − 10.5% = 17%

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Q.3875 There's always a risk that the price of an asset will move adversely in the act of buying or
selling it. This risk is low if assets can be liquidated or a position can be covered quickly, cheaply,
and without moving the price too much. The risk described here is:

A. Balance sheet risk

B. Transactions liquidity risk

C. Systematic risk

D. funding liquidity risk

The correct answer is B.

Transaction liquidity risk is the risk associated with an adverse movement in the price of an asset

during the process of buying or selling it. This risk is low if the asset can be liquidated or if a

position can be covered quickly, inexpensively, and without causing a significant shift in the

price. An asset is considered liquid if it is a good substitute for cash or if it is 'near' cash. An

asset is said to carry a liquidity premium if its price is lower and its expected return is higher

because it is not perfectly liquid. A market is considered liquid if market participants can quickly

and without excessive transaction costs or price deterioration, put on or unwind positions.

Choice A is incorrect. Balance sheet risk refers to the possibility that a company's balance

sheet can portray a misleading picture of its financial strength. It does not directly relate to the

risk associated with asset price movement during transactions.

Choice C is incorrect. Systematic risk, also known as market risk, refers to the overall impact

of market movements and cannot be eliminated through diversification. It does not specifically

refer to the potential for an asset's price to move unfavorably during a transaction.

Choice D is incorrect. Funding liquidity risk pertains to a situation where an entity is unable to

obtain funds at normal prices or quantities, thereby affecting its ability to meet its obligations

when they come due. This type of risk doesn't directly deal with the potential for an asset's price

moving unfavorably during transactions.

Q.3876 Convertible arbitrage hedge funds experienced significant losses during the 2007-2009
subprime crisis. These losses were most likely due to:

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A. Increase of the target’s stock price due to stock market corrections

B. Unavailability of financing due to market conditions

C. The decline of the acquirer’s price as they filed for bankruptcy during the crisis

D. Selling of the highly liquid assets

The correct answer is B.

Convertible arbitrage hedge funds rely heavily on leverage to boost returns. When market

conditions make financing unavailable, as was the case during the subprime crisis, the value of

convertible bonds can plummet. This situation was further exacerbated by increasing

redemptions, which further strained funding liquidity. Convertible bonds also have a limited

'clientele' among investors. When these investors develop an aversion to the product during a

period of market stress, it becomes difficult to sell the product without significant price declines.

The gap between the prices of convertible bonds and their replicating portfolios widened

significantly, with no-arbitrage capital being brought into the market. The theoretical price is the

value of the replicating portfolio, taking into account credit, risk-free rates, and the embedded

option.

Choice A is incorrect. An increase in the target's stock price due to market corrections would

not have caused significant losses for convertible arbitrage hedge funds during the subprime

crisis. Convertible arbitrage strategies involve buying a company's convertible securities and

short selling its common stock. If the stock price increases, it would offset losses on the short

position with gains on the convertible securities.

Choice C is incorrect. The decline of an acquirer’s price as they filed for bankruptcy during the

crisis could cause losses for some hedge funds, but it was not a widespread issue that affected

most convertible arbitrage hedge funds during this period. Moreover, these types of funds

typically do not take large positions in companies that are at high risk of bankruptcy.

Choice D is incorrect. Selling highly liquid assets wouldn't necessarily lead to significant losses

unless those assets were sold at a discount or below their intrinsic value which was not generally

observed during subprime crisis specifically for convertible arbitrage hedge funds.

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Q.3877 ABC Ltd. is a US-based food processing firm. The firm has a ROA of 10%, total assets
equal to $5, equity capital equal to $2. The firm’s cost of debt is 3%. Calculate the firm’s ROE.

A. 19.8

B. 20.1

C. 20.5

D. 21.2

The correct answer is C.

A E +D D
The firm’s leverage = = =1+
E E E
5
L= = 2.5
2

Its

ROE = (ROA × Leverage ratio) − [(Leverage ratio − 1) × cost of debt]

= (0.10 × 2.5) − [(2.5 − 1) × 0.03] = 0.205 or 20.5%

Q.3878 ABC Ltd. is a US-based food processing firm. The firm has a ROA of 10%, total assets
equal to $7, equity capital equal to $2. The firm’s cost of debt is 5%. Calculate the firm’s ROE.

A. 25.5%

B. 27.5%

C. 22.5%

D. 33.5%

The correct answer is C.

7
Leverage ratio = = 3.5
2

ROE = (ROA × Leverage ratio) − [(Leverage ratio − 1) × cost of debt]

= (0.10 × 3.5) − [(3.5 − 1) × 0.05] = 0.225 or 22.5%

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Q.3879 Suppose that an investor borrows $200. He then invests collateral of $225. Calculate the
haircut of this transaction.

A. 25.0

B. 45.0

C. 212.50

D. 225.0

The correct answer is A.

A haircut is equivalent to the value of the collateral less the amount borrowed. The $25
difference is the one referred to as the haircut. The lender aims to ensure that the loan amount is
less than the collateral. From the lender’s perspective, the haircut is the extent to which
collateral value can fall and still be fully collateralized.

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Q.3880 A hedge fund has $1000,000 in cash, corresponding to an initial placement of $1000,000
in equity by its owners. The hedge fund wants to to finance a long position $1000,000 worth of
stocks at the Reg T margin requirement of 50 percent. A broker facilitates the trade by lending
the hedge fund $500,000. Determine the new leverage ratio for the hedge fund.

A. 0.5

B. 1.0

C. 2.0

D. 1.5

The correct answer is D.

Before the trade, this is how the hedge fund's balance sheet looks like:
Assets
Cash: 1,000,000
Liabilities
Equity: 1.000,000
After the trade, here's the hedge fund's balance sheet:
Assets
Cash: 500,000
Stocks: 1000,000
Liabilities
Equity: 1,000,000
Margin loan: 500,000

The leverage ratio (LR) is equal to total assets divided by equity.

LR = 1,500,000/1000,000 = 1.5

Things to Remember

Regulation T specifies the amount of credit brokers-dealers may extend to investors for the

purchase of securities and also sets forth regulations for the use of cash accounts. A margin

account is required for investors who wish to purchase securities with broker-dealer credit.

Under Reg T, investors may borrow a maximum of 50% of the purchase price and must pay the

remaining balance in cash.

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Q.3881 Suppose a company traded at an ask price of $335 and a bid price of $331. The sample
standard deviation of the spread is 0.00019. Calculate the expected transaction cost following
the zero mean normality assumption and 95% confidence interval on the transaction cost.

A. 2.03

B. 2.05

C. 1.06

D. 0.06

The correct answer is B.

1
Expected transaction cost = P × (s + λ ( standard deviation of spread))
2

335 + 331
Midprice (P) = = 333
2

ask price-bid price 335 − 331

s= = = 0.0120
midprice 333

1
Expected transactions cost = 333 × (0.0120 + 1.65(0.00019)) = 2.05
2

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Q.3882 Suppose Delight Inc. traded at an ask price of $200 and a bid price of $199. The sample
standard deviation of the spread is 0.0004. Calculate the 99% spread risk factor for the
transaction.

A. 0.00297

B. 0.00325

C. 0.00353

D. 0.00381

The correct answer is A.

The 99% confidence interval of transaction cost in dollars, i.e., 99% spread risk factor is
expressed as:

1
±P × (s + 2.33σs )
2

and

1
99% spread risk factor = (s + 2.33σs )
2

ask + bid 200 + 199

mid market price = = = 199.5
2 2

and,

ask − bid 200 − 199

s= = = 0.00501
mid market price 199.5

Thus,

1
99% spread risk factor = (0.00501 + 2.33(0.0004)) = 0.00297
2

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Q.3883 A trader estimates that the number of trading days (T) required for the orderly
liquidation of a position. Position is eight trading days (T = 8). By what percentage is the trader
most likely to adjust the VaR?

A. 79%

B. 179%

C. 18.75%

D. 118.75%

The correct answer is A.

To adjust for the fact that the position could be liquidated over several days, the following
formula can be used:

(1 + T)(1 + 2T )
VaRt × ⎷
6T

The adjustment to the overnight VaR of the position is

(1 + 8)(1 + (2 × 8))
⎷ = 1.7854
6 ×8

This means that the trader should increase VaR by 79%.

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Q.3884 Velma Jones placed an order to sell a stock when the market price was $50. Due to
market volatility, by the time Jones’s broker sold the stock, the price had fallen to $48. In the
market, this phenomenon is known as:

A. Bid-ask spread

B. Adverse price impact

C. Slippage

D. Leverage effect

The correct answer is C.

Slippage is a term used in finance to describe a situation where the execution price of a trade is

different from the expected price. This usually occurs due to market volatility and the time delay

between when an order is placed and when it is actually executed. In the case of Velma Jones,

she intended to sell her stock at $50, but due to market fluctuations and the time it took for her

broker to execute the trade, the price had fallen to $48. This difference in price is referred to as

slippage. It is a common occurrence in financial markets, particularly in volatile markets where

prices can change rapidly within a short period of time.

Choice A is incorrect. The bid-ask spread refers to the difference between the highest price

that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. It

does not refer to the difference between an expected execution price and actual execution price

due to market volatility.

Choice B is incorrect. Adverse price impact refers to a situation where large trades cause

significant changes in prices, which can negatively affect traders' profits. While this concept

involves changes in prices, it doesn't specifically refer to the discrepancy between expected and

actual trade execution prices due to market fluctuations.

Choice D is incorrect. The leverage effect refers to how debt can increase a company's return

on equity or amplify potential losses, depending on whether the company's returns exceed its

borrowing costs or not. This concept has no direct relation with differences in expected and

actual trade execution prices caused by market volatility.

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Reading 129: Early Warning Indicators

Q.3844 An indicator that provides information and significant potential stress before the
occurrence of an actual event is most likely known as a:

A. Sharp indicator

B. Granular indicator

C. Leading indicator

D. Lagging indicator

The correct answer is C.

A leading indicator, also known as a forward-looking indicator, is designed to signal potential

stress or risk before the actual occurrence of an event. This type of indicator is particularly

crucial in preparing for systematic risks. It allows institutions to take proactive measures to

mitigate potential losses or disruptions. Leading indicators can be based on a variety of factors,

including economic data, market trends, and internal metrics. By identifying potential risks early,

institutions can adjust their strategies and operations to better manage these risks.

Choice A is incorrect. A sharp indicator does not exist in the context of risk management. It

seems to be a distractor in this question.

Choice B is incorrect. Granular indicators provide detailed information about specific areas or

aspects of risk but they do not necessarily signal potential stress before the actual occurrence of

an event.

Choice D is incorrect. Lagging indicators are measures that change after the economy as a

whole does, hence they do not provide information or signal potential stress before the actual

occurrence of an event.

Q.3845 Early warning indicator triggers are used to initiate management discussions and actions
that call for formal documentation. Which of the following actions is least likely a cost-benefit
decision?

A. Increasing high liquid assets

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B. Continuing to comply with LCR requirements

C. Setting a minimum standard for liquidity buffer according to the bank’s risk appetite

D. Using a set and forget approach to make cost-benefit decisions

The correct answer is D.

The 'set and forget' approach is least likely to be a cost-benefit decision. This approach does not

allow for the strategic management of the potentially catastrophic impacts of insufficient

liquidity in a dynamic market. It is a passive strategy that does not involve active decision-

making based on cost-benefit analysis. Instead, it involves setting a strategy and then leaving it

unchanged, regardless of changes in the market or the bank's financial situation. This approach

can lead to significant risks, as it does not allow for adjustments based on changing market

conditions or the bank's liquidity position. Therefore, it is least likely to be a cost-benefit decision

compared to the other options.

Choice A is incorrect. Increasing high liquid assets is indeed a cost-benefit decision. The

benefit of having more liquid assets is that it provides a safety net in case of financial distress,

but the cost is the opportunity cost of not investing those funds in potentially higher yielding

investments.

Choice B is incorrect. Continuing to comply with LCR (Liquidity Coverage Ratio) requirements

also involves a cost-benefit decision. The benefit here lies in maintaining regulatory compliance

and avoiding penalties, while the cost could be associated with holding high-quality liquid assets

which may yield lower returns.

Choice C is incorrect. Setting a minimum standard for liquidity buffer according to the bank’s

risk appetite also involves a cost-benefit analysis. The benefit comes from ensuring sufficient

liquidity to meet unexpected cash flow needs, while the potential costs are tied to holding

unproductive assets that could otherwise be invested for higher returns.

Choice D (correct answer) does not involve any explicit or implicit trade-off between costs and

benefits as it implies an automatic approach without any active management or decision-making

process involved.

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Q.3846 Companies with substantial trading focus use intraday reporting because they are more
exposed to external market conditions. Intraday liquidity monitoring indicators include the
following, except:

A. Intraday credit lines stretched out to financial institution customers

B. Daily minimum liquidity requirement

C. Daily maximum liquidity requirement

D. Available intraday liquidity

The correct answer is B.

The 'Daily minimum liquidity requirement' is not listed as an intraday liquidity monitoring

indicator in the BCBS-2012 fundamental supervisory guideline. This guideline is a key reference

for financial institutions, particularly those with a substantial trading focus, as it outlines the

indicators that should be monitored to manage exposure to external market conditions. While the

guideline does include a variety of indicators, such as 'Daily maximum liquidity requirement',

'Available intraday liquidity', and 'Intraday credit lines stretched out to financial institution

customers', it does not mention the 'Daily minimum liquidity requirement' as an indicator. This is

likely because the minimum liquidity requirement is a baseline measure that must be maintained

at all times, rather than an intraday measure that can fluctuate based on market conditions.

Choice A is incorrect. Intraday credit lines stretched out to financial institution customers are

indeed recognized as an intraday liquidity monitoring indicator according to the BCBS-2012

fundamental supervisory guideline. These credit lines can provide a measure of the potential

liquidity needs of a financial institution's customers, which in turn can impact the institution's

own liquidity position.

Choice C is incorrect. Daily maximum liquidity requirement is also recognized as an intraday

liquidity monitoring indicator according to the BCBS-2012 fundamental supervisory guideline.

This requirement sets an upper limit on the amount of liquid assets that a financial institution

must hold at any point during the day, providing a buffer against unexpected market shocks or

operational disruptions.

Choice D is incorrect. Available intraday liquidity, which refers to the amount of liquid assets

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that a financial institution has on hand at any given time during the day, is another recognized

intraday liquidity monitoring indicator according to BCBS-2012 guidelines. This measure

provides real-time information about an institution's ability to meet its immediate obligations

without incurring unacceptable losses.

Q.3847 Your supervisor asks you to prepare a list of sound early warning indicators for liquidity
problems for your bank. Which of the following are sound early warning indicators of a potential
liquidity problem?

I. Negative publicity regarding an asset class owned by the institution

II. Stock price declines
III. Widening debt/credit-default-swap spreads
IV. Increase in credit lines
V. Significant deterioration in the bank’s financial condition
VI. Increase in the weighted average maturity of liabilities

A. I, II, III, V

B. I, II, IV, VI

C. II, III, IV, V

D. III, IV, V, VI

The correct answer is A.

The Basel Committee on Banking Supervision (BCBS) provided its “Principles of Sound Liquidity
Management and Supervision”1 (Sound Principles) in September 2008, following the global
financial crisis of 2007-2008. The following figure is a non-exhaustive list of EWIs recommended
by the BCBS.

Rapid asset growth, especially when funded with probable volatile liabilities

Growing concentrations in assets or liabilities

Increases in currency mismatches

Decrease of weighted average maturity of liabilities

Recurring incidents of positions approaching or breaching internal or regulatory limits

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Negative trends associated with a particular product line

Significant deterioration in the bank’s financial condition

Negative publicity Credit rating downgrade

Stock price declines

Rising debt costs

Widening debt/credit-default-swap spreads

Rising wholesale/retail funding costs

Counterparties requesting additional collateral or resisting entering into new

transactions

Drop-in credit lines

Increasing retail deposit outflows

Increasing redemptions of CDs before maturity

Difficulty accessing longer-term funding

Difficulty placing short-term liabilities

Q.3848 Fredric Pete is a risk manager at ABC Bank. Pete wants to forecast the bank’s losses. He
starts by assessing simple measures that indicate whether the bank’s risks are changing over
time (i.e., early warning signs). Fred then applies regression techniques, for example, to forecast
the losses. The early warning signs that Pete assesses most likely include:

I. Audit scores
II. Staff turnover
III. Trade volumes
IV. Stock prices

A. I and IV

B. II and III

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C. I, II and IV

D. All of the above

The correct answer is D.

Early warning indicators are crucial tools in risk management. They provide insights into

potential problems before they become significant issues. In the context of a bank, these

indicators can reveal whether the institution is on the right track or if there are reasons for

concern. The indicators mentioned in the options - audit scores, staff turnover, trade volumes,

and stock prices - all serve as early warning signs. A decline in audit scores could indicate

potential issues with the bank's internal controls or compliance with regulations. An increase in

staff turnover could suggest problems with employee satisfaction or retention, which could

negatively impact productivity and efficiency. Changes in trade volumes could reflect shifts in the

bank's market activity, while fluctuations in stock prices could indicate changes in the bank's

perceived value or financial stability. Therefore, all these indicators would likely be assessed by a

risk manager like Pete when forecasting the bank's losses.

Choice A is incorrect. While audit scores (I) and stock prices (IV) can serve as early warning

signs of changing risks within a bank, this choice does not include other important measures

such as staff turnover (II) and trade volumes (III). Staff turnover can indicate internal issues that

may affect the bank's risk profile, while trade volumes can reflect changes in market activity that

could impact the bank's potential losses.

Choice B is incorrect. Although staff turnover (II) and trade volumes (III) are relevant

measures for predicting potential losses, this choice excludes audit scores (I) and stock prices

(IV). Audit scores provide insights into the effectiveness of a bank's internal controls, which are

crucial for managing risks. Stock prices reflect market perceptions of a company’s riskiness and

future prospects.

Choice C is incorrect. This option includes audit scores(I), staff turnover(II), and stock

prices(IV), but it leaves out trade volumes(III). Trade volumes are an important measure because

they can indicate changes in market activity that could potentially affect the bank's exposure to

financial risks.

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Q.3849 The primary purpose of putting in place early warning indicators is to:

A. It is a measure used in management to indicate how risky an activity is.

B. Ensure that the bank holds enough liquid assets to enable it to meet financial
obligations

C. Safeguard asset quality and ensure that liability limits are not breached

D. Initiate management discussion and necessary corrective action

The correct answer is D.

Early warning indicators (EWIs) are essentially risk management tools that are designed to alert

management about potential risks or issues that could lead to financial distress if not addressed

promptly. The primary purpose of these indicators is to initiate management discussions and

necessary corrective actions. This is akin to the warning lights on a car's dashboard, which alert

the driver to potential issues that need to be addressed to prevent damage to the vehicle.

Similarly, EWIs in a financial institution serve to alert management to potential risks that need to

be addressed to prevent financial distress. These indicators can be related to various aspects of

the institution's operations, including liquidity, credit risk, market risk, and operational risk.

When an EWI is triggered, it serves as a signal for management to discuss the issue and take

necessary corrective actions to mitigate the risk.

Choice A is incorrect. While early warning indicators can provide some insight into the

riskiness of an activity, their primary purpose is not to serve as a measure of risk. They are more

focused on identifying potential risks and threats that may require management intervention.

Choice B is incorrect. Early warning indicators are not specifically designed to ensure that a

bank holds enough liquid assets to meet its financial obligations. This would be more related to

liquidity management strategies and regulatory requirements, rather than the function of EWIs.

Choice C is incorrect. Safeguarding asset quality and ensuring liability limits are not breached

are important aspects of risk management, but they do not represent the primary purpose of

implementing early warning indicators in a financial institution. EWIs primarily serve as signals

for potential risks or threats requiring corrective action by management.

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Q.3850 What is a sharp early warning indicator?

A. An indicator that highlights the past performance

B. An indicator that depends on another performance measure

C. A highly granular indicator, involving a subset of data

D. An indicator that needs professional experience and quantitative skills to decode

The correct answer is C.

A sharp early warning indicator is a highly granular indicator that involves a subset of data. It is

designed to detect subtle changes within a specific segment of data that might otherwise go

unnoticed in the larger data set. This type of indicator is particularly useful in identifying

potential risks or threats at an early stage, allowing for timely intervention and risk mitigation.

For instance, a sharp indicator might detect a drop in deposit balances among high-net-worth

customers, signaling that these crucial customers may be considering leaving the bank. This

early warning allows the bank to take appropriate action to retain these customers and prevent

potential losses.

Choice A is incorrect. An early warning indicator is not necessarily related to past

performance. While historical data can be useful in identifying potential risks, a 'sharp' early

warning indicator specifically refers to a highly granular and specific subset of data, not just any

past performance metrics.

Choice B is incorrect. Although some indicators may depend on other performance measures,

this does not define what a 'sharp' early warning indicator is. The dependency on another

measure does not make an indicator more or less 'sharp'. Instead, the granularity and specificity

of the data used are what characterize a 'sharp' indicator.

Choice D is incorrect. While professional experience and quantitative skills can certainly aid in

interpreting complex indicators, these are not defining characteristics of a 'sharp' early warning

indicator. Such an indicator refers specifically to the use of highly granular and specific subsets

of data for risk identification.

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Q.3852 Early warning signs can be identified using a set of parameters and processes that
identify probable risks at a nascent stage. When potential risk events are recognized at an
earlier stage, an investment bank is able to prepare itself as the event develops. Which one of the
following is LEAST likely an early warning sign for such events?

A. Narrowing of debt or credit default swap spreads

B. Increases in currency mismatches

C. Drop-in credit lines

D. Increasing redemptions of CDs before maturity

The correct answer is A.

The narrowing of debt or credit default swap spreads is not typically considered an early

warning sign for potential risk events in investment banking. In fact, it is usually seen as an

indication that the investment is in a good position. Credit default swaps (CDS) are financial

derivative contracts that allow an investor to 'swap' or offset their credit risk with that of another

investor. When the spread, or difference, between the credit default swap rates of two different

investments narrows, it suggests that the perceived risk of the investment is decreasing. This is

because a narrower spread indicates that the market believes there is a lower chance of default

on the debt. Therefore, rather than being a warning sign, a narrowing of debt or credit default

swap spreads is often viewed as a positive signal in the investment banking world.

Choice B is incorrect. Increases in currency mismatches can serve as an early warning sign for

potential risk events. Currency mismatches occur when the currency of a bank's liabilities differs

from that of its assets. This can lead to exchange rate risk, which could potentially harm the

bank's financial position.

Choice C is incorrect. A drop-in credit lines can also be an early warning sign for potential risk

events. If a bank sees a significant decrease in its credit lines, it may indicate that borrowers are

facing financial difficulties and are less likely to repay their loans, leading to increased credit

risk for the bank.

Choice D is incorrect. Increasing redemptions of CDs before maturity could be an early

warning sign as well. When depositors start withdrawing their deposits before maturity, it might

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indicate a lack of confidence in the bank's stability or profitability, which could lead to liquidity

risks.

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Q.3853 In which of the given circumstances is it most optimal to track early warning indicator
metrics?

A. After an industrial-wide decline in performance

B. During a business as usual environment

C. During periods of institution-specific stress

D. After the occurrence of a loss-causing event

The correct answer is B.

Early warning indicators (EWIs) are designed to provide signals or act as a heads-up in the lead-

up to a potential disaster. They are most effective when used in a 'business as usual'

environment, where everything appears to be in order, or at least going as per expectations. In

such an environment, any deterioration in EWI metrics can be easily detected, setting in motion

a series of steps to avert the impending danger. For instance, if a bank’s liquidity coverage ratio

decreases below a specified threshold, the management can immediately direct the relevant

personnel to liquidate long-term assets and correct the situation. Therefore, tracking EWIs

during a 'business as usual' environment allows for proactive risk management and disaster

prevention.

Choice A is incorrect. Monitoring early warning indicator metrics after an industry-wide

decline in performance may be too late to prevent significant losses or disasters. These metrics

are designed to provide advance notice of potential risks, so they should ideally be monitored

before such a decline occurs.

Choice C is incorrect. While it can be beneficial to monitor these metrics during periods of

institution-specific stress, this is not the most optimal time. The purpose of EWI metrics is to

identify potential risks and prevent disasters before they occur, not during the occurrence of

stressful events.

Choice D is incorrect. Monitoring EWI metrics after the occurrence of a loss-causing event

would not be as beneficial as monitoring them beforehand. The goal of these indicators is to

provide early warnings about potential risks that could lead to losses, so their utility would be

diminished if they were only monitored after a loss has already occurred.

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Q.3854 To accurately monitor liquidity risk, firms are advised to use a spotlight system in
representing and communicating their performance against the thresholds of the EWIs. Which of
the following indicators should a firm be most concerned with?

A. Red

B. Blue

C. Amber

D. Green

The correct answer is A.

The color 'Red' in the spotlight system is used to indicate a significant concern that may warrant

an immediate response. This is because a red indicator implies that the measure has crossed the

threshold of the Early Warning Indicators (EWIs), indicating a high level of liquidity risk. This

could mean that the firm's liquidity position is deteriorating rapidly, and immediate action is

required to prevent potential financial distress or insolvency. Therefore, a firm should be most

concerned with a red indicator as it signals a critical situation that needs urgent attention and

action.

Choice B is incorrect. Blue is not typically used in a spotlight system for liquidity risk

management. The standard colors used are red, amber, and green, each representing different

levels of risk or performance against thresholds.

Choice C is incorrect. Amber indicates that the firm's performance against the Early Warning

Indicators (EWIs) thresholds is at a moderate level of risk. While it does require attention and

possibly some action to mitigate potential risks, it does not represent an immediate threat like

the red indicator.

Choice D is incorrect. Green indicates that the firm's performance against the EWIs thresholds

is within acceptable limits and there are no significant risks identified at this time. Therefore, it

does not require immediate action as compared to a red indicator.

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Q.3855 Swift Investments, a U.S. based firm, is a clearing member at the Chicago Mercantile
Exchange. The firm has put together a comprehensive liquidity risk management framework that
involves the use of a set of early warning indicators to help the firm detect liquidity distress at a
nascent stage. To prudently manage its liquidity risk, which of the following reporting schedules
is most appropriate for the firm’s EWI dashboard?

A. Daily

B. Weekly

C. Intraday

D. Monthly

The correct answer is C.

Intraday reporting is the most appropriate for Swift Investments, given its role as a clearing

member at the Chicago Mercantile Exchange. Clearing members are exposed to significant

market risk and need to be able to respond quickly to changes in market conditions. Intraday

reporting allows the firm to monitor its liquidity risk on a real-time basis and take immediate

action if necessary. This is particularly important for firms with a substantial trading focus, as

they are more exposed to external market conditions. Intraday reporting provides the most

timely information, allowing managers to adjust their strategies and actions in response to

potential crises.

Choice A is incorrect. Daily reporting, while more frequent than weekly or monthly, may not be

sufficient for a firm like Swift Investments that operates in the fast-paced environment of the

Chicago Mercantile Exchange. Liquidity risks can arise and escalate within a single trading day,

making daily reports potentially outdated by the time they are reviewed.

Choice B is incorrect. Weekly reporting would not provide Swift Investments with timely

information about liquidity risks. Given the firm's exposure to market conditions and its role in

clearing transactions, it needs to monitor its liquidity risk indicators more frequently to detect

signs of distress at an early stage.

Choice D is incorrect. Monthly reporting would be even less suitable for Swift Investments

than daily or weekly reporting schedules due to the delay in receiving critical information about

potential liquidity risks. In a volatile market environment, such delays could lead to significant

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financial losses.

Q.5376 When evaluating ABC Bank's liquidity profile, what particular trends should John Doe, a
risk consultant, prioritize as the most prominent warning sign indicating potential liquidity risk
at the bank?

A. The spreads on the bank's issued debt and credit default swap have widened.

B. There has been substantial growth in assets, which has been financed by an expansion
in stable liabilities.

C. While the stock price of the bank's peers has declined, there has been no
corresponding decrease in the stock price of the bank itself.

D. The bank's current ratio has fallen below 1, indicating difficulties in meeting short-
term obligations.

The correct answer is A.

The widening spreads reflect a diminished market confidence in the bank, leading to an increase

in the cost of funding. Widening spreads indicate that investors are demanding higher yields or

compensation for the perceived increase in risk associated with lending to the bank. This can

potentially strain the bank's liquidity position as it becomes more expensive for the bank to

borrow or raise funds.

B is incorrect. A rapid expansion of assets funded by unstable liabilities as opposed to stable

liabilities would pose greater concerns.

C is incorrect. A bank-specific early warning indicator (EWI) that would be more relevant is a

decline in the bank's stock price compared to that of its peers as opposed to no decline in the

bank's stock price.

D is incorrect. In the context of banking and financial institutions, the current ratio is not the

most appropriate indicator of liquidity risk.

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Q.5380 ABC Bank employs a collection of early warning indicators to detect emerging risks and
possible vulnerabilities in its liquidity position. Which of the following serves as an early warning
indicator for a potential liquidity issue?

A. A rapid rise in the leverage ratio and heavy reliance on short-term repo funding.

B. A reduction in the collateral haircuts imposed on the bank's collateralized exposures.

C. An upward revision in the credit rating.

D. Increased diversification of assets

The correct answer is A.

A rapid expansion of leveraged assets accompanied by significant utilization of short-term repos

serves as an early warning sign for a potential liquidity problem. The leverage ratio measures the

level of debt relative to the bank's capital and indicates the potential strain on its liquidity

position. Additionally, relying on short-term repo funding means the bank has a dependence on

short-term borrowing to finance its activities, which can pose liquidity risks if the availability of

funding becomes limited or costly.

B, C and D are incorrect. Decreased collateral haircuts, a credit rating upgrade, and increased

asset diversification are generally positive developments and do not typically indicate an early

warning of a potential liquidity problem.

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Q.5422 Jane Doe is considering investing in Company X. She has optimistic expectations of the
company despite the current poor global economic environment. Which of the following biases
would most likely be present in Jane Doe's valuation of Company X and consequent investment
decision?

A. Forward-looking bias

B. Survivorship bias

C. Illiquidity bias

D. Sample selection bias

The correct answer is A.

A forward-looking bias occurs when the analysis or decision-making process is influenced by

information or expectations about future events. It can lead to overemphasis on future

projections and neglect of historical data or current conditions.

B is incorrect. Survivorship bias refers to the error that arises when only successful or

surviving entities are considered in a study or analysis, while ignoring those that failed or did not

survive. It can lead to an overestimation of performance or outcomes since the unsuccessful

entities are excluded from the analysis.

C is incorrect. Illiquidity bias refers to the distortion or bias that arises when analyzing or

valuing illiquid assets or securities. Illiquid assets are more difficult to sell or trade, and their

pricing may be less transparent or subject to higher transaction costs. This bias can lead to

inaccuracies or underestimation of the true value or risk associated with illiquid assets.

D is incorrect. Sample selection bias occurs when the sample or data used for analysis is not

representative of the entire population or is biased towards certain characteristics or outcomes.

It can lead to erroneous conclusions or generalizations.

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Reading 130: The Investment Function in Financial Services

Management

Q.3856 A security issued by the United States federal government which matures in one year
following the date of issue is most likely a:

A. Treasury note

B. Treasury bond

C. Treasury bill

D. Structured note

The correct answer is C.

A Treasury bill, often referred to as a T-bill, is a short-term debt obligation backed by the U.S.

government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up

to a maximum purchase of $5 million and commonly have maturities of one month (4 weeks),

three months (13 weeks), or six months (26 weeks). However, they can also have a maturity of

one year. They are issued through a competitive bidding process at a discount from par, which

means that rather than paying fixed interest payments like traditional bonds, the appreciation of

the bond provides the return to the holder.

Choice A is incorrect. Treasury notes are medium-term securities issued by the U.S. federal

government with maturities ranging from 2 to 10 years, not one year.

Choice B is incorrect. Treasury bonds are long-term securities issued by the U.S. federal

government with maturities that typically exceed 10 years, far longer than the one-year maturity

period described in the question.

Choice D is incorrect. Structured notes are complex financial instruments that combine a bond

with a derivative component and their maturity periods can vary widely, but they are not

typically issued directly by the U.S. federal government.

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Q.3858 To safeguard public funds, depository institutions in the united states cannot accept
deposits from federal, state and local governments unless they post collateral acceptable to these
government units. This is most likely known as:

A. Statutory requirements

B. Pledging requirement

C. Investment requirements

D. Operational requirements

The correct answer is B.

Pledging requirements refer to the legal obligations that require securities to be pledged as

collateral for specific deposits. In the context of depository institutions in the United States,

these requirements are particularly relevant when dealing with deposits from federal, state, and

local governments. These institutions are not allowed to accept such deposits unless they post

collateral that is deemed acceptable by these governmental units. This is done to safeguard

public funds and ensure that the government's interests are protected in the event of a default.

The nature and extent of these pledging requirements can vary widely from state to state.

However, most states allow a combination of federal and municipal securities to meet these

requirements. Therefore, the term 'pledging requirement' accurately encapsulates this

regulatory obligation imposed on depository institutions.

Choice A is incorrect. Statutory requirements refer to the laws that a company or an

institution must follow. These are broader in scope and not specifically related to the

requirement of providing security in the form of pledged collateral for accepting deposits from

government units.

Choice C is incorrect. Investment requirements pertain to rules and regulations regarding how

institutions can invest their funds. This does not directly relate to the provision of security for

accepting government deposits.

Choice D is incorrect. Operational requirements refer to the day-to-day functioning and

management practices that an institution must adhere to, which does not necessarily include

providing collateral as security for government deposits.

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Q.3859 Assume that an investor currently holds a bond whose par value is $2,000. The bond is
currently priced at $1,600, matures in 5 years, and pays an annual coupon of 8%. Calculate the
yield to maturity of the bond.

A. 13.80%

B. 16.38%

C. 16.59%

D. 17.34%

The correct answer is A.

The coupon amount is 0.08 × 2 , 000 = $160

160 160 160 160 2, 160

1,600 = + + + +
(1 + Y T M)1 (1 + Y T M)2 (1 + Y TM)3 (1 + Y T M)4 (1 + Y T M)5
Y TM = 13.80%

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Q.3860 Any securities which reach maturity within one year is most likely regarded as:

A. Money market securities

B. Capital market securities

C. Federal agency securities

D. Certificates of deposits

The correct answer is A.

Money market securities are short-term debt instruments that are highly liquid and have a

maturity period of one year or less. They are considered low-risk investments and are issued by

governments, financial institutions, and corporations. Examples of money market securities

include Treasury bills, commercial paper, and certificates of deposit. These securities are

typically used by investors for parking their funds temporarily until they find a more lucrative

investment opportunity. The short maturity period of these securities allows investors to get their

principal amount back within a short span, thereby reducing the risk of price fluctuations due to

market volatility.

Choice B is incorrect. Capital market securities typically have a maturity period that exceeds

one year. They include long-term instruments such as stocks and bonds, which are used by

businesses to raise capital for their long-term needs.

Choice C is incorrect. Federal agency securities can have varying maturity periods, ranging

from less than a year to several years. Therefore, they cannot be classified as securities that

mature within one year.

Choice D is incorrect. Certificates of deposits (CDs) also have varying maturities and can

range from a few months to several years depending on the terms set by the issuing bank.

Hence, it's not accurate to categorize all CDs as maturing within one year.

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Q.3861 An investor wants to purchase a $1,500 par-value treasury note that has a 10% coupon
rate and is expected to mature in 5 years. However, the investor decides to sell the security at
the end of the second year for $1,375. If the current price of the Treasury note is $1,200,
calculate the holding period yield of the note.

A. 18.23%

B. 18.98%

C. 19.15%

D. 19.89%

The correct answer is C.

150 (1 , 375 + 150)

1, 200 = +
(1 + H PY ) 1
(1 + H PY )2

Now, using a financial calculator with N=2, PV=-1,200, PMT=150, and FV=1,375:

I
= HP Y = 19.15%
Y

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Q.3863 Suppose that Aaa-rated corporate bonds have an average gross yield to maturity of 8%,
the prime rate on top-quality corporate loans is 6%, and Aaa-rated municipal bonds have a 5%
gross yield to maturity. Calculate the tax-equivalent yield (TEY) for the Aaa-rated municipal
bonds for a taxed financial firm in the top 35% federal income tax bracket.

A. 5.00%

B. 6.52%

C. 7.69%

D. 14.29%

The correct answer is C.

After-tax return on a tax-exempt investment

T EY =
(1 − Investing firm’s marginal tax rate)

Recall that municipal bonds are tax-exempt; thus, the expected after-tax gross returns for Aaa-

rated municipal bonds will be:

5% × (1 − 0) = 5%
5%
T EY = = 7.69%
(1 − 0.35)

This measure means that the Aaa-rated corporate bond and the prime-rated loans would have to

have a before-tax yield of 7.69% to match the Aaa-municipal bond’s after-tax yield of 5.0%.

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Q.3864 Which of the following statements is not true?

A. Treasury bills are the long term debt obligations issued by the federal government

B. Inflation risk is the likelihood that rising prices for goods and services will erode the
purchasing power of interest income and repaid principal from security or loan

C. Bankers' acceptances are considered to be among the safest of all money market
instruments

D. Investment securities are expected to help stabilize financial institutions' income

The correct answer is A.

U.S. Treasury bill is a debt obligation of the united states government that should mature in one
year following the date of issue (short-term). T-bills are issued in weekly or monthly auctions, and
their high degree of security makes them very attractive.
B is true: Rising prices of goods and services distort the purchasing power of interest income
and repaid principal from security or loan. This is known as inflation risk.

C is true: Because they represent a bank’s promise to pay the holder a designated amount of
money on a designated future date, bankers’ acceptances are considered to be among the safest
of all money market instruments.

D is true: Investment security portfolios help to stabilize income, so that revenues level out over
the business cycle—when loan revenues fall, income from investment securities may rise.

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Q.3865 The risk that the bank must sell part of its investment portfolio before its maturity for a
capital loss is known as:

A. Credit risk

B. Business risk

C. Default risk

D. Liquidity risk

The correct answer is D.

Liquidity risk refers to the risk that a bank or other financial institution may encounter when it is

forced to sell part of its investment portfolio before the investments have reached their maturity.

This premature sale could potentially result in a capital loss for the bank. Liquidity risk is a

significant concern for financial institutions as they must always be prepared for the possibility

of needing to liquidate assets quickly to meet their obligations or to respond to an unexpected

event. This risk is inherent in investments that are not easily sold or converted into cash without

a substantial loss in value. These include assets like real estate, certain types of securities, and

other illiquid investments.

Choice A is incorrect. Credit risk refers to the potential loss that a bank may face when a

borrower fails to meet their contractual obligations. It does not refer to the risk associated with

selling investments prematurely.

Choice B is incorrect. Business risk pertains to the uncertainty in profits or danger of loss and

the events that could pose a risk due to some unforeseen events in future, which causes business

to fail. It does not specifically relate to premature sale of investments.

Choice C is incorrect. Default risk, similar to credit risk, refers to the possibility that a

borrower will be unable to make required debt payments and thus default on their obligations.

This type of risk does not encompass situations where banks are forced into premature sale of

their investments.

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Q.3866 Money market instruments which represent a bank's commitment to pay a specified
amount of money on a specific future date under specific conditions, are known as:

A. Eurocurrency deposits

B. Government agency securities

C. Bank qualified bonds

D. Bankers’ acceptances

The correct answer is D.

Bankers' acceptances are regarded as one of the most secure instruments in the money market

because they represent a bank's commitment to pay a specified amount on a future date. These

instruments commonly originate from financial institutions offering credit guarantees to

customers engaged in activities such as exporting, importing, storing goods, or buying currency.

Legally, the financial institution issuing the credit guarantee assumes the primary responsibility

of repaying the customer's debt in exchange for a fee. By providing their name and

creditworthiness, the issuing institution enables their customer to access credit from other

sources at a reduced cost.

A is incorrect: International Eurocurrency deposits are typically short-term, fixed maturity

deposits issued in million-dollar units by the world’s largest banks headquartered in financial

centers around the globe.

B is incorrect: Government agency securities are marketable notes and bonds sold by agencies

owned by the government or sponsored by the government.

C is incorrect: Bank-qualified bonds are those issued by smaller local governments, i.e.,

governments issuing no more than $10 million of public securities per year. Banks buying bank-

qualified bonds are allowed to deduct 80% of any interest paid to fund these purchases. This tax

advantage is not available for nonbank-qualified bonds.

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Q.3867 The most aggressive investment maturity strategy that requires the bank to regularly
shift the maturities of its securities in responses to fluctuations in interest rates called the:

A. Front-End Load Maturity Policy

B. Back-End Load Maturity Policy

C. Barbell Strategy

D. Rate Expectation Strategy

The correct answer is D.

The Rate Expectation Strategy is the most aggressive of all maturity strategies and is

predominantly used by major financial institutions. This strategy involves the continuous

adjustment of securities' maturities in accordance with current economic and interest rate

forecasts. When a rise in interest rates is anticipated, investments are shifted towards the short

end of the maturity spectrum. Conversely, when a fall in interest rates is expected, investments

are moved towards the long end of the spectrum. This strategy requires a deep understanding of

economic trends and interest rate movements, making it a complex but potentially rewarding

approach for institutions with the necessary expertise and resources.

Choice A is incorrect. The Front-End Load Maturity Policy refers to a strategy where the

majority of the investment's costs are paid at the beginning of the investment period. This

strategy does not involve adjusting maturities in response to changes in interest rates.

Choice B is incorrect. The Back-End Load Maturity Policy, on the other hand, involves paying

most of an investment's costs at its maturity or end. Similar to Choice A, this policy does not

require continual adjustments of securities' maturities based on interest rate changes.

Choice C is incorrect. The Barbell Strategy involves investing in short-term and long-term

bonds but avoiding intermediate-term bonds. While this strategy may involve some adjustment

based on interest rates, it does not necessitate continuous adjustment as described in the

question.

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Q.3868 Loans will be terminated or paid off ahead of schedule. This is a particular problem with
residential home mortgages and other consumer loans that are pooled and used as collateral in
securitized assets. This risk is known as:

A. Liquidity risk

B. Prepayment risk

C. Call risk

D. Business risk

The correct answer is B.

Prepayment risk refers to the risk associated with the early repayment of a loan by the borrower.

This risk is particularly relevant to asset-backed securities, as the actual interest and principal

payments received from a pool of securitized loans may differ from the originally expected cash

flows. A common example of this can be seen in mortgage-backed securities, where the

underlying asset is a pool of home loans. The prepayment risk arises when borrowers pay off

their mortgages ahead of schedule, thereby altering the expected cash flows from these

securities.

Choice A is incorrect. Liquidity risk refers to the risk that a firm may not be able to meet its

short-term financial demands due to an inability to convert assets into cash without incurring a

loss. It does not refer to the risk of loans being paid off ahead of their scheduled time.

Choice C is incorrect. Call risk pertains to the possibility that a bond issuer might retire a bond

before its maturity date, something that is usually done when interest rates decline. This does

not directly relate to the early termination or payoff of loans as described in the question.

Choice D is incorrect. Business risk involves risks associated with operating a business such as

changes in market conditions, competition, and regulations among others. It does not specifically

deal with risks associated with loan prepayments.

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Q.3871 The practice of protecting securities purchased from loss of return, no matter which way
interest rates go is regarded as:

A. Portfolio shifting

B. Duration

C. Portfolio immunization

D. Securitization

The correct answer is C.

Portfolio immunization is a strategy that is designed to protect the returns on purchased

securities, regardless of the direction in which interest rates move. This strategy is primarily

concerned with balancing the risks associated with price and reinvestment in an investment

portfolio. The goal of portfolio immunization is to ensure that the portfolio is not adversely

affected by changes in interest rates, thereby safeguarding the returns on the securities

purchased. This is achieved by carefully selecting securities that have offsetting price and

reinvestment risks. In other words, if the price of a security falls due to an increase in interest

rates, the loss is offset by the higher reinvestment return, and vice versa. This ensures that the

total return on the portfolio remains stable, irrespective of changes in interest rates.

Choice A is incorrect. Portfolio shifting involves changing the composition of a portfolio in

response to changes in market conditions or investment goals. It does not necessarily aim to

safeguard returns on purchased securities against interest rate fluctuations.

Choice B is incorrect. Duration is a measure of the sensitivity of the price of a bond or other

debt instrument to a change in interest rates. While it can be used as part of an immunization

strategy, duration itself does not describe a strategy that aims to safeguard returns on purchased

securities irrespective of interest rate fluctuations.

Choice D is incorrect. Securitization refers to the process by which financial assets are pooled

and sold as securities, it doesn't involve any strategy for mitigating risk from fluctuating interest

rates.

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Q.5407 Joshua is a portfolio manager at AlphaOmega Investments. He's considering diversifying

the firm's short-term investment portfolio by including bankers' acceptances. He recognizes that
bankers' acceptances are short-term instruments primarily used in trade credit transactions,
where a bank guarantees the payment of a customer for an export/import transaction. Joshua
also acknowledges that they offer higher yields than T-bills but lower than Eurocurrency
deposits, and they can be discounted at the Federal Reserve Bank. Despite these advantages,
Joshua is concerned about certain disadvantages associated with bankers' acceptances. Based on
his understanding, which of the following concerns about bankers' acceptances is the most valid?

A. The risk that the bank will default on its guarantee of the acceptance.

B. The availability of bankers' acceptances for certain maturities.

C. The possibility that bankers' acceptances could be subject to negative interest rates.

D. The inability to trade bankers' acceptances in the secondary market

The correct answer is B.

Joshua's valid concern about bankers' acceptances is the lack of availability for certain

maturities. The demand and supply of bankers' acceptances may not always match for certain

maturity periods, which can limit the investment opportunities for a portfolio manager.

A is incorrect. While a bank default is theoretically possible, it is highly unlikely. Banks are

carefully regulated and monitored, and they are typically large, well-established institutions. The

risk of a bank defaulting on its guarantee of a banker's acceptance is generally considered to be

quite low.

C is incorrect. Negative interest rates are a phenomenon that typically occur in broader

economic environments and are not specific to individual instruments such as bankers'

acceptances. Moreover, bankers' acceptances are issued at a discount and mature at par value,

which precludes the possibility of negative interest rates on these instruments.

D is incorrect. Bankers' acceptances actually have an active market for secondary trading,

which means they can be sold before maturity. This adds to their attractiveness by providing

liquidity for the investors.

Things to Remember

Bankers' acceptances, being a promise from a bank to pay the holder a certain amount

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on a future date, are among the safest money market instruments.

They often originate from a financial institution's decision to guarantee the credit of a

customer involved in the export, import, or storage of goods or currency purchasing.

The financial firm becomes the primary obligor in the transaction, committing to pay

the customer's debt in return for a fee.

Bankers' acceptances are discount instruments, sold below par and mature at par. The

return for an investor comes from the acceptance rising in price as it nears its maturity.

Their rates of return typically align closely with yields on Eurocurrency deposits and

Treasury bills.

Eligible bankers' acceptances, usually denominated in U.S. dollars, with a maturity of

six months or less, and related to the export or import of goods or storage of

marketable commodities, can be discounted at the Federal Reserve Banks.

Despite the issuer's obligation to pay at maturity, the current holder of a banker's

acceptance can sell it in the secondary market, thus increasing their reserves and

transferring interest rate risk to another investor.

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Q.5423 ABC Bank currently has been experiencing high loan revenues due to a recent surge in
the demand for loans. The bank intends to sell lower-yielding securities at a loss in order to
reduce its current taxable income. Which of the following tools is the bank most likely utilizing?

A. Tax exposure

B. Tax swap

C. Tax shelter

D. Tax exemption

The correct answer is B.

A tax swap refers to a financial strategy where a bank sells a lower-yielding security at a loss in

order to reduce its current taxable income and simultaneously purchases a higher-yielding

security to maintain their desired investment exposure. The purpose of a tax swap is to generate

a tax benefit by offsetting the realized loss against capital gains or taxable income.

A is incorrect. Tax exposure refers to the financial risk and liability that an individual or entity

faces as a result of their tax obligations. It represents the potential negative impact that taxes

can have on one's financial position and profitability.

C is incorrect. A tax shelter is a legal strategy or investment vehicle that allows individuals or

businesses to minimize their tax liability by reducing their taxable income or claiming

deductions, credits, or exemptions provided by tax laws.

D is incorrect. Tax exemption refers to a legal provision that relieves certain individuals,

organizations, or activities from the obligation to pay taxes on specific types of income or

transactions. It grants an exemption or exclusion from taxation, effectively reducing or

eliminating the tax liability for the eligible entity or activity.

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Q.5424 Chris Colombus is a treasury manager at ABC Bank. Chris is training new interns on the
various investment securities that the bank regularly purchases. Which of the following is a
disadvantage of bankers' acceptances that Chris would highlight in his presentation?

A. Limited resale market.

B. Issued in odd denominations.

C. Low yields relative to other financial instruments.

D. More price risk than T-bills.

The correct answer is B.

Bankers' acceptances are financial instruments used in international trade transactions. They are

essentially a guarantee from a bank to pay a specified amount at a future date. When a company

needs to make an international payment, it may use a banker's acceptance to ensure the

recipient receives the funds. A disadvantage of banker's acceptances is that they are issued in

odd denominations. By “odd denominations,” it means that bankers' acceptances are not issued

in standard or commonly used denominations. This makes it challenging for investors or buyers

to trade or resell these securities. Other disadvantages include the income being taxable and

their limited availability at specific maturities.

A is incorrect. A limited resale market is a disadvantage of short-term municipal obligations.

C is incorrect. Low yields relative to other financial instruments is a disadvantage of treasury

bills.

D is incorrect. Short-term treasury notes and bonds (not banker's acceptances) have more price

risk than T-bills.

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Q.5425 Peter Jones is the Chief Finance Officer at ABC Bank. He wants to reduce the Bank's
overall portfolio risk by adding assets with different risk profiles and correlations to the Bank's
current pool of investment securities. Which of the following securities are considered to have an
implicit guarantee of the government?

A. Commercial paper.

B. Federal agency securities.

C. International eurocurrency deposits.

D. Short-term treasury notes.

The correct answer is B.

Federal agency securities are debt securities issued by various government-sponsored entities

(GSEs) or federal agencies in the United States. These entities are created by the U.S.

government to fulfill specific purposes and support various sectors of the economy. While federal

agency securities are not direct obligations of the U.S. government, they are considered to have

an implicit guarantee or backing by the government.

A is incorrect. Commercial paper refers to short-term debt instruments issued by corporations

and financial institutions to meet their short-term funding needs. It's important to note that while

commercial paper is generally considered a relatively safe investment, it is not entirely risk-free.

C is incorrect. Eurocurrency deposits are large fixed-maturity time deposits issued in million-

dollar denominations by major global banks located in financial centers worldwide, with London

being a prominent hub.

D is incorrect. Short-term treasury notes are debt securities issued by the U.S. Department of

the Treasury with maturities typically ranging from a few days to one year. They are considered

low-risk investments as they are backed by the full faith and credit of the U.S. government.

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Reading 131: Liquidity and Reserves Management: Strategies and

Policies

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Q.3885 ABC Bank Limited predicts its cash inflows and outflows over the next one day to be as in
the following table:

Predicted Cash Inflows and Outflows for ABC Bank Ltd.

Deposit withdrawals $129 Sales of bank assets 61
Deposit inflows $119 Stockholder dividend payments 172
Scheduled loan repayments $122 Revenues from sale of 118
non-deposit services
Acceptable loan requests $90 Repayments of bank borrowings 84
Borrowings from the $110 Operating expenses 70
money market

Calculate the bank’s projected net liquidity position within the next one day.

A. -$15

B. -$23

C. $15

D. $23

The correct answer is A.

Cash Inflows Amount Cash Outflow Amount

Deposit inflows $119 Deposit withdrawals $129
Borrowings from the $110 Acceptable loan requests $90
money market
Sales of bank assets 61 Stockholder dividend 172
payments
Revenues from sale of 118 Repayments of bank 84
non-deposit services borrowings
Scheduled loan repayments $122 Operating expenses 70
Total Cash Inflows $530 Total Cash Outflow $545

A financial firm’s net liquidity position = Supplies of liquidity flowing into the financial firm -

Demands on the financial firm for liquidity

= Total cash inflow − Total cash outflow

= $530 − $545 = −$15

Therefore, ABC Bank Ltd. has a projected net liquidity deficit of $15

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Q.3886 Prime savings has a projected net liquidity surplus of $31 million in the coming week.
Given the following table showing Prime Savings’ supply and demand for liquidity, calculate the
total expected stockholder dividend payments for the coming week.

Supplies of Liquidity Flowing into ABC Bank Ltd. Savings

Deposit inflows $31
Revenues from nondeposit service sales $23
Scheduled repayments of previous $5
made customer loans $28
Asset sales $15
Money market borrowings $20
Total supply of liquidity 122

The demand for liquidity flowing from ABC Bank Ltd. savings
Expected quality loan demand $31
Necessary repayments of previous $26
borrowings
Deposit withdrawals $22
Disbursements to cover operating expenses $10
Total demand for liquidity excluding $89
stockholder dividend payments

A. $ 3 million

B. $2 million

C. $7 million

D. $11 million

The correct answer is B.

Net Liquidity Surplus = Total liquidity supply − Total liquidity demand

− Stockholder dividend payments
$31 million = $122 million − $89 million
− Stockholder dividend payments

Therefore, expected stockholder dividend payments must equal $2 million for the coming week.

Q.3888 XYZ Bank has the following forecasts for its checkable deposits, time and savings
deposits, commercial loans, and consumer loans over the next eight months as follows.

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XYZ Bank Forecasts for Deposits and Loans Over the Next Eight Months in US$
Month Checkable Time and Savings Commercial Consumer
Deposits Deposits Loans Loans
January 219 639 729 209
February 216 591 731 267
March 203 593 783 265
April 189 580 785 213
May 210 562 797 211
June 187 589 789 234
July 189 626 791 232
August 209 618 768 230

Employ the sources and uses of funds approach to determine the month, which is likely to have a
liquidity surplus.

A. February

B. March

C. June

D. August

The correct answer is D.

Total Deposits = Checkable Deposits + Time & Saving Deposits

Total Loans = Commercial Loans + Consumer Loans

Change in Previous Total Month's Deposits = Current month's total deposits - Previous months

total deposits

Change in Previous Total Month's Loans = Current month's total loans - Previous month's total

loans

Estimated Liquidity Deficit or Surplus = Change from previous month's total deposits - Change

from previous month's total loans

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Month Total Change from Total Change from Estimated

Deposits Previous Loans Previous Liquidity Defecit
Month's T.Deposits Month's T.Loans or Surplus
January 858 0 938 0 0
February 807 −51 998 60 −111
March 796 −11 1048 50 −61
April 769 −27 998 −50 23
May 772 3 1008 10 −7
June 776 4 1023 15 −11
July 815 39 1023 0 39
August 827 12 998 −25 37

The bank has projected surpluses in April, July, and August. The surpluses should be invested

profitably.

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Q.3889 XYZ Bank has the following forecasts for its checkable deposits, time and savings
deposits, commercial loans, and consumer loans over the next eight months as follows.

XYZ Bank Forecasts for Deposits and Loans Over the Next Eight Months in US$
Month Checkable Time and Savings Commercial Consumer
Deposits Deposits Loans Loans
January 219 639 729 209
February 216 591 731 267
March 203 593 783 265
April 189 580 785 213
May 210 562 797 211
June 187 589 789 234
July 189 626 791 232
August 209 618 768 230

Using the sources and uses of funds approach, which of the following months are likely to result
in a liquidity deficit?

A. February

B. April

C. July

D. August

The correct answer is A.

XYZ Bank has liquidity deficits in half of the months, i.e., February, March, May, and June as in
the following table:

Month Total Change from Total Change from Estimated

Deposits Previous Liabilities Previous Liquidity Deficit
month month or Surplus
January 858 0 938 0 0
February 807 −51 998 60 −111
March 796 −11 1048 50 −61
April 769 −27 998 −50 23
May 772 3 1008 10 −7
June 776 4 1023 15 −11
July 815 39 1023 0 39
August 827 12 998 −25 37

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Q.3890 XYZ can use the following methods to meet its liquidity deficit. Which of the options does
not apply?

A. Aggressive advertising to attract NOW deposits

B. Selling some of their securities

C. Aggressively issuing new loans

D. Selling securities under agreements to repurchase

The correct answer is C.

Aggressively issuing new loans is not a suitable strategy for addressing a liquidity deficit. In fact,

it can exacerbate the problem. When a financial institution issues loans, it essentially provides

funds to borrowers. This reduces the institution's available liquid assets. If the institution is

already facing a liquidity deficit, issuing new loans can further deplete its liquid assets, making

the deficit worse. Therefore, aggressively issuing new loans is not a viable strategy for

addressing a liquidity deficit.

Choice A is incorrect. Aggressive advertising to attract NOW (Negotiable Order of Withdrawal)

deposits can be a suitable strategy for addressing a liquidity deficit. NOW deposits are demand

deposit accounts that allow the holder to write checks against the money deposited. This can

increase the liquidity of XYZ by attracting more funds.

Choice B is incorrect. Selling some of their securities is also a viable strategy for addressing a

liquidity deficit. By selling securities, XYZ can convert these assets into cash, thereby increasing

its liquid resources.

Choice D is incorrect. Selling securities under agreements to repurchase (also known as repo

transactions) can help address a liquidity deficit in the short term. In such transactions, XYZ sells

securities and agrees to repurchase them at a later date at an agreed price. This provides

immediate cash inflow and hence increases liquidity.

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Q.3891 Suppose that a bank's liquidity division estimates that it holds $20 million in hot money
deposits and other IOUs against which it holds 75% liquidity reserve, $12 million in vulnerable
funds against which it plans to hold a 15% reserve and $15 million in stable funds against which
it holds a 10% liquidity reserve. Its loans are currently standing at $130 million, but have
recently reached as high as $150 million and that the bank expects its loans to grow by 8%
annually. Assuming that the reserve requirements on liabilities currently stand at 4%, what is the
bank’s total liquidity requirement.

A. $49.57

B. $68.30

C. $73.68

D. $75.60

The correct answer is A.

Liability liquidity reserve =0.75 × Hot money deposits and non-deposit funds
− legal reserves held
+ 0.15 × (Vulnerable deposit and non
− deposit funds-Legal reserves held)
+ 0.10 × (Stable deposits and non-deposit funds
− Legal reserves held) + Loan liquidity requirement
= 0.75 × (20 − 0.04 × 20)
+ 0.15 × (12 − 0.04 × 12)
+ 0.10 × (15 − 0.04 × 15)
+ 150 × 0.08 + (150 − 130)
= $49.57 million
(held in liquid assets and additional borrowing capacity)

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Q.3894 The following financial information pertains to Daylight Bank:

Assets: Amount
in US$ in
millions
Cash and due from depository institutions 546
U.S. Treasury securities 382
Other securities 550
Pledged securities 503
Federal funds sold and reverse 396
repurchase agreements
Net loans and leases 2, 374
Total Assets 3, 431
Liabilities:
Demand deposits 741
Savings deposits 976
Time deposits 1, 351
Total deposits 2, 686
Core deposits 1, 111
Brokered deposits 214
Federal funds purchased and 488
repurchase agreements
Other money market borrowings 186

Calculate Daylight Bank’s net federal funds and repurchase agreements position.

A. -11.54%

B. -2.68%

C. 2.68%

D. 11.54%

The correct answer is B.

Net federal funds and repurchase agreements position

= (Federal funds sold and reverse repurchase agreements
Federal funds purchased and repurchase agreements
−
Total assets
396 − 488
= = −2.68%
3431

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Q.3895 The following financial information pertains to Daylight Bank:

Assets: Amount
in US$ in
millions
Cash and due from depository institutions 546
U.S. Treasury securities 382
Other securities 550
Pledged securities 503
Federal funds sold and reverse 396
repurchase agreements
Net loans and leases 2, 374
Total Assets 3, 431
Liabilities:
Demand deposits 741
Savings deposits 976
Time deposits 1, 351
Total deposits 2, 686
Core deposits 1, 111
Brokered deposits 214
Federal funds purchased and 488
repurchase agreements
Other money market borrowings 186

Calculate Daylight Bank’s cash position ratio.

A. 7.97%

B. 11.13%

C. 15.91%

D. 32.38%

The correct answer is C.

Cash and cash deposits due from depository institutions

Cash position indicator =
total assets
546
= = 15.91%
3431

A higher proportion of cash implies that the institution is in a stronger position to handle

immediate cash needs.

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Q.3896 The following indicators are negative liquidity indicators. Which is the odd one out?

A. Capacity ratio

B. Pledged securities ratio

C. Hot money ratio

D. All of the above

The correct answer is C.

The Hot money ratio is not a negative liquidity indicator. This ratio is used to determine whether

an institution has balanced its volatile liabilities with the money market instruments it holds.

These instruments can be quickly sold to cover liabilities if necessary. Therefore, a high hot

money ratio can indicate a strong liquidity position as the institution has a significant amount of

liquid assets that can be quickly converted into cash to meet its short-term obligations. This is

contrary to the concept of a negative liquidity indicator, which typically signifies potential

liquidity risks or problems.

Choice A is incorrect. The Capacity ratio is indeed a negative liquidity indicator. It measures

the proportion of an institution's assets that are financed by debt, and a higher ratio indicates

greater financial risk due to potential difficulties in meeting debt obligations.

Choice B is incorrect. The Pledged securities ratio also falls under the category of negative

liquidity indicators. This ratio represents the proportion of an institution's assets that are

pledged as collateral for loans or other obligations, and a higher ratio suggests increased risk

due to reduced flexibility in managing those assets.

Choice D is incorrect. As explained above, both Capacity Ratio and Pledged Securities Ratio

are negative liquidity indicators, hence this option cannot be correct.

Q.3897 No financial institution can confidently tell if it has sufficient liquidity until it has passed
the market’s test. Which of the following is a signal that the management should take note of

A. Stock price behavior

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B. Public confidence

C. Borrowings from the central bank

D. All of the above

The correct answer is D.

All of the options listed are signals that management should take note of when assessing the

liquidity of a financial institution.

Stock price behavior: The behavior of a firm's stock price can be a strong indicator of its

liquidity. If investors perceive that the institution is experiencing a liquidity crisis, they may sell

their shares, leading to a decline in the firm's stock prices. This is because investors are wary of

the risks associated with a liquidity crisis, such as the firm's inability to meet its obligations.

Public confidence: Public confidence is another important factor that can signal liquidity

issues. If customers lose confidence in the firm due to perceived risks, they may withdraw their

investments or stop doing business with the firm. This can lead to a decrease in the firm's liquid

assets, exacerbating the liquidity crisis.

Borrowings from the central bank: If a firm has been forced to borrow in larger volumes and

more frequently from the central bank in its home territory, it could be a sign of liquidity

problems. Central bank officials may also begin to question the institution's borrowings, which

should be a red flag for the management. Therefore, all of the above are signals that

management should take note of when assessing liquidity.

Choice A is incorrect. While stock price behavior can be an indicator of a company's financial

health, it does not directly signal liquidity issues. Stock prices are influenced by a variety of

factors, including market sentiment, economic indicators, and company-specific news. Therefore,

relying solely on stock price behavior to gauge liquidity risk could lead to inaccurate conclusions.

Choice B is incorrect. Public confidence can impact a financial institution's ability to raise

funds and maintain liquidity; however, it is not a direct measure of liquidity risk. Public

confidence can fluctuate based on numerous factors that may or may not be related to the

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institution's actual financial condition.

Choice C is incorrect. Borrowings from the central bank are indeed an important source of

emergency funding for banks facing severe liquidity problems; however, frequent or large-scale

borrowings could indicate underlying issues with the bank's operations or risk management

practices rather than being a direct signal of potential liquidity issues.

Q.3898 One who is responsible for ensuring that the institution maintains an adequate level of
legal reserves is known as?

A. Chief finance officer

B. Chief operational officer

C. Money position manager

D. None of the above

The correct answer is C.

Choice A is incorrect. The Chief Finance Officer (CFO) of a financial institution does play a

significant role in the overall financial management, but they are not typically responsible for

maintaining an adequate level of legal reserves. This task requires specialized knowledge and

quick decision-making skills related to the institution's money position, which is usually the

responsibility of a Money Position Manager.

Choice B is incorrect. The Chief Operational Officer (COO) oversees the day-to-day

administrative and operational functions of a business. While they may be involved in strategic

decisions about reserves, they do not directly manage or maintain legal reserves.

Choice D is incorrect. There is indeed a specific role within financial institutions that handles

the maintenance of legal reserves - it's not 'None of the above'. As mentioned earlier, this role

typically falls under the purview of a Money Position Manager.

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Q.3899 A contractual agreement between bank and customer that permits the bank to move
funds out of a customer checking account to generate higher returns for the customer and lower
reserve requirements for the bank is known as:

A. Clearing balance

B. Sweep account

C. Legal reserve

D. Reserve Maintainance

The correct answer is B.

Choice A is incorrect. A clearing balance refers to the funds that a bank keeps in its account at

a Federal Reserve Bank to meet its reserve requirement and clear financial transactions, not an

agreement between a bank and its customer for fund transfers.

Choice C is incorrect. The legal reserve is the minimum amount of funds that a bank must hold

as reserves, according to central banking regulations. It does not involve any contractual

agreement with customers for transferring funds from their checking accounts.

Choice D is incorrect. Reserve maintenance refers to the process by which banks manage their

required reserves, but it does not refer to any specific type of contractual agreement between a

bank and its customer for fund transfers.

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Q.3900 You are provided with a simple balance sheet for Loud bank. When the bank’s depositors
withdraw $200 million, the bank faces a liquidity challenge.

Assets Amount
Cash $48
Securities $940
Loans $3, 932
Total assets 4, 920
Liabilities and Equity
Deposits $3, 948
Other liabilities $440
Equity $532
Total Liabilities and equity $4, 920

If Loud bank employs the asset conversion method and decides to sell its securities to cover the
deposit drain, what happens to the size of the bank due to withdrawal?

A. Increase

B. Decrease

C. No change

D. Cannot establish from the information

The correct answer is B.

The size of the bank would decrease (shrink) by the amount of deposit withdrawal. Therefore,
the total assets would decline to $4,920-$200 = $4,720 million

Q.3901 You are provided with a simplified balance sheet for Loud bank. When the bank’s
depositors withdraw $200 million, the bank faces a liquidity challenge.

Assets Amount
Cash $48
Securities $940
Loans $3, 932
Total assets 4, 920
Liabilities and Equity
Deposits $3, 948
Other liabilities $440
Equity $532
Total Liabilities and equity $4, 920

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Suppose that Loud bank’s management depends on borrowed liquidity (liability management
strategy) to cover the deposit drain. What happens to the size of the bank?

A. Increase

B. Decrease

C. No change

D. Cannot establish from the information

The correct answer is C.

Liability management, also known as purchased liquidity strategy, involves borrowing

immediately spendable funds to cover all anticipated demands for liquidity. This strategy allows a

firm to keep the volume and composition of its assets portfolio unchanged if it is satisfied with

the assets it currently holds. In the case of Loud bank, the withdrawal of $200 million by its

depositors presents a liquidity challenge. However, if the bank's management decides to borrow

an amount equal to the withdrawal, the size of the bank's balance sheet would remain

unchanged. This is because the decrease in deposits due to the withdrawal would be offset by

the increase in other liabilities due to the borrowed funds. Therefore, the total liabilities and

equity of the bank would remain the same, resulting in no change in the size of the bank.

Choice A is incorrect. The size of the bank will not increase. This is because the bank is

borrowing funds to cover a withdrawal, not to expand its assets or liabilities beyond their current

levels.

Choice B is incorrect. The size of the bank will also not decrease. Although there has been a

withdrawal, this has been offset by borrowing funds, so the overall size of the bank's balance

sheet remains unchanged.

Choice D is incorrect. We can establish from the information provided that there would be no

change in the size of Loud Bank if it borrows an amount equal to the withdrawal. This strategy

allows Loud Bank to maintain its current asset portfolio and meet liquidity demands without

altering its balance sheet's overall size.

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Q.3902 You are provided with a simplified balance sheet for Loud bank. The bank faces liquidity
challenge the moment the bank depositors withdraw $200 million

Assets Amount
Cash $48
Securities $940
Loans $3, 932
Total assets 4, 920
Liabilities and Equity
Deposits $3, 948
Other liabilities $440
Equity $532
Total Liabilities and equity $4, 920

Loud Bank requires cash to cover its unexpected loan demand. The loan officer has $400 million
in loans that she wants to make. Using Loud Bank’s balance sheet, what would happen to the
size of the Loud bank if liability management strategy is used to provide funds for the loans?

A. Increase

B. Decrease

C. No change

D. Cannot establish from the information

The correct answer is A.

The size of the bank, in this context, refers to the total assets of the bank. When a bank uses a

liability management strategy to fund loans, it essentially borrows money to lend it out. This

increases the bank's liabilities (as it now owes money to the entity it borrowed from) and its

assets (as it now has the loan it gave out as an asset). In this case, the loan officer wants to make

$400 million in loans. This would increase the bank's total assets by $400 million, from $4,920

million to $5,320 million. Therefore, the size of the bank would increase.

Choice B is incorrect. A decrease in the overall size of Loud Bank would imply a reduction in

its assets, liabilities, or both. However, implementing a liability management strategy to fund

loans would involve increasing the bank's liabilities (through borrowing or issuing more equity),

which would then be used to increase its assets (by providing more loans). Therefore, this

strategy would not lead to a decrease in the bank's overall size.

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Choice C is incorrect. No change in the overall size of Loud Bank implies that its total assets

and total liabilities remain constant. However, as explained above, implementing a liability

management strategy involves increasing both these components of the balance sheet - hence

there will be an increase rather than no change.

Choice D is incorrect. The information provided about Loud Bank's current financial situation

and proposed strategy is sufficient to establish that implementing a liability management

strategy will result in an increase in the bank's overall size.

Q.3903 Suppose that a bank has a clearing balance averaging $2.5 million during a certain two-
week maintenance period and the Federal funds' interest rate over this same period averaged
8%. Calculate the Federal Reserve credit that it would earn:

A. $547.95

B. $6,575.34

C. $ 7,777.8

D. $15,342.47

The correct answer is C.

Reserve credit = Average clearing balance × Annualized federal funds rate

14 days
×( )
360 days
14
= $2 , 500 , 000 × 0.08 × = $7, 777.8
360

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Q.3904 Suppose Grand Bank's liquidity manager estimates that the bank experiences a liquidity
deficit of $500 million in the coming month with a probability of 45%, a $575 million liquidity
deficit with a probability of 20%, a liquidity surplus of $350 million with a probability of 25%,
and a $100 million liquidity surplus with a probability of 10% What is the bank’s expected
liquidity requirement?

A. -$10.00

B. -$242.50

C. $22.75

D. $30.00

The correct answer is B.

Liquidity Deficit or Probability Expected Value

Surplus in Millions
$(500.00) 45% $(225.00)
$(575.00) 20% $(115.00)
$350.00 25% $87.50
$100.00 10% $10.00
100% $(17.50)

Expected Liquidity Requirement = 0.45 × (−$500 million) + 0.20 × (−$575 million)

+ 0.25 × (+$350 million) + 0.10 × (+$100 million)
= −$225 million − $115 million
+ $87.50 million + $10 million
= −$242.50 million

The bank is faced with an expected liquidity deficit of -$242.5 million in the coming month.

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Q.5379 The following are ABC Bank's estimates of cash inflows and outflows for the coming
week.

Cash Flows USD Million

Scheduled loan repayments 150
Acceptable loan requests 110
Borrowings from money market 120
Operating expenses 50
Deposit withdrawals 80
Deposit inflows 70
Stockholders dividend payments 30
Repayments of bank borrowings 50

What is ABC Bank's net liquidity position at the end of the coming week?

A. 20

B. -20

C. 120

D. 150

The correct answer is A.

Net liquidity position = Cash inflows − Cash outflows

Cash Inflows Cash Outflows

Deposit inflows Deposit withdrawals
Scheduled loan repayments Acceptable loan requests
Borrowings from money market Operating expenses
Stockholders dividend payments
Repayments of bank borrowings

Therefore, ABC Bank's net liquidity position at the end of the coming week is given by:

= (70 + 150 + 120) − (80 + 110 + 50 + 30 + 50) = USD 20 million

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Q.5382 John Doe is an investment analyst at ABC Investment Bank. ABC Investment Bank is the
underwriter for a commercial paper that one of the country's national banks wants to issue. John
Doe is performing an analysis of the national bank's financial statements and calculating its
liquidity indicators over the past five years. Which of the following trends over this period should
John Doe be most concerned about?

A. The ratio of pledged securities at the bank has been decreasing.

B. The loan commitments ratio for the bank has been decreasing.

C. The average net position of the bank in repurchase agreements and government funds
has increased.

D. The capacity ratio of the bank has been rising.

The correct answer is D.

The capacity ratio, which compares net loans and leases to total assets, indicates a decrease in

liquidity when net loans and leases increase in proportion to total assets. This is primarily due to

the illiquid nature of loans and leases.

A is incorrect. Liquidity improves when the number of pledged or unavailable securities

decreases in relation to the total number of securities.

B is incorrect. When loan commitments as a percentage of assets decline, liquidity rises.

C is incorrect. When overnight loans are more than overnight borrowing, liquidity rises.

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Reading 132: Intraday Liquidity Risk Management

Q.3905 Andera Jeremy is a bank treasurer in ABC bank; he realizes that the bank is experiencing
liquidity shortage during the day, and it is unable to pay XYZ bank for its foreign transaction
services owed. Jeremy suggests the use of intraday liquidity as a remedy. Which of the following
definitions best applies to Jeremy's use of the funds?

A. Asset purchasing and funding.

B. Funding for Nostro accounts

C. Collateral pledging

D. Outgoing wire transfers

The correct answer is B.

In the given scenario, the primary purpose of acquiring the intraday fund is to settle the payment

owed to XYZ bank. This purpose aligns with the definition of 'Funding for Nostro accounts'.

Nostro accounts refer to an account that a bank holds in a foreign currency in another bank.

Banks manage the cash they place in a correspondent bank account to a target average monthly

balance as part of the return for providing banking services. The funds in these accounts are

used to settle transactions with other banks, such as the payment owed to XYZ bank in this case.

Therefore, the use of intraday liquidity suggested by Jeremy can be best described as 'Funding

for Nostro accounts'.

Choice A is incorrect. Asset purchasing and funding refers to the acquisition of assets or

investments for the purpose of generating returns. This does not align with Jeremy's proposed

use of funds, which is to address a liquidity shortage issue during the day.

Choice C is incorrect. Collateral pledging involves using an asset as a guarantee for repayment

of a loan, and it does not directly address liquidity shortages during the day. It's more related to

securing long-term loans rather than managing intraday liquidity.

Choice D is incorrect. Outgoing wire transfers refer to electronic transfer of funds from one

bank or credit union to another. While this could be part of managing intraday liquidity, it doesn't

specifically address the issue Jeremy identified - delay in payment due to liquidity shortage.

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Q.3907 A bank treasurer has been getting liquidity recovery during the day by borrowing Fed
funds, London interbank offered rate, and Eurodollar deposits. Which of the following most
accurately states the source under which the credit mentioned above falls?

A. Other term funding

B. Liquid assets

C. Overnight borrowing

D. Intraday credit

The correct answer is C.

Choice A is incorrect. Other term funding refers to longer-term borrowings, not the short-term

liquidity management tools like Fed funds, LIBOR, and Eurodollar deposits that are used for

managing liquidity on a daily basis.

Choice B is incorrect. Liquid assets are cash or assets that can be easily converted into cash.

While Fed funds, LIBOR and Eurodollar deposits can provide liquidity, they themselves are not

considered liquid assets.

Choice D is incorrect. Intraday credit refers to loans that must be paid back within the same

trading day. Although these resources can help manage intraday liquidity needs, they do not fall

under this category as they are not loans but rather interbank borrowing rates and deposit types.

Q.3908 A bank treasurer working for FGH bank has been given an intraday credit whose use had
been determined according to the following characteristics, which he had considered and
approved before the credit processing. The characteristics are listed below:

1. Have a single settlement per day, which is done majorly in the late afternoon timeframe.
2. May either serve as a source or use of funds reliant on the net position of a participant
on any given day.
3. They can be forecast for securities that have multi-day settlements more difficult for
same-day settlement activity

Which of the following choices most accurately outlines the use under which the intraday credit
should be classified?

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A. Outgoing wire transfers

B. Funding for Nostro accounts

C. Collateral pledging

D. Settlements at Payment, Clearing, and Settlement (PCS) Systems

The correct answer is D.

The characteristics outlined in the question are indicative of the operations of Payment, Clearing,

and Settlement (PCS) Systems. PCS systems are integral to the financial markets, facilitating the

exchange of payments, securities, and other financial transactions among financial institutions.

They typically have a single settlement per day, often in the late afternoon. The net position of a

participant on any given day can either serve as a source or use of funds, depending on the

transactions that have taken place. Forecasting for securities with multi-day settlements can be

more challenging for same-day settlement activity due to the complexity and volume of

transactions. Therefore, the intraday credit in question should be classified under Settlements at

PCS Systems.

Choice A is incorrect. Outgoing wire transfers are not the correct category for this intraday

credit use. Wire transfers typically involve the electronic transfer of funds from one account to

another, often across different financial institutions, and do not necessarily align with the

characteristics described in the question such as a single settlement per day or forecasting for

securities with multi-day settlements.

Choice B is incorrect. Funding for Nostro accounts does not fit with these characteristics

either. Nostro accounts are held by a bank in a foreign country (in that country's currency), and

while they can serve as a source or use of funds depending on the net position of a participant on

any given day, they do not typically involve single daily settlements or forecasting for securities

with multi-day settlements.

Choice C is incorrect. Collateral pledging involves using assets as security against a loan and

does not match up with the characteristics described in this scenario such as primarily late

afternoon settlements and more challenging forecasts for same-day settlement activity.

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Q.3909 A group of investors was discussing intraday credit as a source of intraday liquidity. An
expert was invited to take them through the characteristics of intraday credit:

I. Intraday credit is permitted during business hours and covered by the close of business.
II. Lines are often uncommitted and provided without interest charges.
III. Central banks are the only sources of intraday credit for the banking system
IV. Low-interest rates are attached to intraday credit lines.

Which of these statements accurately outlines the characteristics of intraday credit?

A. I & IV

B. III and IV

C. I & II

D. All of the above

The correct answer is C.

Credit lines are often uncommitted and provided without interest rates, however, we have some

changes, especially in Europe.

Moreover, the credit is permitted during business hours and covered by the close of business.

Statement III is incorrect: Central banks are not the only sources of intraday credit as FMUs,

and other institutions can extend the credit to their banks.

Statement IV is incorrect: Intraday credit is issued free of interest

Things to Remember

Intraday credit is a crucial component of the financial system, providing liquidity to financial

institutions during business hours. It is typically uncommitted and provided without interest

charges. While central banks can provide intraday credit, they are not the only sources. Financial

Market Utilities (FMUs) and other institutions can also extend intraday credit to their banks. It's

important to note that intraday credit is not a profit-generating activity for the lender, but a

service to ensure the smooth functioning of financial markets.

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Q.3910 A sound intraday risk structure for overseeing intraday liquidity is of the utmost
importance in risk management. Which of the following accurately states the characteristics of a
sound intraday risk structure?

A. Active risk management

B. Integration with risk governance

C. Risk assessment

D. All of the above

The correct answer is D.

A sound intraday risk structure for overseeing intraday liquidity risk is characterized by all the

options listed. Active risk management involves the continuous monitoring and managing of

risks. It is a proactive approach that seeks to identify potential risks before they materialize and

take appropriate measures to mitigate them. Integration with risk governance refers to the

alignment of the intraday risk structure with the overall risk governance framework of the

organization. This ensures that the intraday risk structure is in sync with the organization's risk

appetite, risk policies, and risk management strategies. Risk assessment is the process of

identifying, analyzing, and evaluating risks. In the context of intraday liquidity risk, risk

assessment involves the identification and evaluation of potential liquidity risks that could arise

during the trading day. Therefore, all these elements - active risk management, integration with

risk governance, and risk assessment - are integral to a sound intraday risk structure.

Choice A is incorrect. While active risk management is a crucial feature of a robust intraday

risk structure, it alone does not constitute the entirety of such a structure. Active risk

management involves continuously monitoring and managing risks as they arise, but this needs

to be complemented by other features like integration with risk governance and regular risk

assessment for the overall structure to be effective.

Choice B is incorrect. Integration with risk governance ensures that the intraday risk structure

aligns with the organization's overall approach to managing risks. However, this integration

alone cannot ensure an effective intraday risk structure without active management of risks and

regular assessment of these risks.

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Choice C is incorrect. Risk assessment involves identifying potential risks and evaluating their

possible impact on the organization's operations. While it forms an integral part of any sound

intraday risk structure, it needs to be combined with active management of these identified risks

and their integration into the broader framework of organizational governance for maximum

effectiveness.

Q.3911 FRM students were discussing the measures for quantifying and monitoring risk levels.
They finally agreed to write down every two measures they think are accurate. Which of the
following states the most accurate measures?

A. Daily maximum intraday liquidity usage and client intraday credit usage

B. Client intraday credit usage and total bank intraday credit lines available and usage

C. Total bank intraday credit lines available and usage and total intraday credit lines to
clients and counterparties.

D. Time-sensitive obligations like settlement positions and payment throughput

The correct answer is A.

The measures mentioned in this option, namely 'Daily maximum intraday liquidity usage' and

'client intraday credit usage', are indeed accurate measures for quantifying risk levels. The 'Daily

maximum intraday liquidity usage' refers to the highest amount of liquidity that a financial

institution uses within a single day. This measure is crucial as it provides insights into the

liquidity needs of the institution and can help in identifying potential liquidity shortfalls. On the

other hand, 'client intraday credit usage' refers to the amount of credit that clients use within a

single day. This measure is important as it provides an understanding of the credit risk exposure

of the institution to its clients. Both these measures together provide a comprehensive view of

the risk levels and are therefore the most accurate among the given options.

Choice B is incorrect. While client intraday credit usage and total bank intraday credit lines

available and usage are important measures, they do not provide a complete picture of risk

levels. They fail to account for the maximum liquidity usage which is crucial in quantifying risk

levels.

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Choice C is incorrect. Total bank intraday credit lines available and usage, along with total

intraday credit lines to clients and counterparties, although significant, do not represent the

most precise measures for quantifying risk levels. These metrics overlook daily maximum

intraday liquidity usage which plays a vital role in assessing overall financial risk.

Choice D is incorrect. Time-sensitive obligations like settlement positions and payment

throughput are important aspects of financial operations but they do not directly quantify risk

levels as effectively as daily maximum intraday liquidity usage or client intraday credit usage

would.

Q.3912 A junior liquidity manager at XYZ Ltd. inquiries from his colleagues about the
perspectives employed by leading institutions to monitor their intraday liquidity risk. He gets the
following options:

I. The amount of intraday credit the institution utilizes

II. The amount of intraday credit that the institution extends to clients
III. Total payments
IV. Settlement positions

Which of the following options are correct?

A. I and II

B. I and III

C. II and III

D. None

The correct answer is A.

The two perspectives for monitoring intraday liquidity risk are the amount of intraday credit the

institution is extending to clients and the amount of intraday credit the institution utilizes.

Intraday credit is a critical component of liquidity management. It refers to the short-term funds

that an institution borrows or lends during the course of a single trading day. The amount of

intraday credit that an institution utilizes can provide insights into its liquidity needs and risk

exposure. Similarly, the amount of intraday credit that an institution extends to its clients can

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indicate the level of risk that it is willing to take on. By monitoring these two aspects, an

institution can effectively manage its intraday liquidity risk.

Choice B is incorrect. While the volume of intraday credit the institution employs (I) is a

crucial perspective for monitoring intraday liquidity risk, the total payments made by the

institution (III) does not provide a comprehensive view of this risk. Total payments do not

necessarily reflect the liquidity position of an institution as they do not account for incoming

funds or other sources of liquidity.

Choice C is incorrect. The volume of intraday credit that the institution provides to its clients

(II) and total payments made by the institution (III) are both important factors, but they do not

fully capture all aspects of intraday liquidity risk. Specifically, they overlook how much intraday

credit an institution itself uses which can be a significant source of risk.

Choice D is incorrect. As explained above

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Q.3913 A bank has been keeping statistics necessary for understanding intraday flows. The
statistics have been listed below: identify the pair that states the most accurate statistics for
understanding intraday flows.

A. Payment amounts and times for each processing step in the payment workflow.

B. Time received or originated and credit status

C. Past credit position and any suspensions of the payment

D. Payer and payee and past credit position

The correct answer is A.

Payment amounts and times for each processing step in the payment workflow are indeed the

most accurate statistics for understanding intraday flows. Intraday flows refer to the movement

of funds within a single trading day. Therefore, knowing the payment amounts and the times for

each processing step can provide a detailed picture of how funds are moving throughout the day.

This information can help banks manage their liquidity, identify potential bottlenecks in the

payment workflow, and make more informed decisions about their operations.

Choice B is incorrect. While the time a payment was received or originated and the credit

status of the payer can provide some insight into intraday flows, they do not offer as

comprehensive a view as payment amounts and times for each processing step. The latter allows

banks to track funds throughout their entire journey within a single trading day, providing more

accurate insights.

Choice C is incorrect. Past credit position and any suspensions of the payment may be useful

for assessing credit risk, but they do not directly contribute to understanding intraday flows.

These statistics are more backward-looking and do not necessarily reflect current fund

movements within a single trading day.

Choice D is incorrect. Information about payer and payee along with past credit position can

be useful in assessing counterparty risk but it does not provide detailed insights into intraday

flows. It lacks information on timing or amount of payments which are crucial for understanding

movement of funds within a single trading day.

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Q.3914 A bank has been keeping statistics on payer and payee information as a way of
understanding its intraday flows, payment system used, any suspensions of the payment, time
received or originated, and routing information. Under which measure of understanding intraday
flow does the above statistics most accurately lie?

A. Total payments

B. Other cash transactions

C. Settlement positions

D. Total intraday credit lines to clients and counterparties

The correct answer is A.

The statistics mentioned in the question are most accurately represented by the total payments

measure for understanding intraday flows. This measure involves tracking all payments made

and received by the bank during the intraday period. It includes details about the payer and

payee, the payment system used, any suspensions of the payment, the time the payment was

received or originated, and routing information. By analyzing these statistics, the bank can gain

valuable insights into its intraday payment flows, which can help it manage its liquidity more

effectively and make more informed decisions about its financial operations.

Choice B is incorrect. Other cash transactions refer to all other forms of cash inflows and

outflows that are not related to payments. These could include investments, borrowings, or any

other form of financial transaction. The data mentioned in the question specifically pertains to

payment-related information and does not encompass all other cash transactions.

Choice C is incorrect. Settlement positions refer to the net obligations that a financial

institution has at the end of a trading day. While payer and payee data can contribute towards

understanding settlement positions, it does not provide a complete picture as it excludes other

factors such as securities trades, foreign exchange deals etc.

Choice D is incorrect. Total intraday credit lines to clients and counterparties refers to the

maximum amount that can be borrowed by clients or counterparties from the financial institution

within a single day. This measure does not directly relate with payer/payee data or payment

system details mentioned in the question.

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Q.3915 Which of the following measures is derived by comparing a client's peak daily intraday
overdraft to the established credit line?

A. Client intraday credit usage

B. Payment throughput

C. Daily maximum intraday liquidity usage

D. Total bank intraday credit lines available and usage

The correct answer is A.

Client intraday credit usage is the measure that is derived by comparing a client's peak daily

intraday overdraft to the established credit line. This measure is crucial as it provides an

indicator of the necessary liquidity required to support a client's business activities. It helps

banks to understand the client's credit usage pattern and manage their credit lines effectively.

This measure is particularly important in managing the risk associated with intraday credit and

ensuring that the client does not exceed their credit limit.

Choice B is incorrect. Payment throughput refers to the total value of payments that can be

processed by a system within a given time period. It does not involve comparing a client's

highest daily intraday overdraft to their established credit line.

Choice C is incorrect. Daily maximum intraday liquidity usage refers to the maximum amount

of liquidity used by an entity during a single day, which may include various transactions and not

just overdrafts compared to credit lines.

Choice D is incorrect. Total bank intraday credit lines available and usage would refer to the

overall capacity of the bank for providing intraday credit and how much of it has been utilized,

rather than focusing on individual client's highest daily intraday overdraft in relation to their

established credit line.

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Q.3916 A bank XYZ usually monitors intraday and end-of-day settlement positions at every
financial market utility in which it participates. It further maximizes the volume of the
transaction-level. The details are taken and stored for further analysis. Which of the following
indicates the most accurate measure for understanding intraday flow that the bank uses?

A. Other cash transactions

B. Total payments

C. Total bank intraday credit lines available and usage

D. Settlement positions

The correct answer is A.

Other cash transactions are the most accurate measure for understanding intraday flow that the

bank uses. In the context of Bank XYZ, it monitors intraday and end-of-day settlement positions

at every financial market utility in which it participates. This monitoring process involves other

cash transactions, which are transactions that do not involve the exchange of physical cash but

are instead conducted electronically or through other means. The bank also maximizes the

volume of transaction-level detail taken and stored for further analysis. This detail includes data

from other cash transactions, which can provide valuable insights into the bank's intraday flow.

Therefore, other cash transactions are the most accurate measure for understanding the

intraday flow that Bank XYZ uses.

Choice B is incorrect. Total payments do not provide a comprehensive understanding of the

intraday flow as they only account for the outgoing funds and not the incoming funds or available

credit lines. They also lack transaction-level detail which is a priority for Bank XYZ.

Choice C is incorrect. While total bank intraday credit lines available and usage can give an

idea about the bank's liquidity position, it does not necessarily reflect all transactions happening

throughout the day, hence it does not fully capture the intraday flow.

Choice D is incorrect. Settlement positions are end-of-day balances and do not provide

information on intraday activities or flows. Therefore, they cannot be used to understand the

intraday flow that Bank XYZ employs.

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Q.3917 Which of the following denotes the methods for tracking intraday flows and monitoring
risk levels?

A. Measures for understanding income flows

B. Measures for quantifying and monitoring risk levels

C. Measurement of credit level

D. Measures for risk aversion

The correct answer is B.

Measures for quantifying and monitoring risk levels is a method for tracking intraday flows and

monitoring risk levels.

A is incorrect: Measures for understanding income flows is not a method for tracking intraday

flows and monitoring risk levels.

C is incorrect: Measurement of credit level does not apply in tracking intraday flows and

monitoring risk levels.

D is incorrect: Measures for risk aversion is not a measure for tracking intraday flows and

monitoring risk levels.

Q.3918 ABC Bank has been a participant of FMU for a significant period. The bank has been
actively-measuring and tracking the flow of outgoing payment transactions relative to total
payments or time markers. Which one of the following is not a reason for the bank to perform
that?

A. To track its volume patterns to aid in ensuring that all the day’s payments are
processed on a timely basis.

B. To meet FMU requirements for submitting a target percentage of payments by a

deadline.

C. To identify and track its peak periods over time and the correlation of this activity with
its intraday liquidity on hand and intraday credit usage.

D. To be able to know which means are best for acquiring intraday liquidity.

The correct answer is D.

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The bank does not actively measure and track the flow of outgoing payment transactions relative

to total payments or time markers to determine the best means of acquiring intraday liquidity.

Intraday liquidity refers to funds that can be accessed during the course of a business day,

usually to meet time-specific obligations. While the bank does monitor its payment transactions,

this activity is not directly linked to the acquisition of intraday liquidity. The bank may use other

methods, such as short-term borrowing or the sale of assets, to acquire intraday liquidity.

Therefore, the assertion that the bank tracks its payment transactions to know the best means of

acquiring intraday liquidity is incorrect.

Choice A is incorrect. Tracking volume patterns is a crucial part of ensuring that all payments

are processed on time. By monitoring these patterns, the bank can anticipate high-volume

periods and allocate resources accordingly to prevent any delays or issues in processing.

Choice B is incorrect. Meeting FMU requirements for submitting a target percentage of

payments by a deadline is another valid reason for monitoring outgoing payment transactions.

The FMU sets these targets to ensure smooth operation of the financial system, and banks must

comply with them.

Choice C is incorrect. Identifying and tracking peak periods over time allows the bank to

understand its intraday liquidity needs better and manage its intraday credit usage more

effectively. This understanding helps in maintaining sufficient liquidity on hand during peak

periods, thus preventing potential liquidity crises.

Q.3919 XYZ Bank Ltd. has been obtaining money from Fed funds to pay debts owed to ABC Bank
Ltd. then servicing the foreign exchange services owed to fed fund providers the next morning.
Which of the following set of choices consists of the source of funds for XYZ and the use for
which the bank puts the funds into?

A. Cash balances and Outgoing wire transfers

B. Incoming funds flow and intraday credit and settlements at payment

C. Overnight borrowings and funding for Nostro accounts

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D. Liquid assets and outgoing wire transfers.

The correct answer is C.

Overnight borrowings and funding for Nostro accounts. In the context of the given scenario, XYZ

Bank Ltd. is obtaining its funds through overnight borrowings. This involves borrowing from

Federal funds, the London Interbank Offered Rate (LIBOR), and Eurodollar deposits. The bank is

then using these funds for funding Nostro accounts. Nostro accounts refer to accounts that a

bank holds in a foreign currency in another bank. Banks manage the cash they place in a

correspondent bank account to a target average monthly balance as part of the return for

providing banking services. Therefore, the funds obtained through overnight borrowings are

being used to transfer cash to a correspondent bank for foreign transaction services provided.

Choice A is incorrect. Cash balances are not the source of funds for XYZ Bank Ltd. in this

scenario. The bank is procuring funds from Federal funds, not from its cash balances. Also,

outgoing wire transfers are a method of transferring money, not a purpose for which these funds

are being utilized.

Choice B is incorrect. Incoming funds flow and intraday credit do not accurately represent the

source from which XYZ Bank Ltd. is obtaining its funds as it's clearly mentioned that the bank is

procuring its fund through overnight borrowings (Federal Funds). Moreover, settlements at

payment do not represent the purpose for which these funds are being utilized as they're used to

service foreign exchange services owed to providers of Federal Funds.

Choice D is incorrect. Liquid assets aren't mentioned as a source of funding in this scenario;

instead, it's specified that XYZ Bank Ltd obtains its funding through overnight borrowings

(Federal Funds). Additionally, similar to choice A, outgoing wire transfers refer to a method of

transferring money rather than representing the purpose for which these borrowed funds are

used.

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Q.5426 Which of the following tools used by Financial Market Utilities (FMUs) to manage
intraday settlement involves maintaining backup credit lines from commercial banks and central
banks for liquidity?

A. Contingent liquidity.

B. Net debit cap.

C. Settlement windows.

D. Collateral.

The correct answer is A.

Contingent liquidity arrangements are credit lines or liquidity facilities established with

commercial banks and central banks to ensure that the FMU has access to funds in case of

unexpected liquidity shortfalls during the intraday settlement process. These arrangements are

an essential part of risk management for FMUs to maintain smooth settlement operations.

B is incorrect. Net debit cap is a tool used by central banks like the Federal Reserve to limit the

amount of intraday credit a depository institution (such as a bank) can obtain from the central

bank. It is not a tool used by FMUs themselves to manage their intraday settlement processes or

liquidity. It's more about regulating the credit extended by central banks to financial institutions.

C is incorrect. Settlement windows refer to specific time periods during the trading day when

settlement of financial transactions occurs. They dictate when transactions will settle but do not

directly involve maintaining backup credit lines or liquidity. While they are important for

organizing settlement processes, they do not pertain to managing intraday liquidity risk through

credit arrangements.

D is incorrect. Collateral is assets that a party pledges to secure a loan or other financial

obligation. While collateral can be used to manage counterparty credit risk, it is not a tool

specifically used by FMUs to manage intraday settlement liquidity. Collateral management is

more related to risk mitigation and ensuring that obligations are met, but it's not a tool for

obtaining additional liquidity during the day.

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Reading 133: Monitoring Liquidity

Q.3920 In monitoring liquidity, it is essential to understand the identification and taxonomy of

cash flows that occur during the business activities of a financial institution. A group of FRM
students were asked to state the two perspectives of classifying cash flows. The students were
then grouped into four sets, depending on their responses as follows. Group A: Time and amount
Group B: Time and Credit scores Group C: Credit potential and amount Group D: Term structure
and time Which group of students stated the most accurate perspectives?

A. Group A

B. Group B

C. Group C

D. Group D

The correct answer is A.

The two perspectives of classifying cash flows are indeed 'Time' and 'Amount'. When classifying

based on 'Time', we distinguish between deterministic and stochastic cash flows. Deterministic

cash flows are those that occur at future moments that are predictable or known with certainty

at the reference time of their occurrence. Stochastic cash flows, on the other hand, are those

that appear at random moments in the future in an unpredictable manner. This classification

allows financial institutions to plan and manage their liquidity effectively.

When classifying based on 'Amount', again we distinguish between deterministic and stochastic

cash flows. Deterministic cash flows occur in an amount known with certainty at the reference

time, while stochastic cash flows are those whose amount cannot be fully determined at the

reference time. This classification helps in understanding the potential variability in the cash

flows and aids in effective risk management.

Choice B is incorrect. The classification of cash flows does not involve credit scores. Credit

scores are used to assess the creditworthiness of an individual or a company, but they do not

directly influence the categorization of cash flows in terms of time and amount.

Choice C is incorrect. Credit potential and amount are not the two perspectives for classifying

cash flows. While the amount is a crucial factor, credit potential refers to a borrower's ability to

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repay debt which does not directly relate to how cash flows are classified.

Choice D is incorrect. Term structure and time do not represent the two perspectives for

classifying cash flows. Term structure relates more to interest rates over different periods, while

time indeed plays a role in classification, it alone with term structure doesn't provide complete

perspective for classifying cashflows.

Q.3921 In the field of financial risk management, cash flows are often categorized into
deterministic and stochastic types, each with distinct characteristics. During a group discussion
for their Financial Risk Management (FRM) exam preparation, four students presented their
understanding of deterministic cash flows. Which of the following statements accurately
represents the characteristics of deterministic cash flows?

A. Deterministic cash flows manifest themselves at some random instants in the future,
and their amount cannot be fully determined

B. Deterministic cash flows occur at future instants that are predictable and occur in an
amount known with certainty

C. Deterministic cash flows amount cannot be predicted, and they occur at future
instants that are predictable.

D. Deterministic cash flows are unpredictable, both in amount and time perspective.

The correct answer is B.

Deterministic cash flows are defined by their predictability both in terms of timing and amount.

That's why they're termed "deterministic" - they're determined and known in advance.

A is incorrect. This statement describes stochastic cash flows, not deterministic ones.

Stochastic cash flows are uncertain both in terms of when they will occur and in what amount.

C is incorrect. This statement is a mix of characteristics. While it correctly states that

deterministic cash flows occur at predictable times, it incorrectly states that their amounts

cannot be predicted.

D is incorrect. This again describes stochastic cash flows. Deterministic cash flows are, by

definition, predictable in both timing and amount.

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Q.3923 An FRM tutor gave his students some characteristics of cash flows and told them to
identify the cash flows. The characteristics were as follows;

a. They are related to financial contracts such as fixed-rate bonds or fixed-rate mortgages
or loans, bonds issued, and loans received by the bank held in its liabilities;
b. They are produced by payments of periodic interests and periodic repayments of the
capital installments if the asset is amortizing.

Which of the following most accurately states the correct cash flows under which the above
characteristics fall?

A. Deterministic cash flows

B. Behavioral cash flows

C. Stochastic cash flows

D. Credit-related cash flows

The correct answer is A.

The characteristics provided in the question are indicative of deterministic cash flows.

Deterministic cash flows are those that are predictable and can be calculated with certainty.

They are often associated with fixed-rate financial contracts such as bonds, mortgages, or loans.

These contracts have predetermined payment schedules, including periodic interest payments

and capital repayments if the asset is amortizing. Therefore, the cash flows generated from these

contracts can be calculated with certainty, making them deterministic.

Choice B (Behavioral cash flows) is incorrect. Behavioral cash flows are typically associated

with the unpredictable behavior of customers, such as prepayments on mortgages or early

withdrawals from deposit accounts. They are not directly linked to financial contracts like fixed-

rate bonds or mortgages, nor are they generated by periodic interest payments and capital

repayments.

Choice C (Stochastic cash flows) is incorrect. Stochastic cash flows refer to those that have

a random probability distribution or pattern that may be analyzed statistically but may not be

predicted precisely. While the described characteristics do involve some level of uncertainty, they

do not necessarily imply randomness in the distribution of these cash flows.

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Choice D (Credit-related cash flows) is incorrect. Credit-related cash flows primarily relate

to the potential losses from a borrower's default on a loan repayment obligation. The

characteristics described in the question pertain more towards deterministic nature of certain

financial contracts rather than credit risk associated with them.

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Q.3924 The liquidity option impact is considered in two ways. A student was asked to give the
ways, and the following choices were recorded as her responses after repeated trials. Which of
the choices give the most accurate answer?

A. Liquidity impact on the balance sheet, and a (positive or negative) financial impact on
cash flows.

B. A (positive or negative) financial impact and contract deposit rate.

C. Contract deposit rate and liquidity impact on the balance sheet

D. Available cash reserves and financial impact

The correct answer is A.

The impact of liquidity options is indeed considered in two ways: the impact on the balance sheet

and the financial impact, which can be either positive or negative, on cash flows. The balance

sheet impact refers to how liquidity options can affect the assets, liabilities, and equity of a

company. The financial impact on cash flows refers to how liquidity options can influence the

inflow and outflow of cash in a company. Therefore, choice A accurately identifies the two ways

in which the impact of liquidity options is considered.

Choice B is incorrect. While a (positive or negative) financial impact is indeed one of the ways

in which the impact of liquidity options is considered, contract deposit rate does not directly

evaluate the impact of liquidity options. Contract deposit rate refers to the interest rate paid on

deposits, which may be influenced by liquidity but it's not a direct measure of its impact.

Choice C is incorrect. Although liquidity's impact on the balance sheet is one way to evaluate

its effect, contract deposit rate as explained above does not directly assess this effect.

Choice D is incorrect. Available cash reserves can be an outcome or result of managing

liquidity but it doesn't represent a method for evaluating the impact of liquidity options. The

financial impact mentioned here could refer to either positive or negative effects on cash flows,

but without specifying that it doesn't fully capture one of the two distinct ways in which these

impacts are typically evaluated.

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Q.3925 You are given the assets, liabilities, and their respective expiry terms of a financial
institution XYZ, as shown in the table below. Given that the assets bear no default risk, no
liquidity options are embedded within the deposit, and both the assets and the liabilities have
been ordered according to their maturity, disregarding which kind of contract they are. Study the
table for building a TSECF for the institution.

Expiry Notional Interest Notional Interest

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 20 6 0 −4
2 0 5 −10 −4
3 0 5 0 −3
4 0 5 0 −3
5 50 5 0 −3
6 0 2 0 −3
7 0 2 −70 −3
8 0 2 0 0
9 0 2 0 0
10 30 2 0 0
> 10 0 − −20 0

Calculate the TSECCF for the assets and liabilities with 1-year expiry term.

A. 22

B. 24

C. 26

D. 30

The correct answer is A.

The term structure of expected cash flows (TSECF) refers to the collection, ordered by date, of
positive and expected cash flows, up to expiry referring to the contract with the longest maturity,
say tk :

TSECCF(t0 , tk) = {Cf+ − + − + −

e (t0 , t0 ), Cfe (t0 , t0 ), Cfe (t0 , t1 ), Cfe (t0 , t1 ), … … , Cfe (t0 ,tk ), Cfe (t0 , tk )} .

For the first year, TSECF = 20 + 6 + 0 − 4 = 22

Q.3926 You are given the assets, liabilities, and their respective expiry terms of a financial
institution XYZ, as shown in the table below. Given that the assets bear no default risk, no
liquidity options are embedded within the deposit, and both the assets and the liabilities have

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been ordered according to their maturity, disregarding which kind of contract they are. Study the
table for building a TSECF for the institution.

Expiry Notional Interest Notional Interest

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 20 6 0 −4
2 0 5 −10 −4
3 0 5 0 −3
4 0 5 0 −2
5 50 5 0 −3
6 0 2 0 −3
7 0 2 −70 −3
8 0 2 0 0
9 0 2 0 0
10 30 2 0 0
> 10 0 − −20 0

Calculate the TSECCF for the assets and liabilities with 6 years expiry term.

A. -2

B. -1

C. 18

D. 69

The correct answer is D.

You are given the assets, liabilities, and their respective expiry terms of a financial institution
XYZ, as shown in the table below. Given that the assets bear no default risk, no liquidity options
are embedded within the deposit, and both the assets and the liabilities have been ordered
according to their maturity, disregarding which kind of contract they are. Study the table for
building a TSECF for the institution.

Assets and Liabilities Classified According to Maturity

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Expiry Notional Interest on Notional on Interest on TSECCF

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 20 6 0 −4 22
2 0 5 −10 −4 13
3 0 5 0 −3 15
4 0 5 0 −2 18
5 50 5 0 −3 70
6 0 2 0 −3 69
7 0 2 −70 −3 −2
8 0 2 0 0 0
9 0 2 0 0 2
10 30 2 0 0 34
> 10 0 − −20 0 14

In generating the TSECCF we calculate the TSECF for the first year and then cumulate the

amounts until the 6th year following TSECCF as follows,

TSECCF(t0 , t6 ) = {CF(t0 , t0 , t1 ), CF(t0 , t0 , t2 ), . . . , CF(t0 , t0 , t6 )}

The cumulated amounts are as in the above table.

Q.3927 ABC bank has repoed one of its real estates from XYZ bank. The FRM manager for ABC
bank has realized that this transaction has affected the bank’s cash flows and liquidity
generation capacity in several ways. Which of the following is not one of the effects?

A. The term structure of the available assets (TSAA) is reduced by an amount equal to the
notional of the repo agreement.

B. The cash flows that the bank receives at the beginning and the negative cash flow at
the end leads to an increase in the term structure of liquidity generation capacity
(TSLGC)

C. The transactions yield a liability in the balance sheet.

D. The transaction leads to an increase in the Bank’s TSAA.

The correct answer is D.

The statement that the transaction leads to an increase in the Bank’s Term Structure of Available

Assets (TSAA) is incorrect. In a repo transaction, the bank sells an asset (in this case, real estate)

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to another bank with an agreement to repurchase it at a later date. This transaction does not

increase the TSAA; instead, it temporarily reduces the TSAA by the notional amount of the repo

agreement. The TSAA will only increase when the bank repurchases the asset. Therefore, choice

D does not accurately represent the effects of the repo transaction on the bank's cash flows and

liquidity generation capacity.

Choice A is incorrect. The term structure of the available assets (TSAA) is indeed reduced by

an amount equal to the notional of the repo agreement. This is because in a repurchase

agreement, ABC bank sells its real estate asset to XYZ bank and agrees to buy it back at a later

date for a higher price. The sale reduces ABC's TSAA by the notional amount of the repo.

Choice B is incorrect. The cash flows that ABC bank receives at the beginning and negative

cash flow at the end do lead to an increase in its term structure of liquidity generation capacity

(TSLGC). This happens because initially, when ABC sells its asset, it receives cash which

increases its liquidity. Later, when it buys back its asset, there's a negative cash flow but this

doesn't affect TSLGC as it was already increased earlier.

Choice C is incorrect. The transaction does yield a liability on ABC's balance sheet as they are

obligated to repurchase their sold asset from XYZ bank in future which represents a financial

obligation or liability.

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Q.3929 Brook Austin, an FRM student, was asked to state the pair of financial transactions that
would help a struggling manager for ABC bank to increase the TSAA for the bank. Austin listed
the four pairs of the transactions he deemed would lead to an increase in TSAA. Which of the
following options is the most accurate?

A. Security lending and Buy/sell back transactions.

B. Repo and purchases

C. Reverse repo and repo

D. Buy/sell back and security borrowing transactions

The correct answer is D.

Buy/sell back transactions and security borrowing transactions are the correct pair of financial

transactions that can help increase the Term Structure of Available Assets (TSAA) for a bank. In

a buy/sell back transaction, the bank buys an asset and agrees to sell it back at a later date. This

transaction increases the TSAA as the bank has an additional asset for the duration of the

contract. Similarly, in a security borrowing transaction, the bank borrows a security for a

specified period, increasing the TSAA as the bank has an additional asset for the duration of the

loan. These transactions increase the TSAA as they increase the number of assets available to

the bank for a specified period.

Choice A is incorrect. Security lending and Buy/sell back transactions do not necessarily lead

to an increase in the Term Structure of Available Assets (TSAA). These transactions are more

related to liquidity management rather than enhancing the TSAA.

Choice B is incorrect. Repo and purchases can potentially increase the TSAA, but it depends

on the nature of assets involved in these transactions. If short-term assets are involved, it may

not significantly enhance the TSAA.

Choice C is incorrect. Reverse repo and repo are essentially short-term borrowing and lending

mechanisms used by banks for liquidity management. They do not directly contribute to

enhancing the term structure of available assets as they primarily involve short-term securities.

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Q.3930 Which of the following statements is least accurate about TSECF based on financial risk
management?

A. In TSECF, cash flows are adjusted to include liquidity options, and thus behavioral
models are used for typical banking products such as sight deposits, prepaying
mortgages, and credit link usage.

B. TSECF Includes the cash flows from all current contracts that include the assets and
liabilities. Cash flows are stochastic in many cases because they link to market indices,
such as Libor or Euribor fixings.

C. Cash flows originated by new business increasing the assets are included; they are
typically stochastic in both the amount and time dimensions, so they are treated
employing models that consider all related risks.

D. TSECF does not include the cash flows from all current contracts that include the
assets and liabilities.

The correct answer is D.

The statement that TSECF does not include the cash flows from all current contracts that include

the assets and liabilities is inaccurate. In fact, TSECF does include the cash flows from all

current contracts. This includes both assets and liabilities. The cash flows are often stochastic,

meaning they are subject to variability due to market indices such as Libor or Euribor fixings.

Therefore, the assertion in choice D is incorrect, making it the least accurate statement about

TSECF.

Choice A is incorrect. The statement accurately describes the TSECF concept, where cash

flows are adjusted to include liquidity options. Behavioral models are indeed used for typical

banking products such as sight deposits, prepaying mortgages, and credit link usage.

Choice B is incorrect. This statement correctly explains that TSECF includes cash flows from

all current contracts involving assets and liabilities. These cash flows can be stochastic as they

often link to market indices like Libor or Euribor fixings.

Choice C is incorrect. The statement correctly mentions that TSECF includes cash flows

originated by new business increasing the assets which are typically stochastic in both amount

and time dimensions. Models considering all related risks are used to treat these types of cash

flows.

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Q.3931 Suppose that you are given assets, liabilities, and their respective expiry terms of a
financial institution, as shown in the table below. Given that the assets bear no default risk, no
liquidity options are embedded within deposits, and the assets and the liabilities have been
ordered according to their maturity, disregarding which kind of contract they are. Study the
table to build the TSECF for the institution.

Expiry Notional Interest on Notional on Interest on

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 25 7 0 −5
2 0 5 −20 −6
3 0 5 0 −3
4 0 5 0 −3
5 60 8 −35 −3
6 0 2 0 −3
7 0 2 −20 −3
8 0 2 0 0
9 0 2 0 0
10 15 2 0 0
> 10 0 − −25 0

Calculate the TSECCF for the assets and liabilities with a term of two years to expiry.

A. -21

B. 6

C. 7

D. 27

The correct answer is B.

The term structure of cumulated expected cash flows (TSECCF) is the collection of expected
cumulated cash flows, starting at t0 and ending at tb ordered by date.

TSECF for year 1 = 25 + 7 + 0 + −5 = 27

TSECCF for year 2 = 27 + 5 − 20 − 6 = 6

Q.3932 Suppose that you are given assets, liabilities, and their respective expiry terms of a
financial institution, as shown in the table below. Given that the assets bear no default risk, no

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liquidity options are embedded within deposits, and the assets and the liabilities have been
ordered according to their maturity, disregarding which kind of contract they are. Study the
table to build the TSECF for the institution.

Expiry Notional Interest on Notional on Interest on

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 25 7 0 −5
2 0 5 −20 −6
3 0 5 0 −3
4 0 5 0 −3
5 60 8 −35 −3
6 0 2 0 −3
7 0 2 −20 −3
8 0 2 0 0
9 0 2 0 0
10 15 2 0 0
> 10 0 − −25 0

Calculate the TSECCF for the assets and liabilities with a term of more than 10 years to expiry.

A. 10

B. 14

C. 27

D. 39

The correct answer is B.

In generating the TSECCF, we calculate the TSECF for the first year and then cumulate the
amounts until the 6th year following TSECCF as follows,

TSECCF(t0, t>10 ) = {CF(t0 , t0 , t1 ), CF(t0 , t0 , t2 ), . . . , CF(t0 , t0 , t>10)}

This is as calculated in the following table.

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Expiry Notional Interest on Notional on Interest on TSECCF

Positive Positive Negative Negative
Cashflows Cashflows Cashflows Cashflows
1 25 7 0 −5 27
2 0 5 −20 −6 6
3 0 5 0 −3 8
4 0 5 0 −3 10
5 60 8 −35 −3 40
6 0 2 0 −3 39
7 0 2 −20 −3 18
8 0 2 0 0 20
9 0 2 0 0 22
10 15 2 0 0 39
> 10 0 − −25 0 14

Q.3935 Assume that a bank decides to sell a quantity of the bond equal to a notional of 300,000
after 10 months (or 0.833 years) for 99.95. Keeping in mind that this trade can be dealt with to
generate liquidity, calculate the term structure of cumulated liquidity generation capacity
(TSCLGC) inflow resulting from this transaction given the interest rate is 10%.

A. 324,840

B. 324,890

C. 494,675

D. 543,785

The correct answer is A.

The calculations are as follows;

The term structure of cumulated liquidity generation capacity (TSCLGC) records an inflow

equivalent to:

Inflow=Amount× price,including the accrued interest

99.95
300, 000 × ( + 10% × 0.833) = 324, 840
100

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Q.3936 A liquidity division in XYZ bank operates a buy/sell back operation. Assume that the bank
buys a bond worth 200,000, 3 months (0.25 years) after it is issued with an interest rate of 10%
and sells it back after 6 months at the forward price. Assume that the purchase price is 99.50 of
the par value. Calculate the amount the bank pays at the start of the contract.

A. 204,000

B. 309,400

C. 403,600

D. 199,000

The correct answer is D.

To calculate the amount the bank pays at the start of the buy/sell back contract, you need to

determine the purchase price of the bond initially.

The purchase price is given as 99.50% of the par value, which means the bank pays 99.50% of

the face value of the bond.

Purchase price = 99.50% of face value = 0.995 * $200,000 = $199,000

So, the bank pays $199,000 at the start of the buy/sell back contract.

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Q.3938 A liquidity division in XYZ bank operates a buy/sell back operation. The bank buys a bond
worth 200,000 with semi-annual coupons of 10% and immediately gets into a forward contract to
sell it back after six months. Assume that the purchase price is 99.50 of the par value and the six-
month forward price is 99.90 of the par value. Calculate the total amount received by the bank
after six months.

A. 202,000

B. 209,800

C. 406,780

D. D. 409,600

The correct answer is B.

Remember that the sum it receives includes accrued interest:

200, 000 × (99.90% + 10% × 0.50) = 209, 800

Q.3939 A liquidity division for RPQ bank decides to lend 600,000 of a bond after 3 months from
purchase for a period of 6 months. In the process, they realize that The TSECF does not record
any cash flow at the inception of the contract, whereas the TSAA shows a reduction of the
available quantity of 600,000. After 6 months, the bond is returned to the bank whereby the bank
receives a fee for the lending, which we assume to be equal to 3.5% p.a. Calculate the value of
the received fee for the lending.

A. 4,800

B. 6,700

C. 10,500

D. 4,200

The correct answer is C.

The received fee for lending is calculated as follows:

600, 000 × (3.5% × 0.5) = 10 , 500

Note that 600,000 represents the notional, 3.5% is the interest rate, and 0.5 represents the

maturity(half-year).

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Reading 134: The Failure Mechanics of Dealer Banks

Q.2292 Coliseu Bank from Porto, Portugal, is a large dealer bank considered “too big to fail” and,
therefore, can expect support from the government and central bank in case of distress. This
support “guarantee” is associated with certain behaviors that may have potentially disastrous
consequences. Which of the following gives an example of such behaviors?

A. Manipulation of financial statements.

B. Taking more inefficient risks.

C. Offering products at exorbitant prices.

D. Only doing business with high net-worth firms and individuals.

The correct answer is B.

The term 'too big to fail' refers to the concept that certain financial institutions are so large and

interconnected that their failure would be disastrous to the economy, and they must therefore be

supported by the government when they face potential failure. The implicit guarantee of

government support can lead these institutions to take on more inefficient risks. This is because

they may operate under the assumption that they will be rescued in the event of a crisis, thereby

reducing their incentives to avoid risky behavior. This moral hazard problem is a major concern

in financial regulation. The expectation of being bailed out if things go wrong can lead to

excessive risk-taking, which can increase the likelihood of financial crises. In the case of Coliseu

Bank, the expectation of government support in times of distress could potentially lead it to take

on more inefficient risks, knowing that it will likely be bailed out if these risks do not pay off.

Choice A is incorrect. While manipulation of financial statements is a fraudulent activity and

can lead to severe consequences, it's not directly related to the 'too big to fail' status of a bank.

This behavior can occur in any organization, regardless of its size or status.

Choice C is incorrect. Offering products at exorbitant prices may be an unethical business

practice but it doesn't necessarily result from the 'too big to fail' status. Banks might charge high

prices due to various reasons such as high operational costs, market conditions or lack of

competition but not specifically because they are considered too big to fail.

Choice D is incorrect. Only doing business with high net-worth firms and individuals does not

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necessarily lead to catastrophic outcomes nor does it stem from the 'too big to fail' status. It

could be part of a bank's business strategy targeting premium segment but this doesn't

inherently pose systemic risk associated with too-big-to-fail institutions.

Q.2293 Molino Bank from Zaragoza, Spain, is experiencing serious problems following the
decline in their capital position due to previous trading losses. At some point in time, Molino’s
clearing bank starts refusing to process its “daylight overdrafts” transactions. Molino is unable
to execute trades or send cash to meet its obligations. What is the result of the situation
concerning Molino Bank?

A. A moderate decrease in daily trading.

B. A severe decrease in daily trading.

C. The bank declares bankruptcy.

D. There is no effect on the bank’s business.

The correct answer is C.

The provided example thoroughly explains a sequence of events leading to the protagonist
bank’s bankruptcy, following loss of confidence in the protagonist bank by its investors: Consider
a protagonist dealer bank, whom we shall call Alpha Bank, whose capital position has just been
severely weakened by trading losses. Alpha seeks new equity capital to shore up the value of its
business, but potential providers of new equity question whether their capital infusions would do
much more than improve the position of Alpha's creditors. Alpha has been operating a significant
prime brokerage business, holding the hedge funds' cash and securities. They begin to shift their
cash and securities to better capitalized prime brokers or, safer yet, custodian banks. Alpha's
short-term secured creditors see no good reason to renew their loans to Alpha. Most of them fail
to renew their loans to Alpha in the form of repurchase agreements, or "repos" (which) have a
term of one day. (

In the normal course of business, Alpha's clearing bank allows Alpha and other dealers the
flexibility of "daylight overdrafts" of cash for the intraday financing of trades. Finally, however,
Alpha receives word that its clearing bank has exercised its right to stop processing Alpha's cash
and securities transactions given the exposure of the clearing bank to Alpha's overall position.
Unable to execute trades or to send cash to meet its obligations, Alpha declares bankruptcy.

The situation in which Molino Bank has found itself results in an inability to do business or fulfill
its obligations, therefore Molino Bank declares bankruptcy.

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Q.2294 Bens bank from Brussels, Belgium, is a dealer bank. It operates in both primary and
secondary markets. In the primary market, the bank most likely intermediates between:

A. Issuers and investors of securities

B. Sellers and buyers

C. Other banks

D. Corporate clients

The correct answer is A.

Dealer banks, such as Bens bank, play a crucial role in the primary market by acting as

intermediaries between issuers and investors of securities. In this role, the dealer bank may

sometimes act as an underwriter. This involves buying equities or bonds from an issuer and then

selling them over time to investors. This process is essential for the functioning of the primary

market as it facilitates the flow of capital from investors to issuers, who may need the funds for

various purposes such as business expansion or debt repayment. The dealer bank earns a profit

from the spread between the price at which it buys the securities from the issuer and the price at

which it sells them to the investors.

Choice B is incorrect. While it's true that banks often act as intermediaries between sellers

and buyers, this is a broad interpretation of the role of a bank. In the context of primary financial

markets, the bank specifically intermediates between issuers and investors of securities, not just

any sellers and buyers.

Choice C is incorrect. Banks do interact with other banks in various capacities, but in the

context of primary financial markets, their role as intermediaries isn't typically focused on other

banks. Instead, they facilitate transactions between issuers who want to raise capital by selling

securities and investors who are willing to buy these securities.

Choice D is incorrect. Although corporate clients can be either issuers or investors in the

primary market scenario described here, this choice doesn't fully capture the intermediary role

played by Bens Bank. The bank acts as an intermediary specifically between issuers (which could

be corporations) and investors (which could also include corporations), not just with corporate

clients in general.

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Q.2295 Kralingen Bank from Rotterdam is a dealer bank. It operates in both primary and
secondary markets. In the latter, the bank most likely intermediates between:

A. Issuers and investors of securities

B. Sellers and buyers

C. Other intermediaries

D. Corporate clients

The correct answer is B.

In the secondary market, dealer banks like Kralingen Bank act as intermediaries between sellers

and buyers. This is because the secondary market is where previously issued securities are

bought and sold. The dealer bank stands ready to buy securities at its bid prices from sellers and

sell securities at its ask prices to buyers. This intermediation process facilitates the smooth

functioning of the secondary market by providing liquidity and ensuring that securities can be

bought and sold at any time. The dealer bank profits from the spread between the bid and ask

prices.

Choice A is incorrect. Issuers and investors of securities are typically involved in primary

markets, not secondary markets. In primary markets, new securities are issued and sold to

investors. Kralingen Bank's role as an intermediary in the secondary market does not involve

direct interaction with issuers of securities.

Choice C is incorrect. While it's possible for a dealer bank like Kralingen Bank to interact with

other intermediaries, this isn't the most likely scenario in the context of its operations in the

secondary market. The main function of a dealer bank in a secondary market is to facilitate

transactions between buyers and sellers.

Choice D is incorrect. Corporate clients could be either buyers or sellers in the secondary

market, but they do not represent both parties that Kralingen Bank would act as an intermediary

between. The bank's role as an intermediary involves facilitating transactions between sellers

and buyers specifically.

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Q.2296 Arrenberg Bank is a large dealer bank performing many over-the-counter trades. What is
the manner in which its over-the-counter trades are negotiated?

A. Trades are negotiated both publicly or privately.

B. Trades are negotiated publicly.

C. Trades are negotiated privately.

D. Trades are negotiated publicly with some portions of the contract kept secret.

The correct answer is C.

Over-the-counter trades are negotiated privately. Dealer banks, such as Arrenberg Bank, play a

significant role in the intermediation of over-the-counter securities markets. These markets

encompass bonds issued by corporations, municipalities, certain national governments, and

securitized credit products. The nature of over-the-counter trades is such that they are privately

negotiated between two parties without the oversight of an exchange. This allows for greater

flexibility in terms of the terms and conditions of the trade, as well as the ability to tailor the

trade to the specific needs and risk profiles of the parties involved. However, this also means that

there is a higher degree of risk involved, as there is less transparency and regulatory oversight

compared to trades conducted on an exchange.

Choice A is incorrect. Over-the-counter trades are not negotiated both publicly and privately.

They are typically negotiated privately between two parties without the supervision of an

exchange.

Choice B is incorrect. Over-the-counter trades are not negotiated publicly. These types of

trades occur directly between two parties, away from the public eye and without the oversight of

an exchange.

Choice D is incorrect. While it's true that some portions of a contract may be kept secret in

over-the-counter trading, it's misleading to say that these trades are negotiated publicly with

some portions kept secret. The negotiation process for over-the-counter trades typically occurs

in private, away from public scrutiny or intervention.

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Q.2297 Grochowska Bank from Poznan, Poland, is intermediating for repurchase agreements
(repos). In the Bank’s repo agreements, what does the term “haircut” mean?

A. “Haircut” is not used in repo agreements.

B. A reduction in returns of a repo.

C. An increase in returns of a repo.

D. A form of risk mitigation for a repo.

The correct answer is D.

Securities dealers intermediate in the market for repurchase agreements or “repos.” A repo is, in
essence, a short-term cash loan collateralized by securities. One counterparty borrows cash from
the other, and as collateral against performance on the loan, that counterparty posts government
bonds, corporate bonds, securities from government-sponsored enterprises, or other securities
such as collateralized debt obligations. The performance risk on a repo is typically mitigated by a
“haircut” that reflects the risk or liquidity of the securities.

Things to Remember

1. Repurchase agreements (repos) are essentially short-term cash loans that are collateralized by

securities. They are a common tool used in the financial industry for short-term borrowing.

2. In a repo, one party borrows cash from the other and posts securities as collateral against the

loan. The securities can be government bonds, corporate bonds, securities from government-

sponsored enterprises, or other securities like collateralized debt obligations.

3. The term 'haircut' in the context of repos refers to a reduction in the value of the collateral

compared to the value of the loan. It is a risk mitigation measure designed to protect the lender

from the risk of a decline in the market value of the collateral.

4. The size of the 'haircut' reflects the perceived risk or liquidity of the securities being used as

collateral. Riskier or less liquid securities would typically require a larger 'haircut'.

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Q.2298 Which of the following best explains how dealer banks benefit from over-the-counter
derivative trading?

A. Charging transaction fees from investors in the form of the bid-ask spread.

B. Taking almost equal but opposite trading positions.

C. Charging a monthly premium with respect to every client.

D. Selling the underlying commodities at a profit.

The correct answer is A.

Dealer banks primarily benefit from over-the-counter derivative trading by charging transaction

fees from investors in the form of the bid-ask spread. The bid-ask spread is the difference

between the highest price that a buyer is willing to pay for an asset and the lowest price that a

seller is willing to accept. An individual looking to buy will find a sell order at the lowest ask,

while a seller will find a buy order at the highest bid. This difference between the bid and ask

prices is the transaction cost, which forms a significant part of the dealer banks' revenues. The

larger the spread, the higher the potential profit for the dealer bank. This is a common practice

in the financial markets and forms a significant part of the revenue for dealer banks involved in

OTC derivative trading.

Choice B is incorrect. While dealer banks may sometimes take nearly equal but opposite

trading positions, this is not the primary way they profit from OTC derivative trading. This

strategy, known as a hedging strategy, is used to mitigate risk rather than generate profits.

Choice C is incorrect. Charging a monthly premium with respect to every client does not

accurately describe how dealer banks primarily profit from OTC derivative trading. While some

banks may charge fees or premiums for certain services, these are typically not the main source

of income in OTC derivative trading.

Choice D is incorrect. Selling the underlying commodities at a profit does not represent the

primary way in which dealer banks profit from their involvement in over-the-counter derivative

trading. In fact, many derivatives do not involve physical delivery of any commodity and are

settled financially instead.

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Q.2299 Utvin Bank from Timisoara, Romania, trades in over-the-counter derivatives as a dealer.
What’s the primary source of profit for the bank?

A. Transaction commission

B. Differences between bid and offer terms

C. Interest rate

D. Change in value of securities

The correct answer is B.

The primary source of profit for a dealer in the over-the-counter derivatives market, such as

Utvin Bank, is the differences between bid and offer terms. This is often achieved by running a

'matched book'. In this strategy, the dealer aims to offset the risk of its client-initiated derivatives

positions by seeking trades that counterbalance each other. Essentially, the dealer profits from

the spread between the buying (bid) and selling (offer) prices of the derivatives. This is similar to

how dealer banks conduct proprietary trading in over-the-counter derivatives markets, where

they trade securities using their own funds, rather than the clients', to earn a profit for

themselves.

Choice A is incorrect. While transaction commissions can be a source of profit for some

financial institutions, it is not the main avenue through which a dealer in the over-the-counter

derivatives market, like Utvin Bank, generates its profits. Dealers typically earn their profits

from the spread between their buying and selling prices.

Choice C is incorrect. Interest rates can affect the profitability of financial institutions but they

are not directly related to how a dealer in an over-the-counter derivatives market makes profits.

The main profit comes from bid-offer spreads rather than changes in interest rates.

Choice D is incorrect. Changes in value of securities can lead to gains or losses for dealers but

this isn't their primary source of income. Dealers primarily make money from bid-offer spreads,

not from holding securities and benefiting (or suffering) from price changes.

Q.2300 Which of the following derivatives are widely held by banks thanks to the nature of their

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business?

A. Futures contracts

B. Options contracts

C. Forward contracts

D. Interest-rate swaps

The correct answer is D.

Banks are heavily involved in the business of lending and borrowing money. They borrow money

from depositors and lend it to borrowers. The interest rate they charge to borrowers is usually

higher than the interest rate they pay to depositors. This difference in interest rates is a major

source of profit for banks. However, changes in interest rates can affect this profit margin. To

manage this risk, banks use interest-rate swaps. An interest-rate swap is a derivative in which

two parties exchange interest payments. One party pays a fixed interest rate, and the other pays

a variable interest rate. The variable rate is often based on a benchmark rate, such as the

London Interbank Offered Rate (LIBOR). By using interest-rate swaps, banks can hedge against

the risk of changes in interest rates. Therefore, due to the nature of their business, banks widely

hold interest-rate swaps.

Choice A is incorrect. Futures contracts are not the most commonly held derivatives by banks.

While futures can be used to hedge risk and speculate on future price movements, they are

standardized contracts traded on an exchange, which limits their flexibility in terms of contract

size and maturity dates. This makes them less suitable for the specific needs of a bank's business

operations.

Choice B is incorrect. Options contracts give the holder the right, but not the obligation, to

buy or sell an underlying asset at a specified price within a certain period of time. Although

options can provide significant leverage and risk management benefits, they are not as

commonly used by banks due to their complexity and higher costs compared to other derivatives.

Choice C is incorrect. Forward contracts are private agreements between two parties to buy or

sell an asset at a specified future date for a price agreed upon today. While forwards can be

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customized according to the needs of each party, they carry counterparty risk since there's no

clearinghouse guaranteeing performance of each party as in futures contracts. Therefore,

forward contracts are also not as commonly held by banks.

Q.2302 Fridau Bank from Leoben, Austria, trades in over-the-counter derivatives. The bank has
purchased 25 positions of 50,000 shares and bonds worth USD 30 per share/bond. Five of those
positions have defaulted, each with USD 50,000 cost in legal and other fees. How does this
influence the total wealth on the derivatives market?

A. The total wealth on the derivatives market is reduced by USD 250,000.

B. The total wealth on the derivatives market is reduced by USD 50,000.

C. The total wealth on the derivatives market is decreased by USD 0.

D. The total wealth on the derivatives market is reduced by USD 3,750,000.

The correct answer is A.

It is an accounting identity that the total market value of all derivatives contracts must be zero –
that is, the total amount of positive (purchased) positions is equal to the total amount of negative
(sold) positions. Contingent on events that may occur over time, derivatives transfer wealth from
counterparty to counterparty, but do not directly add to or subtract from the total stock of
wealth. Indirectly, however, derivatives can cause net losses through the frictional costs of
bankruptcies, such as legal fees, and other costs associated with financial distress.

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Q.2303 Bodrum bank has an exposure of $20m with respect to Aurora bank. The latter has
posted collateral worth $15m. In case Aorora bank defaults, how much does Bodrum stand to
lose?

A. $10m

B. $20m

C. $15m

D. $5m

The correct answer is D.

A useful gauge of counterparty risk in the over-the-counter market is the amount of exposure to
default presented by the failure of counterparties to perform their contractual obligations. These
exposures can be reduced through collateral.

In this example, Bodrum has covered only a part of its exposure to Aurora. In case the latter
defaults, the former would only recover a maximum of $15m by selling the collateral, thus would
lose ($20m - $15m).

Q.2305 Bank A is a dealer bank. It is headed in the direction of a solvency crisis. The bank’s
counterparties in over-the-counter are alarmed and are hastily harvesting assets from the bank
to reduce their exposure. What can the bank do to regain the confidence of its counterparties?

A. Refuse some trades with relatively smaller counterparties.

B. Allow all trades with counterparties based on terms prevailing in the market.

C. Borrow short-term.

D. Borrow long-term

The correct answer is B.

If a dealer bank is perceived to have some risk of a solvency crisis, an over-the-counter

derivatives counterparty would look for opportunities to reduce its exposure to that dealer bank.
If the dealer wants to avoid an adverse signal of its weakness, the dealer cannot afford to refuse
its counterparties the opportunity to make these trades at terms prevailing elsewhere in the
market.
Therefore, the bank will be forced to allow all trades with the counterparties or risk triggering a
death spiral.

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Q.2983 The following standard policy tools are applicable in the treating of the social costs of
bank failures. Which one is NOT?

A. Regulatory supervisions and the requirements for risk-based capital, which reduces
the chance of a solvency threatening capital loss.

B. Deposit insurance, a measure implemented in to protect bank depositors.

C. Regulatory resolutions mechanisms, through which the authorities are given powers to
liquidate or restructure a bank efficiently.

D. Regulatory requirements guiding the departure of prime brokerage customers.

The correct answer is D.

Regulatory requirements guiding the departure of prime brokerage customers is not a standard

policy tool used in treating the social costs of bank failures. This option refers to the rules and

regulations that govern the exit of prime brokerage customers. While these regulations are

important in the context of prime brokerage operations, they do not directly address the social

costs of bank failures. The social costs of bank failures are typically addressed through measures

aimed at preventing bank failures (such as regulatory supervision and risk-based capital

requirements), protecting depositors (such as deposit insurance), and managing the resolution of

failed banks (such as regulatory resolution mechanisms). Therefore, while regulatory

requirements for prime brokerage customers are important in their own right, they do not

directly address the social costs of bank failures and are not typically considered a standard

policy tool in this context.

Choice A is incorrect. Regulatory supervisions and the requirements for risk-based capital are

indeed standard policy tools used to mitigate the social costs associated with bank failures. They

reduce the chance of a solvency threatening capital loss by ensuring that banks maintain

adequate levels of capital based on their risk profile.

Choice B is incorrect. Deposit insurance is another common policy tool used in this context. It

protects bank depositors from losses if a bank fails, thereby maintaining confidence in the

banking system and preventing bank runs which can exacerbate financial crises.

Choice C is incorrect. Regulatory resolution mechanisms are also typically employed to

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manage the fallout from bank failures. These mechanisms give authorities powers to liquidate or

restructure a failing bank efficiently, minimizing disruption to the broader economy and financial

system.

Q.2984 Dealer banks, like any other financial institutions, can face collapse due to a variety of
factors. These factors can range from internal mismanagement to external market forces.
However, not all mechanisms contribute to the collapse of a dealer bank. Which one of the
following mechanisms is NOT typically associated with the collapse of a dealer bank?

A. The flight of short-term creditors.

B. Prime brokerage clients’ departure.

C. Various cash-draining undertakings by derivatives counterparties designed to lower

their exposures to the dealer banks.

D. Additional clearing-bank privileges.

The correct answer is D.

The failure of a dealer bank can be due to key mechanisms which are: the flight of short-term
creditors, the departure of prime brokerage clients, various cash-draining undertakings by
derivatives counterparties designed to lower their exposures to the dealer banks, and the loss of
clearing-bank privileges.

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Q.2985 Which of the following ways is NOT applicable to the mitigation of the risk of liquidity
loss?

A. Establishing lines of bank credit.

B. Dedicating a buffer stock of cash and liquidity securities for emergency liquidity
needs.

C. Establishing regulatory measures of compliance.

D. Laddering the maturities of its liabilities to refinance only a small portion of the debt
within a short period of time.

The correct answer is C.

Establishing regulatory measures of compliance is not a direct method of mitigating the risk of

liquidity loss. While regulatory compliance is important in the overall risk management strategy

of a financial institution, it does not directly contribute to the mitigation of liquidity risk.

Regulatory measures often involve adherence to certain standards and practices that aim to

ensure the overall stability and integrity of the financial system. These measures may indirectly

influence liquidity risk management by imposing certain requirements on capital and liquidity

ratios, but they do not directly address the risk of liquidity loss. Therefore, establishing

regulatory measures of compliance is not a typical strategy used by dealer banks to mitigate the

risk of liquidity loss.

Choice A is incorrect. Establishing lines of bank credit is a common strategy used by dealer

banks to mitigate the risk of liquidity loss. This provides them with an immediate source of funds

in case there is a sudden withdrawal or run by short-term creditors.

Choice B is incorrect. Dedicating a buffer stock of cash and liquidity securities for emergency

liquidity needs is another strategy employed by dealer banks to ensure they have sufficient liquid

assets that can be quickly converted into cash during times of financial stress.

Choice D is incorrect. Laddering the maturities of its liabilities to refinance only a small

portion of the debt within a short period of time helps in managing the risk associated with large

amounts becoming due at once, thus reducing potential liquidity strain.

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Q.5381 Below is a table displaying the financing in the repo market at the end of the quarter for
four broker-dealer banks with A ratings. The figures are in GBP billion.

Financial Security Bank A Bank B Bank C Bank D

Owned 240 189 320 280
Pledged as security 150 110 180 170
Not pledged 90 79 140 110

Which bank is the most susceptible to a liquidity crisis?

A. Bank A

B. Bank B

C. Bank C

D. Bank D

The correct answer is A.

If repo creditors grow apprehensive about a bank's solvency and opt not to renew their positions,

it could trigger a liquidity crisis. Consequently, the bank might face difficulties in raising

adequate cash, thereby exacerbating the crisis.

To manage the situation, the bank may be compelled to hastily sell its assets to buyers who are

aware of its urgency, resulting in lower market valuations for unsold securities. Consequently,

the amount of cash that could be raised through repurchase agreements collateralized by those

securities may decrease.

This vulnerability is directly linked to the proportion of assets that a bank has pledged as

collateral. Bank A would therefore be most susceptible to a liquidity crisis.

150
Bank A = = 62.5%
240
110
Bank B = = 58.2%
189
180
Bank C = = 56.2%
320
170
Bank D = = 60.7%
280

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Reading 135: Liquidity Stress Testing

Q.4125 The stress testing committee for the RTC bank is preparing to undertake a stress test for
the bank. Which of the following factors is unlikely to be considered in the stress test process?

A. Development of critical assumptions

B. Scenario development

C. The suitable scope and structure of the liquidity stress test

D. Profit margins related to the process

The correct answer is D.

Profit margins related to the process are not typically considered during the stress testing

process. Stress testing in banking is a simulation technique used to evaluate a bank's potential

vulnerability to certain unlikely but severe events or market conditions. The primary focus of

stress testing is to assess the bank's resilience in the face of adverse scenarios. It involves the

evaluation of the bank's capital adequacy, exposure to risk, and the potential impact of various

risk factors on the bank's financial condition. While profit margins are an important aspect of a

bank's overall financial health, they are not directly related to the stress testing process. The

stress test is more concerned with the bank's ability to withstand losses and continue its

operations under stressful conditions, rather than its profitability.

Choice A is incorrect. The development of critical assumptions is a crucial part of stress test

planning and execution process. These assumptions help in determining the potential impact of

various risk factors on the bank's operations.

Choice B is incorrect. Scenario development is also an integral part of stress testing. It

involves creating hypothetical situations that could potentially affect the bank's operations, and

then assessing how well the bank would be able to handle these situations.

Choice C is incorrect. Determining the suitable scope and structure of the liquidity stress test

forms a key component in planning a comprehensive stress test for any banking institution. This

helps in understanding how much liquid assets are available to meet short-term obligations

under different scenarios.

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Q.4127 Axon, a fictional financial institution in Liverpool, has been using its available liquidity
for funding of the business and doing orderly clearance of payment transactions. Under which
category of liquidity use does this purpose fall?

A. Contingent liquidity

B. Operational liquidity

C. Strategic liquidity

D. Restricted liquidity

The correct answer is B.

Operational liquidity refers to the cash required for the daily funding of business operations and

the orderly clearance of payment transactions. In the context of a financial institution,

operational liquidity is crucial for maintaining the smooth functioning of the institution's daily

activities. This includes, but is not limited to, the clearance of payment transactions, the funding

of loans, and the management of deposits. Operational liquidity is a key component of a financial

institution's liquidity management strategy, as it ensures that the institution has sufficient cash

on hand to meet its immediate operational needs. In the case of Axon, the use of available

liquidity for the funding of the business and the orderly clearance of payment transactions falls

squarely within the definition of operational liquidity.

Choice A is incorrect. Contingent liquidity refers to the funds that a financial institution sets

aside to meet unexpected cash flow needs or obligations, not for regular business operations or

payment transactions.

Choice C is incorrect. Strategic liquidity is the cash and other liquid assets held by a financial

institution for strategic purposes such as acquisitions, new ventures, or capital investments. It

does not refer to the funds used for daily operational activities like clearing payment

transactions.

Choice D is incorrect. Restricted liquidity refers to assets that are not readily convertible into

cash due to legal or contractual constraints. It does not pertain to the use of available liquidity

for funding business operations and ensuring smooth clearance of payment transactions.

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Q.4129 Which of the following choices is right about designing a stress testing model?

A. Liquidity stress testing begins with identifying the risk and doing event analysis

B. In liquidity stress testing the list of scenarios don’t need to capture material liquidity
appropriately

C. Liquidity stress testing process begins with coming up with assumption

D. The liquidity stress testing process should begin with developing a list of scenarios
capturing material liquidity.

The correct answer is A.

Liquidity stress testing indeed begins with the identification of the risk and conducting an event

analysis. This is a crucial first step in the process as it allows financial institutions to understand

the potential risks they may face and the events that could trigger these risks. Event analysis

involves examining past events that have led to liquidity stress and using this information to

inform the design of the stress testing model. This step is critical in ensuring that the model is

based on realistic and relevant scenarios, thereby enhancing its effectiveness in assessing the

institution's liquidity risk.

Choice B is incorrect. This statement contradicts the fundamental purpose of liquidity stress

testing. The list of scenarios in a liquidity stress test should indeed capture material liquidity

risks appropriately, as this is crucial for assessing the financial institution's ability to maintain

sufficient liquidity under stress scenarios.

Choice C is incorrect. While assumptions are an integral part of any modeling process, they

are not typically the initial step in designing a liquidity stress testing model. The process usually

begins with identifying the risk and conducting an event analysis.

Choice D is incorrect. Although developing a list of scenarios capturing material liquidity risks

forms part of the process, it does not constitute the initial steps involved in designing a liquidity

stress testing model. As mentioned earlier, identifying risk and conducting event analysis

precedes scenario development.

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Q.4130 In a liquidity stress testing scenario, the organizational scope is a crucial component for
consideration. Among the following choices, which one is NOT an entity under which a separate
liquidity stress test should be done?

A. The parent organization

B. Subsidiary legal entities

C. Shared service centers

D. None of the above

The correct answer is D.

'None of the above' is the correct answer because all the entities listed in the options, namely the

parent organization, subsidiary legal entities, and shared service centers, should undergo

separate liquidity stress tests. In a comprehensive liquidity risk framework, the consolidated

stress test should be the central component. However, it may be necessary to conduct stress

testing on subsidiary entities within the organization. Therefore, an institution should perform a

separate liquidity stress test on organizational levels such as the parent organization, service

business units, subsidiary legal entities, lines of business, and shared service centers. For less

material entities or entities with manageable risk assessment, simple entity-level liquidity risk

reporting might be appropriate.

Choice A is incorrect. The parent organization requires a separate liquidity stress test because

it has its own set of financial obligations and risks that need to be assessed independently. It is

crucial to understand the liquidity position of the parent company as it can significantly impact

the overall financial health of the entire organization.

Choice B is incorrect. Subsidiary legal entities also require separate liquidity stress tests. Each

subsidiary may operate in different markets, have different business models, and face unique

risks which can affect their liquidity positions differently. Therefore, conducting individual stress

tests for each subsidiary helps in identifying potential vulnerabilities specific to them.

Choice C is incorrect. Shared service centers also require a separate liquidity stress test as

they provide services across multiple entities within an organization and any disruption in their

operations due to lack of funds could adversely affect other parts of the business.

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Q.4131 Afro Bank, a fictional financial institution in Turkey, has liquidity transfer restrictions.
Which one of the following choices states the best initiative the bank should take in its liquidity
stress testing?

A. The bank should source help to emancipate from the transfer restrictions

B. It should assess the effect of the restrictions on enterprise-level liquidity for both
typical operating environment and stressed conditions

C. The bank should stop the liquidity stress testing scenario until the end of the
restrictions

D. The bank should source other types of liquidity to include in the liquidity stress testing
menu

The correct answer is B.

The bank should assess the effect of the restrictions on enterprise-level liquidity for both typical

operating environment and stressed conditions. Liquidity stress testing is a critical tool for

financial institutions to identify potential vulnerabilities in their liquidity risk management. It

involves creating hypothetical scenarios to evaluate how an institution's liquidity position would

fare under both normal and adverse conditions. In the case of Afro Bank, the liquidity transfer

restrictions could significantly impact its liquidity position. Therefore, it is crucial for the bank to

assess the effects of these restrictions under both typical and stressed conditions. This would

provide the bank with a comprehensive understanding of its liquidity risk profile, enabling it to

take appropriate measures to manage and mitigate this risk. Furthermore, this approach aligns

with the principles of sound liquidity risk management as outlined by the Basel Committee on

Banking Supervision, which emphasizes the importance of stress testing in identifying and

measuring liquidity risk.

Choice A is incorrect. While sourcing help to emancipate from the transfer restrictions might

be beneficial in the long run, it does not directly address the immediate need for managing and

assessing liquidity risk under both normal and stressed conditions. This option does not provide

a solution for liquidity stress testing which is crucial for Afro Bank's current situation.

Choice C is incorrect. Stopping the liquidity stress testing scenario until the end of restrictions

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would not be an effective way to manage and assess its liquidity risk. In fact, it could potentially

exacerbate any existing or future risks as it would leave Afro Bank without a clear understanding

of its financial position during this critical period.

Choice D is incorrect. Sourcing other types of liquidity to include in the liquidity stress testing

menu may seem like a viable option, but it doesn't necessarily address how these transfer

restrictions are affecting enterprise-level liquidity under both typical operating environment and

stressed conditions. It's important that Afro Bank understands how these specific restrictions

impact their overall financial health before seeking alternative sources of liquidity.

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Q.4132 Among the following statements, which one is correct about the currency consideration
in a consolidated liquidity stress testing process?

A. The liquidity stress test is performed based on the available currency

B. Liquidity impact of currency conversion is not necessary in consolidated stress testing

as any currency can be used

C. There should be considerations of liquidity impact of currency conversion

requirements to avoid currency mismatch for offshore subsidiaries.

D. In a consolidated liquidity stress test, the home currency can be used together with
any other available currency.

The correct answer is C.

In a consolidated liquidity stress testing process, it is essential to consider the liquidity impact of

currency conversion requirements. This is to avoid any potential currency mismatch for offshore

subsidiaries. Currency mismatch can occur when the currency of the liabilities differs from the

currency of the assets. This can lead to significant financial risks, especially in times of currency

volatility. Therefore, it is crucial to consider the liquidity impact of currency conversion

requirements in the stress testing process to ensure that the entity has sufficient liquidity to

meet its obligations, regardless of currency fluctuations.

Choice A is incorrect. While the available currency does play a role in liquidity stress testing, it

is not the sole factor to consider. The test also needs to account for potential currency

mismatches and conversion requirements, especially for offshore subsidiaries.

Choice B is incorrect. This statement contradicts the principles of consolidated liquidity stress

testing. It's crucial to consider the liquidity impact of currency conversion as using any currency

without considering its impact can lead to inaccurate results and potential risks.

Choice D is incorrect. Using home currency along with any other available currency without

considering their impacts on liquidity can lead to misleading results in a consolidated liquidity

stress test. It's important to take into account the effects of different currencies and their

conversion requirements.

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Q.4133 According to U.S. regulations, specific foreign banking organizations should conduct
liquidity stress tests for intermediate holding companies and branches. Which of the following
choices is the most valid reason for this regulation?

A. To prevent foreign banks operating in the country from been over-reliant on offshore
funding.

B. Intermediate holding companies and branches share a common currency, hence no

currency conversion.

C. Intermediate companies and branches are more likely to face liquidity challenges
during stress periods

D. It is just a way of monitoring the liquidity levels for the intermediate holding
companies.

The correct answer is A.

The primary reason for the U.S. regulations requiring foreign banking organizations to conduct

liquidity stress tests for their intermediate holding companies and branches is to prevent these

entities from becoming overly reliant on offshore funding. Over-reliance on offshore funding can

pose significant risks to the financial stability of these entities and, by extension, the broader

financial system. Offshore funding sources may be more volatile and less reliable, particularly in

times of financial stress. By requiring liquidity stress tests, regulators can ensure that these

entities have sufficient liquidity buffers to withstand potential disruptions in their offshore

funding sources.

Choice B is incorrect. While it's true that intermediate holding companies and branches may

share a common currency, this is not the primary reason for requiring liquidity stress tests. The

main concern is to ensure that foreign banks operating in the U.S. are not overly reliant on

offshore funding, which could pose a risk to financial stability.

Choice C is incorrect. Although intermediate companies and branches might be more

susceptible to liquidity challenges during stress periods, this does not fully explain why these

entities specifically are required to conduct liquidity stress tests. The key issue being addressed

by this regulation is the potential over-reliance of foreign banks on offshore funding.

Choice D is incorrect. While monitoring liquidity levels for intermediate holding companies

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forms part of the rationale behind these regulations, it does not capture the full scope of

concerns being addressed by requiring foreign banking organizations to conduct liquidity stress

tests for their U.S.-based operations.

Q.4134 FTC bank, a fictional financial institution operating in Tokyo, Japan, has been doing a
liquidity stress test for a time Horizon of more than 12 months. Which of the following choices
most accurately state the disadvantage related to such a time horizon?

A. Banks usually continue to operate expensively indefinitely under stress without

employing a recovery or resolution process.

B. Longer-term projections may be affected by forecast error according to the baseline

balance sheet and statement of income budgeting time horizon.

C. Longer-term projections may lead to unnecessary confusion to those doing the

liquidity stress testing program

D. No institution would keep data for long-term liquidity stress testing

The correct answer is B.

The longer the time horizon for a liquidity stress test, the more susceptible the projections are to

forecast errors. This is primarily due to the inherent uncertainty associated with predicting

future events. The baseline balance sheet and income statement budgeting time horizon serve as

the foundation for these projections. However, as the time horizon extends, the potential for

deviations between the projected and actual figures increases. This is because numerous factors,

such as market conditions, economic trends, and regulatory changes, can significantly influence

a bank's financial performance. Therefore, while long-term liquidity stress tests can provide

valuable insights into a bank's resilience under prolonged stress scenarios, they also carry the

risk of forecast errors, which can lead to inaccurate assessments of the bank's liquidity risk.

Choice A is incorrect. Banks do not operate indefinitely under stress without employing a

recovery or resolution process. It is a standard practice for banks to have contingency plans in

place to manage and mitigate financial stress situations. Therefore, this statement does not

accurately describe a potential disadvantage of adopting a lengthy time horizon for liquidity

stress testing.

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Choice C is incorrect. Longer-term projections do not necessarily lead to confusion in the

liquidity stress testing program. While it may be challenging due to the increased complexity and

uncertainty over longer periods, these challenges can be managed with proper planning,

expertise, and use of sophisticated forecasting models.

Choice D is incorrect. The assertion that no institution would keep data for long-term liquidity

stress testing is false. Financial institutions are required by regulatory bodies to maintain

historical data which can be used for various purposes including long-term liquidity stress

testing.

Q.4135 A financial institution manager for a bank wants to do a liquidity stress test for the bank.
In the process, it reaches a point where he must choose between several testing techniques to
employ in the process. Which among the following is likely to be one of the options available for
the manager?

A. Historical statistical techniques

B. Deterministic models

C. Monte Carlo simulation

D. All of the above

The correct answer is D.

In the context of liquidity stress testing, all the mentioned techniques can be employed.

Historical statistical techniques model an institution's historical pro forma cash flow subject to

the observed cash flow volatility of the institution. An example of this is the cash flow at risk

approach (CFaR). Deterministic models are also useful in liquidity stress testing. They model the

liquidity effect of a forward-looking or historical-based scenario that has been developed by the

institution. An example of such a model is the development of hypothetical liquidity stress

scenarios. Lastly, Monte Carlo simulation is a technique based on simulation modeling and

applies in assessing the liquidity risk done by stress testing variables over a future time frame.

Therefore, the manager can use any of these methods.

Choice A is incorrect. While historical statistical techniques can be used in liquidity stress

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testing, they are not the only methods available. These techniques rely on past data and trends

to predict future outcomes, which may not always provide accurate results due to changing

market conditions and other factors.

Choice B is incorrect. Deterministic models are also a viable option for conducting liquidity

stress tests, but they too are not the only method that can be used. These models use specific

inputs and produce definite outcomes, but they do not account for uncertainty or randomness in

financial markets.

Choice C is incorrect. Monte Carlo simulation is another technique that can be employed in

liquidity stress testing; however, it's not the sole method available either. This technique uses

random sampling to generate numerous scenarios for future outcomes, but it requires significant

computational resources and may still fail to capture all potential risks.

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Q.4136 The treasury committee in a liquidity stress testing program for RTC bank were
considering a hypothetical scenario in the process of liquidity stress testing. Which of the
following characteristics is not considered in the scenario?

A. Define the scenario

B. Distinguish between systematic and idiosyncratic risk

C. Distinguish between sources of liquidity

D. Distinguish between levels of severity

The correct answer is C.

The sources of liquidity are not typically considered in the development of a hypothetical

scenario in a liquidity stress testing program. This is because the focus of such a scenario is

primarily on the potential risks and stressors that could impact the bank's liquidity, rather than

the sources of liquidity themselves. The sources of liquidity are more relevant in the operational

management of liquidity risk, where the bank needs to ensure it has access to sufficient funds to

meet its obligations. In a stress testing scenario, the focus is more on understanding how

different risk factors could impact the bank's liquidity position, and how severe these impacts

could be under different conditions.

Choice A is incorrect. Defining the scenario is a crucial part of the stress testing process. It

involves outlining the potential events or changes in market conditions that could impact the

bank's liquidity position.

Choice B is incorrect. Distinguishing between systematic and idiosyncratic risk is also an

important aspect of stress testing. Systematic risk refers to the risk that affects all entities in a

market, while idiosyncratic risk pertains to risks specific to an individual entity or sector.

Choice D is incorrect. Distinguishing between levels of severity is another key characteristic

considered in hypothetical scenarios for stress testing. This involves identifying and assessing

different degrees of adverse events or conditions, from mild to severe, and their potential impact

on liquidity.

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Q.4137 In developing a liquidity stress test assumption, several essential factors are considered.
Which of the following choices is not among those factors?

A. Qualitative assessment of the expected liquidity behavior for each type of cash flow to
identify where there is significant liquidity risk

B. Quantitative modeling assumptions based on any existing historical data.

C. Matrices of relative modeling assumptions based on scored risk levels and historical
baseline data

D. Matrices of relative modeling assumptions irrespective of scored risk levels and

current data

The correct answer is D.

Matrices of relative modeling assumptions irrespective of scored risk levels and current data are

not typically considered in the development of a liquidity stress test assumption. Liquidity stress

testing involves making assumptions based on historical data and scored risk levels. Current

data may not accurately reflect potential future liquidity scenarios, especially in times of stress.

Therefore, it is not typically used in the development of these assumptions. Instead, historical

data and scored risk levels are used to model potential future scenarios and prepare for adverse

conditions.

Choice A is incorrect. Qualitative assessment of the expected liquidity behavior for each type

of cash flow is indeed a critical component in developing liquidity stress test assumptions. It

helps to identify areas where there might be significant liquidity risk, which can then be factored

into the stress testing process.

Choice B is incorrect. Quantitative modeling assumptions based on any existing historical data

are also typically considered when developing a liquidity stress test assumption. Historical data

can provide valuable insights into past trends and patterns, which can then be used to make

informed predictions about potential future scenarios.

Choice C is incorrect. Matrices of relative modeling assumptions based on scored risk levels

and historical baseline data are often used in the development of a liquidity stress test

assumption. These matrices allow for a more nuanced understanding of potential risks by taking

into account both the severity and likelihood of different outcomes.

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Q.4139 A financial institution is attempting to develop assumptions for its liquidity stress testing.
Which of the following assumptions is NOT considered?

A. Deposit outflows

B. Investment portfolio haircuts

C. Collateral requirement

D. Deposit inflows

The correct answer is D.

Deposit inflows are not typically considered in the assumptions for a liquidity stress test.

Liquidity stress testing primarily focuses on potential scenarios that could lead to a liquidity

crunch or shortfall. Therefore, the assumptions made during this process typically revolve

around factors that could lead to a decrease in available liquidity. Deposit inflows, which

represent an increase in available liquidity, are not typically considered in these assumptions.

This is because the primary aim of liquidity stress testing is to assess the institution's ability to

withstand scenarios where liquidity decreases, not increases.

Choice A is incorrect. Deposit outflows are a crucial assumption in liquidity stress testing. In

times of financial stress, depositors may withdraw their funds, leading to a decrease in the

institution's liquidity. Therefore, it is essential to consider potential deposit outflows during the

process.

Choice B is incorrect. Investment portfolio haircuts are also typically considered during

liquidity stress testing. A haircut refers to the reduction applied to the value of an institution's

assets to account for potential losses that could occur if those assets had to be sold quickly (i.e.,

under stressed market conditions). This reduction can significantly impact an institution's

available liquidity.

Choice C is incorrect. Collateral requirements are another important assumption in this

process. In times of financial stress, counterparties may demand more collateral as security

against default risk, which can strain an institution's available liquid resources.

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Q.4140 In liquidity stress testing, among the considered outputs are stress testing assumptions,
liquidity position metrics, prospective liquidity position metrics, and capital and performance
metrics. Which of the following choices is not among the four key stress testing assumptions?

A. The assumption about the overall stress level represented by the scenario

B. The assumption about the indication of the nature of the scenario, such as systemic,
idiosyncratic, or both systemic and idiosyncratic

C. Assumptions on the expected returns

D. The assumption on the discussion of the impact of the scenario on cash flow

The correct answer is C.

Assumptions on the expected returns are not considered as one of the key stress testing

assumptions in liquidity stress testing. Liquidity stress testing is primarily concerned with a

firm's ability to meet its obligations as they come due without incurring unacceptable losses.

Expected returns, while important in other aspects of financial management, do not directly

impact a firm's liquidity position. Therefore, they are not typically included in the assumptions

used in liquidity stress testing.

Choice A is incorrect. The assumption about the overall stress level represented by the

scenario is indeed a key assumption in liquidity stress testing. It helps to determine the severity

of the potential liquidity crisis and thus, plays a crucial role in risk management.

Choice B is incorrect. The assumption about the indication of the nature of the scenario, such

as systemic, idiosyncratic, or both systemic and idiosyncratic is also an important part of

liquidity stress testing. This helps to understand whether a potential crisis could be due to

factors specific to an individual institution (idiosyncratic) or due to broader market-wide issues

(systemic).

Choice D is incorrect. The assumption on the discussion of impact of scenario on cash flow

forms an integral part of liquidity stress testing as it directly affects a firm's ability to meet its

financial obligations during times of crisis.

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Q.4141 In the governance and control of the liquidity stress testing process, the treasury
committee is considered to be instrumental in the whole process. Which among the following
choices most accurately states one of the responsibilities undertaken by the treasury?

A. Recommends stress testing scenarios

B. Recruits members for the asset-liability committee (ALCO)

C. Designs liquidity risk policy limits relative to stress test results and escalating
exceptions

D. Undertakes the liquidity stress testing frame-work periodical review, procedures, and
controls to keep compliance with policy, regulatory, and control requirements.

The correct answer is A.

Treasury recommends stress testing scenarios.

B is incorrect: It is not the responsibility of the treasury to recruit members of ALCO. The

treasury reviews and monitors components of the institution’s assets and liabilities and

recommend to the ALCO on matters relating to stress testing assumptions.

C is incorrect: Designing liquidity risk policy limits relative to stress test results and escalating

exceptions is the responsibility of the asset-liability committee.

D is incorrect: Internal audit is responsible for undertaking liquidity stress testing frame-work

periodical review, procedures, and controls to keep compliance with policy, regulatory, and

control requirements.

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Q.4142 A group of FRM students was given the following characteristic to identify the committee
of liquidity stress testing governance they belong to: The committee provides independent
validation and control over the management governance of the liquidity stress testing model
concerning the institution’s model risk management policy. Which of the following committee
meets the above description?

A. The asset-liability committee

B. Internal audit

C. Model risk management

D. The Treasury

The correct answer is C.

The Model Risk Management committee is responsible for providing independent validation and

control over the management governance of the liquidity stress testing model. This is in line with

the institution's model risk management policy. The committee's role is to ensure that the model

used for liquidity stress testing is robust, reliable, and accurately represents the institution's

liquidity risk. This involves reviewing the model's assumptions, methodologies, and outputs, and

assessing the model's performance over time. The committee also ensures that the model is used

appropriately within the institution and that any limitations or uncertainties associated with the

model are properly communicated and understood.

Choice A is incorrect. The asset-liability committee (ALCO) is responsible for managing the

balance sheet risk of a financial institution, including interest rate risk and liquidity risk.

However, it does not provide independent validation and control over the management

governance of the liquidity stress testing model.

Choice B is incorrect. While Internal Audit plays a crucial role in assessing the effectiveness of

controls within an organization, its primary function is not to provide independent validation and

control over the management governance of the liquidity stress testing model.

Choice D is incorrect. The Treasury department manages an institution's financial resources

but does not typically oversee or validate models used in stress testing scenarios.

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Q.4143 Which of the following choices is correct about Liquidity stress testing and capital stress
testing integration?

A. To link liquidity stress testing and capital stress testing requires an institution to
incorporate any essential capital infusions of subsidiary entities.

B. For every liquidity stress test scenario, the institution should develop capital impact
assumptions based only on the idiosyncratic conditions that occur under the scenario

C. For every liquidity stress test scenario, the institution should develop capital impact
assumptions based only on the overall market conditions that occur under the scenario

D. For every liquidity stress test scenario, the institution should develop capital impact
assumptions based only on the overall market conditions that occur under the scenario
arise through investment portfolios.

The correct answer is A.

The integration of liquidity stress testing and capital stress testing necessitates that an

institution includes any vital capital infusions from subsidiary entities. This is because the capital

position of an institution can significantly influence its liquidity position. For instance, if a

subsidiary entity is unable to provide the necessary capital infusion during a stress scenario, the

parent institution may face a liquidity crunch. Therefore, it is crucial for institutions to consider

the potential capital infusions from subsidiary entities when linking liquidity stress testing and

capital stress testing.

Choice B is incorrect. While it's true that idiosyncratic conditions are important to consider in

stress testing, they should not be the only factor considered when developing capital impact

assumptions. A comprehensive risk assessment requires considering both idiosyncratic and

market-wide conditions.

Choice C is incorrect. Similar to choice B, relying solely on overall market conditions for

developing capital impact assumptions during a liquidity stress test scenario would not provide a

complete picture of the potential risks. Both idiosyncratic and market-wide conditions need to be

taken into account.

Choice D is incorrect. This option incorrectly suggests that overall market conditions arising

through investment portfolios should be the only consideration for capital impact assumptions in

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every liquidity stress test scenario. This approach would neglect other important factors such as

operational risks, credit risks, and specific business model vulnerabilities which are crucial for a

comprehensive risk assessment.

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Reading 136: Liquidity Risk Reporting and Stress Testing

Q.4050 Which of the following details would not be obtained from a deposit tracker report?`

A. Month-end actuals for deposits by customer type

B. Each month-end change

C. Each month-end forecast for the position to the end of the year

D. Annual loan to deposit ratio (LTD)

The correct answer is D.

The annual loan to deposit ratio (LTD) is not typically included in a deposit tracker report. The

LTD ratio is a measure used by banks to assess their liquidity by dividing total loans by total

deposits. This ratio is used to determine a bank's ability to cover loan losses and withdrawals by

its depositors. However, the deposit tracker report is generated on a weekly or monthly basis

and focuses on providing detailed insights into deposit trends and patterns. Therefore, it does

not include the annual LTD ratio, which is a broader measure of a bank's financial health and

liquidity.

Choice A is incorrect. Month-end actuals for deposits by customer type are typically included

in a deposit tracker report. This information helps financial institutions understand the deposit

trends and patterns of different customer types, which can be useful for strategic planning and

decision-making.

Choice B is incorrect. Each month-end change is also usually included in a deposit tracker

report. This data provides insights into the monthly fluctuations in deposits, enabling financial

institutions to track their performance over time and make necessary adjustments.

Choice C is incorrect. Each month-end forecast for the position to the end of the year is

another detail that's typically found in a deposit tracker report. These forecasts help financial

institutions anticipate future trends and prepare accordingly.

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Q.4051 VTR bank has been receiving most of its funding from current accounts and rolling
deposits. Under what circumstance will the bank treat overnight balances as long-term
according to regulation?

A. If the overnight balances can be demonstrated to be acting as long-term in

“behavioral” terms

B. If the overnight deposits are predictable

C. If the overnight deposits are the primary funding source for bank

D. None of the above

The correct answer is A.

Things to Remember

1. The classification of deposits as short-term or long-term has significant implications for a

bank's liquidity metrics. Long-term deposits are generally considered more stable and reliable,

which can improve the bank's liquidity position and financial stability.

2. The behavior of deposits is a key factor in determining their classification. Deposits that

exhibit long-term behavior, such as consistency and stability, can be treated as long-term, even if

they are technically overnight deposits.

3. The size or significance of the deposits is not a determining factor in their classification. Even

if overnight deposits form a significant part of the bank's funding, they cannot be treated as long-

term unless they exhibit long-term behavior.

4. Predictability of deposits is also not a determining factor in their classification. While

predictability can help the bank manage its cash flows and liquidity, it does not imply that the

deposits are stable or long-term.

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Q.4052 RTC bank, a fictional financial institution in Thailand, has been preparing a daily liquidity
report after stress testing for years. Which among the following is not correct about the bank’s
daily liquidity report?

A. It presents the bank’s marketable assets and liabilities

B. It is prepared for up to one-year maturity and beyond

C. It only presents the bank’s marketable assets

D. It reports the end-of-day liquidity position

The correct answer is C.

The statement that the daily liquidity report only presents the bank's marketable assets is

incorrect. The daily liquidity report is a comprehensive document that provides a detailed

overview of the bank's financial position. It includes not only the bank's marketable assets but

also its liquid assets and liabilities. Marketable assets are those that can be easily sold or

converted into cash without significantly affecting their price. On the other hand, liquid assets

are those that can be quickly converted into cash. Liabilities, in this context, refer to the

financial obligations or debts that the bank owes. Therefore, the report provides a holistic view

of the bank's liquidity position, which is crucial for effective financial management and decision-

making.

Choice A is incorrect. The daily liquidity report of RTC bank does indeed present the bank's

marketable assets and liabilities. This is a crucial part of any liquidity report as it provides an

overview of the bank's financial position, including both its assets that can be easily converted

into cash and its outstanding debts.

Choice B is incorrect. The statement that the report is prepared for up to one-year maturity

and beyond is also accurate. Liquidity reports typically cover short-term periods (up to one year)

but may also include projections for longer periods depending on the institution's needs and

regulatory requirements.

Choice D is incorrect. It correctly states that the daily liquidity report includes information

about RTC Bank’s end-of-day liquidity position, which helps in understanding how much liquid

assets are available at the end of each day for meeting any immediate obligations.

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Q.4053 MCT bank has been preparing a mismatch report after a stress testing process. Which
among the following statements is accurate about mismatch reports?

A. The mismatch report reflects the maturity gap for all assets and liabilities per time
bucket and with an adjustment for liquid securities.

B. The report doesn’t apply in generating the horizon report for cash flow

C. It presents the bank’s marketable assets and liabilities

D. It reports the end-of-day liquidity position

The correct answer is A.

The mismatch report usually comprises of the cumulative liquidity cash flow of both liquidity

daily liquidity report and deposit tracker report

B is incorrect: The mismatch report is used to generate the survival horizon report for

cashflows.

C is incorrect: The bank’s marketable assets and liabilities are presented in a daily liquidity

report

D is incorrect: The end of day liquidity position is presented in a daily liquidity report.

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Q.4054 A financial institution is preparing a large depositor concentration report for a banking
group. What is the most accurate meaning of the word “large” in this case?

A. Someone that owns the majority of shares

B. Someone that undertakes more than USD 50 million withdrawals

C. Someone that deposits a deposit of 5% of total liabilities.

D. None of the above

The correct answer is C.

In a large depositor concentration, the term “large” refers to someone that deposits a deposit of

5% of total liabilities.

A is incorrect: Someone that owns most shares is not referred to as “large” in deposit

concentration

B is incorrect: Large deposit concentration is defined in terms of deposits, not withdrawals

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Q.4055 Off-balance-sheet items serve as potential stress points for a bank’s funding. Which
among the following is not an off-balance sheet item?

A. Liquidity lines

B. Letters of credit

C. Revolving credit facilities

D. Liquid assets

The correct answer is D.

Liquid assets are not considered off-balance-sheet items. Instead, they are included in the asset

portion of a bank's balance sheet. Liquid assets are those assets that can be easily converted into

cash without significantly affecting their value. These include cash, marketable securities, and

government bonds. These assets are crucial for a bank's liquidity management as they can be

quickly sold to meet immediate and short-term obligations, thereby reducing the risk of

insolvency. Therefore, liquid assets are on-balance-sheet items that contribute to a bank's

liquidity and overall financial stability.

Choice A is incorrect. Liquidity lines are indeed classified as off-balance-sheet items. They

represent commitments by a bank to lend funds to a client, and these commitments do not

appear on the balance sheet until they are drawn upon by the client.

Choice B is incorrect. Letters of credit also fall under off-balance-sheet items. These are

guarantees provided by a bank on behalf of its clients for making payments to third parties, and

they do not appear on the balance sheet unless the client defaults and the bank has to make

good on its guarantee.

Choice C is incorrect. Revolving credit facilities are another type of off-balance-sheet item.

These facilities allow clients to borrow up to a certain limit as needed, and repay with flexibility

over time. The undrawn portion of these facilities does not appear on the balance sheet but can

create significant liabilities for banks if all their clients draw down their facilities at once.

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Q.4056 The liability profile is a simple breakdown of the share of each type of liability at the
bank.Which of the following is not a part of the liability profile?

A. Customer individuals

B. Highly liquid security repo

C. Asset-backed securities

D. Highly liquid assets

The correct answer is D.

Highly liquid assets are not part of the liability profile. The liability profile of a bank is a

representation of the bank's financial obligations, i.e., what the bank owes to others. Highly

liquid assets, on the other hand, are assets that can be quickly converted into cash without any

significant loss in value. These assets are part of the bank's asset profile, not its liability profile.

They represent resources that the bank owns and can use to meet its financial obligations.

Therefore, highly liquid assets are not included in the liability profile.

Choice A is incorrect. Customer individuals are indeed a part of the bank's liability profile.

They represent the deposits made by individual customers, which are liabilities for the bank as

they are obligated to return these funds upon demand.

Choice B is incorrect. Highly liquid security repos (repurchase agreements) also form part of a

bank's liability profile. These are short-term borrowing for dealers in government securities and

the dealer sells the government securities to investors, usually on an overnight basis, and buys

them back the following day at a slightly higher price.

Choice C is incorrect. Asset-backed securities can be part of a bank's liability profile if they

have been issued by the bank itself. In this case, they represent obligations that must be met by

generating sufficient returns from the underlying assets.

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Q.4057 Which among the choices is not considered in regular liquidity qualitative reporting
concerning individual liquidity adequacy standards (ILAS)?

A. Details on any increase or decrease in retail deposits

B. Details on average day-to-day opening cash position

C. Details on shrinkage or growth of asset books

D. Details on deposit month-end actuals by customer type

The correct answer is D.

Details on deposit month-end actuals by customer type are not typically included in regular

liquidity qualitative reporting concerning individual liquidity adequacy standards (ILAS). These

details are usually part of a separate report known as the deposit tracker report. This report is

designed to provide a comprehensive view of the bank's deposit base, including the breakdown

by customer type. It helps the bank to understand the composition of its deposit base and to

manage its liquidity risk effectively. However, it is not a standard requirement in the regular

qualitative reporting on liquidity under ILAS.

Choice A is incorrect. Details on any increase or decrease in retail deposits are typically

included in the regular qualitative reporting. This information is crucial as it provides insights

into the liquidity position of the financial institution and can indicate potential liquidity risks.

Choice B is incorrect. The average day-to-day opening cash position is also a typical

component of regular qualitative reporting on liquidity. It helps to understand how much liquid

assets the institution has at its disposal at the start of each business day, which can be critical for

managing daily operations and meeting short-term obligations.

Choice C is incorrect. Information about shrinkage or growth of asset books forms part of this

reporting too. Changes in asset books can significantly impact an institution's liquidity position,

hence it's important to monitor and report these changes regularly.

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Q.4058 The following is an excerpt from Bright Bank’s Deposit Tracker from the End of the year
2018 to July 2019.

Deposit tracker Month-end actuals Month-end actuals Month-end Forecasts Month-end Forecasts
31/12/2018 31/01/2019 31/05/2019 30/06/2019
Total customer deposits 612, 152 423, 804 651, 112 599, 774
Total customer loans 547, 478 373, 381 520, 829 480, 122

Calculate the bank’s loan-to-deposit ratio as at 31/12/2018

A. 0.84

B. 0.86

C. 0.87

D. 0.89

The correct answer is D.

Total customer loans

Loan-to-deposit (LTD) ratio =
Total customer deposits
547, 478
=
612, 152
= 89%

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Q.4059 The following is an excerpt from Bright Bank’s Deposit Tracker from End of the year
2018 to July 2019.

Deposit tracker Month-end actuals Month-end Forecasts

31/12/2018 31/01/2019 31/05/2019 30/06/2019
Total customer deposits 612, 152 423 , 804 651, 112 599, 774
Total customer loans 547, 478 373 , 381 520, 829 480, 122

How much does the bank need to increase its total customer loans by to meet its targeted loan-
to-deposit ratio of 85% on 30/06/2019?

A. 22445

B. 29685

C. 31587

D. 33465

The correct answer is B.

Total customer loans

Loan-to-deposit (LTD) ratio =
Total customer deposits
x
85% =
599, 774
x = 509, 807
Increment = 509, 807 − 480, 122 = 29, 685

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Q.4060 Which among the following choices is correct about derivatives value or notional
treatment concerning UK regulations?

A. For off-balance sheet items, derivative values are not included in the calculation of the
liquidity ratio

B. Derivatives are included to the extent of collateral payable or receivable under an

ISDA/CSA agreement

C. For off-balance sheet items, coupons receivable or payable are not included on their
pay dates

D. None of the above

The correct answer is A.

According to the UK regulations, derivative values or notionals are not included in the

calculation of the liquidity ratio for off-balance sheet items. This means that the value of

derivatives, which are financial instruments whose value is derived from the value of other

assets, are not considered when calculating the liquidity ratio. The liquidity ratio is a measure of

a company's ability to meet its short-term obligations, and it is calculated by dividing a

company's liquid assets by its current liabilities. By excluding derivative values from this

calculation, the UK regulations are effectively saying that these financial instruments do not

contribute to a company's liquidity, or its ability to meet its short-term obligations.

Choice B is incorrect. In the context of UK regulations, derivatives are not included in the

calculation of off-balance sheet items to the extent of their notional value, regardless of whether

collateral is payable or receivable under an ISDA/CSA agreement.

Choice C is incorrect. Coupons receivable or payable on derivatives are indeed included in off-

balance sheet calculations on their pay dates. This statement contradicts standard regulatory

practices and thus, it's inaccurate.

Choice D is incorrect. As explained above, choices B and C contain inaccuracies regarding how

derivatives are treated in relation to off-balance sheet items and liquidity ratios under UK

regulations.

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Q.4061 In preparation of a deposit tracker report, Cate Wilson, the manager of the bank
preparing the report, realized that most of the retail bank deposits consisted of the current
accounts and rolling deposits. How should the bank treat these funds in the regulation process?

A. As long-term liabilities

B. As liquid assets

C. As short-term liabilities

D. None of the above

The correct answer is C.

Current accounts and rolling deposits are considered short-term liabilities in the context of

banking regulations. This is because these types of deposits can be withdrawn by the customer

at any time, making them a liability for the bank. The bank is obligated to return these funds

upon the customer's request, hence they are classified as short-term liabilities. Regulatory

liquidity metrics, which are used to assess a bank's ability to meet its short-term obligations, do

not consider these funds as contributing to the bank's liquidity. This is because these funds can

be withdrawn at any time, potentially leaving the bank without sufficient liquid assets to meet its

obligations. However, there are exceptions to this rule. For instance, if the bank can demonstrate

that these funds are behaving as long-term funds, the local regulator may allow the bank to treat

them as such. This means that if the bank can show that these funds are not likely to be

withdrawn in the short term, they may be classified as long-term liabilities.

Choice A is incorrect. Current accounts and rolling deposits cannot be classified as long-term

liabilities. These are short-term in nature as they can be withdrawn by the depositor at any time,

hence they do not represent a long-term obligation for the bank.

Choice B is incorrect. While current accounts and rolling deposits are liquid from the

depositor's perspective, from the bank's perspective these are not assets but liabilities. The bank

owes these funds to their depositors and therefore, they cannot be classified as liquid assets.

Choice D is incorrect. As explained above, current accounts and rolling deposits should indeed

be classified in a specific way in regulatory processes - namely as short-term liabilities - so 'None

of the above' is not an accurate answer.

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Q.4062 The regulatory authority for ACB bank generated a funding yield curve after conducting
a stress test. They then compared the curve with the ones generated by their peers. The bank’s
management realized that their curve had risen significantly beyond the curves of its peers.
What is the possible implication of these results?

A. ABC is experiencing funding stress

B. ABC is experiencing high liquidity levels

C. ABC has more liabilities than assets

D. ABC has a high level of solvency

The correct answer is A.

ABC is experiencing funding stress. A funding yield curve is a graphical representation of the

interest rates on debt for a range of maturities. It shows the relationship between the interest

rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given

currency. In this case, if ABC bank's funding yield curve rises significantly beyond the curves of

its peers, it indicates that the bank is experiencing funding stress. This could be due to various

factors such as increased borrowing costs, reduced access to funding sources, or a combination

of these factors. The bank may need to take corrective measures to address this issue, such as

improving its liquidity management, reducing its reliance on short-term funding, or increasing its

capital buffers.

Choice B is incorrect. High liquidity levels would typically result in a lower funding yield

curve, not a higher one. This is because when a bank has high liquidity, it means that it has more

assets readily available to meet its short-term obligations, reducing the need for external funding

and thus lowering the cost of such funding.

Choice C is incorrect. Having more liabilities than assets does not necessarily lead to a higher

funding yield curve. While it's true that banks with more liabilities may face greater funding

stress, this relationship isn't direct or guaranteed. Other factors such as the bank's

creditworthiness and market conditions also play significant roles in determining the shape of its

yield curve.

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Choice D is incorrect. A high level of solvency implies that ABC Bank has sufficient assets to

cover its long-term liabilities which should ideally lead to a lower or at least stable yield curve

rather than an elevated one as observed in this case.

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Q.4063 A qualitative monthly report is prepared and send to the head office group treasury for
the banking groups operating across country jurisdictions or multiple subsidiaries for a good
understanding of the liquidity position in the respective countries. Among the components of the
report, the liquidity gap is captured, what is a liquidity gap in this context?

A. A mismatch in the supply or demand for a security or the maturity dates of securities

B. Lower liabilities than assets

C. The difference between the average maturity of assets and liabilities

D. None of the above

The correct answer is A.

A liquidity gap refers to a mismatch in the supply or demand for a security or the maturity dates

of securities. This discrepancy can lead to a cash shortage, which is a critical issue for any

financial institution. The liquidity gap is a crucial component of the monthly report as it provides

an insight into the liquidity position of the banking groups. Understanding the liquidity gap can

help the head office group treasury to make informed decisions regarding the management of

liquidity and to mitigate potential risks associated with liquidity mismatches.

Choice B is incorrect. A liquidity gap does not refer to having lower liabilities than assets. In

fact, a bank may have more assets than liabilities and still face a liquidity gap if the maturity

dates of its assets and liabilities do not align.

Choice C is incorrect. The liquidity gap is not defined as the difference between the average

maturity of assets and liabilities. While this could potentially contribute to a liquidity gap, it does

not fully capture the concept as it ignores other factors such as cash inflows and outflows.

Choice D is incorrect. As explained above, there are specific definitions for what constitutes a

liquidity gap in banking groups operating across multiple jurisdictions or subsidiaries, so 'None

of the above' would be an inaccurate choice.

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Q.4064 A report is based on granular analysis of the firm’s marketable asset holdings, prepared
every month, and submitted in 15 business days after the month-end. Which of the following
reports is most accurately described in the given description?

A. Daily flows report

B. Wholesale liabilities report

C. Liquidity buffer qualifying securities report

D. Currency analysis report

The correct answer is C.

A Liquidity Buffer Qualifying Securities Report is indeed based on a granular analysis of a firm's

marketable asset holdings. It is prepared monthly and is typically submitted within 15 business

days after the end of the month. This report is crucial for firms as it provides a detailed overview

of the liquidity of their assets. It helps firms to understand their financial position better and

make informed decisions regarding their asset management. The report includes information

about the firm's liquid assets, which are assets that can be quickly converted into cash without

affecting their market price. These assets are crucial for a firm's financial stability as they can be

used to meet short-term obligations.

Choice A is incorrect. A daily flows report, as the name suggests, is prepared on a daily basis

and not monthly. It primarily focuses on the inflow and outflow of cash rather than a detailed

examination of marketable asset holdings.

Choice B is incorrect. A wholesale liabilities report mainly deals with the firm's liabilities that

are due for payment to its creditors or lenders. It does not provide a detailed examination of a

firm's marketable asset holdings.

Choice D is incorrect. A currency analysis report primarily focuses on analyzing different

currencies' performance and their impact on the firm's financial position. It does not focus

specifically on the firm's marketable asset holdings.

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Q.4065 How various specific types of cashflow are treated is an essential question in liquidity
reporting. Under what circumstance should a bank treat 50% of deposit funds as long-term
funds?

A. If it is evident that they can remain relatively stable over time

B. If their stability is uncertain

C. If they contribute to the highest portion of the bank’s funding

D. None of the above

The correct answer is A.

A deposit is typically considered a short-term fund. However, regulatory authorities allow for a

different classification under certain conditions. If there is evidence that deposits can remain

stable over a longer period, then 50% of these deposits can be treated as long-term funds. This is

because the stability of these funds over time reduces the liquidity risk for the bank, allowing it

to rely on these funds for longer-term obligations. Therefore, in the context of liquidity reporting,

these deposits can be considered as long-term funds.

Choice B is incorrect. A banking institution cannot categorize deposits as long-term funds if

their stability is uncertain. Long-term funds are typically stable and reliable sources of funding

that can be expected to remain in place over a longer time horizon.

Choice C is incorrect. The contribution of the deposits to the bank's overall funding does not

determine whether they can be classified as long-term funds. It's the stability and predictability

of these funds that matter, not their proportion in the bank's total funding.

Choice D is incorrect. As explained above, a banking institution would be justified in

categorizing 50% of its deposit funds as long-term if it is evident that they can remain relatively

stable over time (choice A). Therefore, 'None of the above' cannot be correct.

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Reading 137: Contingency Funding Planning

Q.4066 Ashley Mathias is the financial risk manager at Sycamore Bank. Ashley plans to design a
contingency funding plan (CFP) for the institution. As a financial risk manager, which of the
following considerations, will she not be mindful of when conducting this exercise? Ashley should
ensure:

A. Support by a communication plan

B. Integration with broader risk management frameworks

C. Inclusion of appropriate stakeholder groups

D. No liquidity gap before beginning the exercise

The correct answer is D.

The presence of a liquidity gap is not a prerequisite for initiating the design of a Contingency

Funding Plan (CFP). A liquidity gap analysis is indeed a crucial component of a CFP, but it is not

a factor that needs to be considered before starting the exercise. The purpose of a CFP is to

ensure that the institution has adequate procedures and policies in place to manage potential

liquidity crises. Therefore, the existence of a liquidity gap should not prevent the initiation of the

CFP exercise. Instead, the identification and management of such gaps are part of the CFP

process itself.

Choice A is incorrect. A communication plan is indeed a prerequisite for initiating a CFP

exercise. It ensures that all relevant parties are informed about the plan, its objectives, and their

roles in it. This helps in smooth execution of the plan when needed.

Choice B is incorrect. Integration with broader risk management frameworks is also necessary

before starting the CFP exercise. This integration allows for better identification and

management of risks associated with liquidity and funding, thereby enhancing the effectiveness

of the CFP.

Choice C is incorrect. Inclusion of appropriate stakeholder groups is another important

prerequisite for initiating a CFP exercise. These stakeholders can provide valuable inputs during

the planning process and ensure that all aspects related to liquidity risk are adequately

addressed in the plan.

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Q.4067 The design of a CFP should integrate with the broader risk management frameworks.
Which among the following choices is not part of the risk management frameworks under
consideration?

A. Enterprise risk management (ERM)

B. Business continuity and crisis management

C. Financial management

D. Capital management

The correct answer is C.

Financial management is not typically considered a part of the risk management frameworks

that are integrated with a Contingency Funding Plan (CFP). While financial management is an

essential aspect of any organization, it does not directly fall under the risk management

frameworks that are considered for integration with a CFP. Financial management primarily

deals with the financial resources of an organization, including budgeting, forecasting, and

financial reporting. It is more concerned with the efficient management of an organization's

financial resources rather than managing risks. However, it is worth noting that financial

management is a crucial framework in the long-term council community plan (LTCCP) analysis.

Choice A is incorrect. Enterprise risk management (ERM) is a crucial framework that should

be integrated with a CFP. ERM provides an organization-wide approach to identify, assess,

manage, and control potential risks. It helps in ensuring the effectiveness and consistency of the

CFP by providing a holistic view of all risks.

Choice B is incorrect. Business continuity and crisis management are also essential

frameworks to integrate with a CFP. These frameworks help in planning for unexpected events or

crises that could disrupt business operations, including financial disruptions. Therefore, they

play an important role in designing an effective CFP.

Choice D is incorrect. Capital management should also be considered when integrating with a

CFP as it involves managing the firm's capital structure to ensure financial stability and mitigate

risks associated with insolvency or bankruptcy.

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Q.4068 Roy Jakes, the financial risk manager for Pathway financial institution, is preparing a
design for a CFP. As an essential consideration in the plan, he must include appropriate
stakeholders. Which among the following members is NOT part of the considered stakeholders?

A. Internal audit committee

B. Risk and capital committee

C. Management committee

D. Operations and technology

The correct answer is A.

Internal audit committee is not a stakeholder when designing a CFP. However, internal audit is

involved with periodical reviews on the liquidity stress testing framework and procedures.

B is incorrect: Risk and capital committee is an essential stakeholder responsible for setting

the principles and parameters for measuring and assigning risk and capital within the business.

C is incorrect: Different management committees such as the asset-liability committee (ALCO),

risk and capital committee, and investment committee are key stakeholders in CFP.

D is incorrect: The operational and technology committee reviews and approves the

institution’s technology planning and strategy.

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Q.4069 In JCL bank, Fatou James is the head of the corporate treasury. Which among the
following choices best lists the roles of her committee?

A. It serves as an advisor and counsel to the management committee and LCT teams

B. It monitors the ongoing business, funding, risk, and liquidity profile as part of its BAU
activities.

C. It provides recommendations on CFP actions.

D. It provides oversight of the LCT and does a consultation with the board of directors to
monitor the institution’s liquidity risk profile

The correct answer is B.

The corporate treasury in a banking institution, such as JCL bank, is primarily responsible for

monitoring the ongoing business, funding, risk, and liquidity profile as part of its Business As

Usual (BAU) activities. This involves keeping a close eye on the bank's financial activities and

ensuring that the bank has sufficient liquidity to meet its obligations. The corporate treasury also

plays a crucial role in managing the bank's financial risks, which includes credit risk, market

risk, and operational risk. By monitoring these aspects, the corporate treasury can help the bank

maintain financial stability and avoid potential financial crises. This role is critical in ensuring

the bank's long-term sustainability and success.

Choice A is incorrect. While the corporate treasury does provide advice and counsel, it is not

its primary responsibility. The main role of the corporate treasury in a banking institution is to

manage financial risks and ensure financial stability, which includes monitoring ongoing

business, funding risk, and liquidity profile.

Choice C is incorrect. Providing recommendations on Contingency Funding Plan (CFP) actions

may be part of the responsibilities of the corporate treasury but it's not its primary duty. The

main function revolves around managing financial risks and ensuring stability.

Choice D is incorrect. Although oversight of Liquidity Contingency Teams (LCT) and

consultation with the board of directors are important tasks performed by the corporate treasury,

they do not constitute its primary responsibilities. The core duties involve managing financial

risks including monitoring ongoing business activities, funding risk, and liquidity profile.

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Q.4070 An effective CFP should ensure that there are contingency plans in place to cushion the
bank when certain events that can potentially impact liquidity happen. Which among the
following events does NOT have a negative liquidity impact on a financial institution?

A. Presence of predatory trade

B. Unavailability of the Federal Home Loan Bank Funding

C. Shifting allocation from short-term funding to long-term funding sources

D. When the intraday debit cap with Fedwire is exceeded

The correct answer is C.

Shifting allocation from short-term funding to long-term funding sources is a strategic move that

can actually enhance a financial institution's liquidity position. Short-term funding sources, while

readily available, can be volatile and subject to sudden changes in the market. On the other

hand, long-term funding sources provide a more stable and reliable stream of capital. By shifting

the allocation towards long-term funding, the institution can ensure a steady flow of funds over a

longer period, thereby reducing the risk of liquidity stress. This strategy also allows the

institution to better manage its cash flow and meet its financial obligations in a timely manner.

Therefore, this action does not have a negative liquidity impact on the financial institution, but

rather, it strengthens its liquidity position.

Choice A is incorrect. The presence of predatory trade can indeed pose a negative impact on a

bank's liquidity. Predatory trading practices, such as front running or pump and dump schemes,

can lead to significant financial losses for the bank and thereby reduce its available liquid assets.

Choice B is incorrect. The unavailability of the Federal Home Loan Bank Funding could also

negatively affect a bank's liquidity. This funding source provides banks with access to secured

loans which they can use to meet their short-term liquidity needs. If this source becomes

unavailable, it could put strain on the bank's liquidity position.

Choice D is incorrect. Exceeding the intraday debit cap with Fedwire could also have negative

implications for a bank's liquidity position. Fedwire is a real-time gross settlement system of

central bank money used by Federal Reserve Banks to transfer funds electronically between

member institutions. If a bank exceeds its intraday debit cap, it may face penalties or restrictions

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that could hinder its ability to manage its daily cash flows effectively.

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Q.4072 Several market factors can affect the institution’s ability to take contingent actions that
help in strengthening the institution’s liquidity position. Which among the following factors does
NOT pose such an effect to institutions?

A. Shutdown of securitization markets

B. Deposit runoff

C. Failure of the counterparties to roll over their deposits

D. Withdrawal of debit caps

The correct answer is D.

The withdrawal of debit caps does not impact an institution's ability to take contingent actions to

strengthen its liquidity position. Debit caps are limits set on the amount that can be debited from

an account in a given period. Withdrawing these caps simply allows institutions to access more

intraday credit, but it does not directly affect their ability to take contingent actions. It is

important to note that while this may not be a typical scenario, it is a possibility that institutions

must consider in their risk management strategies.

Choice A is incorrect. The shutdown of securitization markets can significantly impact an

institution's ability to take contingent actions. Securitization markets provide a source of

liquidity for financial institutions by allowing them to convert assets into cash through the sale of

asset-backed securities. If these markets shut down, it could limit the institution's access to

liquidity and thus its ability to take contingent actions.

Choice B is incorrect. Deposit runoff, which refers to the withdrawal of deposits by customers,

can also affect an institution's liquidity position and its ability to take contingent actions. If a

significant number of depositors withdraw their funds, this could lead to a liquidity crunch for

the institution.

Choice C is incorrect. The failure of counterparties to roll over their deposits can have a direct

impact on an institution's liquidity position and its ability to take contingent actions. When

counterparties decide not to renew or "roll over" their deposits at maturity, this reduces the

available pool of funds that the financial institution has at its disposal.

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Q.4073 When designing a CFP, monitoring and escalation is a key component of the CFP
framework. In the framework, Institutions are required to define early warning indicators using
market and business factors. Which of the following factors is NOT a potential factor considered?

A. Macro-environment measures

B. Industry measures

C. Financial measures

D. Institution-specific measures

The correct answer is C.

Financial measures are not necessarily required by institutions to monitor market trends and

trends among their peer group. The term 'financial measures' is quite broad and does not

specifically pertain to any particular aspect of an institution's operations or the market. While

financial measures can provide valuable insights into an institution's financial health and

performance, they are not typically used as early warning indicators in a Contingency Funding

Plan (CFP). This is because financial measures often reflect the outcomes of various business and

market factors, rather than the factors themselves. Therefore, they may not provide timely or

accurate warnings of potential liquidity crises or other financial risks.

Choice A is incorrect. Macro-environment measures are typically considered in the creation of

a Contingency Funding Plan (CFP). These measures can include economic indicators, market

trends, and geopolitical events that could potentially impact the institution's liquidity position.

Choice B is incorrect. Industry measures are also taken into account when creating a CFP.

These can include industry-specific risks, competitive dynamics, regulatory changes and

technological advancements that could affect the institution's financial stability.

Choice D is incorrect. Institution-specific measures are crucial in developing a CFP as they

directly relate to the institution's own operations and risk profile. These may encompass internal

factors such as operational efficiency, financial performance, strategic initiatives and

management quality.

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Q.4074 Early warning indicators (EWIs) should act as warning signs to the management to
evaluate how changing market conditions and the institution’s business strategy may be
impacted. This should prompt the management to act in advance of oncoming market disruptions
proactively. Which among the following factors is NOT an EWI encompassing market and
business factors?

A. A spike in the market volatility

B. An increase in asset quality

C. Real or perceived negative publicity

D. Canceling loan commitments and refusing to renew maturing loans

The correct answer is B.

An increase in asset quality is not considered an Early Warning Indicator (EWI). EWIs are

typically negative or adverse changes in market or business conditions that signal potential risks

or disruptions. An increase in asset quality, on the other hand, is generally a positive

development for a financial institution. It indicates that the institution's assets are performing

well, which can enhance its financial stability and reduce the likelihood of liquidity stress.

Therefore, an increase in asset quality does not serve as a warning sign of potential market

disruptions or adverse changes in the institution's business strategy.

Choice A is incorrect. A spike in the market volatility can indeed serve as an Early Warning

Indicator (EWI). Increased market volatility may signal potential disruptions or changes in the

financial markets, which could impact a financial institution's business strategy and

performance.

Choice C is incorrect. Real or perceived negative publicity can also be considered an EWI.

Negative publicity, whether based on fact or perception, can affect a financial institution's

reputation and customer trust, potentially leading to loss of business and revenue.

Choice D is incorrect. Cancelling loan commitments and refusing to renew maturing loans can

be seen as an EWI as well. These actions might indicate that the institution is facing liquidity

issues or other internal problems that could negatively affect its operations and profitability.

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Q.4075 An institution must monitor a suite of liquidity health ratios besides reviewing macro-
economic and industry measures as part of a CFP framework. These ratios aid in quantifying the
impact of liquidity risks and supporting decision making on the CFP actions under consideration.
The used capacity to total borrowing capacity is one of the liquidity health ratios. Which of the
following accurately describes this measure?

A. Measures the borrowing capacity available to the institution, based on used capacity
relative to the total borrowing capacity

B. Measures the cushion that liquid assets offer over obligatory funding needs and can be
used to track the level of liquid assets available to offset volatile funding

C. Measures the exposure to credit facilities that may be required at a future date

D. Measures the funding and borrowing enough to finance the institution’s increased
lending banking activities

The correct answer is A.

The 'used capacity to total borrowing capacity' ratio is a measure of the borrowing capacity

available to a financial institution. It is calculated based on the used capacity relative to the total

borrowing capacity. This ratio is crucial as it provides insights into the extent to which the

institution has utilized its borrowing capacity. A higher ratio indicates that the institution has

used a larger portion of its total borrowing capacity, which could potentially signal a higher risk

of liquidity issues. Conversely, a lower ratio suggests that the institution has a larger unused

borrowing capacity, indicating a lower risk of liquidity problems.

Choice B is incorrect. This choice refers to the liquidity coverage ratio (LCR), which measures

the amount of high-quality liquid assets an institution has to meet its short-term obligations. It

does not represent the 'used capacity to total borrowing capacity' ratio.

Choice C is incorrect. This option describes a potential future exposure measure, which

estimates potential changes in credit exposure over time due to market movements or other

factors. It does not describe the 'used capacity to total borrowing capacity' ratio.

Choice D is incorrect. This choice seems to refer more towards a measure of an institution's

ability to finance its lending activities through funding and borrowing, rather than indicating

how much of its total borrowing capacity has been used up, as described by the 'used capacity to

total borrowing capacity' ratio.

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Q.4076 In designing a CFP, institutions develop a series of escalation levels adequately aligned to
the scenarios, contingency actions, and liquidity measures. However, there are no guidelines in
the number of escalation levels required by CFPs. Which among the following statements is
correct about the first level of escalation?

A. At this level, the institution focuses mainly on survival

B. It represents the elevated monitoring of market conditions and its effect on the
business performance

C. At this level, the institution has experienced noticeable markets and idiosyncratic
events that are adversely affecting its business and liquidity risk profile

D. None of the above

The correct answer is B.

The first level of escalation in a Contingency Funding Plan (CFP) is characterized by an

increased level of monitoring of market conditions and their impact on the institution's business

segments and performance. This level does not necessarily indicate a crisis but rather a

heightened state of vigilance. The institution at this stage is not in survival mode or experiencing

adverse market and idiosyncratic events significantly affecting its business and liquidity risk

profile. Instead, it is proactively monitoring the market conditions to identify any potential

threats to its business performance and take necessary actions in a timely manner. This proactive

approach helps the institution to manage its risks effectively and ensure its financial stability.

Choice A is incorrect. The first level of escalation in a CFP does not focus mainly on survival.

This stage is more about monitoring and identifying potential risks rather than dealing with

immediate threats to the institution's survival.

Choice C is incorrect. At the first level of escalation, the institution has not necessarily

experienced noticeable market and idiosyncratic events that are adversely affecting its business

and liquidity risk profile. This stage involves elevated monitoring of market conditions, but it

does not imply that adverse events have already occurred.

Choice D is incorrect. As explained above, option B correctly describes the characteristics and

implications of the first level of escalation in a CFP, so 'None of the above' cannot be correct.

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Q.4077 In designing a CFP, liquidity health measures need to be put into consideration. Which
among the following choices most accurately states the significance of these measures as part of
the monitoring and escalation component of the CFP framework?

A. They indicate the institution’s liquidity base and strength

B. They indicate the institution’s management policy

C. They indicate the institution’s liquidity profile

D. None of the above

The correct answer is A.

Liquidity health measures are pivotal in indicating the institution’s liquidity base and strength.

These measures, such as the proportion of short-term funding to total funding, the deposits-to-

loan ratio for depository businesses, and the firm’s credit rating, are specifically designed to

reflect any deterioration in these metrics that could have a direct and adverse impact on the

institution’s current and projected liquidity profile and strength. Therefore, these measures

serve as a reliable indicator of the institution's liquidity base and strength, making them an

essential component of the CFP framework.

Choice B is incorrect. While the institution's management policy may influence its liquidity

health measures, it is not the primary reason why these measures are significant in designing a

Contingency Funding Plan (CFP). The CFP primarily focuses on the institution's liquidity base

and strength, which directly impacts its ability to meet financial obligations during a crisis.

Choice C is incorrect. Although an institution's liquidity profile can provide insights into its

overall financial health, it does not specifically indicate why liquidity health measures are crucial

in designing a CFP. The main purpose of these measures within a CFP framework is to assess and

monitor the institution's liquidity base and strength.

Choice D is incorrect. As explained above, none of the above cannot be correct as option A

correctly identifies that liquidity health measures indicate an institution’s liquidity base and

strength which forms an integral part of monitoring and escalation component of the CFP

framework.

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Q.4078 Which among the following choices is FALSE about scenario and liquidity gap analysis, a
key component of the CFP framework?

A. Institutions should align their CFP stress scenarios to those in its liquidity stress
testing framework.

B. The scenarios should align to those in other frameworks such as the recovery and
resolution plans

C. The liquidity stress testing scenarios should cover both systemic and institution-
specific risks

D. None of the above

The correct answer is D.

The statement 'None of the above' is false because all the given choices (A, B, and C) are true.

Institutions should align their CFP stress scenarios to those in its liquidity stress testing

framework. The scenarios should also align to those in other frameworks such as the recovery

and resolution plans. The liquidity stress testing scenarios should cover both systemic and

institution-specific risks. Therefore, the assertion that none of the above statements are true is

incorrect.

Choice A is incorrect. Institutions should indeed align their Contingency Funding Plan (CFP)

stress scenarios with those in its liquidity stress testing framework. This alignment ensures that

the institution is prepared for potential liquidity stresses and can respond effectively.

Choice B is incorrect. The statement is true as the scenarios should align with other

frameworks such as recovery and resolution plans. This alignment provides a comprehensive

view of potential risks and ensures that all aspects of risk management are considered in the

planning process.

Choice C is incorrect. The liquidity stress testing scenarios should cover both systemic and

institution-specific risks, which means this statement is also true. By considering both types of

risks, institutions can ensure they are prepared for a wide range of potential stress events.

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Q.4079 Institutions need to document their CFPs and ensure alignment with other risk
management, business continuity, and recovery planning-related policies and procedures. Which
of the following choices is NOT a central part of the CFP policy outline?

A. Governance

B. Monitoring and escalation

C. Planning

D. Reporting

The correct answer is C.

Planning is not typically included as a central part of the Contingency Funding Plan (CFP) policy

outline. While planning is an essential aspect of any risk management or business continuity

strategy, it is not typically included as a separate section within the CFP policy outline. Instead,

the planning process is usually integrated throughout the various sections of the CFP, such as

governance, monitoring and escalation, and reporting. The planning process involves identifying

potential risks, developing strategies to mitigate these risks, and establishing procedures for

responding to potential crisis situations. However, these elements are usually incorporated into

the other sections of the CFP policy outline, rather than being included as a separate planning

section.

Choice A is incorrect. Governance is a crucial component of the Contingency Funding Plan

(CFP) policy outline. It provides the framework for decision-making and accountability within an

organization, ensuring that risk management practices are in place and followed.

Choice B is incorrect. Monitoring and escalation are also key components of a CFP policy

outline. Monitoring ensures that potential risks are identified early, while escalation procedures

ensure that these risks are addressed promptly and by the appropriate personnel.

Choice D is incorrect. Reporting forms an integral part of any CFP policy outline as it

facilitates communication about risk management activities to all relevant stakeholders,

including regulators, senior management, and board members.

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Q.4080 Which of the following components is NOT a part of the CFP framework?

A. Governance and oversight

B. Liquidity monitoring

C. Contingent actions

D. Monitoring and escalation

The correct answer is B.

Liquidity monitoring is not a component of the CFP framework. While it is a critical process in

financial management, it stands as a separate entity and is not included in the CFP framework.

Liquidity monitoring involves the regular assessment of an organization's liquidity position to

ensure that it has sufficient funds to meet its short-term obligations. This process includes

monitoring cash flows, analyzing liquidity ratios, and assessing the organization's overall

financial health. However, it is not directly incorporated into the CFP framework, which focuses

more on contingency planning and risk mitigation strategies.

Choice A is incorrect. Governance and oversight are crucial components of the CFP

framework. They ensure that there is a clear structure for decision-making, accountability, and

control in managing financial resources and mitigating risks.

Choice C is incorrect. Contingent actions are also part of the CFP framework. These are

predefined actions that an organization plans to take if certain risk events occur or certain

conditions are met.

Choice D is incorrect. Monitoring and escalation procedures form an integral part of the CFP

framework as well. They help in identifying potential risks early on and escalating them to the

appropriate level for timely action.

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Reading 138: Managing and Pricing Deposit Services

Q.4081 The following are the major types of deposit plans that depository institutions offer today.
Which one is NOT?

A. Transaction deposits

B. Thrift deposits

C. Hybrid deposits

D. None of the above

The correct answer is D.

Deposit plans can be divided broadly into transaction deposits, thrift or non-transaction deposits,

and hybrid deposits. The primary function of transaction deposits is to make payments, and these

deposits include regular checking accounts and NOW accounts. The principal purpose of thrift

deposits is to serve as accumulated savings and include passbook and statement savings

accounts, CDs, and other time deposit accounts. Hybrid deposits combine transactions and thrift

features and include money-market deposit accounts and Super NOWs.

A is incorrect: Transaction deposits are deposit plans whose primary function of transaction

deposits is to make payments, and these deposits include regular checking accounts and NOW

accounts.

B is incorrect: Thrift deposits are savings accounts that serve as accumulated savings and

include passbook and statement savings accounts, CDs, and other time deposit accounts.

C is incorrect: Hybrid deposits combine transactions and thrift features and include money-

market deposit accounts and Super NOWs.

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Q.4082 Which of the following statements about deposit pricing methods is correct?

A. Cost-plus deposit pricing encourages banks to determine the costs they incur in labor
and, management, and materials, among others, in offering each deposit service.

B. Relationship pricing makes the customers less concerned about the prices of other
competing financial institutions.

C. Conditional pricing is whereby a depository institution sets up a schedule of fees in

which the customer pays a low cost or no fee given that the deposit balance is above
some minimum level.

D. All of the above

The correct answer is D.

A is correct: Cost-plus deposit pricing encourages banks to determine the costs they incur in

labor and management, and materials, among others, in offering each deposit service. Cost-plus

pricing typically calls for a bank to charge deposit service fees enough to cover all the costs of

providing the service in addition to a small margin for profit.

B is correct: In relationship pricing, the depository institution prices deposits according to the

number of services purchased or utilized. The depositor may be given lower fees or have a part

of the cost waived if they have used two or more services.

Relationship pricing increases the dependency of customers on the institution which promotes

greater customer loyalty. This also makes the customers less concerned about the prices of other

competing financial institutions.

C is correct: Depository institutions use conditional pricing as a tool to attract the kind of

depositors they want to have as customers. In this case, a depository institution sets up a

schedule of fees in which the customer pays a low cost or no fee, given that the deposit balance

is above some minimum level but is liable to higher charges if the average balance drops below

that minimum level. Therefore, the price paid by customers is conditional on how they use their

deposit accounts

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Q.4083 XYZ bank determines that its basic checking account costs the bank $5.00 per month in
servicing costs (assume the servicing costs are labor and computer time) and $3.00 per month in
overhead expenses. This account requires a $500 minimum balance. Additionally, the bank also
tries to build a $0.40 per month profit margin on these accounts. Determine the monthly fee that
the bank should charge each customer.

A. $5.00

B. $7.60

C. $8.00

D. $8.40

The correct answer is D.

Recall that a bank should price every deposit service high enough to recover all or most of the

cost of offering that service, using the following cost-plus pricing formula:

Unit price charged the customer for each deposit service

= (Operating expense per unit of deposit service
+ Estimated overhead expense allocated to the deposit service function
+ Planned profit margin from each service unit sold)

In this case,

Unit price charged per month = $5.00 + $3.00 + $0.40 = $8.40

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Q.4084 XYZ bank determines that its basic checking account costs the bank $5.00 per month in
servicing costs (assume the servicing costs are labor and computer time) and $3.00 per month in
overhead expenses. This account requires a $500 minimum balance. Additionally, the bank also
tries to build a $0.40 per month profit margin on these accounts. Further analysis of ABC
Savings Bank customer accounts reveals that for each $120 above the $500 minimum balance
maintained in its checking accounts, the bank saves about 6% in operating expenses with each
customer account. For a customer who is consistent in maintaining an average monthly balance
of $860, how much should the bank charge to protect its profit margin?

A. $4.25

B. $5.00

C. $7.00

D. $7.5

The correct answer is D.

If the bank saves about 6% in operating expenses for each $120 held in balances above the

minimum of $500, then a customer who maintains an average monthly balance of $860 saves the

bank 18% in operating expenses.

New operating expenses = $5.00 − (18% × $5.00) = $4.1

The appropriate amount that the bank should charge to protect its profit margin is therefore

$4.1 + 3.00 + 0.40 = $7.5 per month

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Q.4085 Spike Bank determines from an analysis of its cost-accounting figures that for each
$1,000 minimum-balance checking account it transacts, account processing and other operating
costs will average $10.00 per month. Further, its overhead expenses will run an average of $4.00
per month. The bank’s goal is to achieve a profit margin over these particular costs of 5% of the
total monthly expenses. What monthly fee should it charge a customer who opens a checking
account?

A. $7.00

B. $10.00

C. $14.04

D. $14.70

The correct answer is D.

The appropriate formula is:

Unit price charged per month

= Operating expense per unit + Overhead expense per unit
+ Planned profit margin per unit

Unit price charged per month = $10.00 + $4.00 + (0.05 × (10.00 + 4.00)) = $14.70

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Q.4086 For depository organizations to price their deposits adequately, they must know the cost
of the deposits. Different approaches may be used in determining deposit costs. Which one is the
most appropriate?

A. Historical average cost approach

B. Marginal cost deposit pricing approach

C. Average percentage yield approach

D. None of the above

The correct answer is B.

The marginal cost deposit pricing approach is a method that focuses on the weighted average

cost of new funds raised from various sources that the bank draws upon or plans to draw upon in

the current period. This approach is preferred by depository institutions over the historical

average cost approach because it takes into account the frequent changes in interest rates,

making it a more reliable standard for pricing. The marginal cost deposit pricing approach is

more dynamic and responsive to current market conditions, allowing depository institutions to

price their deposits more accurately and competitively.

Choice A is incorrect. The historical average cost approach is not the most suitable method for

determining deposit costs. This approach uses past data to calculate the average cost of

deposits, which may not accurately reflect current market conditions or future trends. It also

does not take into account changes in interest rates or other factors that can significantly impact

deposit costs.

Choice C is incorrect. The average percentage yield approach calculates the average yield on

all deposits, but it does not provide a clear picture of the actual costs associated with each

individual deposit. This method fails to consider variations in deposit types and terms, which can

lead to inaccurate pricing and potential losses for depository institutions.

Choice D is incorrect. There are indeed methodologies that are considered suitable for

determining deposit costs, hence 'None of the above' is an incorrect choice.

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Q.4087 Use the APY formula needed by the Truth in Savings Act for the following calculation.
Sundeep Raichura is a customer at Bright Bank. Raichura holds a savings deposit in the bank for
a year. The balance in the account stood at $5,000 for 100 days and $200 for the remaining days
of the year. Assume that Bright Bank paid Raichura $20.00 in interest earnings for the year, what
APY did Raichura receive?

A. 0.01

B. 0.0132

C. 0.0154

D. 0.0199

The correct answer is B.

The right formula is:

365
⎡ Interest earned Days in period ⎤
APY earned = 100 ⎢1 + ( ) − 1⎥
⎣ Average account balance ⎦
($5 , 000 × 100 days) + ($200 × 265 days)
Average account balance = = $1, 515
365 days
365
⎡$20.00 365 ⎤
APY = 100 (1 + ) − 1 = 1.32%
⎣ $1,515 ⎦

Q.4088 Brainstorm Savings Bank posts the following fees schedule for its small business
transaction accounts.

Average Monthly Account Balances

Range Monthly Maintenance Fee Charge Per Check
Over $1, 000 $0 $0
$500 − $1 , 000 $2 $0.10
Less than $500 $4 $0.20

What form of business pricing is this?

A. Relationship pricing

B. Conditional pricing

C. Cost-plus profit pricing

D. Marginal cost approach

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The correct answer is B.

Conditional pricing is a pricing strategy where the price of a product or service is determined

based on certain conditions. In this case, Brainstorm Savings Bank is using conditional pricing as

the fees charged are dependent on the average monthly account balance. The bank is

encouraging customers to maintain a higher balance in their accounts by waiving fees for

accounts with an average monthly balance over $1,000. This strategy not only provides the bank

with a more stable funding base but also allows it to have more money available for use. The

higher fees charged on accounts with less than $500 could potentially deter small depositors,

driving them to other banks.

Choice A is incorrect. Relationship pricing refers to a strategy where the bank offers better

rates or lower fees to customers who have multiple relationships with the bank, such as having a

checking account, mortgage, and credit card with the same institution. In this case, there is no

information provided about multiple relationships influencing the fee structure.

Choice C is incorrect. Cost-plus profit pricing involves setting prices based on covering costs

and achieving a certain profit margin. The question does not provide any information about cost

coverage or profit margins in determining fees.

Choice D is incorrect. Marginal cost approach involves setting prices based on the additional

cost of producing one more unit of output (in this case, providing one more transaction). The fee

schedule provided does not appear to be based on marginal costs as it varies by average monthly

balance rather than per transaction.

Q.4089 XYZ Bank establishes that it can attract the following amounts of deposits if it agrees to
offer new depositors and those rolling over their maturing term deposits the interest rates in the
following table:

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Expected Amount of New Deposits Rate of Interest Offered to Depositors

6, 000, 000 3.00%
10, 000, 000 3.25%
12, 000, 000 3.50%
15, 000, 000 3.75%
20, 000, 000 5.50%

Management hopes to invest any new deposits raised in loans yielding 7%. How far should this
thrift institution go in raising its deposit interest rate to maximize total profits (excluding
operational costs)?

A. 0.0325

B. 0.035

C. 0.0375

D. 0.055

The correct answer is C.

Funds Average Total Marginal Change in Expected Difference Total

Raised Rate Interest Cost Total Revenue Expected Additional
Paid Cost less Profit
Marginal
6 , 000, 000 3.00% 180, 000 180, 000 3.00% 7.00% 4.00% 240, 000
10 , 000, 000 3.25% 325, 000 145, 000 3.63% 7.00% 3.38% 375, 000
12 , 000, 000 3.50% 420, 000 95, 000 4.75% 7.00% 2.25% 420, 000
15 , 000, 000 3.75% 562, 500 142, 500 4.75% 7.00% 2.25% 487, 500
20 , 000, 000 5.50% 1, 100, 000 537, 500 10.75% 7.00% −3.75% 300, 000

The calculations are as follows:

Total interest = Funds raised × Average Rate Paid

= 6, 000, 000 × 3.00% = 180, 000

Marginal cost = Change in total cost

= New interest rates × Total funds raised at new rate
− Old interest rate × Total funds raised at old rate
= (3.25 × 10 , 000, 000) − (3.00% × 6, 000000) = 145, 000

Alternatively, marginal cost is the additional interest earned in new deposit money.

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Marginal cost = 325, 000 − 180, 000 = 145, 000

Marginal cost
Change in Total Cost =
New Funds Raised
180, 000
= = 3.00%
6, 000, 000

For the second case,

145, 000
Change in Total Cost = = 3.63% and so on.
10 , 000000 − 6, 000000

XYZ Bank should raise its deposit rate to 3.75%, attracting $15,000,000 in new deposits; because

up to then, the marginal revenue rate is higher than the marginal cost rate, and total profits are

also rising. At 5.50%, the marginal cost rate is higher than the marginal revenue rate, and

overall profits have fallen from a high of $487,500 back down to $300,000.

Q.4090 Young Money Savings Bank realizes that its basic transaction account, which requires a
$300 minimum balance, costs this savings bank an average of $3.00 per month in servicing costs
(including labor and computer time) and $1.50 per month in overhead expenses. The savings
bank also tries to build in a $0.70 per month profit margin on these accounts. What monthly fee
should the bank charge each customer?

A. $3.00

B. $4.50

C. $5.00

D. $5.20

The correct answer is D.

Following the cost-plus-profit approach, the monthly fee should be:

Monthly fee = $3.00 + $1.50 + $0.70 = $5.20 per month.

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Q.4091 Young Money Savings Bank realizes that its basic transaction account, which requires a
$300 minimum balance, costs this savings bank an average of $3.00 per month in servicing costs
(including labor and computer time) and $1.50 per month in overhead expenses. The savings
bank also tries to build in a $0.70 per month profit margin on these accounts. Further analysis of
customer accounts reveals that for each $50 above the $300 minimum in the average balance
maintained in its transaction accounts, Young Money Savings Bank saves about 2% in operating
expenses with each account. For a customer who consistently holds an average balance of $400
per month, how much should the bank charge to cushion its profit margin?

A. $4.00

B. $4.82

C. $5.08

D. $5.10

The correct answer is C.

If the bank saves about 2% in operating expenses for each $50 held in balances above the

minimum of $300, then a customer who maintains an average monthly balance of $400 saves the

bank 4% in operating expenses.

$100
That is, $400 − $300 = = 2 × 2% = 4% saving in the operating costs
$50

New operating expenses = $3.00 − (4% × $3.00) = $2.88

The appropriate amount that the bank should charge to protect its profit margin is therefore

$2.88 + 1.50 + 0.70 = $5.08 per month

Note:

Overheads are the expenditure which cannot be conveniently traced to or identified with any

particular cost unit, unlike operating expenses such as raw material and labor. That's why we

add the $1.5 overhead as a separate item.

Q.4092 Neha Datta maintains a savings deposit with XYZ Credit Union. In 2019, Datta received
$12.25 in interest earnings from her savings account. Her savings deposit had the following
average balance each month:

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Month Account Balance

January 520
February 380
March 440
April 300
May 385
June 470
July 530
August 615
September 750
October 810
November 845
December 530

What was the annual percentage yield (APY) earned on Datta’s savings account?

A. 0.0125

B. 0.0156

C. 0.0196

D. 0.0223

The correct answer is D.

365
⎡ Interest earned Days in period ⎤
APY earned = 100 ⎢(1 + ) − 1⎥
⎣ Average account balance ⎦

Month Account Balance Number of Days AC Balance*

in the Month Days
January 520 31 16, 120
February 380 28 10, 640
March 440 31 13, 640
April 300 30 9, 000
May 385 31 11, 935
June 470 30 14, 100
July 530 31 16, 430
August 615 31 19, 065
September 750 30 22, 500
October 810 31 25, 110
November 845 30 25, 350
December 530 31 16, 430
Total 365 200, 320

200, 320
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200, 320
Average account balance = = $548.82
365 days

365
⎡ $12.25 365 ⎤
APY = 100 (1 + ) − 1 = 2.23%
⎣ $548.82 ⎦

Q.4093 A hypothetical Bank of India quotes an APY of 4.0% on a one-year money market
Certificate of Deposit sold to one of the businesses in town. The firm posted a balance of $3,000
for the first 100 days of the year, $2,500 over the next 100 days, and $1,000 for the remainder of
the year. How much in total interest earnings did this business customer receive for the year?

A. 56.70

B. 60.54

C. 78.36

D. 80.46

The correct answer is C.

Using the APY formula, we proceed as follows:

365
⎡ Interest earned Days in period ⎤
APY earned = 100 ⎢(1 + ) − 1⎥
⎣ Average account balance ⎦

Average account balance

$3, 000 × 100 days) + ($2, 500 × 100 days) + ($1, 000 × 165 days)
= = $1, 959
365 days

365
⎡ Interest 365 ⎤
4.0% = 100 ⎢(1 + ) − 1⎥
⎣ $1 , 959 ⎦

Interest earned = $78.36

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Q.4094 Fatou Heckerman has been holding $ 250,000 in Smart-way Bank and another $250,000
in Pathway Savings Bank. Fatou has learned that the two institutions have merged one month
ago. Fatou reported the case to FDIC to ensure appropriate deposit coverage. How much should
be the total protection offered to Fatou given the above scenario?

A. $50,000

B. $250,000

C. $500,000

D. $25,000

The correct answer is C.

As per the rules of the Federal Deposit Insurance Corporation (FDIC), the standard insurance

amount is $250,000 per depositor, per insured bank, for each account ownership category. This

means that in the event of a bank failure, the FDIC insures deposits up to $250,000.

However, in the case of a merger of two FDIC-insured banks - like in Fatou's situation - the

deposits from the assumed bank continue to be insured separately for some time until they find a

way to transfer some of the funds to other institutions. This grace period gives a depositor the

opportunity to restructure his or her accounts, if necessary

Given that Fatou learned about the merger in December and the banks had merged a month

before, it's less than six months from the merger date. Therefore, Fatou's deposits in both banks

would still be separately insured. As such, she should be covered for $250,000 in each bank, for

a total of $500,000.

Q.4096 ABC Credit Union is launching a new deposit campaign next week in anticipation of
bringing in from $200 million to $700 million in new deposit money, which it expects to invest at
a 7% yield. The management believes that an offer rate on new deposits of 3% would attract
$200 million in new deposits and rollover funds. To attract $300 million, the bank would probably
be forced to offer 4%. ABC’s forecast suggests that $400 million might be available at 4.25%,
$500 million at 4.50%, $600 million at 4.75%, and $700 million at 5.25%. What volume of
deposits should the institution try to avoid to ensure that marginal cost does not exceed marginal
revenue?

A. $300 Million

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B. $400 Million

C. $600 Million

D. $700 Million

The correct answer is D.

Expected Rate Total Marginal Marginal Marginal Expected Total

Inflows in Offered on Interest Interest Cost Revenue Difference In Profits
Millions New Cost Cost Rate Rate Marginal Earned
Funds
Revenues
and
Costs
200 3.00% 6.00 6.00 3.00% 7.00% 4.00% 8.00
300 4.00% 12.00 6.00 6.00% 7.00% 1.00% 9.00
400 4.25% 17.00 5.00 5.00% 7.00% 2.00% 11.00
500 4.50% 22.50 5.50 5.50% 7.00% 1.50% 12.50
600 4.75% 28.50 6.00 6.00% 7.00% 1.00% 13.50
700 5.25% 36.75 8.25 8.25% 7.00% −1.25% 12.25

Total Interest Costs = $Expected inflows x Rate of new funds%

Marginal Interest Costs = Total interest costs for the current expected inflow - Total interest

costs for the previous expected inflow

Marginal Cost Rate = Marginal costs ÷ Increase in the expected inflows

Increase in the Expected Inflows = Current expected inflow - Previous expected inflow

Marginal Revenue Rate = Expected investment yield

Expected Difference in Marginal Revenues and Costs = Marginal revenue rate - Marginal costs

rate

Total Profits Earned = (Marginal revenue rate - Rate offered on new funds)% x Expected inflows

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From the table above, at $700 million, the marginal cost rate of 8.25%% is greater than the

marginal revenue rate of 7.00%. Therefore, ABC Credit Union should try to avoid $700 million in

new deposits.

Q.5414 Given the information below, what is the correct amount for the bank to charge per ATM
visit according to the cost-plus pricing model?

Profit required per ATM visit: USD 0.08

The bank’s target return on capital: 14%

Bank’s return on equity: 17%

Bank’s cost to income ratio: 39%

Operating expense per ATM visit: USD 0.33

Estimated overhead cost allocated per ATM visit: USD 0.42

A. $0.83

B. $0.75

C. $0.97

D. $0.94

The correct answer is A.

Based on a cost-plus pricing formula:

Unit price charged by bank = Operating expense per unit of deposit service
+ Estimated overhead expense allocated to the
deposit service function
+ Profit margin per unit service sold
= 0.33 + 0.42 + 0.08 = $ 0.83

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Reading 139: Managing Nondeposit Liabilities

Q.4097 Promise Bank takes out a loan of $30 million overnight through a repurchase agreement
(RP), which is collateralized by Treasury bills. The current RP rate is 4%. Calculate the interest
costs that the bank pays due to this borrowing.

A. $3,333.33

B. $6,657.67

C. $8,768.90

D. $9,754.78

The correct answer is A.

Interest cost of RP
Amount borrowed × Current RP rate × Number of days in RP borrowing
=
360 days
1
= $30 , 000, 000 × 4% × = 3, 333.33
360

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Q.4098 Short term notes with maturities of 3 or 4 days to 9 months issued by well-known
companies are known as:

A. Commercial paper

B. Negotiable CDs

C. Eurocurrency deposits

D. None of the above

The correct answer is A.

Commercial paper is a type of unsecured, short-term debt instrument issued by corporations,

typically for the financing of accounts receivable, inventories and meeting short-term liabilities.

Maturities on commercial paper rarely range any longer than 270 days. The debt is usually

issued at a discount, reflecting prevailing market interest rates. Commercial paper is an

important part of many money market funds. They are issued with a fixed interest rate and sold

at a discount from face value. The maturity period of commercial paper typically ranges from

overnight to just under 9 months. Since they are issued by well-known companies and are short-

term, they are considered relatively low-risk.

Choice B is incorrect. Negotiable CDs are certificates of deposit that can be traded in the

secondary market, unlike traditional CDs which are held until maturity. They have longer

maturities than commercial papers and are not typically used for short-term financing needs.

Choice C is incorrect. Eurocurrency deposits refer to deposits made in a bank located outside

the country of the currency being deposited. These deposits do not necessarily have to be short-

term and can range from overnight to several years, making them different from the described

financial instrument.

Choice D is incorrect. As explained above, there exists a specific term for these short-term

notes - Commercial Paper (Option A), hence 'None of the above' does not apply here.

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Q.4099 A bank with immediate reserve needs can borrow from the federal reserve. It can acquire
different types of loans, based on its obligations. Gift Bank is a sound financial institution. Its
management agrees to borrow a short term loan whose rate is higher than the federal funds
rate. Which of the following refers to this type of loan?

A. Primary credit

B. Secondary credit

C. Seasonal credit

D. None of the above

The correct answer is A.

Primary credit is the type of loan that the Federal Reserve provides to financially sound

institutions for short-term needs. The interest rate for primary credit is typically higher than the

federal funds rate. This type of credit is usually used to meet unexpected liquidity demands or to

fund regular short-term borrowing needs. The Federal Reserve offers this type of credit with

minimal administrative procedures, usually on a very short-term basis, typically overnight. The

primary credit program is the principal safety valve for ensuring adequate liquidity in the

banking system.

Choice B is incorrect. Secondary credit is typically offered to smaller, less financially secure

institutions that are in need of short-term liquidity or experiencing severe financial difficulties.

This does not align with the scenario presented where Gift Bank is described as a financially

stable institution.

Choice C is incorrect. Seasonal credit is designed to assist small depository institutions in

managing significant seasonal swings in their loans and deposits, which does not apply to the

situation described for Gift Bank.

Choice D is incorrect. The scenario clearly states that Gift Bank has decided to borrow a short-

term loan from the Federal Reserve, which contradicts with this option of 'None of the above'.

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Q.4100 Trust Bank purchases a 50-day negotiable CD with a $10 million denomination from
Promise Bank, bearing a 5% annual yield. How much interest is the bank obliged to pay at the
maturity of the CD?

A. $10,456

B. $12,567

C. $50,678

D. $69,444

The correct answer is D.

Days to maturity
Interest owed = Principal × × Annual interest rate
360 days
50
Interest owed = $10, 000000 × × 5% = $69, 444
360

Q.4101 Central Credit Union borrows $200 million overnight through a repurchase agreement
(RP), which is collateralized by Treasury bills. The current RP rate is 5%. What is the interest
cost that the bank should pay for this borrowing?

A. $27,777.80

B. $30,433.76

C. $33,333.67

D. $46,879.20

The correct answer is A.

Interest cost of RP
Amount borrowed × Current RP rate × Number of days in RP borrowing
=
360 days
1
= $200, 000, 000 × 5% × = $27, 777.80
360

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Q.4102 Prime Limited is expecting new deposit inflows of $400 million and deposit withdrawals
of $600 million next month. The bank has projected that new loan demand will reach $500
million, and customers with approved credit lines will need $200 million in cash. The bank will
sell $375 million in securities but plans to add $100 million in securities to its portfolio. Calculate
the projected available funds gap.

A. $600

B. $625

C. $800

D. $975

The correct answer is B.

Available funds gap (AFG) = Current and projected loans and investments the lending institution
desires to make less current and expected deposit inflows and other available funds)

Projected funds gap = $500 + $200 + ($100 − $375) − ($400 − $600)

= $625

Note:

Current and expected deposit inflows = current and expected inflows - current and expected

deposit outflows

In other words, current and expected deposit inflows is simply the net inflow, which in this case

is negative because the outflows exceed the inflows.

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Q.4103 Suppose that Bluemont bank borrows $85 million using an RP transaction with a
government bond collateral for twelve days, and the current RP rate in the market is 4%. How
much would be the bank’s total interest cost?

A. $113,333.33

B. $123,445.90

C. $134,670.08

D. $167,346.78

The correct answer is A.

Interest cost of RP
Amount borrowed × Current RP rate × Number of days in RP borrowing
=
360 days
12
= $85, 000, 000 × 4% × = $113, 333.33
360

Q.4104 Suppose a depository institution promises a 7% annual interest rate to a buyer of a

$320,000, 150 days Negotiable CD. How much will the depositor have at the maturity date?

A. $9,345

B. 14678

C. $329,333

D. $339,345

The correct answer is C.

Amount due CD customer

Days to marturity
= Principal + principal × × Annual rate of interest
360 days
150
= $320, 000 + 320, 000 × × 7% = $329, 333
360

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Q.4105 Suppose that a commercial bank has a new loan request that meets its quality standards
of $660 million; it expects to purchase $330 million in new Treasury securities being issued on
Friday the same week and expects drawings on credit lines from its best corporate customers of
$358 million. Deposits and other customer funds received today total $456 million, and those
expected in the coming week will inject another $265 million. If the current funding gap is zero,
what is the bank’s estimated available funds gap (AFG) for the coming week?

A. $326

B. $423

C. $347

D. $627

The correct answer is D.

Available funds gap (AFG) = (Current and projected loans and investments the lending

institution desires to make LESS current and expected deposit inflows and other available funds)

AFG = ($660 + $330 + $358) − ($456 + $265) = $1, 348 − $721 = $627 million.

Q.4106 Suppose that banks and other lending affiliates within Niche Bank Holding Company
have a substantial loan demand from several companies that have a significant expansion project
of their facilities before the beginning of the next financial year. The holding company and the
bank in charge have a plan to raise $1 billion in short term funds this week, of which $0.9 billion
will be used to meet these new loan requests. The following table shows the current annual
interest rates on alternative sources of funds.

Market Interest Noninterest cost

rates rates
Federal Funds 2.10% 0.42%
Negotiable CDs 2.25% 0.42%
Eurodollars 2.15% 0.52%
Commercial paper 2.20% 0.67%
Fed Discount Rate 3.10% 0.42%

Calculate the effective cost rates of the Federal Funds and Negotiable CDs, respectively.

A. 2.10% and 2.25%

B. 2.80% and 2.97%

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C. 2.97% and 3.19%

D. 2.80% and 3.91%

The correct answer is B.

Market Noninterest Market Noninterest

Interest Cost Rates Interest Cost
Rates Cost
Federal Funds 2.10% 0.42% 21 , 000, 000 4, 200, 000
Negotiable CDs 2.25% 0.42% 22 , 500, 000 4, 200, 000

Effective cost rate on deposit and nondeposit sources of funds

(Current interest cost on amounts borrowed
+ Noninterest costs incurred to access these funds)
=
Net investable funds raised from this source

Where:

Current interest cost on amounts borrowed

= Prevailing interest rate in the money market × Amount of funds borrowed

For Federal Funds,

market interest cost = 2.10% × 1, 000, 000, 000 = 21 , 000, 000

Noninterest cost = 0.42% × 1, 000, 000, 000 = 4, 200, 000

21,000 ,000+4, 200,000

Thus the effective cost rate of the Federal Funds is 900 ,000,000 = 2.80%

22,500 ,000+4, 200,000

Similarly, the effective coat rate of the Negotiable CDs = 900 ,000,000 = 2.97% .

Q.4107 Suppose that banks and other lending affiliates within Niche Bank holding company have
a substantial loan demand from several companies that have a significant expansion project of
their facilities before the beginning of the next financial year. The holding company and the bank
in charge have a plan to raise $1billion in short term funds this week, of which $0.9 billion will
be used to meet these new loan requests. The following table shows the current annual interest
rates on alternative sources of funds.

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Market Interest Noninterest cost

rates rates
Federal Funds 2.10% 0.42%
Negotiable CDs 2.25% 0.42%
Eurodollars 2.15% 0.52%
Commercial paper 2.20% 0.67%
Fed Discount Rate 3.10% 0.42%

Assume that you are to advise Niche Bank Holding Company management on the best source of
funding to use. Which one would you recommend?

A. Federal Funds

B. Negotiable CDs

C. Eurodollars

D. Federal Discount Rate

The correct answer is A.

Federal Funds is the most cost-effective source of funding for Niche Bank Holding Company. The

total cost of borrowing from the Federal Funds market, which includes both the market interest

cost and the noninterest cost, is the lowest among all the alternative sources of funds. The

market interest cost for Federal Funds is calculated as 2.10% of $1 billion, which equals $21

million. The noninterest cost is calculated as 0.42% of $1 billion, which equals $4.2 million.

Therefore, the total cost of borrowing from the Federal Funds market is $25.2 million. When this

total cost is divided by the amount of funds that will be used to meet the new loan requests ($0.9

billion), the effective cost rate of borrowing from the Federal Funds market is found to be 2.80%.

This is the lowest effective cost rate among all the alternative sources of funds, making Federal

Funds the most cost-effective source of funding for Niche Bank Holding Company.

Choice B is incorrect. Negotiable CDs, while a viable option for raising funds, typically have

higher interest rates compared to Federal Funds. This would mean that Niche Bank Holding

Company would incur more costs in terms of interest payments if they choose this funding

source.

Choice C is incorrect. Eurodollars are deposits denominated in U.S. dollars at banks and bank

branches located outside the United States, and thus involve additional risks such as exchange

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rate risk and country risk which could potentially increase the cost of borrowing for Niche Bank

Holding Company.

Choice D is incorrect. The Federal Discount Rate is usually higher than the rate on Federal

Funds because it's a penalty rate set above market levels to discourage regular use by banks.

Therefore, it would be more expensive for Niche Bank Holding Company to raise funds through

this source.

Q.4109 Suppose that ABC Bank Ltd receives $1,530 million from the following sources. These
sources are listed below with their associated costs:

Funding Amount Interest Noninterest Additional Total

source Costs Costs costs Costs
Money-Market 275 3.03% 0.24% 0.24% 3.51%
Borrowings
Time and Savings 580 2.27% 0.23% 0.60% 3.10%
Deposits
Checkable 385 0.52% 1.96% 0.80% 3.28%
deposits
Stockholders 290 12.75% 12.75%
Equity

Assuming that the bank has earning assets worth $1,240 (i.e.,$1,530-$290), calculate the break-
even cost rate.

A. 1.9%

B. 5.0%

C. 3.2%

D. 6.2%

The correct answer is D.

Total funding costs

Break even cost rate =
Earning assets

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Funding Source Amount Interest Cost Other Cost Total

Money-Market Borrowings 275 8.33 1.32 9.65
Time and Savings Deposits 580 13.17 4.81 17.98
Checkable deposits 385 2.00 10.63 12.63
Stockholders Equity 290 36.98 − 36.98
Total 1, 530 23.50 16.76 77.24

Interest cost = $Amount x Interest costs %

Other costs = $Amount x (Non-interest costs + Additional costs)%

Total costs = $ Interest costs + $Other costs

77.24
Break even cost rate = = 6.2%
1, 240

Q.4110 Suppose that Mug Bank, a fictional financial institution in the Netherlands, has an
estimated cost of overhead expenses and salaries of $13 million. The earning assets are worth
$540 million. Suppose further that the total interest cost is $127 million. Evaluate the bank’s
break-even cost rate on borrowed funds invested in earning assets.

A. 26%

B. 28%

C. 32%

D. 40%

The correct answer is A.

Break-even cost rate on borrowed funds invested in earning assets

Interest cost + (Other operating costs)
127 + 13
= = = 26%
(Total earning assets) 540

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Q.4111 The financial data in the following table belongs to Pathway Bank. Use the data to
evaluate the weighted average overall cost of capital for the institution.

Break-even cost 14.50%

The after-tax cost of stock of stockholder's investment 12%
Tax rate 15%
Stockholder’s investment $260, 000
Earning assets $340, 000

A. 12.9%

B. 15.7%

C. 22.7%

D. 25.3%

The correct answer is D.

The weighted average overall cost of capital is given by:

After-tax cost of
stockholders’ investmentStockholders’ investment
Break-even cost + ×
(1 − Tax rate) Earning assets

Which is equivalent to:

12% $260, 000

14.5% + × = 25.3%
(1 − 0.15) $340, 000

Thus, 25.3% is the lowest rate of return overall fund-raising costs Pathway Bank can afford to

earn on its assets if its equity shareholders invest $260,000 in the institution.

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Q.4112 Which of the following choices is a factor to consider when determining the non-deposit
funding sources to use?

A. Relative cost of raising funds associated with each source.

B. The risk of each funding source

C. The maturity of the funds

D. All of the above

The correct answer is D.

All of the factors listed in the options are crucial when determining the non-deposit funding

sources to use. The relative cost of raising funds associated with each source is important as it

directly impacts the financial performance of the institution. The risk of each funding source is

also a key consideration as it can affect the stability and sustainability of the institution. Lastly,

the maturity of the funds is vital as it can influence the liquidity and cash flow management of

the institution. Therefore, all these factors should be considered when deciding on the non-

deposit funding sources to use.

Choice A is incorrect. While the relative cost of raising funds associated with each source is an

important factor to consider, it is not the only one. Other factors such as risk and maturity of

funds also play a crucial role in deciding on the most suitable non-deposit funding sources.

Choice B is incorrect. The risk associated with each funding source indeed needs to be

evaluated when making this decision, but it alone does not provide a comprehensive view. The

cost and maturity of funds are equally significant considerations.

Choice C is incorrect. The maturity of the funds can influence the decision-making process, but

it cannot be considered in isolation from other factors like cost and risk associated with each

funding source.

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Q.4113 Which of the following types of Negotiable CDs is issued by foreign banks in the US?

A. Domestic CDs

B. Euro CDs

C. Yankee CDs

D. Thrift CDs

The correct answer is C.

Yankee CDs are a type of Negotiable Certificate of Deposit (CD) that are issued by foreign banks

in the United States. These CDs are usually denominated in U.S. dollars. The term 'Yankee' is

often used to refer to foreign entities that are operating in the U.S. market. For instance, 'Yankee

bonds' are bonds issued by foreign entities in the U.S. Similarly, Yankee CDs are CDs issued by

foreign banks in the U.S. These CDs provide an opportunity for foreign banks to raise funds in

the U.S. market. They are subject to the same regulations as the CDs issued by domestic banks.

Therefore, they offer a similar level of risk and return as domestic CDs.

Choice A is incorrect. Domestic CDs are not issued by foreign banks operating within the

United States. Instead, they are issued by domestic banks within their own country.

Choice B is incorrect. Euro CDs are not specific to foreign banks operating in the United

States. They refer to certificates of deposit that are issued outside of the currency's home

country, but not necessarily in Europe or in US.

Choice D is incorrect. Thrift CDs do not specifically pertain to foreign banks operating within

the United States. These types of CDs are typically offered by savings and loan associations or

credit unions rather than foreign banking institutions.

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Q.4114 A loan which is unwritten, often uncollateralized agreements usually negotiated over a
telephone and is payable in the next day is known as:

A. Term loan

B. Overnight loan

C. Continuing contract

D. None of the above

The correct answer is B.

Overnight loans are a type of short-term loan where the duration of the loan lasts for only one

night. They are typically unwritten, often uncollateralized agreements that are usually

negotiated over a telephone. The borrower is expected to repay the loan the following day. These

loans are commonly used in the interbank market to help banks manage their daily cash flow

needs. Banks with surplus funds lend to those in need of short-term cash, and the loan is repaid

the next day when the borrowing bank's customers' payments are deposited.

Choice A is incorrect. A term loan is a monetary loan that is repaid in regular payments over a

set period of time. Term loans usually last between one and ten years, but may last as long as 30

years in some cases. It does not match the characteristics of the loan described in the question

which is expected to be repaid the following day.

Choice C is incorrect. A continuing contract, also known as an evergreen contract or rolling

contract, automatically renews at the end of each term until either party gives notice to

terminate. This type of contract does not align with the features mentioned in the question

where repayment is expected on next day.

Choice D is incorrect. As explained above, there exists a specific term for this type of loan - an

overnight loan - making this option invalid.

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Q.4115 KBC Bank is considering funding a package of new loans for $600 million. Money Bank
has projected that it must raise $800 million to have $600 million available to make the new
loans. It expects to raise $550 million of the total by selling time deposits at an average interest
rate of 5%. Noninterest costs from the time of sale deposits add an estimated 2% in operating
expenses. KBC Bank expects another $250 million to come from noninterest-bearing transaction
deposits, whose noninterest costs are expected to be 3% of the total amount of these deposits.
What is the Bank’s projected pooled-funds marginal cost?

Dollar Interest Non Total Total

Amount rate interest interest non-interest
($ millions) cost rate expenses expenses
Time 550 5.00% 2.00% 27.50 11.00
deposits
Transaction 250 0% 3.00% 0 7.50
deposits
Total 800 27.50 18.50

A. 5.75%

B. 6.25%

C. 2.31%

D. 3.44%

The correct answer is A.

Projected pooled-funds marginal cost

All expected operating expenses
27.50 + 18.50
= = = 5.75%
(All new funds expected) 800

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Q.4116 Trust Bank purchases a 50-day negotiable CD with a $10 million denomination from
Promise Bank, bearing a 5% annual yield. What is the total amount that Promise Bank will have
to pay back to Trust Bank at the end of 50 days?

A. $10,000,000

B. $10,065,765

C. $10,069,444

D. $12,086,657

The correct answer is C.

Amount due CD customer

Days to maturity
= Principal + Principal × × Annual interest rate
360 days
50
= $10, 000, 000 + $10, 000000 × × 5% = $10,069, 444
360

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Q.4117 KBC Bank is considering funding a package of new loans for $600 million. The bank has
projected that it must raise $800 million to have $600 million available to make the new loans. It
expects to raise $550 million of the total by selling time deposits at an average interest rate of
5%. Noninterest costs from the time of sale deposits add an estimated 2% in operating expenses.
The bank expects another $250 million to come from noninterest-bearing transaction deposits,
whose noninterest costs are expected to be 3% of the total amount of these deposits. What
hurdle rate must the bank achieve in its earning assets?

A. 5.46%

B. 7.67%

C. 9.83%

D. 10.33%

The correct answer is B.

The hurdle rate of return is equivalent to:

All expected operating costs

Dollars available to place in earning assets

Dollar Interest Non Total Total

Amount rate interest interest non-interest
($ millions) cost rate expenses expenses
Time 550 5.00% 2.00% 27.50 11.00
deposits
Transaction 250 0% 3.00% 0 7.50
deposits
Total 800 27.50 18.50

(27.50 + 18.50)
= = 0.0767%
600

This means that KCB Bank should earn 7.67% and above on average before taxation on all its

new funds invested in meeting the expected new funding cost.

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Reading 140: Repurchase Agreements and Financing

Q.2239 Sover Bank needs short-term liquidity. It has high-quality US government bonds in its
portfolio. In order to fund its liquidity needs, Sover Bank has entered into a repurchase
agreement (repo) with GNR Bank. According to the repo agreement, Sover bank has to:

A. Sell US government bonds to third parties in order to repay any funds borrowed from
GNR bank.

B. Buy US government bonds from GNR Bank.

C. Pledge US government bonds to receive a loan from GNR Bank.

D. Sell government bonds to GNR Bank with an obligation to repurchase those bonds.

The correct answer is D.

A repurchase agreement, or 'repo', is a form of short-term borrowing for dealers in government

securities. In the case of a repo, a dealer sells government securities to investors, usually on an

overnight basis, and buys them back the following day at a slightly higher price. That slightly

higher price is the overnight interest rate. Thus, repos are essentially collateralized short-term

loans, where the dealer (in this case, Sover Bank) sells the securities to the investor (in this case,

GNR Bank) with the agreement to repurchase them at a later date. The dealer is raising short-

term funds at the expense of the investor's short-term investment needs. The securities serve as

collateral for the loan. Therefore, in the given scenario, Sover Bank would sell government bonds

to GNR Bank with an obligation to repurchase those bonds, which is exactly what choice D

states.

Choice A is incorrect. While selling US government bonds to third parties could potentially

generate funds, it does not align with the concept of a repurchase agreement. In a repo, Sover

Bank would sell securities to GNR Bank and agree to repurchase them at a later date, not sell

them to third parties.

Choice B is incorrect. Buying US government bonds from GNR Bank would require Sover Bank

to expend funds, which contradicts its current need for liquidity. This action does not align with

the nature of a repurchase agreement where Sover bank should be selling or pledging securities

rather than buying more.

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Choice C is incorrect. Pledging US government bonds as collateral for a loan from GNR Bank

could be an option in some circumstances but it's not typically how repos work. In a standard

repo transaction, the borrower (Sover bank) sells securities (US Government Bonds) and agrees

to buy them back later at higher price which includes interest on borrowed money.

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Q.2240 Bolny Bank has entered into a repo agreement with Kovit Bank. In the first part of the
transaction, it receives US government bonds from Kovit Bank. In the second part of the
transaction Bolny bank has to:

A. Return the bonds, which it received as collateral, to Kovit.

B. Receive money from Kovit.

C. Sell bonds back to Kovitat at their market price on the settlement date.

D. Sell bonds to Kovit at the fixed price agreed upon in advance.

The correct answer is D.

In a repurchase agreement, the seller (in this case, Bolny Bank) agrees to sell a security (in this

case, US government bonds) to the buyer (in this case, Kovit Bank) and also agrees to

repurchase the same security at a later date at a fixed price. This fixed price is agreed upon in

advance when the initial sale takes place. Therefore, in the second part of the transaction, Bolny

Bank is required to sell the bonds back to Kovit Bank at the fixed price that was agreed upon in

advance. This is the fundamental principle of a repurchase agreement, which is essentially a

short-term borrowing for dealers in government securities. The dealer sells the government

securities to investors, usually on an overnight basis, and buys them back the following day at a

slightly higher price. The slightly higher price represents the interest rate on the loan.

Choice A is incorrect. Bolny Bank would not return the bonds to Kovit Bank without first

selling them back as per the terms of the repurchase agreement. The purpose of a repo

agreement is for one party to sell securities and agree to repurchase them later, not simply

return them.

Choice B is incorrect. In a repo agreement, Bolny Bank would not receive money from Kovit

Bank in the second part of this transaction. Instead, it's usually the opposite - Bolny bank would

be paying money back to Kovit bank along with some interest.

Choice C is incorrect. The bonds are not sold back at their market price on the settlement date

in a typical repo agreement. Instead, they are sold back at a fixed price agreed upon in advance

which includes an implied interest rate.

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Q.2241 Sokolov Bank is going to enter into a repurchase agreement with Branitzky Bank.
Sokolov Bank will sell high-quality securities to Branitzky bank in the first part of the
transaction. At what price will Branitzkybank sell the aforementioned securities back to Sokolov
Bank?

A. A fixed price agreed upon at the time of entering into the repo agreement.

B. At the market price of the securities at the time of entering into the repo agreement.

C. At the market price of the securities at the time of the second transaction.

D. At the price that should have been agreed upon at the time of the second transaction.

The correct answer is A.

In a repurchase agreement, the price at which the securities will be repurchased is determined

at the time of entering into the agreement. This price is fixed and does not change regardless of

market fluctuations. The reason for this is to provide certainty to both parties involved in the

transaction. The selling party (Sokolov Bank in this case) knows exactly how much it will have to

pay to repurchase the securities, and the buying party (Branitzky Bank) knows exactly how much

it will receive when the securities are repurchased. This eliminates the risk of price volatility that

could potentially result in a loss for either party. Therefore, the price at which Branitzky Bank

will sell the securities back to Sokolov Bank is a fixed price agreed upon at the time of entering

into the repo agreement.

Choice B is incorrect. The resale price in a repurchase agreement is not determined by the

market price of the securities at the time of entering into the repo agreement. It is agreed upon

at the outset of the transaction.

Choice C is incorrect. The resale price in a repurchase agreement does not depend on the

market price of securities at the time of second transaction. This would introduce unnecessary

risk for both parties, as it could result in significant losses if market prices fluctuate unfavorably.

Choice D is incorrect. The resale price cannot be determined or agreed upon at the time of

second transaction as it contradicts with basic principle of repurchase agreements where terms

are set upfront to mitigate risks associated with future uncertainties.

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Q.2242 Ludska Bank entered into a repo agreement with SKA Bank. Under the agreement,
Ludska Bank sold government bonds to SKA Bank as per the following details:

Face amount: USD 1,000,000,

Invoice price: USD 1,100,000,

Repo rate: 4% p.a.,

Settlement date: 90 days after the conclusion of the agreement

What is going to happen on the date of the settlement, assuming the 360-day convention applies?

A. Ludska Bank will repurchase the bonds from SKA Bank for USD 1,100,000.

B. Ludska Bank will repurchase the bonds from SKA Bank for USD 1,000,000.

C. Ludska Bank will repurchase bonds from SKA Bank for USD 1,101,466.66.

D. Ludska Bank will repurchase bonds from SKA Bank for USD 1,111,000.

The correct answer is D.

The formula for calculation of the repurchase price is as follows:

(Repo rate ∗ Repo term in days)

Repurchase price = Invoice price (1 + )
360

Therefore,

(4% ∗ 90)
Repurchase price = 1, 100, 000(1 + ) = 1 , 111, 000
360

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Q.2243 Which of the following statements is correct about repurchase agreements?

A. They can be traded on secondary markets.

B. They are unsecured.

C. They are classified as money market instruments.

D. They can have a maturity period of up to 20 years.

The correct answer is C.

Repurchase agreements are indeed classified as money market instruments. Money market

instruments are short-term debt instruments that are highly liquid and have low risk. They are

used by participants as a means for borrowing and lending in the short term, with maturities that

usually range from overnight to just under a year. Repurchase agreements, or repos, are one

such instrument. In a repo transaction, a dealer sells government securities to investors, usually

on an overnight basis, and buys them back the following day at a slightly higher price. The

difference in price is the interest, or repo rate. Repos are typically used to raise short-term

capital. They are also used by the central banks to conduct monetary policy operations. The repo

market is a crucial component of the financial system as it serves as a source of secured, short-

term funding for a variety of participants, including banks, mutual funds, hedge funds and

securities dealers.

Choice A is incorrect. Repurchase agreements are not typically traded on secondary markets.

They are primarily used for short-term borrowing and lending, often overnight, between financial

institutions.

Choice B is incorrect. Repurchase agreements are not unsecured; they are backed by

collateral, usually in the form of government securities. The borrower sells the securities to the

lender with an agreement to repurchase them at a later date at a higher price.

Choice D is incorrect. While repurchase agreements can have varying maturity periods, they

do not typically extend up to 20 years. Most repos have a maturity period of one day (overnight)

or up to one year.

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Q.2246 For a particular high-quality security transaction, the agreement is ‘repo’ from the point
of view of:

A. The security buyer

B. The security seller

C. The clearinghouse

D. The Federal Reserve

The correct answer is B.

The term 'repo' or repurchase agreement is used from the perspective of the security seller. In a

repo transaction, the seller sells securities to the buyer with an agreement to repurchase them at

a later date. The transaction is essentially a loan, where the seller is the borrower and the buyer

is the lender. The securities act as collateral for the loan. The seller agrees to buy back the

securities at a higher price, and the difference between the selling price and the repurchase

price is the interest on the loan. This arrangement allows the seller to raise short-term capital

while providing the buyer with a secure investment. Therefore, from the perspective of the

security seller, the transaction is a 'repo'.

Choice A is incorrect. The security buyer in a repo transaction is actually entering into a

reverse repo agreement, not a repo. In this case, the buyer is lending money and receiving

securities as collateral.

Choice C is incorrect. The clearinghouse does not participate in the transaction as either the

buyer or seller of securities but rather facilitates transactions between parties and manages risk.

Choice D is incorrect. The Federal Reserve can participate in repo transactions to implement

monetary policy, but it's not always involved in every such transaction. Therefore, it's not correct

to say that every repurchase agreement is considered a 'repo' from the perspective of the

Federal Reserve.

Q.2247 Briggs Bank buys US treasury bonds from Roland Bank under a repo agreement.
Sometime before the settlement date agreed upon in advance, the market value of the bonds
significantly reduces. Which of the following actions would most likely be taken by Briggs bank

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in response to the declining market value? The bank will:

A. Terminate the agreement.

B. Demand immediate maturity of the contract so as to avoid further losses that may
arise from the bonds losing more of their value.

C. Do nothing, except hope that the bonds regain their value as the settlement date
approaches.

D. Demand more collateral.

The correct answer is D.

Repo agreements, such as the one between Briggs Bank and Roland Bank, are typically subject

to margin calls. This means that in a declining market, the borrower of cash (in this case, Roland

Bank) is required to provide additional collateral. The purpose of this is to maintain the overall

value of the collateral, despite the decrease in the market value of the bonds. Therefore, in

response to the declining market value of the U.S. Treasury bonds, Briggs Bank would most

likely demand more collateral from Roland Bank. This action would help Briggs Bank mitigate

the risk of potential losses due to the decrease in the value of the bonds. It's important to note

that the borrower may also withdraw collateral in advancing markets. This flexibility is a key

feature of repo agreements and plays a crucial role in managing risk and maintaining the value

of collateral.

Choice A is incorrect. Terminating the agreement would not be a feasible option for Briggs

Bank as it would result in a breach of contract, which could lead to legal consequences and

damage the bank's reputation. Furthermore, termination does not guarantee recovery of losses

incurred due to the drop in bond value.

Choice B is incorrect. Demanding immediate maturity of the contract may not be possible as

repurchase agreements typically have fixed terms that cannot be altered unilaterally. Moreover,

this action might not prevent further losses if bond prices continue to fall.

Choice C is incorrect. Doing nothing and hoping that the bonds regain their value is a passive

strategy that exposes Briggs Bank to unnecessary risk. It does not actively manage or mitigate

potential losses from declining bond values.

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Q.2248 Voynet Bank buys a security from Bornet bBank under a repo agreement. In the period
leading up to the settlement date, the market value of the security significantly increases.
Assuming a margin call forms part of the agreement, Bornet Bank will most likely:

A. Terminate the agreement.

B. Request that the contract matures immediately so that it can sell the mortgage to third
parties at a profit.

C. Request that the amount of collateral be reduced to reflect the increased value.

D. Do nothing, except wait for maturity of the agreement as scheduled.

The correct answer is C.

In a repurchase agreement, or 'repo', two parties agree to sell and repurchase the same security.

The seller sells the security to the buyer at a price with a commitment to repurchase the same or

another part of the same security at a specified price on a future date. In this case, Voynet Bank

(the buyer) and Bornet Bank (the seller) have entered into such an agreement. As the market

value of the security increases, Bornet Bank, being the borrower of cash, has the right to request

a reduction in the amount of collateral. This is because the increased value of the security

provides greater assurance to Voynet Bank about the return of their cash. This is a common

practice in repo agreements, where margin calls allow the borrower to supply extra collateral in

declining markets and withdraw collateral in advancing markets. Therefore, Bornet Bank is most

likely to request that the amount of collateral be reduced to reflect the increased value of the

security.

Choice A is incorrect. Terminating the agreement would not be a beneficial action for Bornet

Bank. The bank has an obligation to repurchase the security at a later date, and terminating the

agreement would likely result in penalties or other negative consequences.

Choice B is incorrect. Requesting that the contract matures immediately so that it can sell the

mortgage to third parties at a profit is not typically an option in a repurchase agreement. The

terms of these agreements are usually fixed and cannot be altered unilaterally.

Choice D is incorrect. While Bornet Bank could choose to do nothing and wait for maturity of

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the agreement as scheduled, this would not take advantage of the increased value of the security.

By requesting that the amount of collateral be reduced (choice C), Bornet Bank can benefit from

this increase in value.

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Q.2249 After modeling daily cash flows at BBB Bank, its managers strongly believe that the bank
will be unable to meet day-to-day funding requirements in about 1 years’ time. As such, the bank
has to secure long-term funding to avert a possible cash crunch. BBB Bank has high-quality US
treasury bonds in its portfolio. Should the bank sell the bonds under a repo agreement so as to
secure the required funds?

A. Yes, because US treasury bonds are highly marketable.

B. No, because repo financing is usually short-term.

C. Yes, because the repo market is highly illiquid.

D. No, because repo borrowing has to be backed up by collateral of a similar value.

The correct answer is B.

Repo financing is typically short-term in nature. This means that if BBB Bank were to sell its US

treasury bonds under a repo agreement, it would have to buy them back in a short period of

time, typically a few days or months. This would not provide a long-term solution to the bank's

projected cash flow problem. In fact, it could potentially exacerbate the situation. This is

because, in addition to repaying the borrowed amount, the bank would also have to pay accrued

interest. Therefore, using repo financing as a means to secure long-term funding would not be a

viable solution for BBB Bank.

Choice A is incorrect. While it's true that US treasury bonds are highly marketable, this

doesn't necessarily mean they should be sold under a repo agreement to secure long-term

funding. The high marketability of these bonds makes them a good choice for short-term

financing needs, but not necessarily for long-term ones.

Choice C is incorrect. The repo market is actually quite liquid, which makes it suitable for

short-term financing needs but not ideal for securing long-term funding as the bank requires in

this scenario.

Choice D is incorrect. Although it's true that repo borrowing has to be backed up by collateral

of a similar value, this does not make it unsuitable for securing long-term funding. The issue here

isn't the value of the collateral but rather the duration of the financing need - repos are typically

used for short term financing rather than long term.

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Q.2250 During the financial crisis of 2007/2008, repo transactions were partly to blame for the
failure of quite a number of firms. This is because:

A. The repo market was largely unregulated.

B. Firms borrowed money at relatively high-interest rates using low-quality financial

instruments as collateral.

C. Firms borrowed money at relatively low-interest rates using low-quality financial

instruments as collateral.

D. The US government defaulted on most treasury bonds.

The correct answer is C.

During the financial crisis of 2007/2008, many firms borrowed money at relatively low-interest

rates using low-quality financial instruments as collateral. This practice was prevalent in the

repo market, where borrowers financed lower-quality collateral, like lower-quality corporate

bonds and lower-quality mortgage-backed securities, at the relatively low rates and haircuts

available. Lenders, on their part, accepted this collateral in exchange for rates somewhat higher

than those available when lending on higher-quality collateral. Therefore, in case of counterparty

default in a repo agreement, the other party would struggle to sell the securities in the market.

Those lucky enough to find a buyer would still incur heavy losses due to decreased market value.

This practice contributed significantly to the financial crisis as it increased the risk exposure of

firms and made them vulnerable to market fluctuations.

Choice A is incorrect. While it's true that the repo market was not heavily regulated during the

financial crisis, this alone does not fully explain the role of repo transactions in contributing to

the crisis. The key issue was not just lack of regulation but also how firms were using these

transactions.

Choice B is incorrect. This statement is inaccurate because firms were actually borrowing

money at relatively low-interest rates, not high ones, using low-quality financial instruments as

collateral. This practice increased their risk exposure and contributed to their eventual failure

when these low-quality securities significantly dropped in value.

Choice D is incorrect. The US government did not default on most treasury bonds during the

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financial crisis of 2007/2008. In fact, US Treasury bonds are considered one of the safest

investments because they are backed by the full faith and credit of the US government.

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Q.2251 Bank Aluvia has an excess liquidity and it has decided to finance another bank under a
repo agreement. Why would Aluvia Bank prefer a repo transaction to other market products such
as the purchase of stocks?

A. A repo transaction would guarantee a quick return.

B. A repo transaction would be faster and easier to execute.

C. A repo transaction would be risk-free.

D. A repo-transaction would be more secure.

The correct answer is D.

A repo transaction would indeed be more secure. This is primarily due to two factors. First, repo

transactions typically have short maturities. This means that the lender (in this case, Bank

Aluvia) would get its money back in a relatively short period of time, reducing the duration of

exposure to risk. Second, the borrower in a repo transaction is required to provide high-quality

collateral. This collateral serves as a form of security for the lender, ensuring that even if the

borrower defaults on the loan, the lender can sell the collateral to recover its funds. Therefore,

compared to other market products such as stocks, which are subject to market volatility and

other risks, repo transactions provide a higher level of security for the lender.

Choice A is incorrect. While a repo transaction can provide a quick return, it does not

guarantee it. The speed of return in a repo transaction depends on the terms of the agreement

and market conditions.

Choice B is incorrect. Although repo transactions can be executed quickly due to their

standardized nature, they are not necessarily faster or easier than other financial instruments.

The execution speed and ease depend on various factors such as the complexity of the

instrument, market liquidity, and regulatory requirements.

Choice C is incorrect. No financial transaction, including a repo transaction, is completely risk-

free. Repo transactions carry several risks such as counterparty risk (the risk that the other

party will not fulfill its obligations), collateral risk (the risk that the collateral will lose value),

and liquidity risk (the risk that one cannot exit the position without affecting market prices).

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Q.2252 Boulogne Bank sells securities to Betis Bank as part of a repo agreement. Which of the
following statements would not be consistent with best market practice under such agreements?

A. The “buy back” price would be fixed.

B. The contract would be settled overnight.

C. Betis Bank would be free to sell the securities back to Boulogne Bank at any time.

D. The agreement would be legally binding.

The correct answer is C.

A repurchase agreement normally has a fixed settlement date.

Things to Remember

• A repurchase agreement, also known as a repo, is a form of short-term borrowing for dealers in

government securities. The dealer sells the government securities to investors, usually on an

overnight basis, and buys them back the following day.

• For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for

the party on the other end of the transaction (buying the security and agreeing to sell in the

future) it is a reverse repurchase agreement.

• Repurchase agreements are typically used to raise short-term capital. They are also a common

tool of central bank open market operations.

• The 'buy back' price is fixed and includes the original sale price plus an additional amount that

represents the interest on the loan.

• The agreement is legally binding, meaning both parties are obligated to fulfill their respective

obligations.

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Q.2253 Alameda Bank is looking to buy bonds which are “trading special”. Which type of bonds
is the bank looking for?

A. General collateral bonds.

B. Zero-collateral bonds.

C. Bonds issued by the government.

D. Bonds most in demand.

The correct answer is D.

Repo trades can be divided into those using general collateral (GC) and those using special
collateral or "specials." In the former, the lender of cash is willing to take any particular security,
although the broad categories of acceptable securities might be specified with some precision. In
specials trading, the lender of cash initiates the repo in order to take possession of a particular
security. Bonds most in demand to be borrowed are said to be trading special, although any
request for specific collateral is a specials trade.

Things to Remember

1. Repo trades can be divided into those using general collateral (GC) and those using special

collateral or 'specials'.

2. In general collateral trading, the lender of cash is willing to accept any particular security,

although the broad categories of acceptable securities might be specified with some precision.

3. In specials trading, the lender of cash initiates the repo in order to take possession of a

particular security.

4. Bonds most in demand to be borrowed are said to be trading special, although any request for

specific collateral is a specials trade.

5. 'Trading special' does not refer to any specific type of bond (e.g., government bonds, zero-

collateral bonds), but rather to bonds that are most in demand to be borrowed.

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Q.2732 Calculate the financing value per $100 market value of an on-the-run bond if it was
issued on March 31st and trades at a special spread of 0.30%. The bond is expected to trade at
GC rates after September 30th. Use the actual/360 day convention.

A. $0.100

B. $0.187

C. $0.125

D. $0.153

The correct answer is D.

The financing value of the bond can be determined by finding its value for the period that it

trades at the special spread.

Number of days it is traded at the special spread = 183 days

183
Financing value = 100 × × 0.30% = $0.153 per $100
360

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Q.2972 Assuming that a counterparty X sells a €250 million face amount of DBR 4’s of December
9th, 2014, to a counterparty Y , for settlement on April 1st, 2013, at an invoice price of €280.131
million. At the same time, counterparty X decides to rebuy the €250 million face amount five
months later, for settlement on September 1st 2013 at a purchase rate equivalent to the invoice
price including interest at a repo rate of 0.31%. Compute the repurchase price.

A. €250.166 million

B. €259.187 million

C. €281.129 million

D. €280.500 million

The correct answer is D.

By applying the actual/360 convention popular for most money market instruments, and using

153 days between April 1st and September 1st.

Therefore:

(0.0031 × 153)
€280, 131, 000(1 + ) =€280, 500, 072
360
≈ €280.5 Million

Note: Repurchase agreements use the actual/360 day count convention.

They are classified as money market instruments in the same category as T-bills.

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Q.2973 Which of the following is the value of lending $1,000 of cash at a spread of 0.31% for 133
days?

A. $1.145 per $1,000

B. $2.982 per $1,000

C. $1.675 per $1,000

D. $2.442 per $1,000

The correct answer is A.

The value of lending $1,000 of cash at a spread of 0.31% for 133 days is computed as:

(133×; 0.0031)
$1, 000 × = $1.145
360

⇒ $1.145 per $1,000 market value of the bond

Q.2974 Supposing that DBR 4s of face value $120 million of January 14th, 2030, are to be sold by
HJK Bank to a counterparty for settlement for $159 million. HJK Bank selling the DBR 4s then
decides to buy the $120 million face amount some 122 days later for settlement at a buying price
equal to that of the invoice price with a repo rate of 0.26%. At what price can HJK Bank
repurchase the bond?

A. $159.14 million

B. $121.65 million

C. $150.11 million

D. $121.33 million

The correct answer is A.

The repurchase price is:

122
$159 (1 + (0.0026 × )) = $159.14 million
360

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Q.4118 A counterparty K sells a €300 million face amount of DBR 4’s of June 10th, 2016, to a
counterparty W, for settlement on January 1st, 2015, at an invoice price of €350.25 million. At
the same time, counterparty X decides to rebuy the €300 million face amount six months later,
for settlement on July 1st, 2015, at a purchase rate equal to the invoice price with interest at a
repo rate of 0.26%. Compute the repurchase price.

A. 350.16 million

B. 350.56 million

C. 350.71 million

D. 350.85 million

The correct answer is C.

We apply the actual/360 convention popular for most money market instruments. There are using
181 days between January 1st and July 1st.

Repurchase Price
Repo Term in Days
= Principal + (Principal × Repo Rate × )
360 days
Repurchase Price
181
= $350.25 + (350.25 × 0.26% × ) = $350.71 Million
360

Note: Repurchase agreements use the actual/360 day count convention. They are classified as

money market instruments in the same category as T-bills.

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Q.4119 Prime Bank sells DBR 4s of face value $200 million of September 1st, 2040, to a
counterparty for settlement for 250 million. Prime Bank then decides to buy the $200 million
face amount after 183 days for settlement at a buying price equal to that of the invoice price
with a repo rate of 0.34%. At what price can Prime Bank repurchase the bond?

A. $250.43 million

B. $250.57 million

C. $200.68 million

D. $200.97 million

The correct answer is A.

Repo Term in Days

Repurchase Price = Principal (1 + (Repo Rate × ))
360 days
183
Repurchase Price = $250 (1 + (0.34% × )) = $250.43 Million
360

Q.4120 Bright Bank lends $10,000 of cash at a spread of 0.26% for 150 days. Calculate the
Bank’s lending value.

A. $1.034 per $10,000

B. $5.45 per $10,000

C. $10.83 per $10,000

D. $10.68 per $10,000

The correct answer is C.

The value of lending $100 of cash at a spread of 0.26% for 150 days is calculated as:

150 × 0.26%
$10 , 000 × = $10.83
360

i.e., $10.83 per $10,000 market value of the bond.

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Q.4121 Calculate the financing value per $1,000 market value of an on-the-run bond if it was
issued on July 1st 2019and trades at a special spread of 0.50%. The bond is expected to trade at
GC rates after October 31st 2019. Use the actual/360 day convention.

A. $1.57

B. $1.60

C. $1.67

D. $1.69

The correct answer is D.

The financing value of the bond can be determined by finding its value for the period that it
trades at the special spread.

Number of days it is traded at the special spread = 122 days

122
Financing value = 1, 000 × × 0.50% = $1.69 per $1, 000
360

Q.4123 Calculate the value of lending $200 cash at a spread of 0.25% for 150 days.

A. $0.208

B. $0.304

C. $0.308

D. $0.205

The correct answer is A.

150
Lending value (financial advantage) = $200 × 0.25% × = $0.208
360

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Q.4162 The following are characteristics of a Repurchase Agreement. Which one is NOT?

A. It has a specified price

B. It usually takes a short duration

C. It is generally considered a safe investment.

D. It usually takes a long duration.

The correct answer is D.

Repurchase Agreements, commonly known as repos, are typically short-term financial

instruments. They are often used for overnight borrowing but can extend up to 21 days. The

duration of a repo is agreed upon at the initiation of the contract and is typically short to

minimize the risk and provide quick liquidity to the borrower. Therefore, stating that a

Repurchase Agreement usually takes a long duration is incorrect.

Choice A is incorrect. Repurchase Agreements do indeed have a specified price. This price is

agreed upon by both parties at the beginning of the agreement and it represents the amount that

will be repaid at the end of the contract term.

Choice B is incorrect. Repurchase Agreements are typically short-term borrowing instruments,

often with durations as short as overnight. Therefore, this statement accurately represents a

characteristic of a Repurchase Agreement.

Choice C is incorrect. Generally, repos are considered safe investments because they are

collateralized loans - i.e., in case of default by the borrower, the lender can sell off the collateral

to recover their funds. Hence, this statement correctly describes one aspect of repos' nature in

financial markets.

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Q.5378 During a presentation on the quarterly performance of his bank, a risk manager
highlights the differences between repurchase agreements (repos) and reverse repurchase
agreements (reverse repos). Which of the following statements made by the manager is correct?

A. In a repo, the seller of securities agrees to buy them back at a later date at a slightly
lower price.

B. In a reverse repo, the buyer of securities agrees to sell them back at a later date at a
slightly lower price.

C. Repos are typically used to raise cash, while reverse repos are typically used to invest
cash.

D. Repos are initiated by the buyer of securities, while reverse repos are initiated by the
seller of securities.

The correct answer is C.

Repos are typically used by financial institutions to raise cash. In a repo transaction, the seller of

securities agrees to sell them to the buyer at a specified price and then repurchase them at a

later date at a slightly higher price. The securities serve as collateral for the loan. On the other

hand, reverse repos are typically used by financial institutions to invest cash. In a reverse repo

transaction, the buyer of securities agrees to buy them from the seller at a specified price and

then sell them back at a later date at a slightly lower price. The securities serve as collateral for

the investment.

A is incorrect. In a repo, the seller of securities agrees to repurchase them at a later date at a

slightly higher price.

B is incorrect. In a reverse repo, the buyer of securities agrees to sell them back at a later date,

but again, at a slightly higher price. This mirrors a repo but from the perspective of the

counterparty.

D is incorrect. This is not always true. While it's true that the buyer usually initiates the

transaction by making an offer, both repos and reverse repos can be initiated by either party

depending on the market conditions and their individual needs.

Q.5412 Three months after purchasing the bond on its coupon payment date, ABC Bank opts to

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enter into a repurchase agreement (repo) on the bond to generate immediate liquidity. The
bond’s and repo's details are shown below.

Notional (GBP) 10, 000, 000

Annual coupon (paid semiannually) 3.5%
Current price of bond (GBP) 97
Repo interest rate 2%
Repo haircut 3.5%

What is the anticipated cash outflow for ABC Bank when the repo contract reaches its expiration
in 6 months?

A. 9,539,387

B. 9,269,911

C. 9,949,300

D. 9,273,864

The correct answer is A.

Cash inflow at the beginning of the repo:

This is the bond's adjusted price (including the fraction of the coupon) minus the haircut.

Initial Cash Inflow = (Current price of bond + Fraction of Coupon) × Notional × (1 − Repo haircut
1
= (0.97 + 0.035 × ) × 10 , 000, 000 × 0.965
4
= 9, 444, 937.5

Cash outflows at the end of the repo:

This is the initial cash inflow plus the repo interest for the 6-month period.

1
Cash Outflow at the End = Initial Cash Inflow × (1 + Repo interest rate × )
2
= 9, 444, 937.5 × (1 + 0.02 × 0.5)
= 9, 539, 386.88

The anticipated cash outflow for ABC Bank when the repo contract expires in 6 months is GBP

9,539,386.88.

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Reading 141: Liquidity Transfer Pricing: A Guide to Better Practice

Q.4201 Calculate the rate charged for contingent liquidity risk of a line of credit assumed to have
a limit of $56million where $22 million has already been drawn. Further, suppose there is a 38%
chance that the customer will draw on the remaining credit and that the cost of term funding
assets in the liquidity cushion is 7.5 bps.

A. 1.73 bps

B. 2.85bps

C. 4.40 bps

D. 2.71 bps

The correct answer is A.

Limit-Drawn Amount
Rate charged = × Likelihood of Drawdown
Limit
× Cost of Funding Liquidity Cushion

Hence,

($56m − $22m)
× 0.38 × 0.00075 = 0.000173 ≅1.73bps
$56m

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Q.4202 A line of credit has a limit of $120 million, in which $56 million has already been drawn.
An assumption is made that customer K will draw on the remaining credit with a 75% probability
and the cost of term funding assets in the liquidity cushion at 32bps. Calculate the rate charged
for the contingent liquidity risk of the line of credit.

A. 5.14 bps

B. 1.12 bps

C. 12.8 bps

D. 1.28 bps

The correct answer is C.

Formula.

Limit-Drawn Amount
× Likelihood of Drawdown × Cost of Funding Liquidity Cushion
Limit

Hence,

($120m − $56m)
× 0.75 × 0.0032 = 0.00128 ≅12.8bps
$120m

Q.4203 Which of the given options most accurately highlights poorly designed trading book
policies?

A. Banks having trading book funding policies where some assume that assets are held
for a short-term consisting of at least 180 days.

B. Large banks with a considerably vast trading business having their investment and
trading banking activities financed as per the total net funding need in all related
business units

C. Large trading businesses using inadequate haircuts on most of the assets they owe.

D. All of the above

The correct answer is D.

All the options provided in the question are indicative of poorly designed trading book policies.

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The Financial Stability Institute conducted a study analyzing 38 large banks from nine countries

and found that most of these banks had poorly designed trading book policies. The study

revealed that:

1. Many banks had trading book funding policies, but these policies assumed that assets were

held short-term (i.e., for 180 days or less). This approach is problematic because long-term

funding charges only apply when assets roll from the trading book to the banking book,

regardless of whether assets are likely to be held for more than the 180-day threshold.

2. Many of the larger banks, especially those with substantial trading businesses, could not

identify the funding requirements of individual trading desks due to a lack of visibility into

individual business balance sheets. Consequently, trading and investment banking activities were

funded based on the total net funding requirement across all related business units.

3. Banks with significant trading businesses applied insufficient haircuts to many of the traded

assets they held.

Therefore, all the options (A, B, and C) are correct, making choice D the most accurate answer.

Choice A is incorrect. While it's true that assuming assets are held for a short-term of at least

180 days can be part of a poorly designed trading book policy, this alone does not encapsulate all

the characteristics of such policies. There are other factors to consider, such as how the bank

finances its trading and investment banking activities and whether it uses adequate haircuts on

the assets it owes.

Choice B is incorrect. Although large banks with vast trading businesses financing their

investment and trading banking activities based on total net funding need in all related business

units can be an aspect of poorly designed policies, this doesn't cover all possible characteristics.

Other elements like assumptions about asset holding periods and use of haircuts also play a role.

Choice C is incorrect. The use of inadequate haircuts on most assets owed by large trading

businesses can indeed indicate poor policy design, but this isn't the only characteristic to look

out for. Policies regarding asset holding periods and financing methods also contribute to overall

policy design quality.

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Q.4204 Given that a six-year amortizing loan in recent times has the following annual liquidity
premiums: 6, 14, 18,24, 27, 32. Use the matched-maturity marginal cost of funds approach to
calculate the charge of funding liquidity risk of this loan.

A. 32.00 bps

B. 42.33 bps

C. 33.43 bps

D. 24.33 bps

The correct answer is D.

(Term in year 1 × Term liquidity premium) + (Term in year 2 × Term liquidity premium)
+ ⋯ (Term in year n × Term liquidity premium)
Term in year (1 + 2 + 3+ . .. +n)

Thus, the charge of funding liquidity risk of this loan is

(1 × 6) + (2 × 14) + (3 × 18) + (4 × 24) + (5 × 27) + (6 × 32)

= 24.3bps
(1 + 2 + 3 + 4 + 5 + 6)

Q.4205 Calculate the monthly payment required to amortize a loan whose principal is $225,000
at an annual interest rate of 3.25% compounded monthly for a term of 30 years.

A. 739.23

B. 799.21

C. 979.21

D. 2700.21

The correct answer is C.

(P × i)
R=
1 − (1 + i)

Note:

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A loan of P dollars at interest rate i per period may be amortized in an equal periodic payments

of R dollars made at the end of each period.

Where:

i
r=
m

i is the interest rate per period

r is the interest rate on loan (periodic payment)

m is the number of compounding periods per year.

n=m×t

t is the term of the loan

P= 225,000

r =3.25% (0.0325)

m = 12

But,

0.0325
i=
12

n = 12 × 30 = 360

Hence,

0.0325
225, 000 ×
12
R= = $979.21
0.0325−360
1 − (1 + )
12

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Q.4206 Assume the following term liquidity premiums and the average cost of funds were
recorded by a bank at a point before the crisis (Pre-GFC), and more recently.

Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds
Term in years 1 2 3 4 5
Pre-Global Financial Crisis
Term liquidity premium 1 3 5 7 10
Average cost of funds 3 3 3 3 3
Current
Term liquidity premium 5 8 10 18 35
Average cost of funds 10 10 10 10 10

Using the matched-maturity marginal cost of funds approach, calculate the amount of charge
that a one-year non-amortizing bullet loan will be charged for funding liquidity risk if it
originated pre-crisis and more recently, respectively.

A. $1 and $3

B. $1 and $5

C. $3 and $5

D. $10 and $35

The correct answer is B.

From the table, we can see that a one-year non-amortizing bullet loan should have received a
charge of 1 bp if originated pre-crisis, and 5 bps if arisen more recently.

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Q.4207 Suppose the following term liquidity premiums and the average cost of funds were
recorded by a bank at a point before the crisis (Pre-GFC), and more recently.

Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds
Term in years 1 2 3 4 5
Pre-Global Financial Crisis
Term liquidity premium 1 3 5 7 10
Average cost of funds 3 3 3 3 3
Current
Term liquidity premium 5 8 10 18 35
Average cost of funds 10 10 10 10 10

Assume that the principal of the loan was $5 million. Using the matched-maturity marginal cost
of funds approach, calculate the charge that a one-year loan translated to the business unit(s)
writing the loans if it originated pre-crisis and more recently, respectively.

A. $100 and $500

B. $500 and $2,500

C. $1,000 and $2,000

D. $2,000 and $2,500

The correct answer is B.

From the table, a one-year non-amortizing bullet loan should have received a charge of 1 bp if
originated pre-crisis, and 5 bps if arisen more recently. Given the principal of the loan as $5
million. This should have translated to charges of $500(0.0001 × 5, 000, 000) and
$2 , 500(0.0005 × 5 , 000 , 000) , respectively, to the business unit(s) writing the loans.

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Q.4208 Suppose the following term liquidity premiums and the average cost of funds were
recorded by a bank at a point before the crisis (Pre-GFC), and more recently.

Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds
Term in years 1 2 3 4 5
Pre-Global Financial Crisis
Term liquidity premium 1 3 5 7 10
Average cost of funds 3 3 3 3 3
Current
Term liquidity premium 5 8 10 18 35
Average cost of funds 10 10 10 10 10

Prime Bank decides to use the average cost of funds approach to calculate the amount to charge
for funding liquidity risk of five-year non-amortizing loans. How much will the bank charge for
funding liquidity risk of these loans if they arose pre-crisis and more recently, respectively?

A. $1 and $5

B. $3 and $5

C. $3 and $10

D. $10 and $35

The correct answer is C.

Using the average cost of funds technique, the bank will charge 3bps if originated pre-crisis, and
10 bps if arisen more recently.

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Q.4209 A five-year linearly amortizing bullet loan has a principal amount of $2 million. Think of
these as five separate annual loans, each of $400,000, using a matched-maturity marginal cost of
funds approach, calculate the charge that this loan receives using the information provided in
the following table:

Pre-GFC and Current Term Liquidity Premiums and Average Cost of Funds
Term in years 1 2 3 4 5
Pre-Global Financial Crisis
Term liquidity premium 2 6 8 9 12
Average cost of funds 4 4 4 4 4
Difference −2 2 4 5 8

A. 3.93bps

B. 8.93bps

C. 9.83bps

D. 398.00bps

The correct answer is B.

(Term in year 1 × Term liquidity premium) + (Term in year 2 × Term liquidity premium)
+ ⋯ (Term in year n × Term liquidity premium)
Term in year (1 + 2 + 3+? + n)

(1 × 2) + (2 × 6) + (3 × 8) + (4 × 9) + (5 × 12)
= 8.93bps
(1 + 2 + 3 + 4 + 5)

Q.4210 The following are problems with bank liquidity unveiled by the Great Financial Crisis
(GFC). Which is NOT?

A. Most banks failed to use the outcomes of stress-testing in determining their liquidity
cushion size

B. The banks assumed that the assets they had had liquidity cushions believed to be
highly liquid and highly correlated.

C. Most banks preferred liquidity cushions on short-term funding, i.e., overnight on the
assumption that funds would be easy to access, and in case of any market disruptions,
the impact will be short-lived.

D. Banks accounted for the costs, benefits, and risks of liquidity in all or some aspects of

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their business activities.

The correct answer is D.

The statement that banks accounted for the costs, benefits, and risks of liquidity in all or some

aspects of their business activities is not a problem that was unveiled by the GFC. In fact, it is a

good practice that banks should follow. During the GFC, it was noted that many banks failed to

account for these factors. They viewed liquidity as being free and thus perceived zero liquidity

risk. This led them to attribute zero charges to some assets for the cost of using funding liquidity

and conversely, they attributed no credit to some liabilities for the benefit of providing funding

liquidity. This practice was a significant issue as it led to a misrepresentation of the true cost and

benefit of liquidity, thereby contributing to the liquidity problems experienced during the GFC.

Choice A is incorrect. During the GFC, it was indeed observed that most banks failed to use

the outcomes of stress-testing in determining their liquidity cushion size. This was one of the key

issues exposed during the crisis.

Choice B is incorrect. The statement accurately represents another problem revealed during

the GFC. Banks assumed that their assets, which they considered as liquidity cushions, were

highly liquid and highly correlated. This assumption proved to be flawed when these assets

turned out to be illiquid during times of stress.

Choice C is incorrect. It's true that most banks preferred liquidity cushions on short-term

funding, assuming that funds would be easy to access and any market disruptions would have a

short-lived impact. This preference for short-term funding led to significant vulnerabilities when

market conditions worsened.

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Q.4211 There is an $80 million limit on a line of credit and $24 million already drawn. Jack is
expected to draw the remaining with a 45% probability at the cost of term funding assets in the
liquidity cushion at 24bps. Calculate the rate charged for contingent liquidity risk.

A. 0.756 bps

B. 7.56 bps

C. 0.60 bps

D. 75.6 bps

The correct answer is B.

Formula.

Limit-Drawn Amount
Rate charged = × Likelihood of Drawdown
Limit
× Cost of Funding Liquidity Cushion

Hence,

($80m − $24m)
× 0.45 × 0.0024 = 0.000756 ≅7.56bps
$80m

Q.4212 Which of the given options is the most accurate reason why banks choose to use pooled
average costs approach to LTP?

A. It is a more straightforward method

B. It is simple, thus makes it easier for banks to understand and comply with the LTP
process.

C. The average cost of funds approach is vulnerable to transitional changes in banks’ real
market cost of funding, therefore, minimizing net interest income deviation across all
businesses.

D. All of the above

The correct answer is D.

The pooled average costs approach is chosen by banks for Liquidity Transfer Pricing (LTP) due to

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a combination of reasons. Firstly, it is a straightforward method, making it easier for banks to

understand and comply with the LTP process. This simplicity is crucial in ensuring that all

stakeholders within the bank can easily comprehend and adhere to the process. Secondly, the

average cost of funds approach is vulnerable to transitional changes in banks’ real market cost of

funding. This vulnerability can lead to significant deviations in net interest income across all

businesses. By using the pooled average costs approach, banks can minimize these deviations,

ensuring a more stable and predictable net interest income. Therefore, all the given options

collectively provide the most accurate reason for banks' preference for the pooled average costs

approach in LTP.

Choice A is incorrect. While the pooled average costs approach may be more straightforward,

this is not the primary reason why banks opt for this method in LTP. The main advantage of this

approach lies in its ability to minimize net interest income deviation across all businesses, not its

simplicity.

Choice B is incorrect. Although simplicity can make it easier for banks to understand and

comply with the LTP process, it's not the primary reason for choosing the pooled average costs

approach. The key benefit of this method is its capacity to reduce net interest income deviation

across all business units.

Choice C is incorrect. While it's true that the average cost of funds approach can be vulnerable

to transitional changes in a bank’s real market cost of funding, thereby minimizing net interest

income deviation across all businesses, this statement alone does not fully capture why banks

prefer using the pooled average costs approach in LTP.

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Q.4213 Use the matched-maturity marginal cost of funds approach to calculate the cost of
funding liquidity risk given that a four-year amortizing bullet loan has annual liquidity premiums
of 12, 17, 24, 30, respectively.

A. 23.8bps

B. 32.8bps

C. 238bps

D. 832bps

The correct answer is A.

(Term in year 1 × Term liquidity premium) + (Term in year 2 × Term liquidity premium)
+ ⋯ (Term in year n × Term liquidity premium)
Term in year (1 + 2 + 3+? + n)

(1 × 12) + (2 × 17) + (3 × 24) + (4 × 30)

= 23.8bps
(1 + 2 + 3 + 4)

Q.4214 Most banks are moving towards better Liquidity Transfer Pricing policies. Which of the
given options is the most accurate about some of the following steps banks are taking in the
actualization of improved LTP practices?

A. Banks operating with decentralized funding centers are changing towards wholesale
funding controlled centrally via a treasury function.

B. Banks are coming up with trading book procedures and policies

C. Banks with small trading book exposures in their business activities want to do away
with over-trading behaviors by applying higher funding rates on net funding needs upon
breaching certain funding limits.

D. All of the above

The correct answer is D.

All the options provided accurately describe the steps banks are taking to improve their Liquidity

Transfer Pricing (LTP) policies.

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Option A states that banks operating with decentralized funding centers are changing towards

wholesale funding controlled centrally via a treasury function. This is a strategic move aimed at

preventing arbitrage between treasury and business units as well as between the businesses

themselves.

Option B mentions that banks are coming up with trading book procedures and policies. This is a

crucial step as it involves the development of risk limits and controls for trading activities. These

measures are necessary for the proper measuring, monitoring, and assessment of liquidity

threats attached to business units and products.

Option C indicates that banks with small trading book exposures in their business activities want

to do away with over-trading behaviors by applying higher funding rates on net funding needs

upon breaching certain funding limits. This is a strategic move aimed at curbing over-trading

behaviors and ensuring financial stability.

Choice A is incorrect. While it is true that banks are moving towards a more centralized

funding approach, this does not fully capture the strategic steps being taken to enhance LTP

policies. The shift also involves other measures such as implementing trading book procedures

and policies, and applying higher funding rates on net funding needs upon breaching certain

limits.

Choice B is incorrect. Although the development of trading book procedures and policies is

part of the strategic steps being taken by banks to improve their LTP practices, it does not

encompass all the measures being implemented. Other steps include centralizing wholesale

funding through a treasury function and applying higher funding rates on net funding needs

when certain limits are breached.

Choice C is incorrect. The application of higher funding rates on net funding needs upon

breaching certain limits is indeed one of the strategies used by banks to curb over-trading

behaviors in their business activities with small trading book exposures. However, this alone

does not represent all the strategic steps being taken to enhance LTP practices in banking sector.

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Q.4215 The following are the cost components of liquidity transfer pricing (LTP). Which of the
following is NOT?

A. Liquidity risk costs

B. Costs of the liquidity cushion

C. Costs of the liquidity reserves

D. Expense costs

The correct answer is D.

Expense costs are not a component of Liquidity Transfer Pricing (LTP). LTP is a method used by

financial institutions to allocate the costs and benefits of liquidity across different business lines.

It includes several cost components, such as liquidity risk costs, costs of the liquidity cushion,

and costs of the liquidity reserves. However, expense costs, which typically refer to the costs

incurred in the course of conducting business, such as salaries, utilities, and rent, are not

considered a part of LTP. These costs are usually accounted for separately in the financial

institution's overall cost structure.

Choice A is incorrect. Liquidity risk costs are a component of Liquidity Transfer Pricing. These

costs arise from the uncertainty and potential loss caused by an institution's inability to meet its

obligations as they come due without incurring unacceptable losses.

Choice B is incorrect. The costs of the liquidity cushion are also a part of Liquidity Transfer

Pricing. The liquidity cushion refers to the liquid assets held by a financial institution to meet

unexpected cash flow needs or market disruptions, and maintaining this cushion incurs certain

costs.

Choice C is incorrect. The cost of liquidity reserves is another component of Liquidity Transfer

Pricing. Financial institutions need to hold certain reserves as per regulatory requirements,

which can be costly as these funds could have been otherwise invested for returns.

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Q.5418 A risk analyst is having a conversation with her supervisor about the different
approaches to liquidity transfer pricing and the potential effects of each technique. Which of the
following claims made by the risk analyst on liquidity transfer price is most likely correct?

A. The bank's fixed-rate borrowing cost becomes a floating-rate borrowing cost when a
matched-maturity marginal cost of funds technique is used.

B. When management remuneration is based on net income, both an average cost-of-

funds approach and a zero-cost-of-funds approach correctly align the maturity of the
bank's lending and borrowing activities.

C. When a bank uses a zero-cost-of-funds strategy, it frequently ends up with long-term,

very illiquid assets that are financed by stable, long-term liabilities.

D. The balance sheet of a bank often experiences the biggest maturity transformation
when using an average cost of funds strategy.

The correct answer is A.

The bank's fixed rate borrowing cost is converted to floating via a matched-maturity marginal
cost of funds liquidity pricing strategy, which also equals the spread over a reference rate. This
approach ensures that the cost of funds aligns with the maturity of the bank's assets and
liabilities, considering the marginal cost of acquiring additional funds.

B is incorrect. When compensation is based on net income, neither a zero-cost-of-funds

approach nor an average cost-of-funds approach will properly align the maturity of the bank's

lending and borrowing activities. Management might build an important maturity mismatch

between assets and liabilities to boost net income.

C is incorrect. The bank will typically retain long-term, highly illiquid assets matched with

short-term liabilities under a zero-cost liquidity pricing structure.

D is incorrect. The balance sheet maturity transformation for a bank will often be the biggest

under a zero-cost-of-funds liquidity pricing system.

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Reading 142: The US Dollar Shortage in Global Banking and the

International Policy Response

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Q.4164 The stretch to which banks invest in one currency and fund in another via F.X. swaps is
known as:

A. Cross currency funding

B. Funding gap

C. Carry trading

D. Hedging

The correct answer is A.

This term refers to the practice where banks invest in one currency and fund in another through

foreign exchange (F.X.) swaps. This strategy is often employed by banks to take advantage of

differences in interest rates between two currencies. For instance, a bank might invest in a

currency with a high interest rate while funding in a currency with a lower interest rate. This

allows the bank to earn a profit from the interest rate differential. The European and Japanese

banking systems have been known to engage in cross-currency funding extensively since 2000,

taking on significant net on-balance-sheet positions in foreign currencies, particularly in U.S.

dollars.

Choice B is incorrect. A funding gap refers to the difference between a company's available

capital and the amount required to carry out its operations or projects. It does not specifically

involve investing in one currency and funding in another via foreign exchange (F.X.) swaps.

Choice C is incorrect. Carry trading is a strategy that involves borrowing at a low interest rate

and investing in an asset that provides higher returns. While it can involve different currencies,

it doesn't necessarily imply using F.X. swaps for investment and funding purposes as described in

the question.

Choice D is incorrect. Hedging refers to making an investment to reduce the risk of adverse

price movements in an asset, typically by taking an offsetting position in a related security, such

as options or futures contracts. It does not directly relate to the strategy of investing in one

currency and funding another through F.X swaps.

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Q.4165 The international policy response came into place due to the severe U.S. dollar shortage
among banks outside the United States. It brought about the following success. Which of the
following choices is the most accurate?

A. It increased the appetite for foreign currency assets

B. It led to the U.S. dollar funding gap

C. It contributed to the reversal of carry trades

D. It mitigated upward pressure and interbank rate volatility on the U.S. dollar.

The correct answer is D.

The international policy response was successful in mitigating upward pressure and interbank

rate volatility on the U.S. dollar. During the financial crisis, there was a severe shortage of U.S.

dollars among banks outside the United States. This shortage was due to a variety of factors,

including an increased appetite for foreign currency assets, a U.S. dollar funding gap, and the

reversal of carry trades. The international policy response was designed to address this shortage

and stabilize the financial markets. One of the key successes of this response was its ability to

mitigate upward pressure and interbank rate volatility on the U.S. dollar. By doing so, it helped

to stabilize the value of the U.S. dollar and reduce the risk of further financial instability.

Choice A is incorrect. The international policy response was not aimed at increasing the

appetite for foreign currency assets. Instead, it was designed to address the shortage of U.S.

dollars among banks outside the United States during the financial crisis.

Choice B is incorrect. The international policy response did not lead to a U.S. dollar funding

gap; rather, it was a measure taken to alleviate such a gap that had arisen due to the financial

crisis.

Choice C is incorrect. While carry trades may have been affected by various factors during the

financial crisis, there's no evidence that suggests that they were directly influenced by this

particular international policy response.

Q.4166 In a discussion panel on mitigating the recurrence of the great financial crisis, a delegate
mentioned the following causes of the U.S Dollar shortage during the great financial crisis.

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I. Increased appetite for foreign currency assets by non-US investors

II. Cross currency funding
III. U.S. dollar funding gap

Which of the above causes are correct?

A. I and II

B. I and III

C. II and III

D. All of the above

The correct answer is D.

During the great financial crisis, all three factors mentioned played a significant role in the

shortage of the U.S Dollar.

Firstly, there was an increased demand for foreign currency assets, particularly U.S.

denominated claims on non-bank entities, by investors outside the U.S. This increased demand

put pressure on the availability of the U.S Dollar.

Secondly, banks engaged in cross-currency funding, a practice where they invested in one

currency and funded in another via foreign exchange swaps. This practice was particularly

prevalent in the banking systems of Europe and Japan. Since 2000, these banking systems had

taken on significant net on-balance-sheet positions in foreign currencies, especially in U.S.

dollars. The associated currency exposures were left hedged off-balance-sheet, leading to a

situation where the banks were exposed to foreign currency funding risk. In other words, these

banks were at risk that their funding positions could not be rolled over, contributing to the U.S

Dollar shortage.

Lastly, the U.S. dollar funding gap also contributed to the shortage. Non-U.S banks, unlike

domestic banks, had limited access to a stable base of dollar deposits. This forced them to rely

on short-term and potentially more volatile sources of funding, such as commercial paper and

loans from other banks, leading to the U.S. dollar funding gap.

Choice A is incorrect. While it is true that the growing demand for foreign currency assets by

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investors outside the U.S and the practice of cross-currency funding contributed to the shortage

of U.S Dollar during the crisis, this choice ignores another significant factor - The existence of a

U.S. dollar funding gap. This gap was created due to an imbalance between dollar-denominated

liabilities and assets held by financial institutions outside of the United States.

Choice B is incorrect. Although it correctly identifies two factors - The growing demand for

foreign currency assets by investors outside the U.S and The existence of a U.S. dollar funding

gap, it fails to consider another crucial factor - The practice of cross-currency funding. Cross-

currency funding refers to borrowing in one currency (usually low-interest-rate currencies) and

investing in another (usually high-interest-rate currencies). During times of financial stress, this

can lead to a shortage in certain currencies like what happened with USD during the crisis.

Choice C is incorrect. While it rightly points out two factors - The practice of cross-currency

funding and The existence of a U.S. dollar funding gap, it overlooks an important factor -The

growing demand for foreign currency assets by investors outside the U.S., which also played a

role in causing USD shortage during that period.

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Q.4167 The banks' international balance sheet expansions since 2000 are highly associated with
the U.S. dollar shortage. The stock on banks' foreign claims significantly grew from $10 trillion at
the start of 2000 to $34 trillion by the end of 2007. By 2001, international claims were at 10%
while at the end of 2007, it approached 30%. These significant improvements occurred mainly
during the financial innovation period. This innovation period included the following, EXCEPT:

A. Expansion growth in the hedge fund industry

B. The introduction of financial structures

C. The spreading of universal banking

D. Auctioning of the U.S dollar.

The correct answer is D.

Auctioning of the U.S dollar was not a part of the financial innovation period. It was, in fact, an

international policy response aimed at minimizing the level of volatile swap spread during the

great financial crisis. The auctioning of the U.S dollar was a measure taken to provide liquidity to

the market and stabilize the financial system during a period of intense crisis. It was not a part of

the financial innovation that led to the expansion of banks' international balance sheets.

Choice A is incorrect. The expansion growth in the hedge fund industry was indeed a part of

the financial innovation period. Hedge funds played a significant role in providing liquidity to the

market and diversifying investment risks.

Choice B is incorrect. The introduction of financial structures, such as derivatives and

structured products, was also a key development during this period. These instruments allowed

for better risk management and facilitated capital flow across different sectors.

Choice C is incorrect. The spreading of universal banking was another characteristic feature of

this period. Universal banks offer a wide range of financial services under one roof, which

contributed to the expansion in international balance sheets.

Q.4168 You are a student in a Risk Management class. Your lecturer asks you to explain maturity
transformation across banks’ balance sheets. Which of the following is correct about maturity
transformation across banks’ balance sheets?

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A. A maturity mismatch needed to facilitate long term investment projects should allow
banks to earn a spread in a negative sloping yield curve surrounding.

B. Banks do not transfer funds from agents in surplus, demanding short-term deposits to
agents in deficit with long-term financing needs.

C. Banks might be motivated to increase their maturity mismatch excessively and thus,
making themselves vulnerable to funding risks related to short-term liabilities roll-over.

D. It mitigates upward pressure and interbank rate volatility on the U.S dollar

The correct answer is C.

Maturity transformation is a fundamental function of banks, where they convert short-term

liabilities (like deposits) into long-term assets (like loans). This process allows banks to earn a

spread, as long-term interest rates are typically higher than short-term rates. However, this also

exposes banks to funding risks, particularly in times of financial stress. If a bank has a large

maturity mismatch, meaning its liabilities are much shorter-term than its assets, it may face

difficulties in rolling over its short-term liabilities. This could lead to a liquidity crisis if

depositors demand their money back and the bank is unable to meet these demands. Therefore,

while maturity transformation is a necessary function of banks, excessive maturity mismatch can

make banks vulnerable to funding risks.

Choice A is incorrect. While it's true that banks can earn a spread through maturity

transformation, this isn't necessarily tied to a negative sloping yield curve. In fact, banks often

face challenges in such an environment because they're borrowing short-term at higher rates

and lending long-term at lower rates.

Choice B is incorrect. This statement contradicts the fundamental concept of maturity

transformation. Banks indeed act as intermediaries, transferring funds from agents with surplus

(who demand short-term deposits) to those in deficit (who require long-term financing).

Choice D is incorrect. Maturity transformation doesn't directly mitigate upward pressure or

volatility on the U.S dollar interbank rate. The interbank rate depends on various factors like

monetary policy, liquidity in the market etc., not specifically on maturity transformation.

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Q.4169 In a class discussion, each student was asked to mention something about the U.S dollar
shortage during the great financial crisis. The following statements were recorded from the
students’ responses.

I. The dollar shortage refers to a situation where a country has an inadequate supply of the
dollar to manage international trade effectively.
II. During the U.S. dollar shortage, countries had to pay more U.S dollars for imports
relative to the U.S dollars received from exports.
III. The U.S. dollar shortage refers to the mismatches between the maturity, currency, and
counterparty of assets and liabilities.

Which of the following alternatives is correct?

A. I and II

B. II and III

C. I, II, and III

D. None of the above

The correct answer is A.

Statements I and II accurately describe the U.S. dollar shortage during the great financial crisis.

A dollar shortage is indeed a situation where a country lacks a sufficient supply of the U.S. dollar

to effectively manage its international trade. This shortage can occur when a country has to pay

more U.S dollars for its imports than it receives from exports. The U.S. dollar acts as a 'safe

haven' for other countries' currencies, and a shortage can have a significant impact on global

trade. During the great financial crisis, many countries experienced this shortage, which

exacerbated the economic downturn.

Choice B is incorrect. Statement III does not accurately represent the U.S. dollar shortage

during the great financial crisis. The U.S. dollar shortage was not a result of mismatches

between the maturity, currency, and counterparty of assets and liabilities but rather due to a

sudden increase in demand for safe assets like US dollars during times of economic uncertainty.

Choice C is incorrect. As explained above, statement III does not accurately represent the U.S.

dollar shortage during the great financial crisis hence combination I, II and III cannot be correct.

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Choice D is incorrect. Statements I and II do accurately represent aspects of the U.S dollar

shortage that occurred during the great financial crisis hence 'None of the above' cannot be

correct.

Q.4170 Malcolm was asked to identify two main challenges related to international lending of
last resort solved by international swap arrangements. He gave four responses as follows:

I. The Federal Reserve and its foreign counterparts were now accorded power of creating
whatever amounts of money they choose as compared to global financial institutions
administering resources in limited nature.
II. The auctioning of the U.S dollar led to a minimized level of volatile swap spread.
III. The swap network does not consist of information issues that can lead to moral dangers.
IV. It mitigated upward pressure and interbank rate volatility on the U.S. dollar.

Which of the responses correctly identifies the two main challenges?

A. I and III

B. II and IV

C. I and IV

D. None of the above

The correct answer is A.

The two main challenges related to international lending of last resort that are solved by

international swap arrangements are indeed the ones identified in responses I and III. The first

challenge is the limited nature of resources administered by global financial institutions. This is

addressed by the power accorded to the Federal Reserve and its foreign counterparts to create

any amount of money they choose. The second challenge is the potential for information issues

within the swap network to lead to moral hazards. This is mitigated by the absence of such issues

within the swap network. These two benefits directly address the challenges faced in

international lending of last resort, making them the correct responses.

Choice B is incorrect. While the auctioning of the U.S dollar (II) can lead to a reduction in the

volatility of swap spreads, it is not one of the main challenges that international swap

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arrangements are designed to address. The mitigation of upward pressure and volatility in the

interbank rate on the U.S. dollar (IV) is indeed a benefit, but it does not pair with II as one of the

two main challenges addressed by these arrangements.

Choice C is incorrect. The ability of central banks like Federal Reserve and its foreign

counterparts to create any amount of money they choose (I) is indeed a key benefit, but it does

not pair with IV as one of two main challenges addressed by these arrangements. Although

mitigating upward pressure and volatility in interbank rates on U.S. dollar (IV) can be seen as a

benefit, it doesn't form part with I as primary issues that international swap arrangements aim to

solve.

Choice D is incorrect. As explained above, there are indeed pairs among these benefits that

correctly identify two main challenges that international swap arrangements are designed to

address.

Q.4171 The following statements are about the structure of bank operations in long and short of
the banks’ global balance sheets. Which one is most definitely TRUE?

A. Banks management of maturity and currencies are based on a consolidated global

entity instead of per office.

B. Banks actively operating across the world have numerous offices in various countries.

C. Significant mismatches measured on an office’s balanced sheet located in a different

office may be offset/hedged off-balance sheet through an on-balance sheet position
booked by other offices elsewhere

D. All of the above

The correct answer is D.

All the statements provided in the choices accurately reflect the structure and operations of

banks on their global balance sheets. Banks that operate on a global scale have numerous offices

in various countries (Choice B). They manage their maturity and currencies based on a

consolidated global entity instead of per office (Choice A). This implies that significant

mismatches measured on an office’s balance sheet located in a different office may be

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offset/hedged off-balance sheet through an on-balance sheet position booked by other offices

elsewhere (Choice C). Therefore, all the statements are true, making Choice D the most accurate

answer.

Choice A is incorrect. While it's true that banks manage maturity and currencies on a

consolidated global entity basis, this statement alone does not fully capture the complexity of

global banking operations. Banks also manage these aspects at the individual office level, taking

into account local market conditions and regulations.

Choice B is incorrect. The presence of numerous offices in various countries is a characteristic

of globally operating banks, but this statement does not provide any insight into how these banks

manage their global balance sheets or handle mismatches in maturity and currencies.

Choice C is incorrect. Although significant mismatches measured on an office’s balance sheet

may be offset/hedged off-balance sheet through an on-balance sheet position booked by other

offices elsewhere, this statement doesn't encompass all the strategies used by banks to manage

their global operations. Other methods such as netting agreements or internal transfers are also

commonly used.

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Q.4172 Which of the following entails an investor holding a high-yielding currency asset (target
asset), which is financed with a low-yielding currency liability (funding liability)?

A. Carry trade

B. Cross currency funding

C. Hedging

D. Funding gap

The correct answer is A.

A carry trade is a strategy that involves borrowing at a low interest rate and investing in an asset

that provides a higher rate of return. In the context of foreign exchange markets, a carry trade

involves borrowing in a low-yielding currency (funding liability) and investing in a high-yielding

currency (target asset). The investor 'carries' the difference between the two rates. Carry trades

are typically used by large hedge funds and are a major source of leverage in the foreign

exchange market.

Choice B is incorrect. Cross currency funding refers to the process of borrowing in one

currency where rates are low and then using that funding to invest in another currency where

returns are high. While this may seem similar to the scenario described, it does not involve an

investor possessing a target asset that yields high returns. Instead, it involves direct investment

in a different currency.

Choice C is incorrect. Hedging is a risk management strategy used by investors to protect

against potential losses from fluctuations in exchange rates, interest rates or commodity prices.

It does not involve financing an asset with a liability as described in the question.

Choice D is incorrect. The funding gap refers to the difference between available funds

(liabilities) and required funds (assets). This concept does not involve investing or financing

assets with liabilities as described in the question.

Q.4173 Why is the U.S. dollar is referred to as a “safe haven”?

A. It acts as a peg for other countries due to its liquidity.

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B. It has less value relative to other currencies.

C. It is highly illiquid

D. The U.S. has weak political systems

The correct answer is A.

Some features make a currency a “safe haven” for other currencies. One of them is acting as a

peg for other countries since it is highly liquid. Moreover, it is of high value, as compared to

other currencies. Finally, the United States has a stable political system. These make the U.S.

dollar be known as a safe haven.

B is incorrect: The U.S. dollar is considered to have the most substantial value as compared to

other currencies.

C is incorrect: The U.S. dollar has high liquidity. In other words, it is easy to buy or sell.

D is incorrect: The United States has a stable political system; thus, making the U.S. dollar a

stable currency against other currencies.

Things to Remember

1. A 'safe haven' currency is one that investors tend to gravitate towards in times of market

turbulence or economic uncertainty. This is usually because the currency is perceived as being

stable and reliable.

2. The U.S. dollar is often referred to as a 'safe haven' currency due to its high liquidity and the

economic and political stability of the United States.

3. Liquidity refers to the ease with which an asset or security can be bought or sold in the

market without affecting its price. High liquidity is a desirable attribute for any currency as it

allows for easy transactions and conversions.

4. The U.S. dollar's status as the world's primary reserve currency also contributes to its 'safe

haven' status. As the primary reserve currency, many international transactions are denominated

in U.S. dollars, further increasing its liquidity and stability.

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Q.4174 Bank Y wants to investigate whether there is a disconnect between its short-term assets
and short-term liabilities, commonly known as maturity/currency mismatch. The bank’s manager
decided to employ a team that assesses the maturity mismatch across its balance sheet. Upon
establishing a maturity mismatch in the bank’s balance sheet, the team outlines the following
reasons that imply a maturity mismatch:

I. When the bank has more liabilities than assets.

II. When a hedging instrument and the underlying asset's maturities are misaligned
III. When the bank has more assets than liabilities

Which of the following options given by the team is correct?

A. I only

B. II only

C. III only

D. I and II only

The correct answer is B.

Statement II is correct. Maturity mismatch can occur when a bank uses hedging instruments

(like derivatives) to manage its risks, but if these instruments do not align with the maturities of

the underlying assets or liabilities they are intended to hedge, it can create a maturity mismatch.

Statement I is incorrect. Having more liabilities than assets can be a sign of financial

instability, but it doesn't directly relate to maturity mismatch.

Statment III is incorrect. Having more assets than liabilities is generally considered a healthy

financial situation for a bank. It doesn't directly indicate a maturity mismatch.

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Q.4175 The federal reserve may extend a loan using nominal figure collateral of foreign
currencies to foreign central banks. Moreover, a bank can access the funds through U.S. dollar
auction in the bank's respective jurisdiction/country. Which of the following best describes this?

A. International lending of last resort

B. Maturity transformation across banks' balance sheets

C. Cross-currency funding

D. Balance sheet expansion

The correct answer is A.

This term refers to the practice where a central bank, such as the Federal Reserve, provides

financial assistance to foreign central banks in times of financial distress. In this case, the

Federal Reserve extends loans using foreign currencies as collateral to foreign central banks.

These banks can then access these funds through an auction of U.S. dollars within their own

jurisdiction or country. This process allows commercial banks worldwide to access U.S. dollar

liquidity, including those that lack sufficient eligible collateral and subsidiaries, as they can

directly borrow from the Federal Reserve system.

Choice B is incorrect. Maturity transformation across banks' balance sheets refers to the

process where banks borrow funds short-term and lend long-term, thereby transforming short-

term liabilities into long-term assets. This concept does not encapsulate the process of extending

loans using foreign currencies as collateral to foreign central banks.

Choice C is incorrect. Cross-currency funding refers to a situation where an entity borrows in

one currency and then swaps that borrowing into another currency using a cross-currency swap.

This term does not accurately describe the process of Federal Reserve extending loans using

foreign currencies as collateral.

Choice D is incorrect. Balance sheet expansion generally refers to an increase in a company's

assets or decrease in its liabilities on its balance sheet, which can occur due to various reasons

such as acquisition of new assets or reduction of liabilities through repayments etc., but it

doesn't specifically refer to the process described in the question.

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Q.4176 Which of the following correctly defines the U.S. dollar funding gap?

A. The amount of U.S. dollars invested in longer-term assets which are not supported by
longer-term U.S. dollar liabilities.

B. An offshore investment fund, typically formed as a private limited partnership that

engages in speculation using a credit or borrowed capital.

C. A scenario where a country lacks a sufficient supply of the U.S. dollar for effective
management of international trade.

D. A situation that involves an investor holding a high-yielding currency asset (target

asset), which is financed with a low-yielding currency liability (funding liability).

The correct answer is A.

The U.S. dollar funding gap refers to the amount of U.S. dollars invested in longer-term assets

which are not supported by longer-term U.S. dollar liabilities. This situation arises when banks

invest in long-term assets using U.S. dollars but do not have an equivalent amount of longer-term

U.S. dollar liabilities to support these investments. This gap needs to be filled or 'rolled over'

before the maturity of the investments. If the banks are unable to do so, they may face liquidity

issues. This concept is crucial in understanding the dynamics of international finance and the

role of the U.S. dollar as a global reserve currency.

Choice B is incorrect. An offshore investment fund, typically formed as a private limited

partnership that engages in speculation using credit or borrowed capital, does not define the

U.S. dollar funding gap. This choice describes an investment strategy rather than a specific

financial situation related to the U.S. dollar.

Choice C is incorrect. A scenario where a country lacks a sufficient supply of the U.S. dollar for

effective management of international trade does not accurately describe the U.S. dollar funding

gap either. While this could be a result of such a gap, it is not its definition.

Choice D is incorrect. A situation that involves an investor holding a high-yielding currency

asset (target asset), which is financed with a low-yielding currency liability (funding liability) also

fails to define the term correctly as it refers more to carry trade strategy and not specifically to

any imbalance in US dollars.

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Q.4177 A maturity mismatch commonly involves a firm's balance sheet. Which of the following is
correct about a maturity mismatch?

A. It is not visible on a firm’s balance sheet and masks its liquidity.

B. Involves short-term borrowers funding long-term assets

C. It cannot occur in hedging

D. The maturity mismatch needed for the facilitation of long-term investment projects
and for serving the liquidity needs of the investor should allow banks to earn a spread in
a negatively sloped yield curve surrounding.

The correct answer is B.

A maturity mismatch typically involves short-term borrowers funding long-term assets. This

situation arises when a firm uses short-term liabilities to fund long-term assets. This is a common

practice in many financial institutions, particularly banks, where they borrow funds on a short-

term basis (such as deposits from customers) and lend on a long-term basis (such as mortgages

and business loans). This practice allows the firm to earn a spread between the interest it pays

on short-term borrowings and the interest it earns on long-term loans. However, it also exposes

the firm to liquidity risk, as the firm may face difficulties in meeting its short-term obligations if

it cannot quickly convert its long-term assets into cash.

Choice A is incorrect. While a maturity mismatch may not be immediately apparent on a firm's

balance sheet, it does not necessarily mask its liquidity. Liquidity refers to the ability of a firm to

meet its short-term obligations, which can be affected by various factors other than maturity

mismatch.

Choice C is incorrect. Maturity mismatches can indeed occur in hedging scenarios. For

instance, if a company uses short-term futures contracts to hedge against long-term price risks,

this could result in a maturity mismatch.

Choice D is incorrect. This statement incorrectly assumes that banks can always earn a spread

in negatively sloped yield curve environments due to maturity mismatches. However, this isn't

always the case as the spread depends on various factors including interest rates and market

conditions.

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Reading 143: Covered Interest Rate Parity Lost: Understanding the

Cross-Currency Basis

Q.4178 Bright Ltd., a US-based corporation, enters a currency basis swap with Gamble, a British
company, in which the original principal amounts are $300 million and £240 million. That is: At
inception, there is an initial principal exchange in which Bright Ltd. pays Gamble $300 million
and receives £240 million. Subsequently, at each interest payment date, Bright Ltd pays Gamble
the GBP-Libor rate on £240million and receives the USD-Libor rate on $300 million. Finally, at
maturity, a re-exchange of principals occurs in which Bright Ltd pays £240million in exchange
for $300 million. Suppose the spot exchange rate is $1.25 = £1 at the time of entering the swap.
Assuming Bright Ltd. And Gamble both have AA credit ratings at this time and can access funds
at Libor flat, the value of the swap at inception to Bright Ltd is?

A. Positive

B. Negative

C. Zero

D. Cannot be determined from the above information

The correct answer is C.

A cross-currency swap does not involve an initial capital outlay since its initial market value is
zero.

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Q.4180 Suppose the market EUR/USD spot exchange rate is 1.3536 with a one-year forward rate
of 1.3280. The market consists of a risk-free rate of 4% USD and 6% EUR per annum,
respectively. Calculate the ratio of returns.

A. 0.1097

B. 0.9811

C. 12.4500

D. 109.7000

The correct answer is B.

Covered interest rate parity is checked using the formula:

F 1+r
=
S 1 + r∗

1 + Quote currency interest rate

⇒ The ratio of returns =
1 + Base currency interest rate

In this case, the quote currency rate is the US dollar interest rate, while the base currency rate
is the EUR interest rate.

1 + 4%
= = 0.9811
1 + 6%

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Q.4181 Suppose the market USD/EUR spot exchange rate is 1.3536 EUR with a one-year forward
rate of 1.3280 EUR. The market consists of a risk-free rate of 4% USD and 6% EUR, respectively.
Calculate the ratio of forward rate to spot rate.

A. 0.9811

B. 1.0193

C. 0.0189

D. 1.5467

The correct answer is A.

F 1.3280
The ratio of forward to spot rate = = = 0.9811
S 1.3536

Q.4183 Walter runs a business in the United States. He wants to purchase some materials for his
warehouse from France. Walter decides to purchase the warehouse on a mortgage that needs
him to make the payments in euros. However, since his company is in the United States, the main
currency he will receive when conducting business is dollars. Thus, he is required to have the
U.S dollars converted to Euros so that he can make payments to his mortgage in France.
Unfortunately, the dollar’s value is weakening against the euro. This means that Walter will have
to pay expensively for the mortgage payments. What should Walter do so that he does not end up
paying a mortgage that keeps getting more expensive?

A. He should adopt a cross-currency swap.

B. He should adopt a carry trade

C. He should avoid entering any swaps

D. He should wait until when the foreign exchange market has stabilized

The correct answer is A.

A cross-currency swap is a financial derivative that allows two parties to exchange interest

payments and principal in different currencies. The main purpose of a cross-currency swap is to

hedge against foreign exchange risk. In Walter's case, he can use a cross-currency swap to

borrow dollars and convert them into Euros at a fixed rate. This means that Walter will take out a

loan and make interest payments in dollars, his home currency, instead of in Euros. This strategy

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will protect him from the weakening dollar against the euro, and he will not have to worry about

his mortgage payments becoming more expensive. Cross-currency swaps are commonly used in

international finance and are a valuable tool for businesses that have income in one currency and

liabilities in another.

Choice B is incorrect. A carry trade involves borrowing in a low-interest-rate currency and

investing in a high-interest-rate currency. This strategy is not suitable for Walter's situation

because it does not address his need to hedge against the risk of the dollar weakening against

the euro.

Choice C is incorrect. Avoiding entering any swaps would mean that Walter continues to bear

the foreign exchange risk, which could lead to further increases in his mortgage payments if the

dollar continues to weaken against the euro.

Choice D is incorrect. Waiting until when the foreign exchange market has stabilized does not

provide any immediate solution for Walter's predicament. Moreover, there is no guarantee that

waiting will result in favorable conditions as currency markets can be unpredictable.

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Q.4184 Counterparty A wants to carry out a cross-currency swap where it will exchange the
sterling pound for the U.S. dollar with counterparty B. Today, the U.S Libor rate is 1.0% while the
sterling pound Libor rate is -2.6%. A dollar shortage occurs, and counterparty B quotes a basis of
-40 bps. Compute the cost of the swap for counterparty A. (Assume that both parties pay interest
on the currency they receive.)

A. 4.0%

B. 2.0%

C. 2.6%

D. 3.2%

The correct answer is A.

Cost of the swap = 1.0% + 2.6% + 0.4% = 4.0%

Note: The Sterling pound Libor is negative (-2.6%); thus, counterparty B will also have to pay for

it, hence the reason why we add it.

Detailed Explanation

Counterparty A is exchanging pounds for dollars. In other words, it's giving out pounds to

receive dollars. Both parties pay interest on the currency they receive (because they have

technically borrowed that currency). In our case, A should pay the dollar LIBOR (1%) plus the

cross-currency basis (-0.4%). Because B has “borrowed” the pound from A, it should pay the

pound LIBOR (-2.6%) to A. But here's the problem: this rate is negative, and just like in any other

scenario where the interest rate is negative, it would be the lender and not the borrower,

who pays the interest. Counterparty A would have to pay pound interest to B.

At the end of the day, therefore, the total theoretical cost of the Pound/USD currency swap to A

is 1% +0.4% + 2.6% = 4.0%

If the pound LIBOR was +2.6%, party A would have actually received interest on the pound. A's

cost would have been 1% +0.4% - 2.6% = -1.2%; it would receive a net rate of interest of 1.2%

from B.

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Q.4185 Company A wants to transform $60 million floating rate debt into a fixed rate GBP loan.
On trade date, Company A exchanges $60 million with Company B in return for 48 million GBP.
Calculate the GBP/USD exchange rate if their agreement is set to expire in 10 years.

A. 0.50

B. 0.86

C. 0.80

D. 1.25

The correct answer is D.

60
GBP/USD = = 1.25
48

Note that,

The way Foreign exchange is quoted is always interpreted as; you exchange many units of the

denominator currency for 1 unit of the given numerator currency. The rates are different when

you quote GBP/USD or USD/GBP.

For example, in this case, USD/GBP=0.8.

However, the general idea here is to quote GBP/USD instead of USD/GBP.

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Q.4186 Assume that two parties enter a five -year FX currency swap for 100 million. Party, A is a
US firm, while the other, B, is a European firm. The EUR/USD exchange rate is $1.25 by the time
the swap is arranged. In other words, the dollar is EUR 0.8. The start of the swap is December
31st, 2019. On this date, A pays B $100m, while B pays A EUR 80m. Assume that the agreed
dollar interest rate is 6%, while the euro interest rate is 3.5%. Calculate the amount that
company A pays annually to company B.

A. €800,000

B. €900,000

C. €1,900,000

D. €2,800,000

The correct answer is D.

Every year, company A pays €80 , 000, 000 × 3.5% = €2, 800, 000 to Company B.

Q.4187 Assume that a U.S. firm A wants to acquire Japanese yen while a Japanese firm, B, is
aiming to borrow U.S. dollars (USD). Suppose that A wants to borrow ¥100 million. The Japanese
firm needs $50 million. The two firms enter a USD/JPY swap with an exchange rate of 2.
Calculate the quarterly interest amount that A pays to B, given that A pays 4% on ¥100 million
annually, and the interest rates remain unchanged.

A. ¥250,000

B. ¥500,000

C. ¥1,000,000

D. ¥1,500,000

The correct answer is C.

4 1
× 100, 000, 000 × = ¥1, 000, 000
100 4

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Q.4188 An investor borrows $2,000 and converts the funds into British pounds, allowing him to
purchase a British bond. If the purchased bond has a yield of 8% while the equivalent U.S. bond
yield is 5%, calculate the interest rate differential if the exchange rate between dollars and
pounds remains constant.

A. 3.0%

B. 5.0%

C. 6.5%

D. 13.0%

The correct answer is A.

An interest rate differential is simply the difference in the interest rate between two currencies.

This differential in the cash money markets should equal the differential between the forward

and spot exchange rates. Otherwise, arbitrageurs could make a seemingly riskless profit.

In this case, the interest rate differential = 8% - 5%. = 3%

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Q.4189 Calculate the 1-year Euro interest rate that will satisfy the covered interest rate parity if
the EUR/USD spot rate is $1.32 and the U.S dollar has a 1-year interest rate of 6% and the
EUR/USD forward rate is 1.22.

A. 10.24%

B. 29.32%

C. 12.42%

D. 14.69%

The correct answer is D.

(1 + RU SD )
FEUR/USD = S
(1 + RE UR )
(1.06)
1.22 = 1.32
(1 + RE UR )
1.32 × 1.06
⇒ R EU R = −1
1.22
= 0.14688

Thus, the one-year Euro interest rate is 14.69%

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Q.4190 A Japanese company X wants to compute the one-year forward USD/JPY rate, with a spot
yen selling at 132 USD/JPY. The JPY per annum interest rate is equal to 4%, and the annual
interest rate for USD is 11%. Calculate the one-year forward exchange rate USD/JPY.

A. 0.14

B. 123.68

C. 136.87

D. 140.88

The correct answer is B.

According to covered interest rate parity, the interest rate differential between two countries is

equal to the differential between the forward exchange rate and the spot exchange rate.

The forward exchange rate is given by:

T
1 + RJ PY
F =S×( )
1 + R US D
1.04 1
= 132 × ( )
1.11
= 123.6758

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Q.4191 FX swaps and Currency Swaps are derivative instruments utilized in the hedging of
foreign currency exposures. Which of the following correctly points out the similarities between
the two?

A. Both instruments involve the exchange of principal and interest payments in different
currencies.

B. Both instruments are used primarily to manage long-term interest rate risk.

C. Both instruments involve an exchange of currencies.

D. Both instruments are commonly utilized by central banks to manage their currency
reserves.

The correct answer is C.

Both instruments involve an exchange of currencies. However, the key distinction is that FX

swaps involve an agreement to reverse the transaction at a later date, whereas currency swaps

do not necessarily involve a reversal. This similarity captures the essence of the derivative

nature of both instruments and their involvement in the exchange of currencies.

A is incorrect. While currency swaps involve the exchange of principal and interest payments in

different currencies, FX swaps only involve the exchange of currencies without the exchange of

interest payments.

B is incorrect. Currency swaps are used to manage long-term interest rate risk, but FX swaps

are primarily used for short-term foreign exchange exposure management, not long-term interest

rate risk.

D is incorrect. While central banks may use both FX swaps and currency swaps for various

purposes, it is not a common practice for central banks to use currency swaps to manage their

currency reserves. FX swaps are more commonly used for such purposes.

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Q.4192 A hypothetical condition where the correlation between interest rates, spot and forwards
currency value of two countries are equal is referred to as:

A. FX swaps

B. Cross-currency swaps

C. Covered Interest Rate Parity

D. Mark-to-market

The correct answer is C.

Covered Interest Rate Parity (CIP) is the term that describes the hypothetical condition where

the correlation between interest rates, spot, and forward currency values of two countries are

equal. CIP is a no-arbitrage condition in financial economics that states that the nominal interest

rates in two different countries should be equal, once the foreign exchange risk is hedged. This

condition is expressed mathematically as:

F 1+r
=
S 1 + r∗

Where: S is the spot exchange rate in US dollar per foreign currency, F is the corresponding

forward exchange rate, r is the US dollar interest rate, and r∗ is the foreign currency interest

rate. This condition is a cornerstone of the foreign exchange markets and is used to prevent

potential arbitrage opportunities.

Choice A is incorrect. FX swaps are a financial instrument used to hedge against foreign

exchange risk, not a theoretical condition that stipulates an equal correlation between the

interest rates, spot, and forward currency values of two different countries.

Choice B is incorrect. Cross-currency swaps are agreements in which two parties exchange

principal and interest in one currency for the same in another currency. They do not represent a

theoretical condition correlating interest rates, spot and forward currency values.

Choice D is incorrect. Mark-to-market refers to the accounting practice of valuing an asset

according to its current market price rather than its book value. It does not describe any

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correlation between interest rates, spot and forward currency values of different countries.

Q.4193 Assume that the GBP/USD spot exchange rate is 1.500 (i.e., 1 GBP = 1.500 USD).
Further assume that the 180-day USD LIBOR rate stands at 1.2%, and the 180-day GBP LIBOR
rate is 2.0%. Compute the 180-day forward GBP/USD exchange rate.

A. 1.4882

B. 1.4292

C. 1.4276

D. 1.4941

The correct answer is D.

1 +r × T
F=S×
1 + r∗ × T
180
⎛ 1 + 0.012 × 360⎞
= 1.500
⎝ 1 + 0.02 × 180 ⎠
360
≈ 1.49405

Alternatively,

1+r T
F =S×( )
1 + r∗
180
1 + 0.012 360
= 1.500[( )]
1 + 0.02
≈ 1.494106

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Q.4194 Assuming a forward rate of $0.40/JPY, a one-year interest rate for the U.S. currency of
5%, and a spot rate of $0.5/JPY, calculate the current one-year JPY interest rate that will satisfy
the covered interest rate parity.

A. 14.35%

B. 16.53%

C. 31.25%

D. 41.53%

The correct answer is C.

F 1+ r
=
S 1 + r∗
S
r∗ = (1 + r) −1
F
0.50
= ((1 + 0.05) × ) − 1 = 0.3125
0.40

JPY interest rate 31.25%

Q.4195 A currency swap bears counterparty risk unlike an interest-rate swap because:

A. Counterparties are in different countries, making the currency swap vulnerable to

different legal systems, unlike an interest rate swap.

B. The currency swap involves an exchange and re-exchange of principal amounts, unlike
an interest rate swap, making the swap susceptible to movements in exchange rates.

C. FX markets have more credit risk than interest rate markets.

D. Each counterparty is having a lower probability of defaulting in its home currency

than in a foreign currency.

The correct answer is B.

A currency swap involves an exchange and re-exchange of principal amounts, unlike an interest

rate swap, making the swap susceptible to movements in exchange rates. In a currency swap,

two parties agree to exchange principal and interest payments on a loan made in one currency

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for principal and interest payments of a loan of equal value in another currency. The parties use

the exchange rate at the time of the swap to calculate the equivalent amounts. As the life of the

swap progresses, the parties exchange interest payments on their respective principal amounts.

At the maturity of the swap, the parties effectively 'reverse' the swap, exchanging initial

principal amounts. The risk here is that the exchange rate at the maturity of the swap may be

dramatically different from the exchange rate at the inception of the swap, leading to significant

exchange rate risk.

Choice A is incorrect. While it's true that counterparties in a currency swap may be subject to

different legal systems, this does not inherently lead to counterparty risk. Counterparty risk

arises from the potential for one party to default on their contractual obligations, not from

differences in legal systems.

Choice C is incorrect. The statement that FX markets have more credit risk than interest rate

markets is too broad and doesn't directly relate to the specific structure of currency swaps and

interest-rate swaps. Both types of swaps can bear credit risk depending on the specifics of the

contract and parties involved.

Choice D is incorrect. The probability of defaulting isn't necessarily lower in a home currency

than in a foreign currency. This depends on various factors such as economic conditions,

exchange rates, and monetary policy among others which are not inherent characteristics of

these financial instruments.

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Q.5413 John Paul, the chief investment officer at Herald Advisors, is particularly concerned
about the cross-currency basis since the Global Financial Crisis. Which of the following is the
most suitable explanation for the continued presence of a positive cross-currency basis between
two currencies?

A. Regulatory changes have allowed for an expansion in speculative proprietary trading

activities conducted by US banks.

B. Given the overall decrease in global interest rates, the inclusion of a liquidity risk cost
in swap pricing is no longer deemed necessary.

C. The basis increasingly incorporates the financing costs incurred by arbitrageurs to

maintain their positions.

D. As arbitrage positions typically mitigate counterparty risks, the expenses associated

with credit value adjustments have risen.

The correct answer is C.

Following the Global Financial Crisis (GFC), there have been structural changes in how market

participants assess market, credit, counterparty, and liquidity risks, which have imposed stricter

limits on arbitrage opportunities. Consequently, arbitrage now incurs a persistent balance sheet

cost. The cost associated with financing offsetting positions for all arbitrage participants is now

being factored into the FX swap basis.

A is incorrect. Regulatory changes, such as the implementation of the Volcker rule, have

imposed restrictions on speculative proprietary trading activities for US banks since the Global

Financial Crisis (GFC).

B is incorrect. Market participants must incorporate liquidity risk costs into their transactions.

While overall funding costs may have decreased, it does not imply that a charge for liquidity risk

is no longer necessary.

D is incorrect. The incorporation of credit value adjustments into pricing has accounted for the

elimination of counterparty risks in arbitrage positions.

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Reading 144: Risk Management for Changing Interest Rates: Asset-

Liability Management and Duration Techniques

Q.4228 Bright Bank posted the following financial entries:

Interest revenues $83

Interest costs $72
Total earning assets $942

Calculate the bank’s net interest margin.

A. 1.17%

B. 1.56%

C. 2.25%

D. 4.78%

The correct answer is A.

Net interest income

Net interest margin (NIM) =
Total earning assets
$83 − $72
Net Interest Margin = = 0.011677 ≈ 1.17%
$942

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Q.4229 National Bank has a cumulative gap for the coming year of +$128 million. The interest
rates are expected to decrease by one and a half percentage points. Calculate the expected
change in the Bank’s net interest income.

A. -1.23

B. -1.92

C. 1.89

D. 128

The correct answer is B.

Change in net interest income = Total change in interest rate (Percentage points)
× Size of cumulative gap in dollars.

Thus,

Expected change in net interest income = $128 × (−0.015) = −1.92

Q.4230 Mutual Friends Bank has interest-sensitive assets worth $470 million and interest-
sensitive liabilities of $876 million. Calculate its dollar interest-sensitive gap.

A. -$406m

B. -$470m

C. -$876m

D. -$1,346m

The correct answer is A.

Dollar interest sensitive gap (IS GAP) = Interest sensitive assets (IS GAP)
− Interest sensitive liabilities (ISL)
= $470 − $876 = −$406m

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Q.4231 Mutual Friends Bank has interest-sensitive assets worth $470 million and interest-
sensitive liabilities of $876 million and the total value of assets is $1000 million.
Calculate its relative interest-sensitive gap ratio.

A. -30.00%

B. -40.87%

C. -40.60%

D. -50.32%

The correct answer is C.

ISGap
Relative Gap =
Total Assets
($470 − $876)
≈ −0.406 or − 40.60%
$1000

Q.4232 Davidson Bank registered a net interest margin of 2.45% in its previous financial report,
with total interest revenues of $100 million and total interest expenses worth $64 million.
Compute the volume of the earning assets held by the bank.

A. $845.67 million

B. $1,045.23 million

C. $1,236.87 million

D. $1,469.39 million

The correct answer is D.

Net interest income

Net interest margin =
Total earning assets
(100 − 64) million
0.0245 =
Total earning assets
(100 − 64) million
⇒ Total earning assets =
0.0245
= $1, 469.39 million

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Q.4233 Banks find it challenging to forecast interest rate changes on an individual level. Which
of the following correctly identifies factors as to why this happens?

A. Interest rates are determined by the numerous investors trading in the credit market.
A group of banks or an individual cannot set the interest rates.

B. Each market rate of interest has various components – the risk-free interest rate plus
different risk premia. A change in any of these rate components can cause interest rates
to change.

C. Bankers need to have perfect timing to be able to identify the changes in interest
rates. That is, to maximize their predictions, they must have an insight into when the
changes will take place.

D. All of the above.

The correct answer is D.

The complexity of forecasting interest rate changes at an individual level in the banking sector is

due to a combination of factors. Firstly, interest rates are not determined by a single bank or a

group of banks. Instead, they are influenced by the actions of numerous investors trading in the

credit market. This makes it impossible for a single entity to control or predict changes in

interest rates. Secondly, each market interest rate is composed of various components, including

the risk-free interest rate and different risk premia. A change in any of these components can

cause interest rates to fluctuate, adding another layer of complexity to the forecasting process.

Lastly, for accurate forecasting, bankers need to have perfect timing to identify changes in

interest rates. They need to have insight into when these changes will occur to maximize their

predictions. Therefore, all the options (A, B, and C) are correct, making choice D the correct

answer.

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Q.4234 The purchase price of a government bond is $750. It pays $150 per year in interest for 4
years when it matures. If the redemption value of this bond is $1,000, calculate its yield to
maturity if it is purchased today for $750.

A. 12.00%

B. 13.23%

C. 24.87%

D. 25.73%

The correct answer is D.

$150 $150 $150 $150 $1000

$750 = + + + +
1 2 3 4
(1 + YTM) (1 + YTM) (1 + YTM) (1 + YTM) (1 + YTM)4

At YTM of 26%, the bond’s price is $744.78, while at 25%, its bond price is 763.84. Therefore,

the actual YTM is between 25% and 26%.

By linear interpolation, we calculate YTM as follows:

763.84 − 750
YTM = 0.25 + × 0.01 = 0.2573 ≈ 25.73%
763.84 − 744.78

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Q.4235 Suppose that Millennial National bank consists of an average asset duration of 2.53 years
and an average liability duration of 0.65years. Its assets size is a total of $367 million, and the
volume of its liabilities is $219 million. Suppose that its original interest rates were 5% before
rising to 8.5%. Compute Millennial National Bank’s estimated leverage adjusted the duration gap
and the change in its net worth as a result of the rise in interest rates.

A. +1.34 years, -$10.34million

B. +2.14 years, -D10$12.56million

C. +1.34 years, -$13.10million

D. +2.14 years, -$26.21million

The correct answer is D.

Leverage Adjusted Duration Gap

= Dollar-weighted duration of Assets Portfolio − Dollar-weighted Duration of Liability Portfolio
Total Liabilities
×
Total Assets

Millennial National Bank’s duration gap is:

219
2.53 − 0.65 × = +2.14 years
367

The change in net worth:

Δr Δr
Change in value of net worth= − DA × × A − [−DL × × L]
(1 + r) (1 + r)
+0.035 +0.035
− 2.53 × × 367 − [−0.65 × × 219]
(1 + 0.05) (1 + 0.05)
= − $26.21 million

This means that Millennial National Bank’s net worth will drop by approximately $26.21 million

if the interest increases by 3.5%.

Q.4236 A financial firm is seeking to have itself hedged against interest rate fluctuations by the
use of duration-gap analysis. How can the firm management get to know when it is fully hedged
through this approach?

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A. When fully hedged, it will have a zero-duration gap position.

B. When it can track the variations between the interest earned on loans and the interest
paid on deposits

C. When it can get a clear comparison of the amount of liabilities and assets in each
period in the interest rate sensitivity gap table, enabling it to get an estimated
perspective of the interest rates risk of the firm’s balance sheet being assessed.

D. When it has higher interest-rate sensitive liabilities relative to its interest-rate

sensitive assets.

The correct answer is A.

Duration-gap analysis is a financial risk management tool used by firms to hedge against the risk

of interest rate fluctuations. The 'duration' in this context refers to the sensitivity of a financial

instrument's price to changes in interest rates. When a firm is fully hedged using duration-gap

analysis, it means that the dollar-weighted duration of the assets in its portfolio matches the

dollar-weighted duration of its liabilities. In other words, the firm has a zero duration-gap

position. This is because the interest rate risk on the assets is perfectly offset by the interest rate

risk on the liabilities, thereby neutralizing the overall interest rate risk of the firm. Therefore, a

zero duration-gap position is the most accurate indicator that a firm has achieved a fully hedged

position using duration-gap analysis.

Choice B is incorrect. While tracking the variations between the interest earned on loans and

the interest paid on deposits can provide some insight into a firm's financial health, it does not

necessarily indicate a fully hedged position through duration-gap analysis. This is because

duration-gap analysis specifically focuses on managing interest rate risk by aligning the

durations of assets and liabilities, which isn't directly related to the difference in interest earned

and paid.

Choice C is incorrect. Although comparing amounts of liabilities and assets in each period in

an interest rate sensitivity gap table can help estimate perspective of a firm’s balance sheet's

interest rates risk, it doesn't signify that a fully hedged position has been achieved through

duration-gap analysis. A fully hedged position using this method would require matching

durations of assets and liabilities to ensure that changes in interest rates affect both equally.

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Choice D is incorrect. Having higher interest-rate sensitive liabilities relative to its interest-

rate sensitive assets does not indicate a fully hedged position using duration-gap analysis. In

fact, this could expose the firm to greater risk if there are unfavorable movements in market

rates as their cost (liabilities) may increase more than their income (assets). A zero-duration gap

signifies that changes in market rates will have equal impact on both sides leading to no net

effect.

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Q.4237 Suppose that a hypothetical bank has an average yield on rate-sensitive and fixed assets
of 5% and 10%, respectively. Additionally, the bank has rate-sensitive and non-rate-sensitive
liabilities cost of 4% and 6%, respectively. During the coming week, the bank holds $542 million
in rate-sensitive assets and $156 million in rate-sensitive liabilities. Assume that the asset total is
$1,212. Further, suppose that these annualized interest rates remain steady. Assuming that
equity is zero, calculate the firm’s net interest income on an annualized basis.

A. 20.0 million

B. 23.4 million

C. 24.5 million

D. 30.0 million

The correct answer is C.

Net interest income = Total interest income − Total interest cost

= [Average interest yield on rate-sensitive assets × Volume of rate-sensitive assets
+ Average interest yield on fixed (non-rate-sensitive) assets × Volume of fixed assets]
− [Average interest cost on rate-sensitive liabilities × Volume of interest-sensitive liabilities
− Average interest cost on fixed (non-rate-sensitive) liabilities × Volume of fixed
(non-rate-sensitive) liabilities]
= 0.05 × $542 + 0.10 × [$1, 212 − $542] − 0.04 × $156 − 0.06 × [$1 , 212 − $156]
= $24.5 million

Note:

The balance sheet is based on the fundamental equation:

Assets = Liabilities + Equity

​In this case, we've been told there's no equity, which means that:

Assets = Liabilities

Q.4238 The interest-sensitive gap approach is not enough to fully hedge a financial firm from
interest rates risks, thus the need for duration-gap management. The information below
identifies some of the disadvantages of duration-gap management, which one is NOT?

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A. Duration matching (immunization) can be costly and time-consuming

B. Immunization is a dynamic problem such that the duration of liabilities and assets
changes as they near their maturity

C. The interest-sensitive gap fails to put into consideration the implications of interest
rate fluctuations on the positions of equity

D. Duration is not accurate for significant interest rate changes unless convexity is taken
into account

The correct answer is C.

The statement 'The interest-sensitive gap fails to put into consideration the implications of

interest rate fluctuations on the positions of equity' is not a disadvantage of duration-gap

management, but rather a limitation of the interest-sensitive gap approach. The duration gap

management approach, in contrast, does take into account the effects of interest rate

fluctuations on equity positions. This is because duration-gap management involves adjusting the

duration of assets and liabilities to match, thereby reducing the sensitivity of the firm's equity to

changes in interest rates. Therefore, this choice does not accurately represent a disadvantage of

duration-gap management.

Choice A is incorrect. Duration matching, also known as immunization, can indeed be costly

and time-consuming. This is because it requires constant rebalancing of the portfolio to maintain

the duration match as interest rates change and as assets and liabilities move closer to their

maturity dates.

Choice B is incorrect. Immunization is a dynamic problem in that the duration of liabilities and

assets changes as they near their maturity. This means that even if a firm has perfectly matched

its asset and liability durations at one point in time, it will need to continually adjust its portfolio

to maintain this balance due to changes in market conditions or as these instruments approach

their maturity dates.

Choice D is incorrect. Duration alone does not accurately measure interest rate risk for

significant interest rate changes unless convexity is taken into account. Convexity measures the

sensitivity of a bond's price change given a change in interest rates, which becomes more

pronounced when there are large swings in rates. Therefore, ignoring convexity could lead to

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underestimation or overestimation of potential losses or gains from interest rate movements.

Q.4239 Suppose that a treasury bill has a face value of $100 set for payment at maturity. Its
purchase price is $88. If the security is to mature in 120 days, calculate the interest rate
measured using the bank discount rate.

A. 18%

B. 20%

C. 24%

D. 36%

The correct answer is D.

(100 − 88) 360

DR = × = 0.36 = 36%
100 120

Q.4240 Assume that a treasury bill has a face value of $100 set for payment at maturity. Its
purchase price is $88. If the security is to mature in 120 days, calculate the YTM equivalent yield
of this bill.

A. 36.00%

B. 41.48%

C. 50.86%

D. 40.91%

The correct answer is D.

(100 − Purchase Price) 360

YTM equivalent yield = ×
Purchase Price Days of maturity
(100 − 88) 360
= × = 40.91%
88 120

Note that we use 360 days because this is a Treasury bill.

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Q.4241 Pride Bank’s interest-sensitive assets have a value of $500, and its interest-sensitive
liabilities are worth $300. Calculate the interest-sensitive ratio of the bank.

A. 1.67

B. 2.54

C. 2.67

D. 3.84

The correct answer is A.

ISA
Interest Sensitive Ratio (ISR) =
ISL
$500
= = 1.67
$300

Q.4242 Barnhill Bank holds $24 million in government bonds with a duration of 8 years. Suppose
that there is a sudden rise in the interest rates from 7% to 9.5%. Compute the percentage
change that should take place in the bond’s market price.

A. -18.69%

B. -4.56%

C. 7.00%

D. 9.50%

The correct answer is A.

ΔP Δi
= −D [ ]
P (1 + i)
ΔP +0.025
= −8 years × [ ] = −0.1869 or − 18.69%
P (1 + 0.07)

The market price will decrease by 18.69%

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Q.4243 Assuming that Green House National bank holds liabilities and assets with the following
average duration and dollar amount as given below:

Asset Avg. Dollar Liability Avg. Dollar

Composition Duration Amount Composition Duration Amount
(Years) (M) (Years) (M)
Investment- 7.5 80 Deposits 2.3 $376
grade bonds
Commercial 4.23 423 Non-deposit 0.12 $25
loans borrowings
Consumer 3.2 $145
loans
Total Assets $648 Total $401
Liabilities

Calculate the dollar-weighted duration of the bank’s liability portfolio and asset portfolio; thus,
calculate the leverage-adjusted duration gap, respectively.

A. 2.16 years, 4.40 years, 3.06 years

B. 3.06 years, 4.40 years, 2.16 years

C. 4.40 years, 2.16 years, 3.06 years

D. 0.12 years, 3.2 years, 4.23 years

The correct answer is A.

80 423 145
DA = 7.5 × + 4.23 × + 3.2 × = 4.40 years
648 648 648
376 25
DL = 2.3 × + 0.12 × = 2.16 years
401 401

Thus, the leverage-adjusted duration gap is

Total Liabilities
DA – DL ×
Total Assets

Leverage-adjusted duration Gap

401
4.40 − 2.16 × = 3.06 years
648

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Q.4244 A Canadian Treasury bill is available for purchase this week with a price of $89.84 based
on a par value of $100, with its maturity indicated as 124 days. Calculate the discounted rate of
this treasury bill.

A. 2.950 %

B. 29.500%

C. 32.950%

D. 295.000%

The correct answer is B.

100 − Purchase price on loan or security

DR = ( )
100
360
×
Number of days to maturity
100 − 89.84 360
=( )× = 0.2949 ≈ 29.5%
100 124

Q.5389 ABC Bank conducts a scenario analysis to assess the potential impact of the recent
interest rate hikes implemented by the US Federal Reserve, aiming to manage inflation. The
analysis includes a 300 basis points increase in interest rates, along with a duration analysis. The
following presents ABC Bank's balance sheet and the duration of its individual assets and
liabilities.

Assets Amount (USD billion) Duration (years)

Cash 75 0
Federal funds loans 130 1.0
Governments securities and mortgages 160 4.0
Loans and leases 240 2.0
Total assets 605
Liabilities
Interest-bearing marketable deposits 300 0.5
Other borrowings 270 3.0
Total liabilities 570
Shareholder’s Equity 35
Total liabilities & Shareholder’s equity 605

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Which of the following statements best captures the manager's evaluation of this stress scenario
at the 3% current interest rate level?

A. An increase of 3% in interest rates will result in a decrease of USD 16.32 million in the
bank's net worth.

B. An increase of 3% in interest rates will result in an increase of USD 16.32 million in

the bank's net worth.

C. An increase of 3% in interest rates will result in an increase of USD 56.49 million in

the bank's net worth.

D. An increase of 3% in interest rates will result in a decrease of USD 8.44 million in the
bank's net worth.

The correct answer is D.

The duration of the bank's assets and liabilities is:

(75 × 0 + 130 × 1 + 160 × 4 + 240 × 2)

1, 250
DAssets = = = 2.066
605 605
(300 × 0.5 + 270 × 3)
DLiabilities = = 1.6842
570

The effect of a 3% increase in interest rates can be calculated as:

−(2.066 × 0.03 × 605 − (1.6842 × 0.03 × 570)

− ≈ −8.44
1.03 1.03

This implies that an increase of 3% in interest rates will result in a decrease of USD 8.44 million

in the bank's net worth.

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Q.5391 Thomas Peters, the Chief Risk Officer at ABC Bank, is assessing the bank's net worth
sensitivity to a potential interest rate change. By conducting duration analysis, Mr. Peters
evaluates the impact of a 200-basis point change in interest rates on the bank's net worth. Which
of the following statements accurately represents the conclusion made by the CRO?

A. A non-prepayable loan has a lower duration compared to a prepayable mortgage loan,

making it less sensitive to overall interest rate changes.

B. Assets and liabilities exhibit higher sensitivity to changes in interest rates When the
coupon is lower, the duration is higher, or the overall level of interest rates is lower.

C. The percentage change in the value of an asset or liability caused by a 200-basis point
change in interest rates is directly related to its duration and remains unaffected by the
corresponding percentage change in interest rates.

D. Paying a cash dividend of USD 50 million using cash will have no impact on the overall
asset duration of the bank.

The correct answer is B.

The sensitivity of asset and liability values to changes in interest rates is higher for instruments

with lower coupons, higher durations, and lower overall interest rates. When the coupon is

lower, it means the interest payments on the instrument are lower relative to its face value,

resulting in a higher duration. A higher duration implies that the instrument's price is more

sensitive to changes in interest rates.

A is incorrect. A prepayable mortgage often has a shorter duration than a comparable non-

prepayable investment and is less vulnerable to changes in the market's average interest rate.

C is incorrect. The percentage change in an asset or liability's value caused by a 100-basis

point change in interest rates is directly proportional to the asset or liability's duration and also

depends on the same percentage change in interest rates.

D is incorrect. The bank's overall asset duration will be impacted by using USD 50 million of

cash to pay the bank's cash dividend payment, as the bank's overall asset level would decline as

a result of the cash dividend payment.

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Q.5404 The senior management of ABC Bank is discussing ways of protecting the bank against
adverse interest rate changes. One of the managers is explaining to the other senior managers
the bank's use of the net interest margin. Given the information below on ABC Bank, the Bank's
net interest margin (NIM) is closest to?

Cash & cash equivalents $93 , 000, 000

Interest income from loans and investments $143, 000, 000
Shareholder’s equity $300, 000, 000
Interest expense on deposits & borrowed funds $128, 000, 000
Total earning assets $950, 000, 000

A. 1.58%

B. 5.00%

C. 11.37%

D. 42.94%

The correct answer is A.

(Interest income from loans & investments − Interest expense on deposists & borrowed funds
NI M =
(Total earning assets)
($143M − $128M)
NI M = = 0.0158 ≊ 1.58%
$950M

Q.5415 ABC Bank conducts a scenario analysis to assess the potential impact of the recent
interest rate hikes implemented by the US Federal Reserve, aiming to manage inflation. The
analysis includes a 300 basis points increase in interest rates, along with a duration analysis. The
following presents ABC Bank's balance sheet and the duration of its individual assets and
liabilities.

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Assets Amount Duration

(USD million) (years)
Cash 75 0
Federal funds loans 130 1.0
Governments securities and mortgages 160 4.0
Loans and leases 240 2.0
Total assets 605
Liabilities
Interest-bearing marketable deposits 300 0.5
Other borrowings 270 3.0
Total liabilities 570
Shareholder’s Equity 35
Total liabilities & Shareholder’s equity 605

Which of the following statements best captures the manager's evaluation of this stress scenario
at the 3% current interest rate level?

A. An increase of 3% in interest rates will result in a decrease of USD 16.32 million in the
bank's net worth.

B. An increase of 3% in interest rates will result in an increase of USD 16.32 million in

the bank's net worth.

C. An increase of 3% in interest rates will result in an increase of USD 56.49 million in

the bank's net worth.

D. An increase of 3% in interest rates will result in a decrease of USD 8.44 million in the
bank's net worth.

The correct answer is D.

The duration of the bank's assets and liabilities is:

(75 × 0 + 130 × 1 + 160 × 4 + 240 × 2)

1, 250
DAssets = = = 2.066
605 605
(300 × 0.5 + 270 × 3)
DLiabilities = = 1.6842
570

The effect of a 3% increase in interest rates can be calculated as:

−(2.066 × 0.03 × 605 − (1.6842 × 0.03 × 570)

− ≈ −8.44
1.03 1.03

This implies that an increase of 3% in interest rates will result in a decrease of USD 8.44 million

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in the bank's net worth.

Q.5420 John Doe is a treasury analyst at ABC Bank. John has been tasked with calculating the
bank’s discount rate.

Purchase price $95

Required rate of return 12%
Face value $100
Yield to maturity 8%
Matures in 85 days

Using the information provided above on a money market security, what is the discount rate of
the bank?

A. 6.8%

B. 15.0%

C. 21.2%

D. 11.4%

The correct answer is C.

(100 − Purchase price on security) 360

Discount rate = ×
100 Number of days to maturity
(100 − 95) 360
= ×
100 85
= 0.05 × 4.24 = 0.2117 ≅21.2%

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Q.5421 ABC Bank has an average asset duration of four years, average liability duration of three
years, total liabilities amounting to $150 million, and total assets valued at $180 million. Initially,
interest rates stood at 9 percent, but suddenly they increased to 13 percent. What is the change
in the value of ABC Bank's net worth?

A. -$26.42 million

B. -$16.51 million

C. -$9.91 million

D. -$1.10 million

The correct answer is C.

Change invalue in financial institutions net worth

Change in interest rate
= [−Average duration of assets ×
(1 + Original discount rate)
× Total assets]
Change in interest rate
− [−Average duration liabilities ×
(1 + Original discount rate)
× Total liabilities]
0.04 0.04
= [−4 × × $180 million] − [−3 × × $150 million]
(1 + 0.09) (1 + 0.09)
= −26.42 − (−16.51) = −$9.908 million

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Reading 145: Illiquid Assets

Q.2426 Jude Wang, a portfolio manager, works at an investment management firm. She has been
recently asked to manage the endowment fund of a large university. She meets the head of the
university to discuss finer details about the fund, including the composition of the endowment
fund. The university head informs her that the university plans to withdraw a substantial amount
of the fund in next two years and use the money to establish a state-of-the-art financial
laboratory. He also adds that the university board desires to keep the transaction cost as low as
possible. After the discussion, Wang meets her colleague, Jane Jones, with whom she explores
the asset classes that can possibly be included in the endowment fund. According to Jones, Wang
should consider including private equity and real estate in the endowment fund as these asset
classes have low correlation with stocks and bonds and can provide a better diversification effect
to the overall portfolio. Jones goes further to opine that private equity and real estate would
make it easier for Wang to generate an excess return compared to stocks and bonds.
Which of the following does not support the idea of including private equity and real estate in the
portfolio?

A. It would provide a better diversification effect to the portfolio.

B. It would help Wang to generate an excess return.

C. The university needs a substantial amount of funds in next two years for the
laboratory.

D. It would improve the portfolio because of the assets’ low correlation with stocks and
bonds.

The correct answer is C.

Private equity and real estate fall under the category of illiquid assets. Large trades of illiquid
assets results in substantial market movement which may in turn trigger adverse price
movements. Thus, an investor trying to cash in on illiquid assets in a short time period may have
to suffer significant losses due to adverse price movement. Barring a change of plans by the
university, a substantial amount of money is needed in next two years – and that’s where the
problem lies. If the fund invests in illiquid assets, divesting such assets may force the institution
to accept a lower market price or incur substantial transaction costs. Therefore, investment in
illiquid assets must be avoided.

Q.2427 Jude Wang, a portfolio manager, works at an investment management firm. She has been
recently asked to manage the endowment fund of a large university. She meets the head of the
university to discuss finer details about the fund, including the composition of the endowment
fund. The university head informs her that the university plans to withdraw a substantial amount
of the fund in next two years and use the money to establish a state-of-the-art financial
laboratory. He also adds that the university board desires to keep the transaction cost as low as
possible. After the discussion, Wang meets her colleague, Jane Jones, with whom she explores

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the asset classes that can possibly be included in the endowment fund. According to Jones, Wang
should consider including private equity and real estate in the endowment fund as these asset
classes have low correlation with stocks and bonds and can provide a better diversification effect
to the overall portfolio. Jones goes further to opine that private equity and real estate would
make it easier for Wang to generate an excess return compared to stocks and bonds.
Which of the following statements is correct?

A. Jones may include private equity and real estate since they will reduce transaction
costs.

B. Jones must not include private equity and real estate because they may increase
transaction costs.

C. The inclusion of private equity and real estate in the portfolio will have no effect on
transaction costs.

D. Private equity and real estate will make the portfolio more diversified and reduce
transaction costs.

The correct answer is B.

Private equity and real estate are considered illiquid assets. Illiquid assets are those that cannot

be easily bought or sold without a substantial change in price. These assets are characterized by

information asymmetry, which means that the information about these assets is not readily

available or is unevenly distributed among market participants. As a result, the cost of obtaining

information about such assets is high. This increases the transaction costs associated with these

assets. Therefore, including private equity and real estate in the endowment fund may increase

transaction costs, contrary to the university board's desire to keep these costs low. Furthermore,

the university's plan to withdraw a substantial amount from the fund in the next two years may

be hindered by the illiquidity of these assets, as selling them quickly could result in a significant

loss.

Choice A is incorrect. While private equity and real estate can provide diversification benefits,

they do not necessarily reduce transaction costs. In fact, these asset classes often involve higher

transaction costs due to their illiquid nature and the complexity of the transactions involved.

Choice C is incorrect. The inclusion of private equity and real estate in the portfolio will likely

increase transaction costs, not have no effect on them. These asset classes are typically less

liquid than stocks and bonds, which can lead to higher transaction costs.

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Choice D is incorrect. Although private equity and real estate can enhance portfolio

diversification, they do not inherently reduce transaction costs. As mentioned earlier, these asset

classes often come with higher transaction costs due to their illiquidity and complex nature of

transactions.

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Q.2428 The bias associated with returns being observed only when the underlying asset values
are high is best known as:

A. Selection bias

B. Survivorship bias

C. Infrequent trading

D. None of the above

The correct answer is A.

Selection bias is a type of distortion that can occur in financial and economic data. It arises when

the returns are only observed or recorded when the underlying asset values are high. This can

lead to an overestimation of the average return and an underestimation of the risk. For instance,

properties are often sold when their values are high, and companies are typically made public

when stock values are high in buyout funds. This selective observation can skew the data and

create a bias that can impact investment decisions and risk assessments.

Choice B is incorrect. Survivorship bias refers to the tendency of remaining funds in a market

to have better past performance, primarily because funds with poor performance are likely to be

withdrawn from the market. This does not align with the scenario described in the question

where returns are only recorded when asset values are high.

Choice C is incorrect. Infrequent trading refers to a situation where assets are not traded on a

regular basis, which can lead to stale or outdated prices and thus distort return calculations.

However, this concept does not directly relate to recording returns only when asset values are

high.

Choice D is incorrect. The scenario described in the question clearly represents an instance of

selection bias, hence it cannot be 'None of the above'.

Q.2429 Illiquid assets can generate excess return because:

A. They allow the transfer of idiosyncratic risk from liquid markets.

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B. They reduce transaction costs.

C. They generate arbitrage opportunities.

D. They require huge investments.

The correct answer is A.

Illiquid assets can indeed allow the transfer of idiosyncratic risk from liquid markets, which can

lead to the generation of excess returns. In liquid markets, information regarding the assets is

freely available and every participant has equal access to this information. This makes the

generation of alpha (excess return) in such markets a challenging task due to the efficient

market hypothesis, which states that it's impossible to beat the market because the stock market

efficiency causes existing share prices to always incorporate and reflect all relevant information.

However, the market for illiquid assets is often characterized by information asymmetry, where

some investors have more or better information than others. This information asymmetry can be

exploited by informed investors to generate excess returns. Thus, the idiosyncratic risk, which is

the risk inherent in a specific asset or group of assets (as opposed to systemic risk that affects all

assets), of liquid assets can be transferred to illiquid assets and help generate excess returns.

This is because illiquid assets, due to their lack of liquidity, are often priced less efficiently, and

thus may provide opportunities for investors to earn excess returns if they have superior

information or analysis.

Choice B is incorrect. Illiquid assets do not reduce transaction costs. In fact, the opposite is

true. Due to their lack of liquidity, illiquid assets often have higher transaction costs because

they are harder to buy and sell quickly without impacting their price.

Choice C is incorrect. While it's true that arbitrage opportunities can sometimes arise in

illiquid markets due to pricing inefficiencies, this isn't the primary reason for the potential for

excess return generation in illiquid assets. The main reason is that they allow for the transfer of

idiosyncratic risk from liquid markets.

Choice D is incorrect. The requirement of huge investments does not necessarily lead to

excess returns in illiquid assets. While it's true that some illiquid assets may require large

investments, this doesn't inherently generate excess returns.

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Q.2430 Sam Kesler, a portfolio manager, is trying to select stocks for his portfolio. The
investment policy statement of the fund indicates that the portfolio must consist of only liquid
stocks. Kesler has the following investment options:

Category Stock Information

Mid Cap X Going by the latest trading information available, the stock could
be sold at $12.30 and purchased at $12.32.
Mid Cap Y The majority shareholding of the company rests with a family. The
daily turnover of the shares equals 100 stocks only.
Large Cap Z The stock was last traded 2 days ago.
Small Cap A Going by the latest trading information available, the stock could
be sold at $4.65 and purchased at $8.25.

Which of the following statements is correct?

A. Stock Y must not be selected due to its large family holding.

B. Stock Y must be selected due to its daily turnover.

C. Stock Y must be selected due to its large family holding.

D. Stock Y must not be selected as it belongs to the Mid Cap category.

The correct answer is A.

Stock Y must not be selected due to its large family holding. The reason for this is that the large

family holding of Stock Y significantly reduces the number of shares available for trading. This

lack of availability makes the stock illiquid. In the context of portfolio management, liquidity

refers to the ease with which an asset, or security, can be bought or sold in the market without

affecting the asset's price. Highly liquid assets can be sold quickly without having to reduce the

asset's price. In contrast, illiquid assets may require more time to sell and may need to be sold at

a discount to the market price. Therefore, given the fund's investment policy statement that

requires only liquid stocks in the portfolio, Stock Y would not be a suitable choice due to its large

family holding and resulting illiquidity.

Choice B is incorrect. The daily turnover of Stock Y is only 100 stocks, which indicates low

liquidity. A stock with high liquidity would have a higher daily turnover, making it easier to buy

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or sell without causing a significant change in its price. Therefore, the low daily turnover of

Stock Y does not make it suitable for inclusion in Kesler's portfolio.

Choice C is incorrect. The majority shareholding of Stock Y being held by a single family does

not make it suitable for inclusion in Kesler's portfolio. In fact, this could potentially reduce the

stock's liquidity as the family may be less likely to sell their shares, thereby reducing the number

of shares available for trading on the market.

Choice D is incorrect. The fact that Stock Y belongs to the Mid Cap category does not

necessarily mean it should be excluded from Kesler's portfolio. While mid-cap stocks can

sometimes be less liquid than large-cap stocks due to their smaller size and lower trading

volumes, this is not always the case and other factors such as ownership structure and daily

turnover also need to be considered when assessing liquidity.

Q.2431 Sam Kesler, a portfolio manager, is trying to select stocks for his portfolio. The
investment policy statement of the fund indicates that the portfolio must consist of only liquid
stocks. Kesler has the following investment options:

Category Stock Information

Mid Cap X Going by the latest trading information available, the stock could
be sold at $12.30 and purchased at $12.32.
Mid Cap Y The majority shareholding of the company rests with a family. The
daily turnover of the shares equals 100 stocks only.
Large Cap Z The stock was last traded 2 days ago.
Small Cap A Going by the latest trading information available, the stock could
be sold at $4.65 and purchased at $8.25.

The stock(s) which must be included in the portfolio is (are):

A. X and Y

B. X only

C. Y only

D. X and A

The correct answer is B.

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The correct answer is that only Stock X should be included in the portfolio. This is because Stock

X exhibits the highest liquidity among the four options. Liquidity in the stock market is

determined by the ease with which a stock can be bought or sold without causing a significant

change in its price. One of the key indicators of a stock's liquidity is the bid-ask spread, which is

the difference between the highest price that a buyer is willing to pay for a stock (the bid) and

the lowest price at which a seller is willing to sell a stock (the ask). A smaller bid-ask spread

indicates higher liquidity because it means that the stock can be bought or sold at a price close

to the market price. In the case of Stock X, the bid-ask spread is very small ($12.32 - $12.30 =

$0.02), indicating high liquidity. Therefore, Stock X meets the requirement stipulated in the

fund's investment policy statement and should be included in the portfolio.

Choice A is incorrect. While stock X is a viable option due to its narrow bid-ask spread

indicating high liquidity, stock Y is not a good choice. The majority of the shares are held by a

single family and the daily turnover is very low, which suggests that the stock may not be easily

tradable and hence lacks liquidity.

Choice C is incorrect. As explained above, Stock Y has low liquidity due to concentrated

ownership and low daily turnover.

Choice D is incorrect. Although Stock X can be included in the portfolio due to its high

liquidity, Stock A should not be considered because of its wide bid-ask spread ($4.65-$8.25),

which indicates lower liquidity.

Q.2432 Sam Kesler, a portfolio manager, is trying to select stocks for his portfolio. The
investment policy statement of the fund indicates that the portfolio must consist of only liquid
stocks. Kesler has the following investment options:

Category Stock Information

Mid Cap X Going by the latest trading information available, the stock could
be sold at $12.30 and purchased at $12.32.
Mid Cap Y The majority shareholding of the company rests with a family. The
daily turnover of the shares equals 100 stocks only.
Large Cap Z The stock was last traded 2 days ago.
Small Cap A Going by the latest trading information available, the stock could
be sold at $4.65 and purchased at $8.25.

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The majority shareholding of Y decreases the:

A. Profitability of the company.

B. Number of shares available for trading.

C. Transaction costs.

D. Both the number of shares available for trading and the transaction costs.

The correct answer is B.

The majority shareholding of stock 'Y' by a single family significantly reduces the number of

shares available for trading. In the context of stock markets, liquidity refers to the ability to

quickly buy or sell a particular security without causing a significant change in its price. A stock

is considered liquid if there are enough shares available in the market for trading. When a single

entity, such as a family, holds the majority of a company's shares, the number of shares available

for trading in the market decreases. This reduction in available shares makes the stock less

liquid, as there are fewer shares that can be bought or sold quickly without impacting the stock's

price. Therefore, the majority shareholding of stock 'Y' decreases the number of shares available

for trading, making it less suitable for inclusion in a portfolio that requires liquid stocks.

Choice A is incorrect. The majority shareholding of a company does not directly affect the

profitability of the company. Profitability is determined by factors such as revenue, costs, and

operational efficiency, which are independent of who holds the majority shares.

Choice C is incorrect. While transaction costs can be influenced by liquidity and trading

volume, they are not directly affected by who holds the majority shares in a company.

Transaction costs are typically determined by factors such as brokerage fees and bid-ask

spreads.

Choice D is incorrect. As explained above, while the number of shares available for trading can

be influenced by who holds the majority shares in a company (as it may limit supply), transaction

costs are not directly affected by this factor.

Q.2433 Avery Mason, a financial analyst, is investigating the performance of a mutual fund based

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on the information on returns provided in the following table:

Fund Historical Return Fund Status

1 6% Active
2 −12% Closed due to acquisition
3 8% Active
4 −8% Closed due to poor performance
5 10% Active

Mason only considers the funds that are still active for the analysis. The results of his analysis
are exposed to:

A. Selection bias

B. Survivorship bias

C. Infrequent sampling

D. None of the above

The correct answer is B.

Survivorship bias refers to the analytical error of focusing only on the entities that have

'survived' a particular process and overlooking those that did not because of their lack of

visibility. In the context of financial analysis, survivorship bias can significantly skew the results

of an analysis if it only considers the funds that are still active and ignores the ones that have

been closed. This is because the performance of the closed funds could have been poor, and

excluding them from the analysis could lead to an overestimation of the overall performance of

the mutual funds.

In this case, Mason's analysis is subject to survivorship bias because he only considers the active

funds for his analysis. By doing so, he excludes the funds that have been closed due to

acquisition or poor performance. This could lead to an overestimation of the average return of

the mutual funds, as the closed funds, which might have had lower returns, are not considered in

the calculation. Therefore, the results of Mason's analysis are not representative of the overall

performance of all the funds, leading to a biased conclusion.

Choice A is incorrect. Selection bias refers to the bias introduced by the selection of

individuals, groups or data for analysis in such a way that proper randomization is not achieved,

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thereby ensuring that the sample obtained is not representative of the population intended to be

analyzed. In this case, Mason's decision to include only active funds does not constitute selection

bias because he has a valid reason for his choice - he wants to analyze funds that are currently

operational.

Choice C is incorrect. Infrequent sampling refers to a situation where data points are collected

at intervals that are too wide, leading to potential inaccuracies in analysis due to missing

fluctuations within those intervals. This type of bias does not apply here as there's no

information suggesting infrequent or irregular sampling of return data.

Choice D is incorrect. As explained above, Mason's analysis would most likely be subject to

survivorship bias since he only includes active (or surviving) funds in his study and excludes

those which have been closed.

Q.2434 A fund manager has quarterly and daily returns of stocks A and B. In order to calculate
the volatility of the two stocks, the fund manager utilizes the quarterly return of A and the daily
return of B. The computed volatility values are given below:

Stock A Stock B
Return frequency Quarterly Daily
Volatility 0.33 0.43

Based on the above result, the fund manager argues that stock A is less risker than stock
B.Which of the following statements is accurate?

A. The fund manager is incorrect.

B. The fund manager is incorrect as the volatility is not a true measure of riskiness.

C. The fund manager is correct.

D. The fund manager is incorrect as the daily return of stock B makes its volatility lower
than that of A.

The correct answer is A.

The fund manager's conclusion is incorrect. The reason for this is that the frequency of return

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reporting for the two stocks is different. Stock A's returns are reported quarterly, while Stock B's

returns are reported daily. This difference in reporting frequency can significantly impact the

calculated volatility of the stocks. In general, the more frequently returns are reported, the

higher the calculated volatility will be. This is because more frequent reporting captures more of

the short-term fluctuations in the stock's price, which are reflected in the calculated volatility.

Therefore, the higher volatility of Stock B does not necessarily mean that it is riskier than Stock

A. It could simply be a result of the more frequent reporting of its returns. To accurately compare

the riskiness of the two stocks, the fund manager would need to calculate their volatilities using

the same frequency of return reporting.

Choice B is incorrect. While it's true that volatility isn't the only measure of riskiness, it is a

significant factor in assessing the risk of an investment. Therefore, saying that volatility isn't a

true measure of riskiness oversimplifies the concept and doesn't accurately reflect its

importance in risk assessment.

Choice C is incorrect. The fund manager's conclusion that stock A is less risky than stock B

based on their respective volatilities is flawed because he used different time frames (quarterly

for A and daily for B) to calculate these volatilities. This makes the comparison invalid as it does

not provide an apples-to-apples comparison.

Choice D is incorrect. The statement incorrectly suggests that using daily returns would

inherently make stock B's volatility lower than that of A. However, whether a stock’s volatility

will be higher or lower depends on its price movements and not merely on the frequency of

return calculations.

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Q.2435 Which of the following is one of the processes usually employed to account for infrequent
trading?

A. Unsmoothing

B. Noise reduction

C. Autocorrelation

D. Filtering

The correct answer is A.

To account for the infrequent trading bias, we need to unsmoothing the returns. In the process,
the noise is added back to the reported returns to uncover the true return.

Q.2436 Alco Bank is contemplating creating an index to value artistic work. As art works are not
actively traded, the bank decides to create an index from data reported by its members. The
members include the major auction firms and art advisors situated in the city.

Sam Park is looking to invest in the art work space to diversify his portfolio. In order to make an
informed decision, he decides to use the index created by the bank to calculate the expected
return.
The returns as indicated by the bank’s index exhibit:

A. Autocorrelation

B. Unsmoothing

C. Auto regression

D. Filtering

The correct answer is A.

Autocorrelation refers to a situation where current values are influenced by previously recorded

values. In the context of an illiquid asset such as art, there is limited trading data available. As a

result, managers often rely on the most recent and most comparable sales data to estimate the

current value of such an asset. They may also use past appraised values, whether estimated or

perceived. In these circumstances, the final value assigned to the asset will exhibit strong

autocorrelation with the past values used. These values will constitute the index. Consequently,

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the asset's returns computed based on the index will also show autocorrelation with previous

returns. This is because the index, and by extension the returns, are influenced by past values,

creating a correlation between current and past values. This characteristic of autocorrelation is

particularly prevalent in illiquid markets such as the art market, where trading data is sparse

and valuations are often based on past sales or appraisals.

Choice B is incorrect. Unsmoothing refers to the process of adjusting smoothed returns to

reflect their true volatility. In this case, the bank's index is not smoothing or adjusting the

returns, but rather compiling data from its members to evaluate the value of artistic works.

Choice C is incorrect. Autoregression is a type of time series model that uses observations

from previous time points as input for a regression equation to predict the value at the next time

point. This concept does not apply here because there's no mention in the question about using

past data points for predicting future values in constructing this art index.

Choice D is incorrect. Filtering refers to a technique used in signal processing where an

unwanted part of a signal (such as random noise) is removed, or desired part (such as certain

component frequencies) are extracted by altering aspects of its spectrum. This concept doesn't

apply here because there's no indication that Alco Bank plans on removing or extracting any

specific parts from their data while creating this art index.

Q.2437 Alco Bank is contemplating creating an index to value artistic work. As art works are not
actively traded, the bank decides to create an index from data reported by its members. The
members include major auction firms and art advisors situated in the city.

Sam Park is looking to invest in the artworks space to diversify his portfolio. In order to make an
informed decision, he decides to use the index created by the bank to calculate the expected
return.
The index created by Alco Bank is an example of a (an):

A. True index

B. Appraisal index

C. Equal-weighted index

D. Transaction index

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The correct answer is B.

An appraisal index is a type of index that is constructed using valuation estimates provided by

experts, rather than actual transaction prices. In the context of the question, Alco Bank is

creating an index to value artistic works using data reported by its members, which include

major auction firms and art advisors. These members are likely to provide their expert opinions

or appraisals on the value of the artworks, rather than actual transaction prices, as artworks are

not actively traded. Therefore, the index created by Alco Bank is an appraisal index. This type of

index is often used in markets where assets are not frequently traded, such as the art market,

real estate market, and private equity market. It allows investors like Sam Park to estimate the

expected return on their investment in these illiquid markets.

Choice A is incorrect. A true index is a type of index that reflects the actual performance of the

assets it represents. In this case, Alco Bank is not creating a true index because it's using data

provided by its members rather than actual transaction prices from the open market.

Choice C is incorrect. An equal-weighted index assigns the same weight to all components in

the portfolio, regardless of their market value or other characteristics. This scenario does not

provide any information suggesting that Alco Bank plans to assign equal weights to all artworks

in its proposed index.

Choice D is incorrect. A transaction index uses actual transaction prices for its calculation,

which would require frequent trading of artworks on an open market - something that isn't

happening here as stated in the question.

Q.2438 Michael Bay is thinking to include real estate in his portfolio to generate excess returns
and to diversify his portfolio. He studies a report prepared by a big consultancy firm on the real
estate sector. The report outlines the future prospects of the sector and also contains the list of
recent transactions carried out and the return generated.

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Date Return
Building A 12/2/2016 12.00%
Building B 13/06/2016 11.60%
Building C 12/1/2016 13.00%
Building D 4/9/2016 11.00%
Building E 9/10/2016 14.00%

The report also mentions that there has been an increase in real estate transactions in recent
times due to increases in land prices. Furthermore, it adds that the number of transactions
increased from 3 in 2015 to 28 in 2016, indicating the changing fortunes of real estate.Based on
the returns contained in the report and by computing the corresponding market return, Bay tries
to calculate the beta (β) and alpha (α – also known as excess return) of the real estate sector. β
turns out to be 0.65 while α stands at 3.45%. Thus, Bay concludes that the real estate sector is
less risky than the market, and an excess return of 3.45% can be easily generated by investing in
real estate.The report on real estate exhibits a:

A. Survivorship bias

B. Selection bias

C. Infrequent sampling bias

D. Both selection bias and infrequent sampling bias

The correct answer is D.

The report exhibits both selection bias and infrequent sampling bias. Selection bias occurs when

the data used to calculate the returns is not representative of the entire population. In this case,

the report only includes the returns observed in the year 2016, a year when the real estate

sector was performing well. This means that the returns were only observed when the values of

the underlying assets were high, which is indicative of selection bias. Infrequent sampling bias,

on the other hand, occurs when the trading of an asset is too infrequent and only summary data

spanning a relatively long period is present. In this case, the beta has been underestimated and

the alpha has been overestimated, which is indicative of infrequent sampling bias. Therefore, the

report exhibits both selection bias and infrequent sampling bias.

Choice A is incorrect. Survivorship bias refers to the tendency of remaining funds in a market

to have better performance than the actual average because only they have survived. In this

case, there is no mention of any funds or investments being removed from consideration due to

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poor performance, so survivorship bias does not apply.

Choice B is incorrect. Selection bias occurs when certain data points are more likely to be

chosen for analysis than others, leading to a non-random sample that may not be representative

of the whole population. While it's possible that selection bias could occur in this scenario if Bay

only considered successful real estate transactions when calculating beta and alpha, there's no

evidence in the question that suggests this happened.

Choice C is incorrect. Infrequent sampling bias refers to errors that can occur when data

points are collected at irregular intervals or frequencies which can lead to misinterpretation of

trends or patterns. Although there was an increase in transactions from 2015-2016, we don't

know if these were evenly distributed throughout each year or clustered at certain times which

could potentially introduce infrequent sampling bias.

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Q.2439 Michael Bay is thinking to include real estate in his portfolio to generate excess returns
and to diversify his portfolio. He studies a report prepared by a big consultancy firm on the real
estate sector. The report outlines the future prospects of the sector and also contains the list of
recent transactions carried out and the return generated.

Date Return
Building A 12/2/2016 12.00%
Building B 13/06/2016 11.60%
Building C 12/1/2016 13.00%
Building D 4/9/2016 11.00%
Building E 9/10/2016 14.00%

The report also mentions that there has been an increase in real estate transactions in the recent
times due to increases in land prices. Furthermore, it adds that the number of transactions
increased from 3 in 2015 to 28 in 2016, indicating the changing fortunes of real estate.
Based on the returns contained in the report and by computing the corresponding market return,
Bay tries to calculate the beta (β) and alpha (α – also known as excess return) of the real estate
sector. β turns out to be 0.65 while α stands at 3.45%. Thus, Bay concludes that the real estate
sector is less risky than the market, and an excess return of 3.45% can be easily generated by
investing in real estate.Which of the following statements is accurate?

A. Bay has overestimated the values of α and β.

B. Bay has overestimated the value of α but the value of β is correctly estimated.

C. Bay has overestimated the value of β but the value of α is correctly estimated.

D. Bay has overestimated the value of α and understated the value of β.

The correct answer is D.

Due to selection bias, the returns were observed when the underlying asset values were high.
Therefore, the selection bias overestimates the value of α (excess return). The higher observed
returns result in an underestimation of β. The security market line, when plotted, gives a flatter
line instead of a steeper one.

Q.2440 Michael Bay is thinking to include real estate in his portfolio to generate excess returns
and to diversify his portfolio. He studies a report prepared by a big consultancy firm on the real
estate sector. The report outlines the future prospects of the sector and also contains the list of
recent transactions carried out and the return generated.

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Date Return
Building A 12/2/2016 12.00%
Building B 13/06/2016 11.60%
Building C 12/1/2016 13.00%
Building D 4/9/2016 11.00%
Building E 9/10/2016 14.00%

The report also mentions that there has been an increase in real estate transactions in the recent
times due to increases in land prices. Furthermore, it adds that the number of transactions
increased from 3 in 2015 to 28 in 2016, indicating the changing fortunes of real estate. Based on
the returns contained in the report and by computing the corresponding market return, Bay tries
to calculate the beta (β) and alpha (α – also known as excess return) of the real estate sector. β
turns out to be 0.65 while α stands at 3.45%. Thus, Bay concludes that the real estate sector is
less risky than the market, and an excess return of 3.45% can be easily generated by investing in
real estate.The estimates of α and β can be made more robust by:

A. Decreasing the number of observations.

B. Using a multifactor risk model.

C. Using daily returns.

D. None of the above.

The correct answer is B.

Using a multifactor risk model can indeed make the estimates of alpha (&alpha) and beta

(&beta) more robust. The alpha (&alpha) of an investment indicates the excess return that the

investment generates over the expected return, given its beta (&beta) and the expected market

return. Beta (&beta), on the other hand, measures the investment's sensitivity to market

movements. A beta (&beta) of 1 indicates that the investment's price will move with the market,

while a beta (&beta) less than 1 indicates that the investment will be less volatile than the

market. A beta (&beta) greater than 1 indicates that the investment's price will be more volatile

than the market. Therefore, by using a multifactor risk model, one can account for multiple risk

factors that could affect the returns of the real estate sector, rather than just considering the

market portfolio as the sole risk factor. This can provide a more comprehensive and accurate

estimation of the risk and return characteristics of the real estate sector, thereby making the

estimates of alpha (&alpha) and beta (&beta) more robust.

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Choice A is incorrect. Decreasing the number of observations would not make the estimates of

alpha and beta more robust. In fact, it would likely lead to less reliable estimates due to a

smaller sample size. More data points generally provide a better representation of the

population, leading to more accurate and reliable results.

Choice C is incorrect. Using daily returns might increase the number of observations, but it

may not necessarily improve the robustness of alpha and beta estimates. Daily returns can be

very volatile and may introduce noise into the data, which could distort true underlying patterns

or trends.

Choice D is incorrect. As explained above, both decreasing the number of observations (choice

A) and using daily returns (choice C) are unlikely to improve the robustness of alpha and beta

estimates in this context.

Q.2758 People tend to overstate expected returns and understate the risk of illiquid assets. This
is due to certain biases that affect their judgment. These biases include all of the following,
except the:

A. Survivorship bias

B. Infrequent sampling bias

C. Selection bias

D. Availability bias

The correct answer is D.

Availability bias refers to the tendency of individuals to base their decisions on information that

is readily available to them, rather than seeking out all possible information. This bias can lead

to skewed perceptions and decisions, as the information that is most readily available may not be

the most accurate or comprehensive. In the context of illiquid assets, availability bias might lead

an investor to overestimate the returns or underestimate the risks based on the limited

information they have. However, it does not directly cause investors to overstate the expected

returns and understate the risk of illiquid assets like the other biases listed. Therefore,

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availability bias is the correct answer.

Choice A is incorrect. Survivorship bias can contribute to the overestimation of returns and

underestimation of risks associated with illiquid assets. This is because this bias involves

focusing on the assets that have 'survived' or performed well in the past, while ignoring those

that have failed or performed poorly. As a result, investors may overestimate the expected

returns and underestimate the risks associated with these surviving assets.

Choice B is incorrect. Infrequent sampling bias also contributes to this issue as it refers to a

situation where investors do not frequently update their information about an asset's

performance due to its illiquidity. This can lead them to overlook recent changes in market

conditions or other relevant factors, thereby causing them to overestimate expected returns and

underestimate potential risks.

Choice C is incorrect. Selection bias refers to a situation where investors selectively focus on

certain information while ignoring other relevant data when making investment decisions. In the

context of illiquid assets, this could mean focusing only on positive performance data while

ignoring negative indicators, leading again to an overestimation of returns and underestimation

of risk.

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Q.3024 In 2012, a taxonomy of how illiquidity comes about in the market was given by Vayanos
and Wang. Which of the following is not a source of market illiquidity according to Vayanos and
Wang (2012)?

A. Costs of transaction

B. Symmetric information

C. The effect of prices

D. Search frictions

The correct answer is B.

Symmetric information is not a source of market illiquidity according to the taxonomy proposed

by Vayanos and Wang in 2012. In the context of financial markets, symmetric information refers

to a situation where all market participants have equal access to relevant information. This

scenario promotes market liquidity as it reduces the risk of information asymmetry, where one

party has superior information compared to others. In a market characterized by symmetric

information, investors are more likely to engage in trading activities as the fear of being

exploited due to lack of information is minimized. Therefore, symmetric information encourages

market liquidity rather than causing market illiquidity.

Choice A is incorrect. Transaction costs are indeed a cause of market illiquidity according to

Vayanos and Wang's classification system. High transaction costs can deter investors from

trading, thereby reducing liquidity in the market.

Choice C is incorrect. The effect of prices on liquidity is a recognized factor in Vayanos and

Wang's taxonomy. If prices are volatile or uncertain, this can lead to decreased trading activity

and thus lower liquidity.

Choice D is incorrect. Search frictions are also considered a cause of market illiquidity by

Vayanos and Wang's classification system because they make it more difficult for buyers and

sellers to find each other, which reduces the number of transactions taking place in the

marketplace.

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Q.3025 Expected returns can be overstated and the risk of illiquid assets understated due to
some key biases. Survivorship bias is one of these biases. How does survivorship bias arise?

A. The survivorship bias is is the result of infrequent trading where risk estimates like
volatility, correlations and betas get too low when calculated using past data.

B. The survivorship bias results from the tendency of returns to be only observed as the
underlying values of the asset get high as compared to other assets.

C. The survivorship bias results from the tendency of poorly performing funds to stop
their activities.

D. All the above.

The correct answer is C.

The tendency of poorly performing funds to stop reporting leads to the survivorship bias.
Ultimately, most of these funds will fail, although their failures are rarely counted. Therefore, as
compared to the reported data, the true illiquid asset returns are worse due to this fact.

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Q.5377 In light of a scarcity of investment opportunities in public markets, a US pension fund is

evaluating the feasibility of investing in illiquid markets within the US. What specific
characteristics of illiquid markets in the US should the pension managers consider?

A. Over the past two decades, there has been a general increase in the proportion of
illiquid assets within institutional portfolios.

B. In the midst of the 2008 Global Financial Crisis, liquidity evaporated in the repo
markets while remaining relatively unaffected in the commercial paper markets.

C. Municipal bonds tend to exhibit higher liquidity compared to pink sheet over-the-
counter equities.

D. The combined value of traditional publicly traded liquid markets, consisting of stocks
and bonds, exceeds the total wealth invested in illiquid assets.

The correct answer is A.

In the past two decades, both pensions and endowments have raised their allocations to

alternative assets, growing from approximately 5% to 20-25%. This trend is important to

consider because it indicates a growing recognition of the potential benefits of investing in

illiquid assets, such as private equity, real estate, infrastructure, and other alternative

investments.

B is incorrect. Both markets experienced a severe contraction in liquidity.

C is incorrect. The turnover rate for municipal bonds is less than 10%, significantly lower

compared to the approximate 35% turnover rate observed in OTC equities.

D is incorrect. In comparison to the size of US stocks and bonds, the US real estate markets are

significantly larger.

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Q.5402 Tom Jones, a portfolio manager at BlackStone Advisors, wants to add illiquid assets to the
fund he oversees to boost performance. He is speaking with the company's chief investment
officer about the characteristics of illiquid assets. Which of the following statements made by
Tom Jones is correct regarding represents a correct statement about illiquid assets?

A. The inclusion of the returns of the full population of funds can theoretically eliminate
survivorship bias and reporting bias.

B. Despite being viewed as biased, infrequent trading can nonetheless produce enough
data for precise beta and correlation calculations.

C. By exclusively reporting the returns of funds that have surpassed a specified

threshold, survivorship bias causes inflation in the reported returns of illiquid assets.

D. The reporting bias leads to an overstatement of the reported returns of illiquid assets
since it only includes the returns of funds that have managed to stay in operation
throughout a specific time period.

The correct answer is A.

The inclusion of the whole population of funds could potentially reduce survivorship and

reporting biases. By including all funds, including those that have ceased to operate or

underperformed, survivorship bias is reduced as the sample represents the entire population.

Reporting bias is also mitigated as it includes all funds, preventing the exclusion of

underperforming funds and resulting in a more accurate representation of returns.

B is incorrect. Despite being viewed as biased, infrequent trading or sampling will result in

beta, correlation, and volatility estimates that are excessively low.

C is incorrect. By only reporting the returns of funds that have generated an adequate return,

reporting bias improves illiquid asset-reported returns.

D is incorrect. Survivorship bias improves the reported returns on illiquid assets by only

including the returns of funds that have remained in operation for a predetermined amount of

time.

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Q.5417 Tom Jones, a portfolio manager at BlackStone Advisors, wants to add illiquid assets to the
fund he oversees to boost performance. He is speaking with the company's chief investment
officer about the characteristics of illiquid assets. Which of the following statements made by
Tom Jones is correct regarding about about illiquid assets?

A. The inclusion of the returns of the full population of funds can theoretically eliminate
survivorship bias and reporting bias.

B. Despite being viewed as biased, infrequent trading can nonetheless produce enough
data for precise beta and correlation calculations.

C. By exclusively reporting the returns of funds that have surpassed a specified

threshold, survivorship bias causes inflation in the reported returns of illiquid assets.

D. The reporting bias leads to an overstatement of the reported returns of illiquid assets
since it only includes the returns of funds that have managed to stay in operation
throughout a specific time period.

The correct answer is A.

The inclusion of the whole population of funds could potentially reduce survivorship and

reporting biases. By including all funds, including those that have ceased to operate or

underperformed, survivorship bias is reduced as the sample represents the entire population.

Reporting bias is also mitigated as it includes all funds, preventing the exclusion of

underperforming funds and resulting in a more accurate representation of returns.

B is incorrect. Despite being viewed as biased, infrequent trading or sampling will result in

beta, correlation, and volatility estimates that are excessively low.

C is incorrect. By only reporting the returns of funds that have generated an adequate return,

reporting bias improves illiquid asset-reported returns.

D is incorrect. Survivorship bias improves the reported returns on illiquid assets by only

including the returns of funds that have remained in operation for a predetermined amount of

time.

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