Fine 412 Final Exam Cards

Front 1

When business and household spending declines, the fed ______, whereas to slow down the economy they _______

Back 1

Stimulates the economy by reducing ST int rates, increases ST int rates

Front 2

Why do Financial institutes face unexpected risk when interest rates uenxpectedly rise?

Back 2

Int on ST liab. could outweigh ST assets, income from interest could be less than interest expense, wipes out owner's equity

Front 3

What are the bank's assets and bank's liabilities?

Back 3

Assets: ST Securities issued by Treasuries, ST loans made by bank to borrowing customers, variable rate loans made by bank to borrowing customers
Liabilities: Borrowings from money markets, ST savings accounts, money-market deposits

Front 4

What is Tier 1 capital?

Back 4

Amount originally paid to purchase shares of stock for the bank, retained profits minus accumulated losses, and other qualifiable Tier 1 capital securities,

Front 5

What is asset-liability management?

Back 5

Asset-liability management: Control a bank’s exposure to changes in market interest rates and limit its losses in its net income or equity

Front 6

The repricing model applies to _____, whereas the duration gap model applies to ________

Back 6

net income, owners equity

Front 7

How do you determine rate sensitive assets and liabilities in a given time period?

Back 7

1) It matures during the period and the funds will be rolled over into a new asset/liability
2) Financial instrument with a variable interest rate
a) The interest rate applied to the oustanding principal changes contractually during the period

Front 8

Give some examples of rate sensitive assets and liabilities

Back 8

Assets: T-bills- If you are currently invested in a t-bill which you hold to maturity. Just before maturity, say interest rates rise. Therefore, if you will reinvest in t-bills in an auction, you will be able to buy T-bills offering higher interest rates, or higher discount to face value.
Adjustable rate mortgages
Liabilities:
Commercial Paper
Issuance floating rate bonds

Front 9

What is the Repricing Model Formula?

Back 9

GAP= RSA- RSL
RSA: Rate sensitive assets
RSL: Rate sensitive liabilities

Front 10

What are the drawbacks of the repricing model?

Back 10

1) Ignores market value effects of interest rate changes
2) Only a ST measure of int rate exposure
3) Ignores effects of interest rate changes on rate insensitive assets/liabilities

Front 11

Describe the duration gap model

Back 11

1) Focus on market value of net worth change in response to int rate changes
2) When interest rates change, what is impact on market values of bank's total assets v. total liabilities
3) Asks the question: Is it possible to immunize market value of SHer equity?

Front 12

What are the steps in duration gap analysis?

Back 12

1) Forecast interest rates
2) Estimate the market value of bank assets, liabilities, and stockholder's equity
3) Estimate the weighted average duration of assets and the weighted average duration of liabilities
4) Forecast changes in the market value of stockholder's equity across different interest rate environments

Front 13

What is the formula for duration of an asset/liability portfolio?

Back 13

Da= Summation wi* Dai

Where wi= dollar amount of the ith aset divided by total liabilities
Dai= Macauley Duration of the ith asset/liability in the portfolio

Front 14

What is the leverage adjusted duration gap?

Back 14

Measures degree of mismatch in duration of assets and liabilities
Larger the absolute gap, higher the exposure to interest rate risk

Front 15

What do positive and negative duration gaps imply?

Back 15

Positive: Indicates assets are more sensitive to IR changes than liabilities, when IR fall, assets fall more proportionately in value than liabilities and equity will fall accordingly
Negative: Indicates liabilities are most IR sensitive than assets

Front 16

What are the problems with duration gap?

Back 16

Duration matching can be costly
Immunization is a dynamic problem
Large Interest Rate Changes
Correct duration gap analysis requires each future cash flow be discounted by a distinct discount rate
Banks may have limited flexibility in altering duration gap

Front 17

Define a derivative security

Back 17

Provides payoffs/ cash flows that are determined by the prices of other assets such as bond or other commodity prices

Front 18

Define a futures contract

Back 18

A contract that calls for the delivery of an asset at a specified future delivery date, for an agreed upon price called a futures price, to be paid on delivery

Front 19

What is the conversion factor in interest rate futures?

Back 19

Defines the price received by the party with the short position

Front 20

What are the two uses for futures contracts?

Back 20

1) Speculation: Use futures to profit from movements in futures prices
2) Hedging: Use futures to protect portfolios from adverse interest rate movements

Front 21

Describe a long futures hedge

Back 21

1) Undertaken to protect against a rise in cash price of a bond
2) Hedger usually needs to buy the asset in the future
3) Pension fund manager expecting huge cash flows in the future, worry is that dropping interest rates will make bond more expensive
4) Take long futures position. Make money. Use extra cash to buy more expensive bonds

Front 22

Describe a short futures hedge

Back 22

1) Used to protect against a decline in bond cash price
2) Hedger usually needs to sell an asset in the future
3) Take short futures position: Make money and no need to liquidate extra bonds from portfolio

Front 23

How do you find the number of contracts for a long or short hedge?

Back 23

Number of K's= PVBP of bond to be hedged/ PVBP of CTD

Front 24

Define an interest-rate swap

Back 24

Two parties agree to exchange periodic interest payments, between a fixed and variable stream of interest payments, based on predetermined dollar principal, called notional principal amount

Front 25

Define swap rate

Back 25

Swap rate is simply the fixed rate that makes the PV of all floating rate payments equal to PV of all fixed rate payments in the swap.

Front 26

What is contraction risk in regards to mortgage backed securities?

Back 26

Prepayment speed of MBS increases as interest rates fall, compresses duration of bond, decrease extent of bond price rise

Front 27

What is extension risk in regards to mortgage backed securities?

Back 27

Prepayment speed of MBS decreases as interest rates rise, extends duration of bond, increases extent of bond price rise