Question 1

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

Accepted Answer

When interest rates are expected to rise, the value of existing bonds falls, since new bonds will offer higher yields. Therefore, bankers prefer to buy short-term bonds, which will mature sooner, allowing them to reinvest the principal at the higher rates sooner than they would be able to with long-term bonds.

Question 2

Banks earn profits from off-balance sheet loan sales

Accepted Answer

The answer of Banks earn profits from off-balance sheet loan...

Question 3

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

Accepted Answer

Mortgages are not considered a backup line of credit as they serve as a primary loan for purchasing a property, rather than as a backup source of funds in case of unforeseen circumstances. Loan commitments, overdraft privileges, and standby letters of credit are all examples of backup lines of credit as they provide access to additional funds if needed.

Question 4

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

Accepted Answer

When banks involved in trading activities attempt to outguess markets, they are engaging in speculation, which involves taking on risky positions in the hopes of earning a profit from changes in market prices. Forecasting involves using data and analysis to make predictions about future market trends, diversifying involves spreading investments across a range of assets to manage risk, and riskless arbitrage involves exploiting price discrepancies in different markets to guarantee a profit.

Question 5

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

Bruce can reduce interest rate risk by either shortening the duration of the bank's assets to increase their rate sensitivity or by lengthening the duration of the bank's liabilities. Shortening the duration of assets will make them less vulnerable to interest rate fluctuations, while lengthening the duration of liabilities will give the bank more time to adjust to changes in interest rates. Therefore, option A is the best choice as it provides both possible solutions.

Question 6

Examples of off-balance-sheet activities include

Accepted Answer

Off-balance-sheet activities refer to any financial activities that are not reported on a company's balance sheet. Trading activities are considered off-balance-sheet activities as they involve buying and selling financial instruments such as stocks, bonds, and derivatives, which do not appear on a company's balance sheet. The extension of loans to depositors, borrowing from other banks, and selling negotiable CDs are all examples of on-balance-sheet activities as they involve the creation of assets and liabilities that are recorded on a company's balance sheet.

Question 7

A reason why rogue traders have bankrupt their banks is due to

Accepted Answer

Rogue traders are able to exploit weaknesses in a bank's internal controls, which are designed to prevent unauthorized trading activity, fraudulent behavior, and accounting errors. When these fail, the losses can be significant enough to bankrupt the bank. Therefore, a failure to maintain proper internal controls is the best answer. Choices A and B are actually measures that could prevent rogue trading from happening in the first place, while choice C refers more to unintentional accounting errors, rather than intentional actions by rogue traders.

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

The principal-agent problem that exists for bank trading activities can be reduced through

Accepted Answer

The principal-agent problem arises when one entity, the principal, hires another entity, the agent, to perform a task on its behalf. The agent may have incentives that are not aligned with the principal's interests, leading to moral hazard and adverse selection problems. In the context of bank trading activities, the bank is the principal and the traders are the agents. The traders may take on excessive risk or engage in fraudulent activities to increase their own profits, which may not be in the best interests of the bank's shareholders or depositors.

To reduce the principal-agent problem for bank trading activities, it is important to create internal controls that separate trading activities from bookkeeping. This means that there should be independent oversight of trading activities, such as by a risk management or compliance department that is separate from the trading desk. This can help to ensure that trades are made in accordance with established policies and procedures, and that traders are not able to manipulate the books to hide losses or engage in unauthorized activities. By separating the functions of trading and bookkeeping, the bank can also reduce the risk of collusion between traders and other employees who may be responsible for recording trades and keeping track of the bank's overall financial position.

Question 10

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

Accepted Answer

Selling negotiable CDs is an on-balance sheet activity involving the sale of a bank's liabilities. 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 11

-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 12

Banks develop statistical models to calculate their maximum loss over a given time period.This approach is known as the

Accepted Answer

The approach described in the question, where statistical models are used to calculate maximum loss over a given time period, is known as the value-at-risk approach. Stress testing involves testing a bank's resilience to various scenarios, including extreme events. The trading-loss approach may refer to a specific approach used to calculate trading losses, but is not a commonly used term in the context of overall risk management. The doomsday approach is not a recognized term in risk management.

Question 13

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

Accepted Answer

Off-balance sheet activities such as guarantees of securities and back-up credit lines increase the risk a bank faces as they become liable to fulfill their obligations in case of default by the borrower. This potential liability is not reflected in the balance sheet, hence increasing the risk of the bank.

Question 14

Assume a bank has $200 million of assets with a duration of 2.5,and $190 million of liabilities with a duration of 1.05.If interest rates increase from 5 percent to 6 percent,the net worth of the bank falls by

Accepted Answer

The answer of Assume a bank has $200 million of...

Question 15

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 and loans that will appreciate in value as interest rates fall. This strategy will allow the bank to earn higher returns on its assets while its liabilities, such as deposits, earn lower interest rates. This will improve the bank's net interest margin and profitability.

Question 16

Assume a bank has $200 million of assets with a duration of 2.5,and $190 million of liabilities with a duration of 1.05.The duration gap for this bank is

Accepted Answer

Duration gap = (assets duration - liabilities duration)
Duration gap = (2.5 - 1.05)
Duration gap = 1.45 years

Therefore, the duration gap for this bank is 1.5 years. Option C is the correct answer.

Question 17

When banks calculate the losses the institution would incur if an unusual combination of bad events happened,the bank is using the ________ approach.

Accepted Answer

A stress-test is a risk management tool used by banks and financial institutions to evaluate the potential impact of adverse events on their financial health. In a stress-test, banks use various scenarios to model the effects of potential losses due to market volatility, credit risk, liquidity risk, and other factors. By subjecting their portfolios to different stress scenarios, banks can assess their resilience and adjust their risk management strategies accordingly. The purpose of stress-testing is to provide an early warning of potential vulnerabilities in the financial system and to ensure that banks are prepared for unexpected events. Neither B), C), nor D) accurately describe the approach used by banks to calculate potential losses.

Question 18

One way for banks to reduce the principal-agent problems associated with trading activities is to

Accepted Answer

Setting limits on the amount of a trader's transactions can help reduce the principal-agent problems associated with trading activities as it limits the amount of risk a trader can take on, reducing the potential for large losses that could be detrimental to the bank. This can also incentivize the trader to make more careful and informed decisions when conducting trades. The other options, such as allowing traders to have more flexibility in conducting trades or encouraging them to take on more risk, can actually increase the potential for principal-agent problems and increase the risk of losses for the bank. Having the person responsible for recording the transactions also does not necessarily address the issue of the trader taking on excessive risk.

Question 19

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 20

Traders working for banks are subject to the

Accepted Answer

Traders working for banks are subject to the principal-agent problem, which arises due to conflicts of interest between the trader (agent) and the bank (principal) they work for. The trader may act in their own self-interest rather than in the best interest of the bank, leading to potential losses for the bank.

Quiz 9: Banking and the Management of Financial Institutions