BF 826 MID-TERM EXAMINATION

NAME: ______________________________

1. In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?

The funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI.

2. What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?

First, FIs collect and process information more efficiently than individual savers. Second, FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds. Third, by diversifying the asset base FIs provide secondary securities with lower price-risk conditions than primary securities. Fourth, FIs provide economies of scale in transaction costs because assets are purchased in larger amounts. Finally, FIs provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with short-term deposits.

3. What factors have caused the decrease in loan volume relative to other assets on the balance sheets of commercial banks? How has each of these factors been related to the change and development of the financial services industry during the 1990s and early 2000s? What strategic changes have banks implemented to deal with changes in the financial services environment?

Corporations have utilized the commercial paper markets with increased frequency rather than borrow from banks. In addition, many banks have sold loan packages directly into the capital markets (securitization) as a method to reduce balance sheet risks and to improve liquidity. Finally, the decrease in loan volume during the early 1990s was due in part to the recession in the economy.

As deregulation of the financial services industry continued during the 1990s, the position of banks as the primary financial services provider continued to erode. Banks of

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BF 826 MID-TERM EXAMINATION

NAME: ______________________________all sizes have increased the use of off-balance sheet activities in an effort to generate additional fee income. Letters of credit, futures, options, swaps and other derivative products are not reflected on the balance sheet, but do provide fee income for the banks.

4. How does the liability maturity structure of a bank’s balance sheet compare with the maturity structure of the asset portfolio? What risks are created or intensified by these differences?

Deposit and non-deposit liabilities tend to have shorter maturities than assets such as loans. The maturity mismatch creates varying degrees of interest rate risk and liquidity risk.

5. Contrast the balance sheet of a life insurance company with the balance sheet of a commercial bank and that of a savings association. Explain the balance sheet differences in terms of the differences in the primary functions of the three organizations.

Life insurance companies have long-term liabilities because of the life insurance products that they sell. As a result, the asset side of the balance sheet predominantly includes long-term government and corporate bonds, corporate equities, and a declining amount of mortgage products. The asset side of a commercial bank’s balance sheet is comprised primarily of short- and medium-term loans to corporations and individuals and some treasury securities. The principal asset category for a savings association is long-term mortgages.

In effect, all three companies use large degrees of financial leverage to fund assets that primarily consist of debt securities. While the face value of deposits is fixed for banks and savings associations, the composition of liabilities for insurance companies is stochastic. The primary liability category for a life insurance company is policy reserves that reflect the expected payment commitments on existing policy contracts. Insurance companies also sell short- and medium-term debt instruments called GICs that are used to fund their pension plan business. The liabilities of savings associations are primarily short-term deposit accounts, while banks utilize short-term deposits and short-term borrowed funds, depending on the size of the bank.

6. How would the balance sheet of a life insurance company change if it offered to run a private pension fund to another company?

The primary change in the balance sheet of a life insurance company would be an increase in the liability accounts that reflect these pension plans. Guaranteed investment contracts (GICs) and separate account categories likely would increase, depending on the

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BF 826 MID-TERM EXAMINATION

NAME: ______________________________type of pension plans provided to the customers. The premiums and contributions would be invested in the normal asset categories of the insurance company, except in cases where the pension fund requires aggressive investment strategies. In this case, the funds may be invested in specific equity mutual funds.

7. This legislation separated commercial and investment banking:Glass-Steagal act of 1933

8. Insurance companies will charge a higher premium for which of the insurance lines listed below? Why?

a.Low-severity, high-frequency lines versus high-severity, low-frequency lines.

Insurance companies have a more difficult time predicting the severity of losses for high- severity low-frequency lines of business, such as earthquakes and hurricanes. In addition, these catastrophic events cause severe damage, meaning the individual risks in the insured pool are not independent. As a result, premiums for high-severity low-frequency lines will be charged higher premiums than low-severity high-frequency lines.

b. Long-tail versus short-tail lines.

Similarly, losses in long-tail lines of business are harder to predict than in short-tail lines, because claims can be made years after the premiums have been made. Thus, premiums in this category of business will be higher. Modern day examples of such lines include coverage for product liabilities, such as exposure to asbestos or chemicals like agent-orange.

9. In what ways have changes in the investment banking industry mirrored changes in the commercial banking industry?

First, both industries have seen a concentration of business among the larger firms. This concentration has occurred primarily through the merger and acquisition activities of several of the largest firms. Second, firms in both industries tend to be divided along product line services provided to customers. Some national full-line firms provide service to both retail customers, in the form of brokerage services, and corporate customers, in the form of new issue underwriting. Other national full-line firms specialize in corporate finance and security trading activities. Third, the remaining firms specialize in more limited activities such as discount brokerage, regional full service retail activities, etc. This business line division is not dissimilar to that of the banking

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BF 826 MID-TERM EXAMINATION

NAME: ______________________________industry with money center banks, regional banks, and community banks. Clearly product line overlap occurs between the different firm divisions in each industry.

10. What are the seven key activity areas for securities firms? How does each activity area assist in the generation of profits, and what are the major risks for each area?

The seven major activity areas of security firms are:

a) Investing: Securities firms act as agents for individuals with funds to invest by establishing and managing mutual funds and by managing pension funds. The securities firms generate fees that affect directly the revenue stream of the companies.

b) Investment Banking: Investment banks specialize in underwriting and distributing both debt and equity issues in the corporate market. New issues can be placed either privately or publicly and can represent either a first issued (IPO) or a secondary issue. Secondary issues of seasoned firms typically will generate lower fees than an IPO. In a private offering the investment bank receives a fee for acting as the agent in the transaction. In best-efforts public offerings, the firm acts as the agent and receives a fee based on the success of the offering. The firm serves as a principal by actually takes ownership of the securities in a firm commitment underwriting. Thus the risk of loss is higher. Finally, the firm may perform similar functions in the government markets and the asset-backed derivative markets. In all cases, the investment bank receives fees related to the difficulty and risk in placing the issue.

c) Market Making: Security firms assist in the market-making function by acting as brokers to assist customers in the purchase or sale of an asset. In this capacity the firms are providing agency transactions for a fee. Security firms also take inventory positions in assets in an effort to profit on the price movements of the securities. These principal positions can be profitable if prices increase, but they can also create downside risk in volatile markets.

d) Trading: Trading activities can be conducted on behalf of a customer or the firm. The activities usually involve position trading, pure arbitrage, risk arbitrage, and program trading. Position trading involves the purchase of large blocks of stock to facilitate the smooth functioning of the market. Pure arbitrage involves the purchase and simultaneous sale of an

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BF 826 MID-TERM EXAMINATION

NAME: ______________________________

asset in different markets because of different prices in the two markets. Risk arbitrage involves establishing positions prior to some anticipated information release or event. Program trading involves positioning with the aid of computers and futures contracts to benefit from small market movements. In each case, the potential risk involves the movements of the asset prices, and the benefits are aided by the lack of most transaction costs and the immediate information that is available to investment banks.

e) Cash Management: Cash management accounts are checking accounts that earn interest and may be covered by FDIC insurance. The accounts have been beneficial in providing full-service financial products to customers, especially at the retail level.

f) Mergers and Acquisitions: Most investment banks provide advice to corporate clients who are involved in mergers and acquisitions. This activity has been extremely beneficial from a fee standpoint during the 1990s.

g) Back-Office Service Functions: Security firms offer clearing and settlement services, research and information services, and other brokerage services on a fee basis.

11. What is the difference between a private-placement and a public offering?

A public offering represents the sale of a security to the public at large. A private placement involves the sale of securities to one or several large investors such as an insurance company or a pension fund.

12. What are the risk implications to the investment banker from underwriting on a best-efforts basis versus a firm commitment basis? If you operated a company issuing stock for the first time, which type of underwriting would you prefer? Why? What factors may cause you to choose the alternative?

In a best efforts underwriting, the investment banker acts as an agent of the company issuing the security and receives a fee based on the number of securities sold. With a firm commitment underwriting, the investment banker purchases the securities from the company at a negotiated price and sells them to the investing public at what it hopes will be a higher price. Thus the investment banker has greater risk with the firm commitment underwriting, since the investment banker will absorb any adverse price movements in the security before the entire issue is sold.

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BF 826 MID-TERM EXAMINATION

NAME: ______________________________Factors causing preference to the issuing firm include general volatility in the market, stability and maturity of the financial health of the issuing firm, and the perceived appetite for new issues in the market place. The investment bank will also consider these factors when negotiating the fees and/or pricing spread in making its decision regarding the offering process.

13. Closed-end investment companies A) have a fixed number of shares. B) can trade at a price that is greater than, equal to, or less than the NAV. C) will trade at a different price as the number of shares of the fund changes. D) a and c above. E) a and b above.

14. What is the primary function of finance companies? How do finance companies differ from commercial banks?

The primary function of finance companies is to make loans to individuals and corporations. Finance companies do not accept deposits, but borrow short- and long-term debt, such as commercial paper and bonds, to finance the loans. The heavy reliance on borrowed money has caused finance companies to hold more equity than banks for the purpose of signaling solvency to potential creditors. Finally, finance companies are less regulated than commercial banks, in part because they do not rely on deposits as a source of funds.

15. How do finance companies make money? What risks does this process entail? How do these risks differ for a finance company versus a commercial bank?

Finance companies make a profit by borrowing money at a rate lower than the rate at which they lend. This is similar to a commercial bank, with the primary difference being the source of funds, principally deposits for a bank and money and capital market borrowing for a finance company. The principal risk in relying heavily on commercial paper as a source of financing involves the continued depth of the commercial paper market. Economic recessions may affect this market more severely than the effect on deposit drains in the commercial banking sector. In addition, the riskier asset customers may have a greater impact on the finance companies.

16. Section 20 subsidiaries of commercial banks are special because A) they are allowed to trade securities for individual customers.

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BF 826 MID-TERM EXAMINATION

NAME: ______________________________

B) they are allowed to offer cash management services to customers. C) they are allowed to provide securities underwriting services to corporate

customers. D) they can only provide services which are not prohibited by the Glass-Steagal

Act. E) More than one of the above are true.

17. The net asset value of a mutual fund is A) determined by the marking-to-market process. B) found by dividing the cumulative value of all asset positions held by the fund

by the total number of asset shares held by the fund. C) found by dividing the cumulative value of all asset positions held by the fund

by the total number of shares in the fund. D) a and c above. E) a and b above.

18. Consider a no-load mutual fund with $200 million in assets and 10 million shares at the start of the year, and $250 million in assets and 11 million shares at the end of the year. During the year investors have received income distributions of $2 per share, and capital gains distributions of $0.25 per share. Assuming that the fund carries no debt, and that the total expense ratio is 1%, what is the rate of return on the fund? A) 36.25% B) 24.85% C) 23.85% D) There is not sufficient information to answer this question

Answer: B Difficulty: Medium (2.72+2+.25)/ 20.00 = 14.85%

19. A bank invested $50 million in a two-year asset paying 10 percent interest per annum and simultaneously issued a $50 million, one-year liability paying 8 percent interest per annum. What will be the bank’s net interest income each year if at the end of the first year all interest rates have increased by 1 percent (100 basis points)?

Net interest income is not affected in the first year, but NII will decrease in the second year.

Year 1 Year 2Interest income $5,000,000 $5,000,000Interest expense $4,000,000 $4,500,000Net interest income $1,000,000 $500,000

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BF 826 MID-TERM EXAMINATION

NAME: ______________________________

20. What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?

Credit risk is the possibility that promised cash flows may not occur or may only partially occur. FIs that lend money for long periods of time, whether as loans or by buying bonds, are more susceptible to this risk than those FIs that have short investment horizons. For example, life insurance companies and depository institutions generally must wait a longer time for returns to be realized than money market mutual funds and property-casualty insurance companies.

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