Deck 10: Off-Balance Sheet Banking and Contingent Claims Products

Question 1

Which of the following statements is are) false?

A)A loan commitment is similar to a common stock put option in that a loan commitment buyer has the right to sell its indebtedness to the bank at a prespecified price over a prespecified time period.
B)Similar to a common stock put option, a loan commitment seller has the obligation to honor the contract when the buyer decides to exercise the commitment.
C)Common stock put options are transferable, while loan commitments are not.
D)Loan commitments can be partially exercised, while put options are either exercised in full or not at all.
E)All of the above is false

Answer 1

B

Question 2

The regulatory taxes argument suggests that the popularity of loan commitments is due to

A)the commitment buyer's tax advantage as a result of recording the loan interest at a lower rate.
B)the commitment seller's ability to generate fee revenue without having to fund it until later.
C)special tax treatment that applies to loan commitment.
D)all of the above
E)a and c only

Answer 2

B

Question 3

The following is are) disadvantages of a swap relative to an interest rate futures contract:

A)a swap contract is not a standardized contract
B)lower default risk with a swap
C)higher transaction costs due to the customer-specific nature of a swap
D)a and c only
E)all of the above

Answer 3

D

Question 4

The following contracts impose a contingent liability on the bank:

A)loan sales
B)options
C)standby letters of credit
D)all of the above
E)only b and c

Question 5

The seller of a loan commitment may be compensated by

A)a usage fee.
B)a commitment fee.
C)an interest rate spread between the contract rate and the spot rate at the time the commitment is taken down.
D)a and b only
E)a, b, and c are correct

Question 6

With a loan commitment agreement, the commitment seller is exposed to

A)the risk of lending to high-risk borrowers
B)the risk of lending at low margin
C)the risk that it may not be able to fund the commitment
D)all of the above
E)a and b only

Question 7

The following contracts do not necessarily impose a contingent liability on a bank;

A)loan sales
B)loan commitment
C)standby letters of credit
D)interest rate swaps
E)all of the above

Question 8

The risk sharing argument for the existence of loan commitments suggests that

A)borrowers are less risk averse than the banks and therefore are willing to buy loan commitments.
B)borrowers, who are more risk averse than the banks, pay the banks to bear part of the interest rate risk.
C)the credit risk of the borrowers can be lowered if the banks are willing to sell loan commitments than if the borrowers borrow in the spot market.
D)the borrowers would face less liquidity risk in the future if the banks are willing to sell loan commitments.
E)none of the above

Question 9

Suppose there are two banks, A and B.Bank A has an investment in fixed-rate 15-year mortgages which are financed by short-term funds whose rate is indexed to the T-Bill rate.Bank B holds 5-year floating-rate loans whose rate is indexed to the prime rate which are financed by 10-year fixed-rate bonds.They agree to structure the following swap: Bank A agrees to pay bank B the fixed-rate interest for ten years and bank B agrees to pay bank A the floating rate interest.Through this swap, the banks can reduce

A)liquidity risk since each bank will hold a more liquid investment after the swap.
B)credit risk since bank A is more specialized in fixed-rate loan while bank B is more specialized in floating-rate loan
C)interest rate risk since each bank is exposed to changes in future interest rates
D)a and b only
E)all of the above

Question 10

The reputation and contractual discretion argument suggests that the banks have an incentives to sell loan commitments because

A)the contract contains "escape" clauses that allow the banks to change the contract terms in order to maintain their good reputation.
B)for banks with high reputational capital, the contract allows the banks to charged higher prices for future loan commitments
C)the contract allows the banks not to honor the commitment due to the "escape" clauses and therefore can conserve the scarce financial capital
D)b and c only
E)all of the above

Question 11

Which of the following statements is are) false about standby letters of credit?

A)They are often used in international trade to facilitate transactions involving a seller with insufficient knowledge of the creditworthiness of the buyer.
B)They are used by banks as credit enhancements for securitizations in a nervous market.
C)They are a performance guarantor of an account party but do not involve a funding transaction.
D)Similar to loan commitments, they contain a MAC clause.
E)None of the above

Question 12

A loan commitment

A)gives its seller the right to lend a prespecified amount to a prespecified customer at prespecified terms.
B)obligates its seller to lend a prespecified amount to a prespecified customer at prespecified terms.
C)gives its buyer the flexibility of renegotiating a loan contract with its seller.
D)only a and c
E)only b and c

Question 13

A fixed rate loan commitment

A)gives its seller the right to change an adjustable rate contract to a fixed rate contract.
B)gives its buyer the right to borrow at a fixed rate which is known in advance.
C)protects its buyer from interest rate uncertainty.
D)protects its seller from interest rate uncertainty.
E)both b and c

Question 14

Relative to debt refinancing, a swap has the following advantages):

A)a swap has less disclosure requirements
B)a swap has lower transaction costs
C)a swap provides a better hedge against interest rate risk
D)all of the above
E)a and b only

Question 15

Regulators consider standby letters of credit to be the riskiest of all contingent claims offered by banks because

A)a standby letter of credit is exposed to a high degree of interest rate risk.
B)a standby letter of credit guarantees performance even in the event of a default.
C)a standby letter of credit is usually unsecured.
D)b and c only
E)all of the above

Question 16

As an instrument to hedge interest rate risk, a swap has the following advantages) over an interest rate futures contract:

A)with a swap, one need not worry about the cross-hedging risk.
B)swap can be tailored to suit the customer's needs.
C)swap requires less disclosure.
D)swap has lower default risk.
E)a and b only

Question 17

Loan commitments may be effective in mitigating moral hazard because

A)the borrowers are required to post highly-valued collateral.
B)the bank offers low enough interest rate to induce borrowers not to take on riskier projects and the banks are compensated by a commitment fee at the time the commitment is sold.
C)the borrowers view the commitment fee as a sunk cost in deciding what projects to undertake.
D)a and c.
E)b and c.

Question 18

A variable rate loan commitment

A)normally stipulates a borrowing rate based on an index rate.
B)provides as much interest rate insurance as a fixed rate loan commitment.
C)gives its seller the right to change the pre-specified interest rate to reflect the prevailing interest rate.
D)gives its buyer the right to change from a fixed rate contract to a variable rate contract
E)all of the above

Question 19

The "general nervous clause" in a loan commitment contract

A)allows the bank to change the loan contract rate to reflect changes in the interest rate environment in order to break even.
B)allows the bank to change from a fixed rate to a variable rate contract and vice versa.
C)allows the bank not to honor the commitment when the customer's financial condition has materially deteriorated between the time the contract was sold and the time the customer can exercise it.
D)all of the above
E)a and c only

Question 20

Which of the following is are) the demand-side explanations for the existence of loan commitments?

A)regulatory taxes
B)protection against future credit rationing
C)liquidity guarantors for suppliers
D)b and c
E)all of the above

Question 21

Use the following information for questions
The Merriweather Industries has an investment opportunity which requires $200 at t = 1 and will pay off at t = 2.At t = 0 it is uncertain about the probability distribution of the random payoff of the project since the payoff depends on a state of nature which will be revealed privately to the management at t = 1 before making a decision to invest in the project.At t = 0, the firm has a belief that there is an equal probability that the state will be good or bad at t= 2.In the good state, the project will pay off $450 with probability 0.8 and zero with probability 0.2.In the bad state, the project will pay off $300 with probability 0.8 and zero with probability 0.2.At t = 0, the firm needs raw materials supplies of $40 from a supplier who agrees to extend a trade credit so that the firm pays back the $40 plus the agreed-upon interest at t = 2.It is known at t = 0 that the interest rate between t = 1 and t = 2 will be 8%.Moreover, the time between t = 0 and t = 1 is so short so that discounting can be ignored.Jim Merriweather, the CEO, suffers a personal cost of $10 to initiate the project.The firm has two alternatives: borrow $200 in the spot market after learning the state of nature, or purchase a loan commitment at t = 0 prior to knowing the state of nature) which would entitle it to borrow $200 at t = 1.Everybody is risk neutral, and the bank and trade creditors provide credit at a competitive term.
Suppose that the trade creditors assume that the project will be undertaken only if the good state is revealed you charge 35% rate to break-even), what is the firm's total repayment obligation?

A)$378
B)$324
C)$270
D)$108
E)$54

Question 22

Use the following information for questions
The Merriweather Industries has an investment opportunity which requires $200 at t = 1 and will pay off at t = 2.At t = 0 it is uncertain about the probability distribution of the random payoff of the project since the payoff depends on a state of nature which will be revealed privately to the management at t = 1 before making a decision to invest in the project.At t = 0, the firm has a belief that there is an equal probability that the state will be good or bad at t= 2.In the good state, the project will pay off $450 with probability 0.8 and zero with probability 0.2.In the bad state, the project will pay off $300 with probability 0.8 and zero with probability 0.2.At t = 0, the firm needs raw materials supplies of $40 from a supplier who agrees to extend a trade credit so that the firm pays back the $40 plus the agreed-upon interest at t = 2.It is known at t = 0 that the interest rate between t = 1 and t = 2 will be 8%.Moreover, the time between t = 0 and t = 1 is so short so that discounting can be ignored.Jim Merriweather, the CEO, suffers a personal cost of $10 to initiate the project.The firm has two alternatives: borrow $200 in the spot market after learning the state of nature, or purchase a loan commitment at t = 0 prior to knowing the state of nature) which would entitle it to borrow $200 at t = 1.Everybody is risk neutral, and the bank and trade creditors provide credit at a competitive term.
Assuming that your bank charges 35% interest while the trade creditors charge 170%, what is the firm's NPV at t = 0 before the state is realized)?

A)$43.33
B)$30.42
C)$21.67
D)$18.56
E)-$27.78

Question 23

Use the following information for questions
The Trekkie Fashion knows at t = 0 that it will have at t = 1 a risky investment opportunity.There are two mutually exclusive projects, A and B, each requiring a $105 investment.If A is undertaken at t = 1, it will generate $160 with probability 0.8 and zero with probability 0.2 at t= 2.If B is undertaken, it will generate $165 with probability 0.6 and zero with probability 0.4 at t = 2.The firm approaches your bank for a $105 loan.Your bank cannot observe the firm's project choice.The riskless single-period interest rate is 8% at t = 0.At t = 0, it is not known what the riskless interest rate at t = 1 will be, but it is common knowledge that this rate can be 4% or 12% with equal probability.The projects are the only assets the firm has, and everybody is risk-neutral.The Trekkie Fashion has two choices: it can wait until t = 1 and borrow in the spot market, or it can purchase a loan commitment from your bank at t = 0 for a predetermined term at t = 1.The loan market is competitive.
Suppose that the interest at t = 1 is 4% and you assume that B will be chosen, what is the firm' NPV if A is chosen instead?

A)-$28.80
B)-$17.60
C)-$10.20
D)$10.40
E)$17.10

Question 24

Use the following information for questions
The Merriweather Industries has an investment opportunity which requires $200 at t = 1 and will pay off at t = 2.At t = 0 it is uncertain about the probability distribution of the random payoff of the project since the payoff depends on a state of nature which will be revealed privately to the management at t = 1 before making a decision to invest in the project.At t = 0, the firm has a belief that there is an equal probability that the state will be good or bad at t= 2.In the good state, the project will pay off $450 with probability 0.8 and zero with probability 0.2.In the bad state, the project will pay off $300 with probability 0.8 and zero with probability 0.2.At t = 0, the firm needs raw materials supplies of $40 from a supplier who agrees to extend a trade credit so that the firm pays back the $40 plus the agreed-upon interest at t = 2.It is known at t = 0 that the interest rate between t = 1 and t = 2 will be 8%.Moreover, the time between t = 0 and t = 1 is so short so that discounting can be ignored.Jim Merriweather, the CEO, suffers a personal cost of $10 to initiate the project.The firm has two alternatives: borrow $200 in the spot market after learning the state of nature, or purchase a loan commitment at t = 0 prior to knowing the state of nature) which would entitle it to borrow $200 at t = 1.Everybody is risk neutral, and the bank and trade creditors provide credit at a competitive term.
As a bank lending officer, what interest rate should you charge in order to break-even?

A)8%
B)15%
C)25%
D)35%
E)45%

Question 25

Use the following information for questions
The Trekkie Fashion knows at t = 0 that it will have at t = 1 a risky investment opportunity.There are two mutually exclusive projects, A and B, each requiring a $105 investment.If A is undertaken at t = 1, it will generate $160 with probability 0.8 and zero with probability 0.2 at t= 2.If B is undertaken, it will generate $165 with probability 0.6 and zero with probability 0.4 at t = 2.The firm approaches your bank for a $105 loan.Your bank cannot observe the firm's project choice.The riskless single-period interest rate is 8% at t = 0.At t = 0, it is not known what the riskless interest rate at t = 1 will be, but it is common knowledge that this rate can be 4% or 12% with equal probability.The projects are the only assets the firm has, and everybody is risk-neutral.The Trekkie Fashion has two choices: it can wait until t = 1 and borrow in the spot market, or it can purchase a loan commitment from your bank at t = 0 for a predetermined term at t = 1.The loan market is competitive.
Suppose that the bank assumes that A will be chosen and that the interest rate at t = 1 is 12%, what is the firm's NPV if project B is chosen?

A)$18.80
B)$17.10
C)$10.80
D)$10.40
E)-$17.60

Question 26

Explain how a loan commitment is isomorphic to a common stock put option.How is it different?

Question 27

Use the following information for questions
The Merriweather Industries has an investment opportunity which requires $200 at t = 1 and will pay off at t = 2.At t = 0 it is uncertain about the probability distribution of the random payoff of the project since the payoff depends on a state of nature which will be revealed privately to the management at t = 1 before making a decision to invest in the project.At t = 0, the firm has a belief that there is an equal probability that the state will be good or bad at t= 2.In the good state, the project will pay off $450 with probability 0.8 and zero with probability 0.2.In the bad state, the project will pay off $300 with probability 0.8 and zero with probability 0.2.At t = 0, the firm needs raw materials supplies of $40 from a supplier who agrees to extend a trade credit so that the firm pays back the $40 plus the agreed-upon interest at t = 2.It is known at t = 0 that the interest rate between t = 1 and t = 2 will be 8%.Moreover, the time between t = 0 and t = 1 is so short so that discounting can be ignored.Jim Merriweather, the CEO, suffers a personal cost of $10 to initiate the project.The firm has two alternatives: borrow $200 in the spot market after learning the state of nature, or purchase a loan commitment at t = 0 prior to knowing the state of nature) which would entitle it to borrow $200 at t = 1.Everybody is risk neutral, and the bank and trade creditors provide credit at a competitive term.
Assuming a loan commitment rate of 8% and the trade creditors charge 35%, what is the firm's NPV in the bad state at t = 1)?

A)$132.33
B)$27.78
C)$21.22
D)$12.22
E)-$9.88

Question 28

Use the following information for questions
The Merriweather Industries has an investment opportunity which requires $200 at t = 1 and will pay off at t = 2.At t = 0 it is uncertain about the probability distribution of the random payoff of the project since the payoff depends on a state of nature which will be revealed privately to the management at t = 1 before making a decision to invest in the project.At t = 0, the firm has a belief that there is an equal probability that the state will be good or bad at t= 2.In the good state, the project will pay off $450 with probability 0.8 and zero with probability 0.2.In the bad state, the project will pay off $300 with probability 0.8 and zero with probability 0.2.At t = 0, the firm needs raw materials supplies of $40 from a supplier who agrees to extend a trade credit so that the firm pays back the $40 plus the agreed-upon interest at t = 2.It is known at t = 0 that the interest rate between t = 1 and t = 2 will be 8%.Moreover, the time between t = 0 and t = 1 is so short so that discounting can be ignored.Jim Merriweather, the CEO, suffers a personal cost of $10 to initiate the project.The firm has two alternatives: borrow $200 in the spot market after learning the state of nature, or purchase a loan commitment at t = 0 prior to knowing the state of nature) which would entitle it to borrow $200 at t = 1.Everybody is risk neutral, and the bank and trade creditors provide credit at a competitive term.
Suppose you offer a loan commitment at 8%.What is the loan commitment fee?

A)$54
B)$40
C)$32
D)$16
E)$10

Question 29

Use the following information for questions
The Trekkie Fashion knows at t = 0 that it will have at t = 1 a risky investment opportunity.There are two mutually exclusive projects, A and B, each requiring a $105 investment.If A is undertaken at t = 1, it will generate $160 with probability 0.8 and zero with probability 0.2 at t= 2.If B is undertaken, it will generate $165 with probability 0.6 and zero with probability 0.4 at t = 2.The firm approaches your bank for a $105 loan.Your bank cannot observe the firm's project choice.The riskless single-period interest rate is 8% at t = 0.At t = 0, it is not known what the riskless interest rate at t = 1 will be, but it is common knowledge that this rate can be 4% or 12% with equal probability.The projects are the only assets the firm has, and everybody is risk-neutral.The Trekkie Fashion has two choices: it can wait until t = 1 and borrow in the spot market, or it can purchase a loan commitment from your bank at t = 0 for a predetermined term at t = 1.The loan market is competitive.
Suppose that your bank offers a loan commitment at an interest rate of 30%.How much should you charge the firm for a commitment fee?

A)$10.50
B)$8.40
C)$3.47
D)$2.38
E)$1.67

Question 30

Use the following information for questions
The Trekkie Fashion knows at t = 0 that it will have at t = 1 a risky investment opportunity.There are two mutually exclusive projects, A and B, each requiring a $105 investment.If A is undertaken at t = 1, it will generate $160 with probability 0.8 and zero with probability 0.2 at t= 2.If B is undertaken, it will generate $165 with probability 0.6 and zero with probability 0.4 at t = 2.The firm approaches your bank for a $105 loan.Your bank cannot observe the firm's project choice.The riskless single-period interest rate is 8% at t = 0.At t = 0, it is not known what the riskless interest rate at t = 1 will be, but it is common knowledge that this rate can be 4% or 12% with equal probability.The projects are the only assets the firm has, and everybody is risk-neutral.The Trekkie Fashion has two choices: it can wait until t = 1 and borrow in the spot market, or it can purchase a loan commitment from your bank at t = 0 for a predetermined term at t = 1.The loan market is competitive.
Assuming a loan commitment rate of 30%, which option should the firm choose?

A)Spot market since its NPV under the spot market arrangement is $3.50 higher than under the loan commitment.
B)Spot market since its NPV under the spot market arrangement is $4.30 higher than under the loan commitment.
C)Loan commitment since its NPV under the loan commitment contract is $12.67 higher than under the spot market arrangement.
D)Loan commitment since its NPV under the loan commitment contract is $8.37 higher than under the spot market arrangement.
E)Loan commitment since its NPV under the loan commitment contract is $4.30 higher than under the spot market arrangement.

Question 31

Use the following information for questions
The Merriweather Industries has an investment opportunity which requires $200 at t = 1 and will pay off at t = 2.At t = 0 it is uncertain about the probability distribution of the random payoff of the project since the payoff depends on a state of nature which will be revealed privately to the management at t = 1 before making a decision to invest in the project.At t = 0, the firm has a belief that there is an equal probability that the state will be good or bad at t= 2.In the good state, the project will pay off $450 with probability 0.8 and zero with probability 0.2.In the bad state, the project will pay off $300 with probability 0.8 and zero with probability 0.2.At t = 0, the firm needs raw materials supplies of $40 from a supplier who agrees to extend a trade credit so that the firm pays back the $40 plus the agreed-upon interest at t = 2.It is known at t = 0 that the interest rate between t = 1 and t = 2 will be 8%.Moreover, the time between t = 0 and t = 1 is so short so that discounting can be ignored.Jim Merriweather, the CEO, suffers a personal cost of $10 to initiate the project.The firm has two alternatives: borrow $200 in the spot market after learning the state of nature, or purchase a loan commitment at t = 0 prior to knowing the state of nature) which would entitle it to borrow $200 at t = 1.Everybody is risk neutral, and the bank and trade creditors provide credit at a competitive term.
Assuming that the break-even interest rate is 35%, will the firm undertake the project when the bad state is revealed?

A)Yes, the NPV = $52.33
B)Yes, the NPV = $26.17
C)No, the NPV = -$16.77
D)No, the NPV = -$10
E)No, the NPV = -$1

Question 32

Use the following information for questions
The Merriweather Industries has an investment opportunity which requires $200 at t = 1 and will pay off at t = 2.At t = 0 it is uncertain about the probability distribution of the random payoff of the project since the payoff depends on a state of nature which will be revealed privately to the management at t = 1 before making a decision to invest in the project.At t = 0, the firm has a belief that there is an equal probability that the state will be good or bad at t= 2.In the good state, the project will pay off $450 with probability 0.8 and zero with probability 0.2.In the bad state, the project will pay off $300 with probability 0.8 and zero with probability 0.2.At t = 0, the firm needs raw materials supplies of $40 from a supplier who agrees to extend a trade credit so that the firm pays back the $40 plus the agreed-upon interest at t = 2.It is known at t = 0 that the interest rate between t = 1 and t = 2 will be 8%.Moreover, the time between t = 0 and t = 1 is so short so that discounting can be ignored.Jim Merriweather, the CEO, suffers a personal cost of $10 to initiate the project.The firm has two alternatives: borrow $200 in the spot market after learning the state of nature, or purchase a loan commitment at t = 0 prior to knowing the state of nature) which would entitle it to borrow $200 at t = 1.Everybody is risk neutral, and the bank and trade creditors provide credit at a competitive term.
Assuming that the break-even interest rate is 35%, what is the firm's NPV in the good state net of the CEO's personal cost)?

A)$270.00
B)$83.33
C)$52.33
D)$26.17
E)-$10

Question 33

Use the following information for questions
The Trekkie Fashion knows at t = 0 that it will have at t = 1 a risky investment opportunity.There are two mutually exclusive projects, A and B, each requiring a $105 investment.If A is undertaken at t = 1, it will generate $160 with probability 0.8 and zero with probability 0.2 at t= 2.If B is undertaken, it will generate $165 with probability 0.6 and zero with probability 0.4 at t = 2.The firm approaches your bank for a $105 loan.Your bank cannot observe the firm's project choice.The riskless single-period interest rate is 8% at t = 0.At t = 0, it is not known what the riskless interest rate at t = 1 will be, but it is common knowledge that this rate can be 4% or 12% with equal probability.The projects are the only assets the firm has, and everybody is risk-neutral.The Trekkie Fashion has two choices: it can wait until t = 1 and borrow in the spot market, or it can purchase a loan commitment from your bank at t = 0 for a predetermined term at t = 1.The loan market is competitive.
Suppose that the interest rate at t = 1 is 12% and assuming that project B will be chosen, what interest rate should you charge to break-even under the spot market borrowing alternative?

A)35.67%
B)44.67%
C)73.33%
D)86.67%
E)120.33%

Question 34

Use the following information for questions
The Trekkie Fashion knows at t = 0 that it will have at t = 1 a risky investment opportunity.There are two mutually exclusive projects, A and B, each requiring a $105 investment.If A is undertaken at t = 1, it will generate $160 with probability 0.8 and zero with probability 0.2 at t= 2.If B is undertaken, it will generate $165 with probability 0.6 and zero with probability 0.4 at t = 2.The firm approaches your bank for a $105 loan.Your bank cannot observe the firm's project choice.The riskless single-period interest rate is 8% at t = 0.At t = 0, it is not known what the riskless interest rate at t = 1 will be, but it is common knowledge that this rate can be 4% or 12% with equal probability.The projects are the only assets the firm has, and everybody is risk-neutral.The Trekkie Fashion has two choices: it can wait until t = 1 and borrow in the spot market, or it can purchase a loan commitment from your bank at t = 0 for a predetermined term at t = 1.The loan market is competitive.
Assuming that the borrower will choose project A under the spot market borrowing alternative, what interest rate should you charge to break-even when the interest rate at t = 1 is 4%?

A)8%
B)12%
C)20%
D)30%
E)35%