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   Business 171a                                                                     Professor Reza
   Spring 2008                                                             San Jose State University
                                            Final Examination

   Instructions and notes:
  I. Please put your name on BOTH the scantron and this exam. If your name is missing from either,
     you will receive ZERO on the exam – no exception and no changes afterwards.
 II. Please put your test version on the scantron. If the version is missing, your exam will be assigned
     a version at random and corrected; the result will not be changed.
III. This is a closed-book, closed-notes exam. Do not consult others. You may use only a calculator.
IV. There is one correct answer to each problem. Multiple answers receive zero point.
 V. Unless specified otherwise, approximations should be rounded to 2 places after the decimal.
     Unless specified otherwise, a debt security has a face (par) value of $1,000
VI. Unless specified otherwise, assume that
            a. investors maximize their net worth (i.e., they are “rational”) and firms maximize their
                 common shareholders’ net worth.
            b. all markets are efficient.
            c. firms are typical of the industry in which they operate.


F 1  iD
 =       ,              where F= forward forex rate (in $ per foreign currency)
S 1  iW
                                 S=Spot forex rate (in $ per foreign currency)
                                 iD = US interest rate
                                 iW= foreign interest rate

                   1       1 
PV of annuity = C             N 
                                     where C = regular periodic payment
                    i i(1  i) 
       i = the annual rate of interest
       N= the number of periods payments are made/received

               L
ΔE = - [DA -      DL] A Δr/(1+r) ; E = Equity; A =Assets; L = Liabilities; D = duration of A
               A
or L; r = interest rate; the term in the brackets [.] represents duration (or leverage-adjusted
duration) gap. Also ΔA = - DA A Δr/(1+r) and ΔL = - DL L Δr/(1+r).




1. Regarding interest rates on 3-month T-bills:
   (a) The current rate is around 8%-9% (mostly because of the sub-prime issue) , lower than any
       time in the past 25 years
   (b) The T-bill rate is always the same as the Fed funds rate
   (c) The current rate is around 1.5%-2.5%
   (d) The current rate is around 4%-5%, not much higher than at any time in the past 25 years



                                                                                                      1
2. The relationship between bond price and the rate of interest is best described by:
   (a) They move in the same directions and convex
   (b) They move in opposite directions and convex
   (c) They move in opposite directions along a straight line
   (d) None of the above

3. Consider the various influences on the overall market rate of interest.
   (a) When there is less willingness to borrow, interest rates tend to fall
   (b) When the risk of default by issuers of bonds rises, interest rates tend to rise
   (c) When the risk of default by issuers of bonds falls, interest rates tend to fall
   (d) Both (a) and (b)
   (e) Both (a) and (c)

4. Yield to maturity and the spot interest rate are the same.
   (a) True
   (b) False

5. Data suggest that in the recent past (say, the past 20-25 years)
   (a) Short-term interest rates have generally been less volatile than long-term rates
   (b) Short-term interest rates have generally been as volatile as long-term rates
   (c) Short-term interest rates have generally been more volatile than long-term rates

6. Consider two bonds A and B. Both have the same YTM and the same maturity. But A pays a
   coupon rate of 8% while B pays a coupon rate of 12%.
   (a) Without knowing the exact YTM we cannot determine the bonds’ durations
   (b) Without knowing the exact maturities we cannot determine the bonds’ durations
   (c) Bond A has the shorter duration
   (d) Bond B has the shorter duration

7. Everything else the same, if consumers find owning homes more attractive than before, the
   result would be a lower overall market rate of interest.
   (a) True
   (b) False

8. You check the newspaper and notice that yields on almost all corporate and Treasury bonds
   have increased. The yield increases may perhaps be explained by which one of the following
   (a) An decrease in current and expected future returns of real corporate investments
   (b) Increased Chinese purchases of U.S. Treasury Bills/Bonds
   (c) An increase in U.S. inflationary expectations
   (d) Decreases in the U.S. Government budget deficit
   (e) Both (c) and (d)




                                                                                                2
9. The future value in 3 years of $1,000 received today if your investment pays 6% compounded
   annually is
   (a) 1,000 (1.06)3
   (b) 1.06 (1,000) 3
   (c) 1,000 (6%) 3 +1,000
   (d) (1.06) 3/ 1,000

10. A negotiated non-standardized agreement between a buyer and seller (with no third party
    involvement) to exchange an asset for cash at some future date, with the price set today is
    called a (an)
    (a) Future
    (b) Option
    (c) Forward
    (d) None of the above

11. Major liabilities for banks include
    (a) Business loans
    (b) Deposits by clients
    (c) Interest expense paid on deposits
    (d) Equity capital
    (e) Securities held for sale

12. You bought a stock 1 year ago for $50. You received a dividend of $2 today and then sold your
    stock immediately for $45.
    (a) Total rate of return on your stock is -6%, consisting of +4% in dividend yield and -10% in
        capital gain
    (b) Total rate of return on your stock is +15.56%, consisting of +4.44% in dividend yield and
        +11.11% in capital gain (figures are rounded)
    (c) Total rate of return on your stock is +11.11%, consisting of +4% in dividend yield and
        +7.11% in capital gain
    (d) None of the above

13. You sell a June 2008 crude oil futures when the June futures crude oil price is $114.
    (a) Since you and your counterparty are bound to trade at the price of $114, then the value of
        your contract remains unchanged regardless of what happens to the spot price of crude oil
        at delivery time
    (b) The value of your contract is zero at contract time but will be positive (i.e., you earn a
        profit) if the spot price of crude oil is higher than $114 at delivery time in June
    (c) The value of your contract is zero at contract time but will be negative (i.e., you lose) if the
        spot price of crude oil is higher than $114 at delivery time in June
    (d) Regardless of what the spot price of crude oil is at delivery time in June, you will not
        experience a loss
    (e) Both (a) and (c)




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14. You invest $1,000 in a one-year, Japanese yen-denominated riskfree government bond that
    offers 3% per year in return. The current spot exchange rate is $1 = ¥ 100.
    (a) This guarantees that you will end up with $1,030 in one year
    (b) This guarantees that you will receive ¥ 103,000 but you are subject to foreign exchange
        risk; to eliminate the forex risk you should sell ¥ 103,000 in the forward (or futures )
        market
    (c) This guarantees that you will receive ¥ 103,000 but you are subject to foreign exchange
        risk; to eliminate the forex risk you should buy ¥ 103,000 in the forward (or futures )
        market
    (d) There is no way to eliminate the forex risk since one cannot predict the exchange rate in
        the future with certainty

15. One reason commercial banks are strictly regulated is that because of asymmetric information
    between banks and depositors the government provides insurance for deposits. But this leads to
    moral hazard.
    (a) True
    (b) False

16. We observe the current rate on one-year loan to be 3% and the rate on two-year loan to be 5%.
    What is the market expect that the one-year loan to be next year, rounded to one digit after the
    decimal (under the Unbiased Expectations Theory)? [note: use the model that was presented in
    the lecture, Feb-14]
    (a) 7.0%
    (b) 3.0 %
    (c) Some figure between 3% and 5%, but cannot be determined more precisely
    (d) Cannot be determined at all since it is a future rate

17. In general, depository institutions’ profits tend to rise
    (a) When the yield curve is downward sloping
    (b) When the yield curve is flat
    (c) When the Federal Reserve discount rate is high but the long-term interest rates are low
    (d) When the yield curve is upward sloping




                                                                                                    4
18. We observe the spot one-year US Government security rate to be lower than the spot two-year
    US Government security. What can be inferred about the one-year US Government security
    rate expected one year from now?
    (a) Next year’s one-year rate is expected to be higher than the current one-year rate
    (b) Next year’s one-year rate is expected to be lower than the current one-year rate
    (c) Next year’s one-year rate is expected to be the same as the current one-year rate
    (d) There is nothing that can be inferred from the current rates about next year’s rates

19. You buy a bond for $960. The bond pays interest of $100 at the end of year 1, at which time
    you sell it for $980. The rate of return you expect to earn on this investment is approximately
    (a) 2.08 %
    (b) 10.53 %
    (c) 12.50 %
    (d) 10.47 %
    (e) None of the above

20. Bond A has duration 4 years; Bond B has duration 3 years.
    (a) If interest rates fall, Bond A’s price rises by a greater percentage than the rise in the price
        of B
    (b) If interest rates fall, Bond A’s price rises by a smaller percentage than the rise in the price
        of B
    (c) If interest rates fall, Bond A’s price falls by a greater percentage than the fall in the price of
        B
    (d) If interest rates fall, Bond A’s price falls by a smaller percentage than the fall in the price
        of B
    (e) The percentage changes in bond prices have nothing to do with duration

21. Among differences between ordinary bonds and most ordinary mortgages is (are)
    (a) ordinary bonds pay coupon semiannually but ordinary mortgages make their payments
        monthly
    (b) ordinary bonds are amortized but ordinary mortgages are not
    (c) ordinary mortgages are amortized but ordinary bonds are not
    (d) both (a) and (b)
    (e) both (a) and (c)

22. You have borrowed a $100,000, 6-year, 5%-fixed-rate balloon payment mortgage,
    compounded yearly. You make your payments at the end of each year. What are your
    payments?
                                                          C       C             C
    (a) Use the formula to solve for C: $100,000 =          1      2  ...
                                                       105 105
                                                        .       .            1056
                                                                              .

    (b) $5,000 for 6 years, plus $100,000 at the end of the 6th year

                                                          C       C          C  100000
    (c) Use the formula to solve for C : $100,000 =         1      2  ...
                                                       105 105
                                                        .       .               1056
                                                                                 .




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23. The required reserve ratio is R=10%. The monetary authorities inject $100 in currency into the
    banking system. Assume no leakages of any kind.
    (a) This will increase the amount of required reserves by $100
    (b) This will increase the total money supply by $1,000
    (c) This will increase the total money supply by $100
    (d) Both (a) and (b)
    (e) Both (a) and (c)

24. You promise to take delivery of 1,000 barrels of oil in June at the price of $106. This means
    that
    (a) You have a short position and if the spot price at delivery time is lower than $106 you
         make a profit
    (b) You have a short position and if the spot price at delivery time is lower than $106 you
         incur a loss
    (c) You have a long position and if the spot price at delivery time is lower than $106 you make
         a profit
    (d) You have a long position and if the spot price at delivery time is lower than $106 you incur
         a loss

25. You have promised to accept delivery of a security on June 20, 2008 in exchange for $40, if
    your counterparty chooses to deliver it to you. You do not owe anything if your counterparty
    decides not to deliver the security to you. This represents a
    (a) Put option that you have sold
    (b) Call option that you have bought
    (c) Short future (or forward) position
    (d) Long future (or forward) position
    (e) Call option that you have sold

26. You hold (i.e., own) a call option on a stock with exercise price X = $30 and expiration time on
    April 20, 2008. The current price of the stock is p = $35. The value of this option moments
    before expiration is
    (a) $0 if p ≤ $30
    (b) $5 if p = $25
    (c) $5 if p = $35
    (d) Both (a) and (b)
    (e) Both (a) and (c)

27. A U.S. investor has borrowed pounds (£), converted them to dollars and invested the dollars in
    the U.S. to take advantage of interest rate differentials. To cover the currency risk the investor
    should
    (a) Sell pounds forward
    (b) Buy dollars forward
    (c) Buy pounds forward
    (d) Sell pounds spot
    (e) None of the above




                                                                                                     6
28. A U.S. bank converted $1 million to Swiss francs to make a Swiss franc loan to a valued
    corporate customer when the exchange rate was 1.5 francs per dollar. The borrower agreed to
    repay the principle plus 5% in francs interest in 1 year. The borrower repaid Swiss francs at
    loan maturity and when the loan was repaid the exchange rate was 1.4 francs per dollar. What
    was the bank's dollar rate of return?
    (a) 6.00 %
    (b) 12.50 %
    (c) -11.67 %
    (d) 7.14 %
    (e) -2.00 %

29. The Fed targets
    (a) The prime rate
    (b) The mortgage rates
    (c) The stock market
    (d) The 3-month T-bill rate
    (e) None of the above

30. When the FI increases the number borrowers to whom it lends the result is
    (a) To reduce the specific (or unique) component of credit risk
    (b) To reduce the systematic component of credit risk
    (c) Both (a) and (b)
    (d) Neither (a) nor (b)

31. To avoid liquidity risk, a depository institution must have
    (a) Stored liquidity
    (b) Purchased liquidity
    (c) Either or both (a) and (b)
    (d) None of the above

32. Consider a commercial bank’s Balance Sheet, with required reserves ratio of 10%.


                             Assets                           Liabilities and Equity
             Reserves                         $ 10     Deposits                    $ 100
             Loans                               80    Borrowed Funds                 15
             Securities                          45    Equity                          20

          If depositors withdraw $5, the bank can fulfill its legal requirement by
    (a)   selling some of its securities
    (b)   selling some of its loans
    (c)   borrow more funds
    (d)   all of the above
    (e)   only (a) and (b)




                                                                                                    7
33. You buy a bond for $250.255. The bond pays interest of $100 at the end of year 1 and another
    $100 at the end of year 2 year 2, at which time you sell it for $980. The (annualized) rate of
    return you expect to earn on this investment is approximately 12 %.
    (a) True
    (b) False

34. A bank has total assets of $120 million and $15 million in equity. The managers of the bank
    realize that $10 million of its $100 million loan portfolio will not be repaid. After the bank
    charges off the bad loans the bank's equity to asset ratio will be approximately
    (a) 12.50 %
    (b) 10.00 %
    (c) 4.55 %
    (d) 4.17%

35. Liquidity risk arises from
    (a) Unexpected loan demand
    (b) Unexpected deposit withdrawals
    (c) Loan defaults
    (d) All of the above
    (e) Only (a) and (b)

36. A bank has invested in U.S. Treasury securities that mature in 2 years, to be held until
    maturity. The investments are funded with 6 month maturity deposits. During the next two
    years, this bank faces
    (a) Reinvestment risk
    (b) Refinancing risk
    (c) Default risk
    (d) None of the above

37. Adverse selection and client moral hazard explain why
    (a) FIs screen and monitor borrowers
    (b) there is government deposit insurance
    (c) depository institutions are required to hold reserves
    (d) all of the above
    (e) Only (b) and (c)

38. It is because of adverse selection and client moral hazard that FIs
    (a) Ration credit
    (b) Require collateral
    (c) Both of the above
    (d) None of the above




                                                                                                     8
39. To reduce or minimize interest rate risk, a FI
    (a) should lend at the highest rate possible but borrow at the lowest rate possible
    (b) should lend at the longest possible maturity but borrow at the shortest possible maturity
    (c) should select the duration of the securities it buys and sells to be very similar
    (d) All of the above
    (e) None of the above

40. The reason why credit problem (i.e., default) can be serious for commercial banks is
    (a) Banks are highly leveraged
    (b) Banks are required to keep 10% in required reserves
    (c) Both of the above
    (d) None of the above

41. Credit scoring systems attempt to determine
    (a) Which borrower will default and which will not
    (b) What is the probability of default by any particular borrower
    (c) When is a particular borrower likely to default
    (d) All of the above
    (e) None of the above

42. You just bought $1,000 worth of UK pound-denominated 1-year bonds that pay 8%
    interest annually. The current spot rate is £1= $2. What will your total return be if the
    pound’s spot rate is £1=$1.60 by maturity?
    (a) +13.6 %
    (b) +33 %
    (c) +35 %
    (d) -13.6 %
    (e) cannot be determined since we don’t know the forward rate of exchange

43. The rate of interest on 3-month US T-bill is 6%, the foreign exchange spot rate is
    £1=$2, and the forward rate is £1 = $2.01. For what rate of interest on 3-month UK
    government bills would you find it profitable to invest in the UK bills?
    (a) 5.5% or more
    (b) 5.0% or less
    (c) 5.5% or less
    (d) None of the above




                                                                                                    9
44. A callable bond
    (a) Gives the issuer the right to force the bondholder to sell the bond back to the issuer
        at the call price; these bonds offer a higher rate of return than similar bonds but
        without the call provision
    (b) Gives the bondholder the right to force the issuer to buy the bond back at the call
        price; these bonds offer a lower rate of return than similar bonds but without the
        call provision
    (c) Has a “call option” attached to it, giving the bondholder the right to buy common
        stock in the issuing firm at the exercise price; these bonds offer lower returns than
        similar bonds but without the call option.

45. The repricing approach to interest rate risk involves
    (a) Measuring the impact of interest rate changes on the equity value of the FI
    (b) Measuring the impact of interest rate changes on the income of the FI
    (c) Measuring the impact of interest rate changes on the duration of the FI’s assets
    (d) All of the above
    (e) None of the above

46. Consider the FI with Assets = $700 on which it earns interest at the rate of 8% and
    Liabilities = $500 on which it pays interest at the rate of 6%. If interest rates rise by 1
    percentage point (100 basis points) across the board, the impact on the FI’s profits will
    be
    (a) $ +7
    (b) $ -2
    (c) $ +2
    (d) $ -7
    (e) None of the above




                                                                                             10
47. Consider the balance sheet of a FI as shown below. Assume that the FI pays the same
    rate of interest on its borrowed funds as it receives on funds it lends (this is assumed to
    simplify the problem): the rate of interest for this FI rises from 6% to 8%. The
    durations are DA = 5 for assets and DL = 6, and r = rate of interest.

                      Assets                   Liabilities and Equity
          Assets               9000     Liabilities                 7000
                                        Equity                      2000
              Total            9000           Total                 9000

         If the FI wants to eliminate interest risk on its equity value
   (a)   it should manage its assets and liabilities to make its DA = DL .
   (b)   it should manage its assets and liabilities to make Δr /(1+r) = 0
   (c)   it should make its L/A = 0
   (d)   none of the above

48. Use the information in Question 47. To eliminate interest risk on its equity value, the
    FI
    (a) Should get its L/A= 5/6
    (b) Should get its L/A = 6/5
    (c) Should reduce its assets to A = 0
    (d) None of the above

49. Use the information in Question 47. The impact on the equity value of the FI of the
    interest rate change is
    (a) $ + 56.60
    (b) $ - 55.55
    (c) $ - 56.60
    (d) $ +55.55
    (e) None of the above

50. Use the information in Question 47. The impact on the asset value of the FI of the
    interest rate change is
    (a) $ -849.06
    (b) $ -833.33
    (c) $ +833.33
    (d) -16,981.13
    (e) None of the above




                                                                                              11
51. Liquidity risk can be managed through
    (a) “storing” liquidity – which means holding excess reserves
    (b) “purchasing” liquidity – which means purchasing US Treasury securities when
        needed
    (c) Both of the above
    (d) None of the above

52. Among the causes in the shortfall (i.e., insufficient amount) of liquidity for a FI is (are)
    (a) Unexpected withdrawals of liabilities
    (b) Unexpected rise in assets
    (c) Both of the above
    (d) None of the above

53. Using stored liquidity to offset a deposit drain will reduce the size of the bank as
    measured by its assets, but using purchased liquidity to offset the drain will not.
    (a) True
    (b) False

54. Which one of the following situations creates the most liquidity risk?
    (a) Long term assets funded by long term liabilities
    (b) Short term assets funded by short term liabilities
    (c) Long term assets funded by short term liabilities
    (d) Short term assets funded by long term liabilities
    (e) Long term liabilities funded by short term assets

55. The two main reasons why runs on U.S. commercial banks no longer occur are
    (a) Reserve requirements and higher bank liquidity ratios
    (b) Required positive financing gap and bank use of purchased liquidity
    (c) The FDIC and the discount window
    (d) Both (a) and (c)
    (e) None of the above




                                                                                             12
56. A bank has a negative (leverage-adjusted) duration gap. Interest rates decline. Which
    one of the following best describes the effects of the interest rate change? The bank's
    market value of equity
    (a) is unchanged since the market value of its assets and liabilities move in the same
        direction.
    (b) goes up because the market value of its assets goes up by more than the market
        value of its liabilities goes down.
    (c) goes down because the market value of its assets goes up by more than the market
        value of its liabilities goes down.
    (d) goes down because the market value of its assets goes down by more than the
        market value of its liabilities goes down.
    (e) goes down because the market value of its liabilities increases by more than the
        market value of its assets increases

57. Some U.S. investors have started to invest in Malaysian bonds (both government and
    private). One reason is that the Malaysian currency is expected to appreciate relative to
    the US dollar.
    (a) True
    (b) False




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