Question 1

If a banker expects interest rates to fall in the future, her best strategy for the present is ________.

Accepted Answer

If the banker expects interest rates to fall in the future, she should increase the duration of the bank's assets. This means investing in longer-term bonds or fixed-rate loans that will earn a higher interest rate than short-term investments, and will retain their higher rate even as new investments are made at lower rates. This will maximize profits for the bank in a falling interest rate environment.

Question 2

Because of an expected rise in interest rates in the future, a banker will likely ________.

Accepted Answer

When expecting a rise in interest rates, a banker would prefer buying short-term rather than long-term bonds. This is because the value of long-term bonds would decrease more significantly as interest rates rise, making short-term bonds a safer investment in a rising interest rate environment.

Question 3

Bruce the Bank Manager can reduce interest rate risk by ________ the duration of the bank's assets to increase their rate sensitivity or, alternatively, ________ the duration of the bank's liabilities.

Accepted Answer

To reduce interest rate risk, Bruce may choose to shorten the duration of the bank's assets to increase their rate sensitivity, which means that the assets will be more responsive to changes in interest rates. Alternatively, he may choose to lengthen the duration of the bank's liabilities, which will also increase rate sensitivity of the bank's overall balance sheet. Therefore, the best choice is A - shortening the duration of assets or lengthening the duration of liabilities (either one or both).

Question 4

Because ________ are less liquid for the depositor than ________, they earn higher interest rates.

Accepted Answer

Savings accounts are less liquid than chequable deposits because they typically have restrictions on the number of withdrawals or transfers allowed, leading to higher interest rates compared to the more liquid chequable deposits.

Question 5

Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap times the change in the interest rate is called ________.

Accepted Answer

This is the definition of basic gap analysis.

Question 6

Examples of off-balance-sheet activities include ________.

Accepted Answer

Off-balance-sheet activities refer to any financial transaction or arrangement that does not appear on a company's balance sheet. Loan sales are a common example of off-balance-sheet activities where a bank sells its loans to other financial institutions, which helps to generate fee income, reduce risk exposure or shift risk to other parties without recognizing the financial transaction on its balance sheet. The other options given- B) extending loans to depositors, C) borrowing from other banks and D) selling negotiable CDs- are all on-balance-sheet activities because they are recorded in a bank's balance sheet as assets or liabilities.

Question 7

The difference of rate-sensitive liabilities and rate-sensitive assets is known as the ________.

Accepted Answer

The difference between rate-sensitive liabilities and rate-sensitive assets is known as the gap.

Question 8

Your bank has the following balance sheet:
Assets Liabilities
Rate-sensitive $100 million Rate-sensitive $75 million
Fixed-rate 100 million Fixed-rate 125 million
What would happen to bank profits if the interest rates in the economy go down? Is there anything that you could do to keep your bank from being so vulnerable to interest rate movements?

Accepted Answer

The answer of Your bank has the following balance sheet:
Assets...

Question 9

-If interest rates rise by 5 percentage points, say, from 10 to 15 percent, bank profits (measured using basic gap analysis) will ________.

Accepted Answer

Basic gap analysis focuses on the difference between the dollar amount of a bank's rate-sensitive assets and the dollar amount of its rate-sensitive liabilities. If interest rates rise, and a bank has more rate-sensitive liabilities than assets, its net interest income, and thus profits, will decline. The specific amount of decline (e.g., $1.5 million) depends on the size of the gap and the magnitude of the interest rate change, but without specific figures on the bank's assets and liabilities, the exact calculation cannot be provided. However, the correct choice is the one that indicates a decline in profits, which aligns with the principles of gap analysis when liabilities are more rate-sensitive than assets.

Question 10

Off-balance sheet activities involving guarantees of securities and back-up credit lines ________.

Accepted Answer

Off-balance sheet activities involving guarantees of securities and back-up credit lines increase the risk a bank faces because it exposes the bank to potential losses if the borrower defaults on their obligation. Even though these activities are not recorded on a bank's balance sheet, they may still impact its financial well-being.

Question 11

When banks involved in trading activities attempt to outguess markets, they are ________.

Accepted Answer

When banks attempt to outguess markets, they are speculating.

Question 12

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

Accepted Answer

The maturity bucket approach to gap analysis involves dividing a bank's assets and liabilities into different maturity buckets and then measuring the sensitivity of the bank's profits to changes in interest rates by multiplying the gap (the difference between the interest-sensitive assets and liabilities) for several maturity subintervals times the change in the interest rate. This approach allows for a more detailed analysis of interest rate risk.

Question 13

All of the following are examples of off-balance sheet activities that generate fee income for banks except ________.

Accepted Answer

Selling negotiable CDs is actually an on-balance sheet activity as it involves the creation of an asset (the CD) on the bank's balance sheet. Foreign exchange trades, guaranteeing debt securities, and back-up lines of credit are all examples of off-balance sheet activities that generate fee income for banks.

Question 14

If the First National Bank has a gap equal to a negative $30 million, then a 5 percentage point increase in interest rates will cause profits to ________.

Accepted Answer

The answer of If the First National Bank has a...

Question 15

-Assuming that the average duration of its assets is five years, while the average duration of its liabilities is three years, then a 5 percentage point increase in interest rates will cause the net worth of First National to decline by ________ of the total original asset value.

Accepted Answer

The net worth decline can be calculated using the difference in duration of assets and liabilities multiplied by the change in interest rates. Here, the duration gap is 5 years (assets) - 3 years (liabilities) = 2 years. A 5 percentage point increase in interest rates would lead to a 2 years * 5% = 10% decline in net worth relative to the total original asset value.

Question 16

Which of the following is not an example of a backup line of credit?

Accepted Answer

Mortgages are not typically considered backup lines of credit. They are typically used to secure a specific loan, rather than serving as a backup source of funding. Loan commitments, overdraft privileges, and standby letters of credit are all examples of backup lines of credit, as they provide access to additional funds in case of unexpected expenses or cash flow issues.

Question 17

Duration analysis involves comparing the average duration of the bank's ________ to the average duration of its ________.

Accepted Answer

Duration analysis involves comparing the average duration of a bank's assets to the average duration of its liabilities to assess interest rate risk.

Question 18

-Assuming that the average duration of its assets is four years, while the average duration of its liabilities is three years, then a 5 percentage point increase in interest rates will cause the net worth of First National to ________ by ________ of the total original asset value.

Accepted Answer

The net worth of First National will decline because the duration of its assets is longer than the duration of its liabilities. This means that the value of its assets will decrease more than the value of its liabilities when interest rates increase. The difference in duration (4 years - 3 years = 1 year) multiplied by the change in interest rates (5 percentage points) gives a 5 percent decline in the total original asset value.

Question 19

If a bank's liabilities are more sensitive to interest rate movements than are its assets, then ________.

Accepted Answer

if a bank's liabilities are more sensitive to interest rate movements than are its assets, then an increase in interest rates will lead to an increase in the cost of funds for the bank since deposits that pay relatively low interest rates represent the bank's liabilities. As a result, this will reduce bank profits.

Question 20

-If interest rates rise by 5 percentage points, say from 10 to 15 percent, bank profits (measured using basic gap analysis) will ________.

Accepted Answer

Basic gap analysis assesses the difference between the amounts of rate-sensitive assets and rate-sensitive liabilities. If interest rates rise, and a bank has more rate-sensitive liabilities than assets, its net interest income, and thus profits, will decline. The specific amount (e.g., $0.5 million) would depend on the bank's exact gap and the size of the interest rate change.

Quiz 12: Banking and the Management of Financial Institutions