This Paper Is Not To Be Removed From The Examination Halls

This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON 279 0024 ZA

996 D024 ZA
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diploma in Economics and Access Route for Students in the
External Programme
Principles of Banking and Finance
Thursday, 14th May 2009 : 2.30pm to 5.30pm
Candidates should answer FOUR of the following EIGHT questions: ONE from Section A,
ONE from Section B and TWO further questions from either section. All questions carry
equal marks.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.
© University of London 2009

UL09/0181 PLEASE TURN OVER
D02 Page 1 of 4
SECTION A
Answer one question from this section and not more than a further two questions. (You are
reminded that four questions in total are to be attempted with at least one from Section B.)
1. (a) What is meant by securitisation? Outline the process and identify the advantages
to a financial institution in securitising its assets. (5 marks)
(b) Explain the main characteristics of the recent crisis of the sub-prime mortgage
lending. (12 marks)
(c) Discuss the three main changes in US banking regulation that occurred in the
1980s and 1990s. (8 marks)
2. (a) Explain how to reduce/solve the problems arising from moral hazard in equity
markets. (12 marks)
(b) Explain the hypotheses, the framework, and the main findings of the delegated
monitoring theory. (13 marks)
3. (a) Explain the empirical evidence on market underreaction in the context of weak
and semi-strong form efficiency. (14 marks)
(b) Describe and discuss the evidence on calendar effects in the context of weak form
efficiency. Refer specifically to the so-called ‘January effect’. (11 marks)
4. (a) What are the methods used by banks to measure the credit risk concentration of
their loan portfolios? Explain and provide examples where appropriate.
(10 marks)
(b) ‘Banks can manage credit risk through collateral and endorsement.’ Discuss.
(9 marks)
(c) Describe credit scoring models based on linear discrimination analysis. Identify
any problems associated with using these types of model. (6 marks)
UL09/0181
D02 Page 2 of 4
SECTION B
reminded that four questions in total are to be attempted with at least one from Section A.)
5. (a) Consider the two following mutually exclusive projects (Alfa and Beta):
Cash flows
Project C0 C1 C2
Alfa -1000 700 150
Beta -1000 0 1000
Assuming an opportunity cost of capital of 10 per cent, what is the NPV of the
two projects? Which project would you accept? (5 marks)
(b) What type of cash flows have to be discounted in the NPV method? Explain why.
(5 marks)
(c) Explain what is meant by the ‘opportunity cost of capital’ in the context of the
NPV method. (5 marks)
(d) Explain the additivity property of the NPV method. (5 marks)
(e) Assume that the hurdle rate used in the IRR (Internal Rate of Return) method is
the opportunity cost of capital used in the NPV calculation. What is the
implication in terms of the investment recommendation of the two methods (NPV
and IRR)? (5 marks)
6. (a) Consider the following portfolio composed of three stocks (X, Y, Z):
Stock Quantity Price (£) Beta
X 100 1.5 0.7
Y 120 1.7 0.95
Z 210 1.1 1.05
What is the beta of this portfolio? (5 marks)

(b) What are the assumptions underlying the CAPM (Capital Asset Pricing Model)?
(5 marks)
(c) Under the CAPM framework, how do you express the expected return of a stock?
(5 marks)
(d) Discuss the methods for the estimation of the market risk premium under the
CAPM framework. Support your answer with empirical evidence.
(7 marks)
(e) What sort of value of beta would you expect for:
i. an aggressive company, and,

ii. a highly levered company? Explain your answers. (3 marks)
UL09/0181
D02 Page 3 of 4
7. (a) Explain what is meant by informational efficiency, valuation efficiency and
allocative efficiency. (6 marks)
(b) Theoretically derive a framework to analyze whether markets are informationally

efficient. (10 marks)
(c) Explain why the concept of informational efficiency is important in capital

budgeting and portfolio management. (9 marks)
8. (a) From the perspective of a commercial bank, what are the two main effects caused
by a change in market interest rates? Explain and provide numerical examples to
support your answer. (8 marks)
(b) Consider Bank ABC. Extracts from the balance sheet are as follows (values in £
millions and duration in years):
Value Duration
Commercial loans 5000 2.5
Mortgages 4200 7.8
T-bonds 2000 0.9
Deposits 7500 1.3
Corporate bond 2000 1.6
What is the duration gap for Bank ABC? (4 marks)
(c) What is the change in the market value of equity as a percentage of assets if
interest rates rise from 4% to 5%? (2 marks)
(d) In the framework of duration gap analysis, what assumptions are made about the
change in interest rates across different maturities? (3 marks)
(e) Critically discuss the main problems associated with duration gap analysis.
(4 marks)
(f) Explain why market risk management is important in banking.

(4 marks)
END OF PAPER
UL09/0181
D02 Page 4 of 4
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON 279 0024 ZB

996 D024 ZB
BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diploma in Economics and Access Route for Students in the
External Programme
Principles of Banking and Finance
Thursday, 14th May 2009 : 2.30pm to 5.30pm
Candidates should answer FOUR of the following EIGHT questions: ONE from Section A,
ONE from Section B and TWO further questions from either section. All questions carry
equal marks.
A calculator may be used when answering questions on this paper and it must comply in all
respects with the specification given with your Admission Notice. The make and type of
machine must be clearly stated on the front cover of the answer book.
© University of London 2009

UL09/0182 PLEASE TURN OVER
D01 Page 1 of 4
SECTION A
reminded that four questions in total are to be attempted with at least one from Section B.)
1. (a) What is meant by securitisation? Outline the process and identify the advantages
to a financial institution in securitising its assets. (5 marks)
(b) Explain the main characteristics of the recent crisis of the sub-prime mortgage
lending. (12 marks)
(c) Discuss the three main changes in US banking regulation that occurred in the
1980s and 1990s. (8 marks)
2. (a) Explain how to reduce/solve the problems arising from moral hazard in debt
markets. (12 marks)
(b) Explain the hypotheses, the framework, and the main findings of the delegated
monitoring theory. (13 marks)
3. (a) Explain the empirical evidence on market overreaction in the context of weak and
semi-strong form efficiency. (14 marks)
(b) Describe and discuss the evidence on calendar effects in the context of weak form
efficiency. Refer specifically to the so-called ‘January effect’. (11 marks)
4. (a) What are the methods used by banks to measure the credit risk concentration of
their loan portfolios? Explain and provide examples where appropriate.
(10 marks)
(b) ‘Banks can manage credit risk through collateral and endorsement.’ Discuss.
(9 marks)
(c) Discuss the mechanisms used by banks to reduce the moral hazard problem in the
monitoring of credit risk. (6 marks)
UL09/0182
D01 Page 2 of 4
SECTION B
reminded that four questions in total are to be attempted with at least one from Section A.)
5. (a) Consider the two following mutually exclusive projects (A and B):
Cash flows
Project C0 C1 C2
A -1500 900 250
B -1500 0 1500
Assuming an opportunity cost of capital of 10 per cent, what is the NPV of the
two projects? Which project would you accept? (5 marks)
(b) What type of cash flows have to be discounted in the NPV method? Explain why.
(5 marks)
(c) Explain what is meant by the ‘opportunity cost of capital’ in the context of the
NPV method. (5 marks)
(d) Explain the additivity property of the NPV method. (5 marks)
(e) Assume that the hurdle rate used in the IRR (Internal Rate of Return) method is
the opportunity cost of capital used in the NPV calculation. What is the
implication in terms of the investment recommendation of the two methods (NPV
and IRR)? (5 marks)
6. (a) Consider the following portfolio composed of three stocks (A, B, C):
A 500 1.5 0.8
B 520 1.7 0.97
C 610 1.1 1.04

(b) What are the assumptions underlying the CAPM (Capital Asset Pricing Model)?
(5 marks)
(c) Under the CAPM framework, how do you express the expected return of a stock?
(5 marks)
(d) Discuss the methods for the estimation of the market risk premium under the
CAPM framework. Support your answer with empirical evidence.
(7 marks)
(e) What sort of value of beta would you expect for:

UL09/0182
D01 Page 3 of 4
7. (a) Explain what is meant by informational efficiency, valuation efficiency and
allocative efficiency. (6 marks)
(b) Theoretically derive a framework to analyze whether markets are informationally

efficient. (10 marks)
(c) Explain why the concept of informational efficiency is important in capital

budgeting and portfolio management. (9 marks)
8. (a) From the perspective of a commercial bank, what are the two main effects caused
by a change in market interest rates? Explain and provide numerical examples to
support your answer. (8 marks)
(b) Consider Bank First. Extracts from the balance sheet are as follows (values in £
millions and duration in years):
Value Duration
Loans (short term) 4000 0.8
Mortgages 3200 7.8
T-bonds 1000 0.9
Deposits 8500 1.3
Municipal bond 1500 1.6
What is the duration gap for Bank First? (4 marks)
(c) What is the change in the market value of equity as a percentage of assets if
interest rates decrease from 5.5% to 4.5%? (2 marks)
(d) In the framework of duration gap analysis, what assumptions are made about the
change in interest rates across different maturities? (3 marks)
(e) Critically discuss the main problems associated with duration gap analysis.
(4 marks)
(f) Explain why market risk management is important in banking. (4 marks)
END OF PAPER
UL09/0182
D01 Page 4 of 4
Examiners’ commentaries 2009
24 Principles of banking and finance
Specific comments on questions – Zone A

SECTION A
Answer one question from this section and not more than a further
two questions. (You are reminded that four questions in total are
to be attempted with at least one from Section B.)
Question 1
a. What is meant by securitisation? Outline the process and identify the
advantages to a financial institution in securitising its assets. (5 marks)
Reading for this question:
Candidates may like to refer to pp.79–80 of the subject guide, and to
p.461 (fifth edition) or p.459 (sixth edition) of Mishkin and Eakins,
Financial markets and institutions.
Approaching the question:
The Examiners would expect candidates to begin with a clear
definition of securitisation, which is the process of transforming illiquid
financial assets (such as loans and mortgages) into marketable
securities. (1 mark.)
Then candidates should go on to discuss this more in detail to show
that they understand the process used by a financial institution in
securitising its assets. An outstanding answer would also provide an
intuition about the advantages associated to the phases of the process
of securitisation. Financial intermediaries can cheaply bundle together
a portfolio of loans (e.g. mortgages, credit card receivables,
commercial and computer leases) with varying small denominations
(often less than $100,000), collect the interest and principal payments
on the loans in the bundle, and then pay them out to third parties.
(1 mark.)
By dividing the portfolio of loans into standardised amounts, the claims
to the principal and interests can be sold to third parties as securities.
These securities are liquid and well diversified. (1 mark.)
Financial institutions make profits by servicing the loans and charge a
fee to the third party for this service. (1 mark.)
The development of securitisation allows other financial institutions,
and not only banks, to originate loans, evaluate credit risks, bundle
these loans and sell them as securities. (1 mark.)
1
b. Explain the main characteristics of the recent crisis of the sub-prime

mortgage lending. (12 marks)
Candidates may like to refer to pp.51–52 of the subject guide.
Part b) requires candidates to discuss the case of the recent crisis of the
sub-prime mortgage lending. The skill candidates are expected to
demonstrate is the ability to produce an essay with clear paragraphs
for each of the steps describing the features of this crisis. Candidates do
not have to focus too much on specific details, but should provide the
overall picture with a focus on the links between the different aspects.
Candidates are first expected to explain that over the recent past
structured credit markets experienced a rapid growth under benign
conditions. Investors showed a high-risk appetite that has stimulated
further development by financial institutions of techniques for
unbundling and distributing risks through financial markets. This has
led to a marked expansion of the so-called sub-prime mortgage market.
(2 marks.) However, recently the US sub-prime market has
experienced serious problems. These problems materialised in a
financial crisis, which spread internationally. (1 mark.)
Good candidates at this regard should note that the term sub-prime
generally refers to borrowers who do not qualify for prime interest
rates because they have weakened credit histories, low credit scores,
high debt-burden ratios or high loan-to-value ratios.) (1 mark.)
Candidates should then go on with the discussion of characteristics of
the US sub-prime market that have contributed to the recent problems:
• In 2005 and 2006, the competition among the sub-prime
originators intensified. To maintain volumes and/or increase
market share, originators introduced product innovations (e.g.
‘affordable lending’ products, often incorporating low initial ‘teaser’
rates that are reset after two or so years). (2 marks.)
• In the same years, there was an apparent weakening of lending
standards. Loans were made with increasingly high loan-to-value
ratios and often without full documentation. (1 mark.)
• Most originators sold the loans to larger banks, who in turn
securitised them and sold them to end-investors. Therefore banks
had significant warehouses of sub-prime mortgages. Nevertheless,
the distribution of assets from warehouses relies on continued
market liquidity. This explains the recent, large injection of liquidity
arranged by central banks to stem the crisis. (2 marks.)
Dealers purchase mortgages from originators, and the price paid (bid)
is based on a sample of mortgages. If the whole pool of mortgages does
not conform to this sample the dealer can ‘put back’ the loan pool to
the originator. If the borrower makes no payments at all, or defaults in
the first few months, this is classified as an ‘early payment default’ and
again the dealer can return the specific loan to the originator. The right
to return such loans helps to align the incentives between the
originators who underwrite the risk and the dealers who securitise the
mortgages. However, due to the obligation to take back the mortgages,
2
some originators went bankrupt, and the risk then flowed back to the
banks that held their direct credit lines. (3 marks.)
Note that an appropriate discussion of this last point makes the answer
an outstanding one.
c. Discuss the three main changes in US banking regulation that occurred in
the 1980s and 1990s. (8 marks)
Candidates may like to refer to pp.41–42 of the subject guide and to
pp.474–78 (fifth edition) or pp.472–75 (sixth edition) of Mishkin and
Eakins, Financial markets and institutions.
A good way to tackle this question would be to discuss critically the
three main regulatory changes occurred in the US (the erosion of the
Glass-Steagall Act prohibitions, the elimination of the Glass-Steagall
Act, the relaxation of the historical restriction on banks’ crossing state
boundaries). Good answers would provide a desciption of the changes,
whereas outstanding answers would discuss the implications of the
changes for the intermediaries operating in the financial system.
An outstanding answer would be structured in an essay style that
covers the following points on the three regulatory changes:
• The erosion of the Glass-Steagall Act prohibitions. (1 mark.) In
1987 the Federal Reserve allowed affiliates of approved commercial
banks to engage in underwriting activities as long as the revenue
did not exceed a specified amount – which started at 10 per cent,
but was raised to 25 per cent – of the affiliates’ total revenues. (1
mark.) In 1988 the Federal Reserve used a loophole in s.20 of the
Glass-Steagall Act to allow three commercial banks (Bankers’ Trust,
Citicorp and J.P. Morgan) to underwrite corporate debt securities
and to underwrite stocks. Two competitive reasons determined this
legislative change. (1 mark.) On the one hand, brokerage firms
began to engage in the traditional banking business of issuing
deposits. On the other hand, foreign banks’ activities in the USA
eroded the position of national US banks. (1 mark.)
• The elimination of the Glass-Steagall Act. The Gramm-Leach-Bliley
Financial Services Modernization Act of 1999 allows securities firms
and insurance companies to purchase banks, and allows banks to
underwrite insurance and securities and engage in real estate
activities. (1 mark.)
• The relaxation of the historical restriction on banks’ crossing state
boundaries. (1 mark.) The Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994 stated that after 1997 banks
would be essentially unrestricted with regard to inter-state banking,
except in states that opted out or imposed other restrictions. (1
mark.) Nationwide banks are now beginning to emerge. (1 mark.)
3
Question 2
a. Explain how to reduce/solve the problems arising from moral hazard in
equity markets. (12 marks)
pp.383–86 (fifth edition) pp.376–79 (sixth edition) of Mishkin and
Candidates are required to discuss the solutions to the moral hazard
problem in equity markets.
The Examiners were then looking for the list of the four main tools
used to reduce/solve moral hazard in the equity market:
1. monitoring
2. government regulation to increase information
3. financial intermediaries active in the equity market
4. debt contracts.
(1 mark for listing the four tools.)
Good answers would be structured as an essay style answer which
covered the four tools.
1. Stockholders can engage in the monitoring (auditing) of firms’
activities to reduce moral hazard. There are several reasons why
monitoring is needed: to ensure that information asymmetry is not
exploited by one party at the expenses of the other; the value of equity
contracts cannot be ascertained with certainty when the contract is
made; the value of many financial contracts (i.e. future return on a
stock) cannot be observed or verified at the moment of purchase, and
the post-contract behaviour of a counterparty determines the ultimate
value of the contract; the long-term nature of many financial contracts
implies that information acquired before the contract is agreed may
become irrelevant at maturity due to changes in conditions. (Up to 2
marks were awarded.)
Outstanding candidates would explain that monitoring is expensive in
terms of money and time, or rather it is a costly state verification. In
addition, if you know that other stockholders are paying to monitor the
activities of the firm you hold stocks in, you can free ride on the
activities of the others. As every stockholder can free ride on others,
the free-rider problem reduces the amount of monitoring that would
reduce the moral hazard (principal-agent) problem. This is the same as
with adverse selection and makes equity contracts less desirable. (Up
to 2 marks were awarded.)
2. Governments have incentives to reduce the moral hazard problem
(same as with adverse selection). Several measures are used by
governments: laws to force firms to adhere to standard accounting
principles (i.e. to make profit verification easier); laws to impose stiff
criminal penalties on people who commit the fraud of hiding/stealing
profits. However these measures are only partially effective as these
frauds are difficult to discover. (1 mark.)
4
3. Financial intermediaries operating in the equity market are able to

avoid the free-rider problem in the face of moral hazard. Venture
capital firms are an example of an intermediary that is able to avoid
the free-rider problem in the face of moral hazard. They use the funds
of their partner to help entrepreneurs to start new business; in
exchange for the use of the venture capital the firm receives an equity
share in the new business. Venture capital firms have their
representatives participating in the management of the firm (i.e. easier
profit verification and thus lower moral hazard). Moreover, the equity
in the firm is not marketable to anyone but the venture capital firm
(i.e. elimination of the free-riding of other investors on the venture
capital’s verification activities). (Up to 3 marks were awarded.)
4. Debt contracts are a way to reduce moral hazard. Moral hazard affects
equity contracts because they are claims on profits in all situations,
whether the firm makes or loses money. Consequently, there is the need
to structure a contract that confines moral hazard to certain situations,
and thus reduces the need to monitor managers. This is a debt contract,
a contractual agreement to pay the lender a fixed amount of money
independently from the profits of the firm. Therefore debt contracts are
preferred to equity contract. The presence of moral hazard in equity
markets explains why stocks are not the most important external source
of financing for firms. (Up to 3 marks were awarded.)
b. Explain the hypotheses, the framework, and the main findings of the
delegated monitoring theory. (13 marks)
Here candidates are expected to demonstrate their knowledge and
understanding of hypotheses, framework and key findings of the
delegated monitoring theory, as formulated by Diamond (1984).
Excellent answers will describe this theory by using the appropriate
technical terms.
Main idea of the delegated monitoring theory: Since monitoring
borrowers is costly, it is efficient for surplus units (lenders) to delegate
the task of monitoring to specialised agents such as banks. Banks have a
comparative advantage relative to direct lending in monitoring activities
in the context of costly state verification. In fact, they have a better
ability to reduce monitoring costs because of their diversification.
(Up to 2 marks for the explanation of the main idea.)
Hypotheses required for delegated monitoring to work:
1. existence of scale economies in monitoring, that means that a
typical bank finances many projects
2. small capacity of investors as compared to the size of investments,
that means that each project needs the funds of several investors
3. low cost of delegation, that means that the cost of monitoring the
financial intermediary itself has to be less than the surplus gained
from exploiting scale economies in monitoring investment projects.
(One mark awarded for each of the hypotheses.)
5
Framework of the delegated monitoring theory: it is based on the

existence of n identical firms that seek to finance projects and the
requirement by each firm of an investment of one unit.
The cash flow y that the firm obtains from its investment is a priori
unobservable to lenders. This is where moral hazard arises.
Moral hazard can be solved by:
• either ‘monitoring’ the firm (at cost K)
• or ‘designing’ a debt contract characterised by a non-pecuniary
cost C.
(Up to 3 marks awarded for the description of the framework.)
Main findings: Assume that K<C. If the firm has a unique financier, it
would be efficient to choose the monitoring option. However, assume
that each investor owns only 1/m, so that m of them are needed for
financing the project. Assume also that the total number of investors is
m*n, so that all the projects can be financed. Direct lending implies
that each of the m investors monitors the financed firm: the total cost
is n*m*K.
If a bank (financial intermediary) emerges, it can choose to monitor
each firm (total cost n*K) or to sign a debt contract with each of them
(total cost n*C). Since K<C, the first solution is preferable: the bank is
a delegated monitor, which monitors borrowers on behalf of lenders
(note that the bank is not monitored by its lenders – the depositors).
Financial intermediation (delegated monitor) dominates direct lending
as soon as n is large enough: this means that diversification exists (i.e.
a large number of loans are held by the intermediary). Diversification
is important because it increases the probability that the intermediary
has sufficient loan proceeds to repay a fixed debt claim to depositors.
(Up to 5 marks awarded for the explanation of the findings.)
Question 3
a. Explain the empirical evidence on market underreaction in the context of
weak and semi-strong form efficiency. (14 marks)
Detailed evidence in Bernard and Thomas ‘Post-earnings
announcement drift: delayed price response or risk premium?’, Journal
of accounting research 27 1989, pp.1–36.
This question relates to the empirical evidence on market
underreaction, and therefore relates to the validity of semi-strong
efficiency in stock markets.
Candidates should begin by stating that evidence on market
underreaction constitutes an anomaly related to earnings
announcements. Although empirical evidence generally confirms rapid
adjustment to new information (as shown in the evidence in favour of
the semi-strong-form efficiency), recent evidence shows that stock
prices do not instantaneously adjust. Two key anomalies are pointed
out: stock price overreaction and underreaction. (1 mark.)
6
A definition of underreaction should be provided: underreaction to

earnings announcements means that stock prices do not fully
incorporate the new information embodied in the unexpected earnings
announcement. (1 mark.)
Candidates are then expected to move to the citation of the empirical
evidence that shows that adjustment to extreme bad news takes several
months: there is a market overreaction and subsequent gradual
adjustment (see for example the evidence in Ball and Brown, 1968,
then confirmed by Bernard and Thomas, 1989). (1 mark for citing the
authors.)
The Examiners then expect the description of the methodology and
findings of the study by Bernard and Thomas (1989). They calculate
the Cumulative Abnormal Returns (CAR) for 10 portfolios with
different levels of unexpected good or bad earnings over the years
1974–1986. CARs are measured for the pre- and post-announcement
period. Portfolio 10 contains the 10 per cent of the stocks with the
highest earnings performance, portfolio 1 the lowest 10 per cent.
Looking at Bernard and Thomas (1989), portfolio 10 outperformed
portfolio 1 in the two months following the announcement, and the
difference in the excess returns has been equal to +4 per cent. Prices of
good news stocks continue to rise in the two months after the earnings
announcement, whereas prices of bad news stocks continue to fall.
Investors thus can get an excess return in the short term by buying
good news stocks and selling bad news stocks. Such a trading strategy
is known as momentum strategy. The possibility of profitably
implementing a momentum strategy in such a framework is
inconsistent with semi-strong-form efficiency.
(Up to 5 marks were awarded for the discussion of the study by
Bernard and Thomas (1989). Examiners would expect an excellent
answer to describe this evidence by using the appropriate technical
terms.)
Outstanding candidates were expected to make the link with the
empirical evidence on underreaction existing at a different level of
informational efficiency – the weak form efficiency (see results in
Jegadeesh and Titman, 1993). This evidence suggests buying past
winner stocks and selling past losers to get excess returns. Here the
definition of winners and losers is based on historical prices and not
the release of any new information. To buy stocks that have increased
in price in the recent past and to sell those that have performed poorly
yields significant excess returns over 3- to 12-month holding periods.
Once again this evidence suggests excess returns associated with a
momentum strategy, but this evidence is inconsistent with the weak-
form efficiency (not the semi-strong form) because the strategy is
based on historical prices only.
(Up to 5 marks were awarded for the discussion of underreaction in
the context of weak form efficiency.)
Candidates should finally note that both overreaction and
underreaction alternatively characterise the behaviour of prices in
financial markets, and empirical evidence provides a roughly equal
number of examples of overreaction and underreaction. (1 mark.)
7
b. Describe and discuss the evidence on calendar effects in the context of

weak form efficiency. Refer specifically to the so-called ‘January effect’.
(11 marks)
pp.386–89 (fifth edition) pp.379–83 (sixth edition) of Mishkin and
Candidates should begin with a clear list of the possible calendar
effects, and then focus on the so-called ‘January effect’, which shows
that stocks returns are greater in January than in any other month of
the year.
(Definitions of calendar effect and January effect are awarded 1 mark
each.)
• A calendar effect represents a pattern in stock returns related to
either the day of the week, the week of the month or the month of
the year. Examples of calendar effects are the January effect, the
lower returns on Monday than in other days of the week, and the
occurrence of most of daily returns at the beginning and end of the
day.
• The January effect shows that stock returns (particularly for small
stocks) are greater in January than in any other month of the year.
Candidates should also make clear that the empirical evidence on the
January effect is inconsistent with the random walk behaviour, and
gives strong indications against market weak-form efficiency. (Up to 3
marks were awarded for showing a good understanding of the January
effects, as explained here below.)
The January effect seems to indicate a trading rule: buy small stocks at
the end of December and sell them at the end of January. In this way
you will make a profit. Why is the existence of the January effect
problematic? Assume that all investors observe such a January strategy
generating excess returns. All investors would follow it. But the
consequence would be an increase in prices at the end of December
(because of the increase in demand), and a decrease at the end of
January (due the increase in supply). Therefore excess returns would
tend to be eliminated. The continued existence of the January effect is
puzzling. Specifically, it is inconsistent with random-walk behaviour,
and gives strong indications against weak-form market efficiency.
Good candidates are then expected to discuss the hypotheses that have
been advanced to explain this effect. These include:
• Association of the January effect with the small firms effect: as
reported in Fama (1991), over the period 1941–1981, the return
experienced in January was 8.06 per cent for small stocks and
1.342 per cent for large stocks. In both cases the January return was
higher than the average return in other months, but also most of
the January effect was associated with small stocks. Note however
that in recent years – the period 1981–1991 – the difference in
January returns between large and small stocks was less
pronounced. (Up to 2 marks were awarded to explain the small firm
8
effect. Examiners would expect an excellent answer to describe the

relevant study associated with the explanation.)
• Taxation impacts (i.e. tax-selling hypothesis). Investors sell
securities for which substantial losses have been incurred before the
end of the year, in order to benefit from a tax loss. Such investors
do not invest the proceeds back into the market until the new year.
The selling in December would depress prices, whereas the
purchasing in early January would generate increases in prices.
However, even this explanation does not seem completely plausible:
in fact we do not observe in financial markets any negative
December effect when the tax-loss incentive induce selling the
stocks. (Up to 2 marks were awarded for explaining the taxation
effect.)
• Implications of the remuneration structure of fund managers.
Haugen and Lakonishok (1988) hypothesise that portfolio manager
behaviour around the turn of the year may be a major cause of the
January/small-firm effect and that the effect may result from
window dressing or performance hedging. Window dressing can be
value reducing (because of the unnecessary transaction costs
necessary to discern true rather than ‘dressed up’ portfolio
composition) whereas performance hedging may be associated with
investor value maximisation (thanks to the possibility of locking in
superior performance). Cheng-few, Porter and Weaver (1998)
suggest that the hypothesis of performance hedging is more likely
than the one of window dressing. (Up to 2 marks were awarded to
explain the implications of the remuneration structure of fund
managers. Examiners would expect an excellent answer to describe
the relevant study associated with the explanation.)
Question 4
a. What are the methods used by banks to measure the credit risk
concentration of their loan portfolios? Explain and provide examples
where appropriate. (10 marks)
Candidates may like to refer to p.111 of the subject guide.
The Examiners would expect candidates to begin with a list of methods
used by banks to measure credit risk concentration in their loan
portfolios: migration analysis and concentration limits. (1 mark.)
Candidates should then demonstrate their knowledge and
understanding of the two methods.
In migration analysis, banks monitor the credit ratings (as provided by
Standard and Poor’s and Moody’s) of a number of firms in an industry.
If they decline faster than the historical trend of the industry, banks
reduce the lending to the industry. A loan migration matrix provides
the probability of a pool of loans being upgraded, downgraded or
defaulting over some period.
(Up to 3 marks for discussing migration analysis, a further 3 marks for
providing an example with an hypothetical rating migration matrix.)
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Concentration limits are set by banks in terms of the proportion of the

loan portfolio that can go to any single borrower. Banks typically set
concentration limits to reduce exposures to certain industries and/or
geographic areas. Bank regulators impose a limit on loan concentration
to individual borrowers equal to 10 per cent of a bank’s capital.
(Up to 3 marks for explaining concentration limits.)
b. ‘Banks can manage credit risk through collateral and endorsement.’
Discuss. (9 marks)
Candidates may like to refer to p.109 of the subject guide and to p.620
(fifth edition) or p.622 (sixth edition) of Mishkin and Eakins, Financial
markets and institutions.
A good way to tackle this question would be to critically discuss the
following points: definition of collateral, identification of the assets
commonly used as collateral, relationship between the characteristics
of collateral and amount of the loan.
As regards the definition, loans with collateral requirements are often
referred to as secured loans. Collateral are the assets used by the
borrower to guarantee the repayment of the debt. In case of
bankruptcy, the lender can sell these assets and use the proceeds. Once
the asset is used as collateral, the borrower is assumed not to dispose
of it. (Up to 3 marks were awarded for these definitions.)
Assets that are commonly used as collateral are: real properties, cars
and goods that can be mortgaged; equipment and inventories;
accounts receivable; securities and saving accounts. (1 mark.)
In terms of the the maximum amount of the loan in proportion to the
collateral, the bank must take the following factors into account. The
higher the volatility of the collateral’s value and the lower its
marketability, the smaller the amount of the loan. On average, banks
can lend up to 90 per cent of the value of high-trade treasury bills, but
only up to 75 per cent of the value of high-capitalisation stocks, and
much less on inventories. (Up to 2 marks were awarded.)
Outstanding answers should mention the following points:
In the case of commercial loans, a particular form of collateral required
by banks is known as compensating balances: a firm receiving a loan
must keep a required minimum amount of funds in a cheque account
at the bank. (1 mark.)
There is a difference between the USA and Europe, since in the USA
short-term loans tend to be unsecured, whereas in Europe they tend to
be either collateralised or endorsed by a third party. (1 mark.)
If a loan is endorsed by a third party (just in case the borrower goes
bankrupt), the third party is committed to repaying the debt. This
additional guard against loss from default is similar to providing
collateral as far as the lending bank is concerned. (1 mark.)
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c. Describe credit scoring models based on linear discrimination analysis.

Identify any problems associated with using these types of model. (6
marks)
The Examiners would first expect to find the general idea behind
discrimination models: to divide borrowers into high or low default
risk classes on their observed characteristics. (1 mark.)
Good candidates should then go on with the description of the widely
used model developed by Altman (1985) for US publicly-traded
manufacturing firms. The measure of the default risk (Zi) depends on
the value of various financial ratios of the borrower (Xi) and the
weighted importance of these ratios (based on past observed
experience of defaulting and non-defaulting firms). (Up to 2 marks for
providing this explanation.)
Outstanding candidates would also provide the Altman’s discriminant
function:
Z = 1.2 X1 + 1.4 X2 + 3.3X3 + 0.6X4+ 1.0X5
where X1= working capital/total assets; X2 = retained earnings/total
assets; X3= earnings before interests and taxes/total assets; X4 =
market value of equity/book value of long-term debt; X5 = sales/total
assets. The higher the value of Z, the lower the default risk.
(Up to 2 marks were awarded for providing the equation and for
explaining the terms accurately.)
The Examiners finally expect a discussion of the problems associated
with discrimination models. First, they usually discriminate only
between two extreme cases: default and non-default status. Second,
there is no economic rationale for expecting weights and variables to
remain constant over short periods. Third, these models ignore
important – but difficult to quantify – characteristics, such as
reputation. (Up to 2 marks were awarded for the discussion of the
problems of the model.)
SECTION B
to be attempted with at least one from Section A.)
Question 5
a. Consider the two following mutually exclusive projects (Alfa and Beta):
Cash flows
Project C0 C1 C2
Alfa -1000 700 150
Beta -1000 0 1000
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Assuming an opportunity cost of capital of 10 per cent, what is the NPV of

the two projects? Which project would you accept? (5 marks)
NPV(Alfa) -239.6694
NPV(Beta) -173.5537
For each NPV calculation: 1 mark was awarded for correct input data
into NPV formula and 1 mark for correct answer for NPV.
Candidates should make clear that neither project should be accepted.
(1 mark was awarded for this concluding remark.)
b. What type of cash flows have to be discounted in the NPV method?
Explain why. (5 marks)
Candidates may like to refer to p.124 of the subject guide, and to p.144
of Brealey, Myers and Allen, Principles of corporate finance (ninth
edition).
The Examiners expect to read that the cash flows to be discounted in
the NPV method are ‘incremental cash flows’, which are the additional
cash flows from the project. (2 marks were awarded for this
statement.)
Good candidates would make clear that sunk costs have to be excluded
from the above calculation, because they are incurred whether or not
the project is accepted. (2 marks were awarded for this concept.)
Excellent candidates would stress that the implicit assumption about
cash flows associated with the investment project is that they can be
estimated without error. However, in the real world, the cash flows
associated with investment projects represent forecasts, and not real
values. Therefore the cash flows have to be estimated in an uncertain
framework. (1 mark was awarded for expressing this view.)
c. Explain what is meant by the ‘opportunity cost of capital’ in the context
of the NPV method. (5 marks)
edition).
A good way to tackle this question is by providing the definition of the
opportunity cost of capital – it is the rate of return used to discount the
expected cash inflows has to be the rate of return offered by equivalent
investment alternatives in the capital market. (1 mark was awarded for
this definition.)
Candidates should further explain that the label ‘opportunity’ derives
from the fact that it represents the return forgone by investing in the
project rather than in financial assets (securities). (1 mark.)
12
Excellent candidates would illustrate that the opportunity cost of

capital is a market-determined opportunity cost. The assumption is that
shareholders can reinvest their money at this market-determined rate.
(Up to 2 marks were awarded for this.)
Note that in the context of a firm, the label ‘cost of capital’ indicates
that the costs of all the sources of capital (both equity issues and debt
issues) have to be taken into account. (1 mark was awarded for
providing this detail.)
d. Explain the additivity property of the NPV method. (5 marks)
Candidates should first explain the meaning to the additivity property
(i.e. the NPV of projects X and Y is equal to the NPV of project X plus
the NPV of project Y) and should also provide the relevant notation:
NPV ( X + Y ) = NPV ( X ) + NPV (Y )
(1 mark was awarded for providing the definition and equation.)
Candidates are then expected to discuss the implications of the
additivity property:
• The value of the firm is simply the sum of the values of the separate
projects. (1 mark.)
• When there are mutually exclusive projects, the NPV method
indicates that the project with the largest positive NPV should be
adopted. The reason for this is that the project with the largest NPV
generates the largest NPV of the firm’s aggregated cash flows. (1
mark.)
Outstanding candidates should demonstrate their understanding of the
additivity property by noting that the additivity property holds because
present values are all measured in today’s dollars. (1 mark.)
Excellent candidates could also propose one example to clarify the
point that the choice of project relies on the additivity property.
Assume that project X is a positive NPV project, while project Y is a
negative NPV. The joint project (X+Y) will have a lower NPV than
project X on its own. The NPV enables managers to avoid choosing bad
projects just because they are packaged with good ones. (1 mark was
awarded for motivating the answer with an example.)
e. Assume that the hurdle rate used in the IRR (Internal Rate of Return)
method is the opportunity cost of capital used in the NPV calculation.
What is the implication in terms of the investment recommendation of
the two methods (NPV and IRR)? (5 marks)
The Examiners awarded 5 marks for the intuition that the two
methodologies would give the same result, and thus the same
investment recommendation. (Note that Examiners did not expect
candidates to prove this on a theoretical/numerical basis.)
13
Question 6
a. Consider the following portfolio composed of three stocks (X, Y, Z):
X 100 1.5 0.7
Y 120 1.7 0.95
Z 210 1.1 1.05

Value (£) Proportion
X 150 0.2564
Y 204 0.3487
Z 231 0.3949
Portfolio 585
(2 marks were awarded for correct calculation of the weight of each

stock.)
Beta port 0.925385
(1 mark was awarded for correct input data into formula, 2 marks for
correct answer.)
b. What are the assumptions underlying the CAPM (Capital Asset Pricing
Model)? (5 marks)
Candidates may like to refer to p.150 of the subject guide, and to
pp.221–22 of Brealey, Myers and Allen, Principles of corporate finance
(ninth edition).
Candidates should explain the four assumptions of the CAPM. A good
answer would explain each of the four assumptions as follows:
1. Investors maximise their utility only on the basis of expected
portfolio returns and return standard deviations. (1 mark.)
2. Unlimited amounts can be borrowed or loaned at the risk-free rate.
(1 marks.)
3. Markets are perfect and frictionless (i.e. no taxes on sales or
purchases, no transaction costs, and no short sales restrictions). (1
mark.)
14
4. Investors have homogeneous beliefs regarding future returns, which

means that all investors have the same information and assessment
about expected returns, standard deviations and correlations of all
feasible portfolios. (1 mark.)
Excellent candidates should note that assumptions 1–3 were implicit in
the mean-standard deviation analysis, while assumption 4 is an
additional one needed to develop the CAPM. (1 mark.)
(Candidates would get 2 marks only overall if they would simply list
the four assumptions with no further explanation.)
c. Under the CAPM framework, how do you express the expected return of
a stock? (5 marks)
(ninth edition).
Candidates are expected to write the equation for the expected return
under the CAPM framework:
[
E ( Ri ) = R f + β i E ( RM ) − R f
*
]
(1 mark for the equation with the explanation of the variables in the
equation.)
Candidates need then to provide accurate descriptions of the variables
(full marks are awarded with the appropriate technical language is
used):
βi = the covariance of the returns on asset i with the return on a
market portfolio, divided by the variance of the market return.
Formally, this is β i =
σ iM
σ M2
(2 marks.)
E(RM) = expected return on the market portfolio. (1 mark.)
[E(RM) – Rf] = market risk premium, which is the amount by which
the return of the market portfolio is expected to exceed the risk-free
rate. (1 mark.)
(Candidates would get 2 marks only overall for the equation plus very
general definitions of the variables.)
d. Discuss the methods for the estimation of the market risk premium under
the CAPM framework. Support your answer with empirical evidence. (7
marks)
Good answers to this question discuss the methods for the estimation
of the market risk premium under the CAPM. Excellent answers to this
question would also provide the relevant empirical evidence to
15
support/contrast each method. Specifically candidates should

demonstrate their ability to handle opposing views/theories.
The Examiners expect candidates to explain that the market risk
premium can be estimated either by using an arithmetical average or a
geometric average of historical returns. (1 mark.)
Then candidates should show that the empirical evidence shows that
the risk premium measured by geometric averages is much lower than
the premium based on arithmetic averages. For example the
annualised geometric equity risk premium relative to bills was 5.06 per
cent for the USA (instead of 7.05 per cent). Accordingly, the Global
investment returns yearbook 2005 (LBS/ABN Amro) estimates that the
plausible forward-looking risk premium for the world’s major markets
would be of the order of 3 per cent relative to bills on a geometric
mean basis, whereas the corresponding arithmetic mean risk premium
would be around 5 per cent. (Up to 3 marks were awarded for the
discussion of the empirical evidence.)
Excellent candidates would then conclude that the market risk
premium cannot be measured with precision, and practitioners and
scholars are still debating its magnitude and the method to be used for
the estimation. The arithmetic average is the norm for the estimation,
but the debate is still open (for example Jacquier et al., 2003 show that
the correct estimation requires compounding at a weighted average of
the arithmetic and geometric historical averages). (Up to 3 marks were
awarded for the discussion of the different views.)
e. What sort of value of beta would you expect for:
Here candidates are expected to demonstrate their understanding of
the concept of beta with an application to real life. The Examiners were
looking for the intuition that beta should be higher than 1 for both an
aggressive company (1 mark) and also for a highly leveraged company
(2 marks), and for explanations for this.
Question 7
a. Explain what is meant by informational efficiency, valuation efficiency
and allocative efficiency. (6 marks)
The Examiners would expect candidates to provide a clear definition of
the three types of efficiency, focusing on the differences between them.
(Up to 2 marks were awarded for a good definition of each type.)
A financial market is referred to as informational efficient when
security prices fully reflect all available information.
16
Informational efficiency is a more specific form of the general valuation

efficiency, which refers to whether the prices of the securities traded
on a market reflect the true fundamental (also termed intrinsic or fair)
value of the securities. Under valuation efficiency, all prices are always
correct, and reflect market fundamentals (items that have a direct
impact on future cash flows of the security). Therefore, the market
price of a security is the fair price, and has to be equal to the expected
cash flows from the security using all relevant information.
Informational efficiency is a more specific form than valuation
efficiency, because it assumes that expectations are optimal forecasts
using all available information, but not that market prices reflect the
fair value.
Valuation efficiency and informational efficiency are conditions for the
achievement of the most general efficiency condition of financial
markets: allocative efficiency. This refers to whether a market allocates
productive resources to most productive investments in performing its
main function of channelling funds from saver-lenders to spender-
borrowers
b. Theoretically derive a framework to analyse whether markets are
informationally efficient. (10 marks)
Excellent candidates should not simply list the set of equations used in
the derivation of the dividend discount model, but should provide the
economic intuition behind each equation, as shown here below. The
Examiners do not award a pass to candidates for simply listing a set of
equations.
In order to derive a theoretical framework for informational market
efficiency, candidates need to recall the equation for the estimation of
the expected rate of return on a stock (E(R)). Candidates can
generalise this equation for every financial asset (both bonds and
stocks) in any period t to t+1 by writing the following equation:
C + Pt +1 − Pt
E ( R) =
Pt (9.1)
where:
C = cash flow received from the security (dividend or coupon) in the
period t to t+1
Pt = price of the security at time t
Pt+1 = Price of the security at time t+1.
(1 mark for the correct equation and correct explanation of each item
in the equation.)
Candidates should then recall that the efficient market hypothesis
(EMH) assumes that financial markets are efficient when security
prices incorporate all available information. Therefore, in efficient
markets the expected value has to be equal to the forecasted value
17
using all available information. (1 mark.) This means that in efficient

markets the expected return on a security (E(R)) will equal be to the
optimal forecast of the return using all available information (RF).
(1 mark.) Candidates are expected to write the formal derivation:
E ( R) = R F (9.2)
(1 mark for the correct equation.)
Candidates should then state that although we cannot observe the
expected return, we know how to measure the value of E(R). Therefore
equation (9.2) has important implications for how prices of securities
change on financial markets. (1 mark.) As in equilibrium (when the
quantity of securities demanded is equal to the quantity supplied), the
expected return (E(R)) equals the equilibrium return (E(R*)), derived
either with the Capital Asset Pricing Model (CAPM) or the Asset Pricing
Theory (APT). (1 mark.) Implicit in the notion of efficient market is the
assumption that a fair price for a security exists. This fair price is
known as the equilibrium price. Formally, in equilibrium:
E ( R ) = E ( R* ) (9.3)
(1 mark for intuition on the fair price, correct equation and correct
explanation.)
To describe the pricing behaviour in efficient markets, we can replace
E(R) with E(R*) in equation (9.2). Thus we obtain:
E ( R* ) = R F (9.4)
(1 mark for the correct intuition, correct equation and correct
explanation.)
Candidates should conclude by stating that equation (9.4) means that
current prices in financial markets have to be set so that the optimal
forecast of a security return equals the expected return in equilibrium.
(1 mark.)
Candidates should finally refer to the alternative way to express this
concept – in efficient markets security prices fully reflect all available
information. Therefore from equation (9.1):
C + Pt +1 − Pt
RF = = E ( R* )
Pt (9.5)
explanation.)
c. Explain why the concept of informational efficiency is important in
capital budgeting and portfolio management. (9 marks)
The Examiners expect candidates to comment on three main reasons
that explain the relevance of informational efficiency in capital
budgeting.
First, given the main objective of capital budgeting (i.e. to maximise
shareholder wealth and therefore to maximise the value of the firm’s
18
stocks), it follows that it is important that financial markets are able to

value the firm’s stocks correctly. The signal given by the financial
market to the stockholders (through the price) has to reflect the firm’s
decisions on investment projects in a correct way. (Up to 3 marks for a
similar explanation.)
Second, given that capital budgeting techniques use a discount rate for
the appraisal of real assets, if financial markets were inefficient, it
would be virtually impossible for managers to take rational capital
investment decisions on behalf of stockholders because it would be
impossible to identify the opportunity cost of capital to be used in the
Net Present Value calculation. Therefore different investments with the
same degree of risk could generate different rates of return, and the
managers would not be able to choose the best available forgone rate
of return. (Up to 3 marks for a similar explanation.)
Third, given that one main assumption in portfolio theory is that a
financial market is reasonably efficient, if a financial market is
inefficient in pricing securities, then the equilibrium return (measured
by the CAPM or the APT) would lose credibility. (Up to 3 marks for a
Question 8
a. From the perspective of a commercial bank, what are the two main
effects caused by a change in market interest rates? Explain and provide
numerical examples to support your answer. (8 marks)
The Examiners would award marks for candidates who constructed
clear paragraphs which explained the two main elements to interest
rate risk:
• income effect as a result of:
i) refinancing risk – the risk that the cost of re-borrowing funds
will be higher than the returns earned on assets. (1 mark.)
Candidates should go on with an example to explain this in
more detail to show that they understand the definition and
have not simply learnt it from a book. (Up to 2 marks were
awarded for a good example.)
ii) reinvestment risk – the risk that the returns on funds to be
reinvested will be lower than the cost of funds. (1 mark.)
• market value effect – change in the present value of cash flows on
assets and liabilities. (2 marks.)
19
b. Consider Bank ABC. Extracts from the balance sheet are as follows
(values in £ millions and duration in years):
Value Duration
Commercial loans 5000 2.5
Mortgages 4200 7.8
T-bonds 2000 0.9
Deposits 7500 1.3
Corporate bond 2000 1.6
What is the duration gap for Bank ABC? (4 marks)

Candidates may like to refer to p.628 (fifth edition) or p.630 (sixth
edition) of Mishkin and Eakins, Financial markets and institutions.
Weighted asset duration = 2.5 x (5000/13200) + 7.8 x
(4200/13200)+ 0.9 x (2000/13200)+ 1.6 x (2000/13200) = 3.8075
years.
(2 marks were awarded for correct answer.)
Liability duration = 1.3 years.
(1 mark was awarded for correct answer.)
L 
DURgap = DURa −  x DURl  = 3.8075 − (7500 / 13200) x1.3 = 3.0689
 A 
years.
c. What is the change in the market value of equity as a percentage of
assets if interest rates rise from 4% to 5%? (2 marks)
∆Eq ∆i
= − DUR gap × = −2.95%
TA 1+ i
(1 mark was awarded for correct equation, 1 mark for correct answer.)
d. In the framework of duration gap analysis, what assumptions are made
about the change in interest rates across different maturities? (3 marks)
Candidates should show their deep understanding of the duration
property and explain that interest rates on different maturities change
exactly the same amount. (2 marks were awarded for this
explanation.) Excellent candidates would then infer that the slope of
the yield curve remains unchanged. (1 mark.)
20
e. Critically discuss the main problems associated with duration gap

analysis. (4 marks)
Candidates should explain and discuss the main problems associated
with duration gap analysis:
• The duration measure assumes a linear relationship between
interest rates and asset values (flat interest rate yield curve and
parallel shifts). However the relationship is normally convex. The
greater the convexity, the less useful the duration gap analysis. (Up
• The duration gap analysis is based on an approximation, and thus
only works well for small changes in interest rates. (Up to 2 marks
were awarded.)
f. Explain why market risk management is important in banking. (4 marks)
In part f) candidates are expected to demonstrate their ability to
discuss the reasons for the importance of market risk measurement in
banking. A very good answer would be structured as an essay-style
answer which covered the following three points:
• It provides information on the risk exposure taken by a bank’s
traders, which has to be compared with the bank’s capital resources.
(1 mark.)
• It enables banks to compare the returns to market risk in different
areas of trading, in order to identify the areas with the greatest
potential returns per unit of risk where to direct more capital and
resources. (1 mark.)
• Under the current regulations of the Bank for International
Settlements (BIS) on market risk and capital requirements, in
certain cases banks are allowed to use their own (internal) market
risk models to calculate their capital requirements. (Up to 2 marks
were awarded for this point.)
21
Specific comments on questions – Zone B

SECTION A
to be attempted with at least one from Section B.)
Question 1
a. What is meant by securitisation? Outline the process and identify the
advantages to a financial institution in securitising its assets. (5 marks)
The Examiners would expect candidates to begin with a clear
definition of securitisation, which is the process of transforming illiquid
financial assets (such as loans and mortgages) into marketable
securities. (1 mark.)
Then candidates should go on to discuss this more in detail to show
that they understand the process used by a financial institution in
securitising its assets. An outstanding answer would also provide an
intuition about the advantages associated to the phases of the process
of securitisation. Financial intermediaries can cheaply bundle together
a portfolio of loans (e.g. mortgages, credit card receivables,
commercial and computer leases) with varying small denominations
(often less than $100,000), collect the interest and principal payments
on the loans in the bundle, and then pay them out to third parties. (1
mark.)
By dividing the portfolio of loans into standardised amounts, the claims
to the principal and interests can be sold to third parties as securities.
These securities are liquid and well diversified. (1 mark.)
Financial institutions make profits by servicing the loans and charge a
fee to the third party for this service. (1 mark.)
The development of securitisation allows other financial institutions,
and not only banks, to originate loans, evaluate credit risks, bundle
these loans and sell them as securities. (1 mark.)
1
b. Explain the main characteristics of the recent crisis of the sub-prime

mortgage lending. (12 marks)
Part b) requires candidates to discuss the case of the recent crisis of the
sub-prime mortgage lending. The skill candidates are expected to
demonstrate is the ability to produce an essay with clear paragraphs
for each of the steps describing the features of this crisis. Candidates do
not have to focus too much on specific details, but should provide the
overall picture with a focus on the links between the different aspects.
Candidates are first expected to explain that over the recent past
structured credit markets experienced a rapid growth under benign
conditions. Investors showed a high-risk appetite that has stimulated
further development by financial institutions of techniques for
unbundling and distributing risks through financial markets. This has
led to a marked expansion of the so-called sub-prime mortgage market.
(2 marks.) However, recently the US sub-prime market has
experienced serious problems. These problems materialised in a
financial crisis, which spread internationally. (1 mark.)
Good candidates at this regard should note that the term sub-prime
generally refers to borrowers who do not qualify for prime interest
rates because they have weakened credit histories, low credit scores,
high debt burden ratios or high loan-to-value ratios). (1 mark.)
Candidates should then go on with the discussion of characteristics of
the US sub-prime market that have contributed to the recent problems:
• In 2005 and 2006, the competition among the sub-prime
originators intensified. To maintain volumes and/or increase
market share, originators introduced product innovations (e.g.
‘affordable lending’ products, often incorporating low initial ‘teaser’
rates that are reset after two or so years). (2 marks.)
• In the same years, there was an apparent weakening of lending
standards. Loans were made with increasingly high loan-to-value
ratios and often without full documentation. (1 mark.)
• Most originators sold the loans to larger banks, who in turn
securitised them and sold them to end-investors. Therefore banks
had significant warehouses of sub-prime mortgages. Nevertheless,
the distribution of assets from warehouses relies on continued
market liquidity. This explains the recent, large injection of liquidity
arranged by central banks to stem the crisis. (2 marks.)
Dealers purchase mortgages from originators, and the price paid (bid)
is based on a sample of mortgages. If the whole pool of mortgages does
not conform to this sample the dealer can ‘put back’ the loan pool to
the originator. If the borrower makes no payments at all, or defaults in
the first few months, this is classified as an ‘early payment default’ and
again the dealer can return the specific loan to the originator. The right
to return such loans helps to align the incentives between the
originators who underwrite the risk and the dealers who securitise the
mortgages. However, due to the obligation to take back the mortgages,
2
some originators went bankrupt, and the risk then flowed back to the
banks that held their direct credit lines. (3 marks.)
Note that an appropriate discussion of this last point makes the answer
an outstanding one.
c. Discuss the three main changes in US banking regulation that occurred in
the 1980s and 1990s. (8 marks)
A good way to tackle this question would be to discuss critically the
three main regulatory changes occurred in the US (the erosion of the
Glass-Steagall Act prohibitions, the elimination of the Glass-Steagall
Act, the relaxation of the historical restriction on banks’ crossing state
boundaries). Good answers would provide a desciption of the changes,
whereas outstanding answers would discuss the implications of the
changes for the intermediaries operating in the financial system.
An outstanding answer would be structured in an essay style that
covers the following points on the three regulatory changes:
• The erosion of the Glass-Steagall Act prohibitions. (1 mark.) In
1987 the Federal Reserve allowed affiliates of approved commercial
banks to engage in underwriting activities as long as the revenue
did not exceed a specified amount – which started at 10 per cent,
but was raised to 25 per cent – of the affiliates’ total revenues. (1
mark.) In 1988 the Federal Reserve used a loophole in s.20 of the
Glass-Steagall Act to allow three commercial banks (Bankers’ Trust,
Citicorp and J.P. Morgan) to underwrite corporate debt securities
and to underwrite stocks. Two competitive reasons determined this
legislative change. (1 mark.) On the one hand, brokerage firms
began to engage in the traditional banking business of issuing
deposits. On the other hand, foreign banks’ activities in the USA
eroded the position of national US banks. (1 mark.)
• The elimination of the Glass-Steagall Act. The Gramm-Leach-Bliley
Financial Services Modernization Act of 1999 allows securities firms
and insurance companies to purchase banks, and allows banks to
underwrite insurance and securities and engage in real estate
activities. (1 mark.)
• The relaxation of the historical restriction on banks’ crossing state
boundaries. (1 mark.) The Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994 stated that after 1997 banks
would be essentially unrestricted with regard to inter-state banking,
except in states that opted out or imposed other restrictions. (1
mark.) Nationwide banks are now beginning to emerge. (1 mark.)
3
Question 2
a. Explain how to reduce/solve the problems arising from moral hazard in
debt markets. (12 marks)
Candidates are required to discuss the solutions to the moral hazard
problem in debt markets.
Good candidates should first explain that debt contracts reduce the
amount of moral hazard in comparison to equity contracts, but they do
not solve the problem. Borrowers have incentives to take investments
riskier than lenders would like: borrowers get all the gains from a risky
investment if they succeed, but lenders lose most, if not all, of their
loan if borrowers do not succeed. (1 mark.)
The Examiners were then looking for the list of the three main
solutions:
1. making debt contract incentive-compatible (i.e. aligning the
incentives of borrowers and lenders)
2. monitoring and enforcement of restrictive covenants
3. financial intermediaries.
(1 mark for listing the three tools.)
Good answers would be structured as an essay-style answer which
covered the three solutions.
First, investors are more likely to take on riskier investment projects
when using borrowed funds than when using their own funds. Thus
the moral hazard problem can be reduced by increasing the stake of
personal net worth (the difference between personal assets and
liabilities). One way to reduce the moral hazard problem is to make
debt contract incentive-compatible, or rather to align the incentives of
the borrowers and lenders. (1 mark.)
A second way in which the moral hazard problem can be reduced is by
introducing restrictive covenants into debt contracts. A restrictive
covenant is a provision aimed at restricting the borrower’s activity.
Examiners here expected a discussion of the four types of possible
covenants (and relevant examples). (Up to 4 marks were awarded.)
Outstanding candidates would explain that although covenants reduce
moral hazard problems, they do not eliminate them: it is not possible
to rule out every risky activity. Moreover, in order to make covenants
effective, they must be monitored and enforced. (1 mark.) Monitoring
typically involves increasing returns to scale, which implies that it is
more efficiently performed by specialised financial institutions.
Individual lenders tend to delegate the monitoring activities instead of
performing them directly. Thus the monitor has to be given an
incentive to do its job properly. (1 mark.) However, because
monitoring and enforcement are costly activities, investors can free-
ride on the monitoring and enforcement undertaken by other investors.
4
Thus in the bond market (as well as in the stock market) the free-rider
problem arises. The consequence will be that insufficient resources will
be devoted to these activities. (1 mark.)
Third, financial intermediaries, and especially banks, can be seen to
provide solutions both to the incentive problem and to the free-rider
problem. They solve the incentive problem using several mechanisms,
such as reputation effects, and the option for depositors to withdraw
their money should the bank managers prove incompetent. They do
not face the same free-rider problem, as they primarily make private
loans not traded on the market. Banks therefore gain the full benefits
of their monitoring and enforcement activities and have an incentive to
devote sufficient resources to them. The possibility of overcoming
moral hazard with adequate instruments (such as screening and
monitoring), favoured by the existence of established long-term
relationships, enables this theory to emphasise the peculiar nature and
role of banks in the allocation process. (2 marks.)
b. Explain the hypotheses, the framework, and the main findings of the
delegated monitoring theory. (13 marks)
Here candidates are expected to demonstrate their knowledge and
understanding of hypotheses, framework and key findings of the
delegated monitoring theory, as formulated by Diamond (1984).
Excellent answers will describe this theory by using the appropriate
technical terms.
The main idea of the delegated monitoring theory is as follows: Since
monitoring borrowers is costly, it is efficient for surplus units (lenders)
to delegate the task of monitoring to specialised agents such as banks.
Banks have a comparative advantage relative to direct lending in
monitoring activities in the context of costly state verification. In fact,
they have a better ability to reduce monitoring costs because of their
diversification.
(Up to 2 marks for the explanation of the main idea.)
Hypotheses required for delegated monitoring to work:
1. existence of scale economies in monitoring, that means that a
typical bank finances many projects
2. small capacity of investors as compared to the size of investments,
that means that each project needs the funds of several investors
3. low cost of delegation, that means that the cost of monitoring the
financial intermediary itself has to be less than the surplus gained
from exploiting scale economies in monitoring investment projects.
(One mark awarded for each of the hypotheses.)
Framework of the delegated monitoring theory: It is based on the
existence of n identical firms that seek to finance projects and the
requirement by each firm of an investment of one unit.
The cash flow y that the firm obtains from its investment is a priori
unobservable to lenders. This is where moral hazard arises.
5
Moral hazard can be solved by:

• either ‘monitoring’ the firm (at cost K)
• or ‘designing’ a debt contract characterised by a non-pecuniary cost
C.
(Up to 3 marks awarded for the description of the framework.)
Main findings: Assume that K<C. If the firm has a unique financier, it
would be efficient to choose the monitoring option. However, assume
that each investor owns only 1/m, so that m of them are needed for
financing the project. Assume also that the total number of investors is
m*n, so that all the projects can be financed. Direct lending implies
that each of the m investors monitors the financed firm: the total cost
is n*m*K.
If a bank (financial intermediary) emerges, it can choose to monitor
each firm (total cost n*K) or to sign a debt contract with each of them
(total cost n*C). Since K<C, the first solution is preferable: the bank is
a delegated monitor, which monitors borrowers on behalf of lenders
(note that the banks is not monitored by its lenders – the depositors).
Financial intermediation (delegated monitor) dominates direct lending
as soon as n is large enough: this means that diversification exists (i.e.
a large number of loans is held by the intermediary). Diversification is
important because it increases the probability that the intermediary has
sufficient loan proceeds to repay a fixed debt claim to depositors.
(Up to 5 marks awarded for the explanation of the findings.)
Question 3
a. Explain the empirical evidence on market overreaction in the context of
weak and semi-strong form efficiency. (14 marks)
Detailed evidence in Bernard and Thomas ‘Post-earnings
announcement drift: delayed price response or risk premium?’, Journal
of accounting research 27 1989, pp.1–36.
This question relates to the empirical evidence on market overreaction,
and therefore relates to the validity of semi-strong efficiency in stock
markets.
Candidates should begin by stating that evidence on market
overreaction constitutes an anomaly related to earnings
announcements. Although empirical evidence generally confirms rapid
adjustment to new information (as shown in the evidence in favour of
the semi-strong-form efficiency), recent evidence shows that stock
prices do not instantaneously adjust. Two key anomalies are pointed
out: stock price overreaction and underreaction. (1 mark.)
A definition of overreaction should be provided: market overreaction
means that prices may disproportionately increase (decrease) to good
(bad) news announcements, and the pricing error is corrected only
slowly. (1 mark.)
6
Candidates are then expected to move to the citation of the empirical

evidence that shows that adjustment to extreme bad news takes several
months: there is a market overreaction and subsequent gradual
adjustment (see for example the evidence in Ball and Brown, 1968,
then confirmed by Bernard and Thomas, 1989). (1 mark for citing the
authors.)
The Examiners then expect the description of the methodology and
findings of the study by Bernard and Thomas (1989). They calculate
the Cumulative Abnormal Returns (CAR) for 10 portfolios with
different levels of unexpected good or bad earnings over the years
1974–1986. CAR are measured for the pre- and post-announcement
period. Portfolio 10 contains the 10 per cent of the stocks with the
highest earnings performance, portfolio 1 the lowest 10 per cent. As
shown in Bernard and Thomas (1989), portfolio 10 (extreme good
news) disproportionately increases its performance in the days
immediately preceding the announcement, instead portfolio 1 (extreme
bad news) disproportionately decreases its performance. However, in
the medium-long term after the announcement, the performance of
portfolio 10 decreases and the performance of portfolio 1 markedly
increases. It seems that there is an overreaction before the
announcement, and then the market needs subsequent gradual
adjustments to correct the reaction to the unexpected information. As a
consequence investors could get excess returns by implementing a
trading strategy: to buy (sell) stocks immediately after the
announcement of bad (good) news, and sell (buy) them after several
months when the price has risen (fallen) again. This trading strategy is
known as contrarian strategy. The possibility of profitably
implementing a contrarian strategy in such a framework is inconsistent
with semi-strong-form efficiency.
(Up to 7 marks were awarded for the discussion of the study by
Bernard and Thomas (1989). Examiners would expect an excellent
answer to describe this evidence by using the appropriate technical
terms.)
Outstanding candidates were expected to make the link with the
empirical evidence on overreaction existing at a different level of
informational efficiency – the weak form efficiency (see, for example,
DeBondt and Thaler, 1987). This evidence indicates that portfolios
composed by extreme ‘losers’ (stocks that have performed poorly in the
recent past) dramatically outperformed prior portfolios formed by
extreme ‘winners’ (stocks that have increased in price in the recent
past). In the 36 months after the portfolio formation, extreme loser
portfolios earned 25 per cent more than extreme winner portfolios.
Once again, we have evidence of the possibility of getting excess
returns out of a contrarian strategy. But in this case, such a possibility
is inconsistent with the weak-form efficiency because the definition of
winners and losers is based on historical returns and not on the release
of a new piece of information.
(Up to 4 marks were awarded for the discussion of overreaction in the
context of weak-form efficiency.)
7
b. Describe and discuss the evidence on calendar effects in the context of

weak form efficiency. Refer specifically to the so-called ‘January effect’.
(11 marks)
Candidates should begin with a clear list of the possible calendar
effects, and then focus on the so-called ‘January effect’, which shows
that stocks returns are greater in January than in any other month of
the year.
(Definitions of calendar effect and January effect are awarded 1 mark
each.)
• A calendar effect represents a pattern in stock returns related to
either the day of the week, the week of the month or the month of
the year. Examples of calendar effects are the January effect, the
lower returns on Monday than in other days of the week, and the
occurrence of most daily returns at the beginning and end of the
day.
• The January effect shows that stock returns (particularly for small
stocks) are greater in January than in any other month of the year.
Candidates should also make clear that the empirical evidence on the
January effect is inconsistent with random-walk behaviour, and gives
strong indications against market weak-form efficiency. (Up to 3 marks
were awarded for showing a good understanding of the January
effects, as explained here below.)
The January effect seems to indicate a trading rule: buy small stocks at
the end of December and sell them at the end of January. In this way
you will make a profit. Why is the existence of the January effect
problematic? Assume that all investors observe such a January strategy
generating excess returns. All investors would follow it. But the
consequence would be an increase in prices at the end of December
(because of the increase in demand), and a decrease at the end of
January (due the increase in supply). Therefore excess returns would
tend to be eliminated. The continued existence of the January effect is
puzzling. Specifically, it is inconsistent with random-walk behaviour,
and gives strong indications against weak-form market efficiency.
Good candidates are then expected to discuss the hypotheses that have
been advanced to explain this effect. These include:
• Association of the January effect with the small firms effect: as
reported in Fama (1991), over the period 1941–1981, the return
experienced in January was 8.06 per cent for small stocks and
1.342 per cent for large stocks. In both cases the January return was
higher than the average return in other months, but also most of
the January effect was associated with small stocks. Note however
that in recent years – the period 1981–1991 – the difference in
January returns between large and small stocks was less
pronounced. (Up to 2 marks were awarded to explain the small firm
8
effect. Examiners would expect an excellent answer to describe the

relevant study associated with the explanation.)
• Taxation impacts (i.e. tax-selling hypothesis). Investors sell
securities for which substantial losses have been incurred before the
end of the year, in order to benefit from a tax loss. Such investors
do not invest the proceeds back into the market until the new year.
The selling in December would depress prices, whereas the
purchasing in early January would generate increases in prices.
However, even this explanation does not seem completely plausible:
in fact we do not observe in financial markets any negative
December effect when the tax-loss incentive induce selling the
stocks. (Up to 2 marks were awarded for explaining the taxation
effect.)
• Implications of the remuneration structure of fund managers.
Haugen and Lakonishok (1988) hypothesise that portfolio manager
behaviour around the turn of the year may be a major cause of the
January/small-firm effect and that the effect may result from
window dressing or performance hedging. Window dressing can be
value reducing (because of the unnecessary transaction costs
necessary to discern true rather than ‘dressed up’ portfolio
composition) whereas performance hedging may be associated with
investor value maximisation (thanks to the possibility to lock in
superior performance). Cheng-few, Porter and Weaver (1998)
suggest that the hypothesis of performance hedging is more likely
than the one of window dressing. (Up to 2 marks were awarded to
explain the implications of the remuneration structure of fund
managers. Examiners would expect an excellent answer to describe
the relevant study associated with the explanation.)
Question 4
a. What are the methods used by banks to measure the credit risk
concentration of their loan portfolios? Explain and provide examples
where appropriate. (10 marks)
The Examiners would expect candidates to begin with a list of methods
used by banks to measure credit risk concentration in their loan
portfolios: migration analysis and concentration limits. (1 mark.)
Candidates should then demonstrate their knowledge and
understanding of the two methods.
In migration analysis, banks monitor the credit ratings (as provided by
Standard and Poor’s and Moody’s) of a number of firms in an industry.
If they decline faster than the historical trend of the industry, banks
reduce the lending to the industry. A loan migration matrix provides
the probability of a pool of loans being upgraded, downgraded or
defaulting over some period.
(Up to 3 marks for discussing migration analysis, a further 3 marks for
providing an example with an hypothetical rating migration matrix.)
9
Concentration limits are set by banks in terms of the proportion of the

loan portfolio that can go to any single borrower. Banks typically set
concentration limits to reduce exposures to certain industries and/or
geographic areas. Bank regulators impose a limit on loan concentration
to individual borrowers equal to 10 per cent of a bank’s capital.
(Up to 3 marks for explaining concentration limits.)
b. ‘Banks can manage credit risk through collateral and endorsement.’
Discuss. (9 marks)
A good way to tackle this question would be to critically discuss the
following points: definition of collateral, identification of the assets
commonly used as collateral, relationship between the characteristics
of collateral and amount of the loan.
As regards the definition, loans with collateral requirements are often
referred to as secured loans. Collateral are the assets used by the
borrower to guarantee the repayment of the debt. In case of
bankruptcy, the lender can sell these assets and use the proceeds. Once
the asset is used as collateral, the borrower is assumed not to dispose
of it. (Up to 3 marks were awarded for these definitions.)
Assets that are commonly used as collateral are: real properties, cars
and goods that can be mortgaged; equipment and inventories;
accounts receivable; securities and saving accounts. (1 mark.)
In terms of the the maximum amount of the loan in proportion to the
collateral, the bank must take the following factors into account. The
higher the volatility of the collateral’s value and the lower its
marketability, the smaller the amount of the loan. On average, banks
can lend up to 90 per cent of the value of high-trade treasury bills, but
only up to 75 per cent of the value of high-capitalisation stocks, and
much less on inventories. (Up to 2 marks were awarded.)
Outstanding answers should mention the following points:
In the case of commercial loans, a particular form of collateral required
by banks is known as compensating balances: a firm receiving a loan
must keep a required minimum amount of funds in a cheque account
at the bank. (1 mark.)
There is a difference between the USA and Europe, since in the USA
short-term loans tend to be unsecured, whereas in Europe they tend to
be either collateralised or endorsed by a third party. (1 mark.)
If a loan is endorsed by a third party (just in case the borrower goes
bankrupt), the third party is committed to repaying the debt. This
additional guard against loss from default is similar to providing
collateral as far as the lending bank is concerned. (1 mark.)
10
c. Discuss the mechanisms used by banks to reduce the moral hazard

problem in the monitoring of credit risk. (6 marks)
The Examiners first expect to find the list of the two mechanisms to
monitor the borrower’s activities: to write covenants into loan contracts
and to establish long-term customer relationship. (1 mark.)
Good candidates would then go on with the discussion of each
mechanism.
Writing covenants into loans: The loan contract may contain covenants
restricting or encouraging various future actions of the firm to enhance
the probability of the repayment. The rationale behind covenants is
that the loan is backed both by the firm’s assets and also by the stream
of future cash flow produced by the firm. (Up to 2 marks were
awarded for demonstrating the knowledge of this mechanism.)
The existence of long-term customer relationships benefits the bank as
well as the borrower. In case the borrower has previous loan contracts
with the bank, there are lower costs of monitoring for the bank because
the monitoring procedures have already been established. As a
consequence of the lower costs, the borrower may obtain loans at
lower interest rates. Moreover, the borrower has the incentive to avoid
risky activities, even if these activities are not specifically addressed in
the covenants of the loan contract. In case the bank is not satisfied with
the borrower’s behaviour, it may discourage the borrower from these
activities by threatening to refuse new loans in the future. (Up to 3
marks were awarded for demonstrating the knowledge of this
mechanism.)
SECTION B
to be attempted with at least one from Section A.)
Question 5
a. Consider the two following mutually exclusive projects (A and B):
Cash flows
Project C0 C1 C2
A -1500 900 250
B -1500 0 1500
Assuming an opportunity cost of capital of 10 per cent, what is the NPV of
the two projects? Which project would you accept? (5 marks)
11
NPV(A) -475.2066
NPV(B) -260.3306
For each NPV calculation: 1 mark was awarded for correct input data
into NPV formula and 1 mark for correct answer for NPV.
Candidates should make clear that none of the project should be
accepted. (1 mark was awarded for this concluding remark.)
b. What type of cash flows have to be discounted in the NPV method?
Explain why. (5 marks)
edition).
The Examiners expect to read that the cash flows to be discounted in
the NPV method are ‘incremental cash flows’, which are the additional
cash flows from the project. (2 marks were awarded for this
statement.)
Good candidates would make clear that sunk costs have to be excluded
from the above calculation, because they are incurred whether or not
the project is accepted. (2 marks were awarded for this concept.)
Excellent answers will stress that the implicit assumption about cash
flows associated with the investment project is that they can be
estimated without error. However, in the real world, the cash flows
associated with investment projects represent forecasts, and not real
values. Therefore the cash flows have to be estimated in an uncertain
framework. (1 mark was awarded for expressing this view.)
c. Explain what is meant by the ‘opportunity cost of capital’ in the context
of the NPV method. (5 marks)
Candidates may like to refer to p.124 of the subject guide , and to
p.119 of Brealey, Myers and Allen, Principles of corporate finance (ninth
edition).
A good way to tackle this question is by providing the definition of the
opportunity cost of capital – it is the rate of return used to discount the
expected cash inflows has to be the rate of return offered by equivalent
investment alternatives in the capital market. (1 mark was awarded for
this definition.)
Candidates should further explain that the label ‘opportunity’ derives
from the fact that it represents the return forgone by investing in the
project rather than in financial assets (securities). (1 mark.)
Excellent candidates would illustrate that the opportunity cost of
capital is a market-determined opportunity cost. The assumption is that
12
shareholders can reinvest their money at this market-determined rate.

(Up to 2 marks were awarded for this.)
Note that in the context of a firm, the label ‘cost of capital’ indicates
that the costs of all the sources of capital (both equity issues and debt
issues) have to be taken into account. (1 mark was awarded for
discussing this detail.)
d. Explain the additivity property of the NPV method. (5 marks)
Candidates should first explain the meaning to the additivity property
(i.e. the NPV of projects X and Y is equal to the NPV of project X plus
the NPV of project Y) and should also provide the relevant notation:
NPV ( X + Y ) = NPV ( X ) + NPV (Y )
(1 mark was awarded for providing the definition and equation.)
Candidates are then expected to discuss the implications of the
additivity property:
• The value of the firm is simply the sum of the values of the separate
projects. (1 mark.)
• When there are mutually exclusive projects, the NPV method
indicates that the project with the largest positive NPV should be
adopted. The reason for this is that the project with the largest NPV
generates the largest NPV of the firm’s aggregated cash flows. (1
mark.)
Outstanding candidates should demonstrate their understanding of the
additivity property by noting that the additivity property holds because
present values are all measured in today’s dollars. (1 mark.)
Excellent candidates could also propose one example to clarify the
point that the choice of project relies on the additivity property.
Assume that project X is a positive NPV project, while project Y is a
negative NPV. The joint project (X+Y) will have a lower NPV than
project X on its own. The NPV enables managers to avoid choosing bad
projects just because they are packaged with good ones. (1 mark was
awarded for motivating the answer with an example.)
e. Assume that the hurdle rate used in the IRR (Internal Rate of Return)
method is the opportunity cost of capital used in the NPV calculation.
What is the implication in terms of the investment recommendation of
the two methods (NPV and IRR)? (5 marks)
The Examiners awarded 5 marks for the intuition that the two
methodologies would give the same result, and thus the same
investment recommendation. (Note that Examiners did not expect
candidates to prove this on a theoretical/numerical basis.)
13
Question 6
a. Consider the following portfolio composed of three stocks (A, B, C):
A 500 1.5 0.8
B 520 1.7 0.97
C 610 1.1 1.04

Value
(£) Proportion
A 750 0.3254
B 884 0.3835
C 671 0.2911
Portfolio 2305
(2 marks were awarded for correct calculation of the weight of each

stock.)
Beta port 0.935063
(1 mark was awarded for correct input data into formula, 2 marks for
correct answer.)
b. What are the assumptions underlying the CAPM (Capital Asset Pricing
Model)? (5 marks)
(ninth edition).
Candidates should explain the four assumptions of the CAPM. A good
answer would explain each of the four assumptions as follows:
1. Investors maximise their utility only on the basis of expected
portfolio returns and return standard deviations. (1 mark.)
2. Unlimited amounts can be borrowed or loaned at the risk-free rate.
(1 mark.)
3. Markets are perfect and frictionless (i.e. no taxes on sales or
purchases, no transaction costs, and no short sales restrictions).
(1 mark.)
14
4. Investors have homogeneous beliefs regarding future returns, which

means that all investors have the same information and assessment
about expected returns, standard deviations and correlations of all
feasible portfolios. (1 mark.)
Excellent candidates should note that assumptions 1–3 were implicit in
the mean-standard deviation analysis, while assumption four is an
additional one needed to develop the CAPM. (1 mark.)
(Candidates would get 2 marks only overall if they simply listed the
four assumptions with no further explanation.)
c. Under the CAPM framework, how do you express the expected return of
a stock? (5 marks)
(ninth edition).
Candidates are expected to write the equation for the expected return
under the CAPM framework:
*
[
E ( Ri ) = R f + β i E ( RM ) − R f ]
(1 mark for the equation with the explanation of the variables in the
equation.)
Candidates then need to provide accurate descriptions of the variables
(full marks are awarded with the appropriate technical language is
used):
βi = the covariance of the returns on asset i with the return on a
market portfolio, divided by the variance of the market return.
Formally, this is β i = σ iM
2
σM
(2 marks.)
E(RM) = expected return on the market portfolio. (1 mark.)
[E(RM) – Rf] = market risk premium, which is the amount by which
the return of the market portfolio is expected to exceed the risk-free
rate. (1 mark.)
(Candidates would get 2 marks only overall for the equation plus very
general definitions of the variables.)
d. Discuss the methods for the estimation of the market risk premium under
the CAPM framework. Support your answer with empirical evidence. (7
marks)
The Examiners expect candidates to explain that the market risk
premium can be estimated either by using an arithmetical average or a
geometric average of historical returns. (1 mark.)
15
Then candidates should show that the empirical evidence shows that
the risk premium measured by geometric averages is much lower than
the premium based on arithmetic averages. For example the
annualised geometric equity risk premium relative to bills was 5.06 per
cent for the USA (instead of 7.05 per cent). Accordingly, the Global
investment returns yearbook 2005 (LBS/ABN Amro) estimates that the
plausible forward-looking risk premium for the world’s major markets
would be of the order of 3 per cent relative to bills on a geometric
mean basis, whereas the corresponding arithmetic mean risk premium
would be around 5 per cent. (Up to 3 marks were awarded for the
discussion of the empirical evidence.)
Excellent candidates would then conclude that the market risk
premium cannot be measured with precision, and practitioners and
scholars are still debating its magnitude and the method to be used for
the estimation. The arithmetic average is the norm for the estimation,
but the debate is still open (for example Jacquier et al., 2003 show that
the correct estimation requires compounding at a weighted average of
the arithmetic and geometric historical averages). (Up to 3 marks were
awarded for the discussion of the different views.)
e. What sort of value of beta would you expect for:
i) an aggressive company, and,
ii) a highly levered company? Explain your answers. (3 marks)
Here candidates are expected to demonstrate their understanding of
the concept of beta with an application to real life. The Examiners were
looking for the intuition that beta should be higher than 1 for both an
aggressive company (1 mark) and also for a highly leveraged company
(2 marks), and candidates should provide explanations for this.
Question 7
a. Explain what is meant by informational efficiency, valuation efficiency
and allocative efficiency. (6 marks)
The Examiners would expect candidates to provide a clear definition of
the three types of efficiency, focusing on the differences between them.
(Up to 2 marks were awarded for a good definition of each type.)
A financial market is referred to as informational efficient, when
security prices fully reflect all available information.
Informational efficiency is a more specific form of the general valuation
efficiency, which refers to whether the prices of the securities traded
on a market reflect the true fundamental (also termed intrinsic or fair)
value of the securities. Under valuation efficiency, all prices are always
correct, and reflect market fundamentals (items that have a direct
impact on future cash flows of the security). Therefore, the market
price of a security is the fair price, and has to be equal to the expected
16
cash flows from the security using all relevant information.

Informational efficiency is a more specific form than valuation
efficiency, because it assumes that expectations are optimal forecasts
using all available information, but not that market prices reflect the
fair value.
Valuation efficiency and informational efficiency are conditions for the
achievement of the most general efficiency condition of financial
markets: allocative efficiency. This refers to whether a market allocates
productive resources to most productive investments in performing its
main function of channelling funds from saver-lenders to spender-
borrowers.
b. Theoretically derive a framework to analyse whether markets are
informationally efficient. (10 marks)
Excellent candidates should not simply list the set of equations used in
the derivation of the dividend discount model, but should provide the
economic intuition behind each equation, as shown here below. The
Examiners do not award a pass to candidates for simply listing a set of
equations.
In order to derive a theoretical framework for informational market
efficiency, candidates need to recall the equation for the estimation of
the expected rate of return on a stock (E(R)). Candidates can
generalise this equation for every financial asset (both bonds and
stocks) in any period t to t+1 by writing the following equation:
C + Pt +1 − Pt
E ( R) =
Pt (9.1)
where:
C = cash flow received from the security (dividend or coupon) in the
period t to t+1
Pt = price of the security at time t
Pt+1 = Price of the security at time t+1.
(1 mark for the correct equation and correct explanation of each item
in the equation.)
Candidates should then recall that the efficient market hypothesis
(EMH) assumes that financial markets are efficient when security
prices incorporate all available information. Therefore, in efficient
markets the expected value has to be equal to the forecasted value
using all available information. (1 mark) This means that in efficient
markets the expected return on a security (E(R)) will equal be to the
optimal forecast of the return using all available information (RF). (1
mark.) Candidates are expected to write the formal derivation:
E ( R) = R F (9.2)
(1 mark for the correct equation.)
17
Candidates should then state that although we cannot observe the

expected return, we know how to measure the value of E(R). Therefore
equation (9.2) has important implications for how prices of securities
change on financial markets. (1 mark.) As in equilibrium (when the
quantity of securities demanded is equal to the quantity supplied), the
expected return (E(R)) equals the equilibrium return (E(R*)), derived
either with the Capital Asset Pricing Model (CAPM) or the Asset Pricing
Theory (APT). (1 mark.) Implicit in the notion of efficient market is the
assumption that a fair price for a security exists. This fair price is
known as the equilibrium price. Formally, in equilibrium:
E ( R ) = E ( R* ) (9.3)
(1 mark for intuition on the fair price, correct equation and correct
explanation.)
To describe the pricing behaviour in efficient markets, we can replace
E(R) with E(R*) in equation (9.2). Thus we obtain:
E ( R* ) = R F (9.4)
explanation.)
Candidates should conclude by stating that equation (9.4) means that
current prices in financial markets have to be set so that the optimal
forecast of a security return equals the expected return in equilibrium.
(1 mark.)
Candidates should finally refer to the alternative way to express this
concept – in efficient markets security prices fully reflect all available
information. Therefore from equation (9.1):
C + Pt +1 − Pt
RF = = E ( R* )
Pt (9.5)
(1 mark the correct intuition, correct equation and correct
explanation.)
c. Explain why the concept of informational efficiency is important in
capital budgeting and portfolio management. (9 marks.)
The Examiners expect candidates to comment on three main reasons
that explain the relevance of informational efficiency in capital
budgeting.
First, given the main objective of capital budgeting (i.e. to maximise
shareholder wealth and therefore to maximise the value of the firm’s
stocks), it follows that it is important that financial markets are able to
value the firm’s stocks correctly. The signal given by the financial
market to the stockholders (through the price) has to reflect the firm’s
decisions on investment projects in a correct way. (Up to 3 marks for a
18
Second, given that capital budgeting techniques use a discount rate for
the appraisal of real assets, if financial markets were inefficient, it
would be virtually impossible for managers to take rational capital
investment decisions on behalf of stockholders because it would be
impossible to identify the opportunity cost of capital to be used in the
Net Present Value calculation. Therefore different investments with the
same degree of risk could generate different rates of return, and the
managers would not be able to choose the best available forgone rate
of return. (Up to 3 marks for a similar explanation.)
Third, given that one main assumption in portfolio theory is that a
financial market is reasonably efficient, if a financial market is
inefficient in pricing securities, then the equilibrium return (measured
by the CAPM or the APT) would lose credibility. (Up to 3 marks for a
Question 8
a. From the perspective of a commercial bank, what are the two main
effects caused by a change in market interest rates? Explain and provide
numerical examples to support your answer. (8 marks)
The Examiners would award marks for candidates who constructed
clear paragraphs which explained the two main elements to interest
rate risk:
1. income effect as a result of:
i) refinancing risk – the risk that the cost of re-borrowing funds
will be higher than the returns earned on assets. (1 mark.)
ii) reinvestment risk – the risk that the returns on funds to be
reinvested will be lower than the cost of funds. (1 mark.)
awarded for a good example).
2. market value effect – change in the present value of cash flows on
assets and liabilities. (2 marks.)
19
b. Consider Bank First. Extracts from the balance sheet are as follows
(values in £ millions and duration in years):
Value Duration
Loans (short term) 4000 0.8
Mortgages 3200 7.8
T-bonds 1000 0.9
Deposits 8500 1.3
Municipal bond 1500 1.6
What is the duration gap for Bank First? (4 marks)

Weighted asset duration = 0.8 x (4000/9700) + 7.8 x (3200/9700)+
0.9 x (1000/9700)+ 1.6 x (1500/9700) = 3.2433 years.
Liability duration = 1.3 years.
(1 mark was awarded for correct answer.)
L 
DURgap = DURa −  x DURl  = 3.2433 − (8500 / 9700) x1.3 = 2.1041
A 
years.
c. What is the change in the market value of equity as a percentage of
assets if interest rates decrease from 5.5% to 4.5%? (2 marks)
∆Eq ∆i
= − DURgap × = +1.99%
TA 1+ i
(1 mark was awarded for correct equation, 1 mark for correct answer.)
d. In the framework of duration gap analysis, what assumptions are made
about the change in interest rates across different maturities? (3 marks)
Candidates should show their deep understanding of the duration
property and explain that interest rates on different maturities change
exactly the same amount. (2 marks were awarded for this
explanation.) Excellent candidates would then infer that the slope of
the yield curve remains unchanged. (1 mark.)
20
e. Critically discuss the main problems associated with duration gap

analysis. (4 marks)
Candidates may like to refer to p.115 of the subject guide and to
Candidates should explain and discuss the main problems associated to
duration gap analysis:
• The duration measure assumes a linear relationship between
interest rates and asset values (flat interest rate yield curve and
parallel shifts). However the relationship is normally convex. The
greater the convexity, the less useful the duration gap analysis. (Up
• The duration gap analysis is based on an approximation, and thus
only works well for small changes in interest rates. (Up to 2 marks
were awarded.)
f. Explain why market risk management is important in banking. (4 marks)
In part f) candidates are expected to demonstrate their ability to
discuss the reasons for the importance of market risk measurement in
banking. A very good answer would be structured as an essay-style
answer which covered the following three points:
• It provides information on the risk exposure taken by a bank’s
traders, which has to be compared with the bank’s capital resources.
(1 mark.)
• It enables banks to compare the returns to market risk in different
areas of trading, in order to identify the areas with the greatest
potential returns per unit of risk where to direct more capital and
resources. (1 mark.)
• Under the current regulations of the Bank for International
Settlements (BIS) on market risk and capital requirements, in
certain cases banks are allowed to use their own (internal) market
risk models to calculate their capital requirements. (Up to 2 marks
were awarded for this point.)
21

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UNIVERSITY OF LONDON 279 0024 ZA

Principles of Banking and Finance

Thursday, 14th May 2009 : 2.30pm to 5.30pm

© University of London 2009

What is the beta of this portfolio? (5 marks)

i. an aggressive company, and,

(b) Theoretically derive a framework to analyze whether markets are informationally

(c) Explain why the concept of informational efficiency is important in capital

What is the duration gap for Bank ABC? (4 marks)

(f) Explain why market risk management is important in banking.

UNIVERSITY OF LONDON 279 0024 ZB

Principles of Banking and Finance

Thursday, 14th May 2009 : 2.30pm to 5.30pm

© University of London 2009

What is the beta of this portfolio? (5 marks)

i. an aggressive company, and,

(b) Theoretically derive a framework to analyze whether markets are informationally

(c) Explain why the concept of informational efficiency is important in capital

What is the duration gap for Bank First? (4 marks)

(f) Explain why market risk management is important in banking. (4 marks)

Examiners’ commentaries 2009

24 Principles of banking and finance

Specific comments on questions – Zone A

b. Explain the main characteristics of the recent crisis of the sub-prime

3. Financial intermediaries operating in the equity market are able to

Framework of the delegated monitoring theory: it is based on the

A definition of underreaction should be provided: underreaction to

b. Describe and discuss the evidence on calendar effects in the context of

effect. Examiners would expect an excellent answer to describe the

Concentration limits are set by banks in terms of the proportion of the

c. Describe credit scoring models based on linear discrimination analysis.

Alfa -1000 700 150

Beta -1000 0 1000

Assuming an opportunity cost of capital of 10 per cent, what is the NPV of

Excellent candidates would illustrate that the opportunity cost of

Stock Quantity Price (£) Beta

X 100 1.5 0.7

Y 120 1.7 0.95

Z 210 1.1 1.05

What is the beta of this portfolio? (5 marks)

Value (£) Proportion

(2 marks were awarded for correct calculation of the weight of each

4. Investors have homogeneous beliefs regarding future returns, which

support/contrast each method. Specifically candidates should

Informational efficiency is a more specific form of the general valuation

using all available information. (1 mark.) This means that in efficient

stocks), it follows that it is important that financial markets are able to

Commercial loans 5000 2.5

Mortgages 4200 7.8

T-bonds 2000 0.9

Deposits 7500 1.3

Corporate bond 2000 1.6

What is the duration gap for Bank ABC? (4 marks)

e. Critically discuss the main problems associated with duration gap

Examiners’ commentaries 2009

24 Principles of banking and finance

Specific comments on questions – Zone B

b. Explain the main characteristics of the recent crisis of the sub-prime