FN1024

Summer 2020 online assessment guidance

FN1024 Principles of Banking and Finance
The assessment will be an open-book take-home online assessment within a 24-
hour window. The requirements for this assessment remain the same as the
originally planned closed-book exam, with an expected time/effort of 3 hours.

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.

You should complete your examination using pen and paper. Please use BLACK
ink only.

Handwritten work then needs to be scanned, converted to PDF and then uploaded to
the VLE as ONE individual file including the coversheet. Each scanned sheet
should have your candidate number written clearly at the top. Please do not write
your name anywhere on any sheet.

The paper will be available at 12.00 midday (BST) on Tuesday 16 June 2020.

You have until 12.00 midday (BST) on Wednesday 17 June 2020 to upload your
file into the VLE submission portal. However, you are advised not to leave your
submission to the last minute. A late penalty will be applied pro-rata of 5 percentage
marks for every hour (or part) late outside of the 1 hour.

If you think there is any information missing or any error in any question, then you
should indicate this but proceed to answer the question stating any assumptions you
have made.

The assessment has been designed with a duration of 24 hours to provide a more
flexible window in which to complete the assessment and to appropriately test the
course learning outcomes. As an open-book exam, the expected amount of effort
required to complete all questions and upload your answers during this window is no
more than 3 hours. Organise your time well and avoid working all night.

You may use any calculator for any appropriate calculations, but you may not use
any computer software to obtain solutions. Credit will only be given if all workings are
shown.

You are assured that there will be no benefit in you going beyond the expected 3
hours of effort. Your assessment has been carefully designed to help you show what
you have learned in the hours allocated.

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This is an open book assessment and as such you may have access to additional
materials including but not limited to subject guides and any recommended reading.
But the work you submit is expected to be 100% your own. Therefore, unless
instructed otherwise, you must not collaborate or confer with anyone during the
assessment. The University of London will carry out checks to ensure the academic
integrity of your work. Many students that break the University of London’s
assessment regulations did not intend to cheat but did not properly understand the
University of London’s regulations on referencing and plagiarism. The University of
London considers all forms of plagiarism, whether deliberate or otherwise, a very
serious matter and can apply severe penalties that might impact on your award. The
University of London 2019-20 Procedure for the Consideration of Allegations of
Assessment offences is available online at:

https://london.ac.uk/sites/default/files/governance/assessment-offence-procedure-
year-2019-2020.pdf

The University of London’s Rules for Taking Online Timed Assessments have been
included in an update to the University of London General Regulations and are
available at:

https://london.ac.uk/sites/default/files/regulations/progregs-general-2019-2020.pdf

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SECTION A

Candidates should answer ONE question and NO MORE THAN TWO further
questions from this section.

1. (a) Discuss the main causes of illiquidity and insolvency in banking and
discuss the relationship between them. (10 marks)

(b) Explain operational risk and market risk as it affects banks. Give
examples. (5 marks)

(c) Explain credit risk as it affects banks and discuss the techniques banks
can use to manage the moral hazard created by a credit risk exposure.
(10 marks)

2. (a) Explain how banks are able to act as intermediaries by reconciling

conflicting requirements of lenders and borrowers and reducing costs.
(12 marks)

(b) Explain the Diamond theory of delegated monitoring and discuss its
contribution to our understanding of financial intermediation. (13 marks)

3. (a) With reference to examples, discuss the characteristics and consequences

of financial bubbles. (12 marks)

(b) Discuss the empirical evidence on market under-reaction in the context of

weak and semi-strong form efficiency. (13 marks)

4. (a) Explain asymmetric information in lending/borrowing and discuss how

adverse selection influences the lending decision of banks. (11 marks)
(b) Explain how moral hazard affects equity contracts and discuss why moral
hazard is lower for debt contracts compared to equity contracts.
(9 marks)
(c) Explain why loan contracts suffer less from free-riding problems compared to
bonds or other public financing. (5 marks)

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SECTION B

Candidates should answer ONE question and NO MORE THAN TWO further questions from
this section.

5. (a) Plantfood paid an annual dividend of $3 on its common stock and

promises that the dividend will grow by 3% per year. If the stock’s market
price is $30, what is required rate of return for this stock? (3 marks)

(b) Datasoft is currently paying dividends of $0.70 a share. These dividends

are expected to grow at a rate of 20% for the next two years and at a constant
growth rate of 3.5% thereafter. What would be the current price of Datasoft
shares given a required return of 15%? (4 marks)

(c) Compare and contrast the risk and return for debt and equity securities
from the perspective of both lenders/investors and issuers. (9 marks)

(d) Formally derive and discuss the dividend discount model used for the
valuation of common stocks. (9 marks)

6. (a) Explain a factor model. (6 marks)

(b) Consider two stocks (A and B), whose returns are determined by the
following two-factor model:

RA =0.04+0.8F1 + 0.5F2 + εA ;
RB =0.06+0.7F1 + 0.3F2 + εB

What is the factor model for a portfolio made up of 30% in stock A and 70% in
stock B? (4 marks)

(c) Outline the key features of Markowitz’s modern portfolio theory (MPT) and
hence explain the main lessons for an investor from MPT (the use of
appropriate diagrams is encouraged). (15 marks)

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 7. (a) Compare and contrast income gap and duration gap analysis as techniques for
management of interest rate risk by banks.
(12 marks)

(b) Consider the following balance sheet of Fairview Bank:

Assets (£) Duration Liabilities (£) Duration

Variable-rate 1900 8.3 Money market 3700 1.1
mortgages deposits
Fixed-rate 1500 7.1 Savings 4200 3.2
mortgages deposits
Commercial 6500 5.0 Variable-rate 2200 1.5
loans CDs
Physical capital 2900 Equity 2700

Total 12800 Total 12800

What will be the change in net interest income at the year-end if interest rates
decrease by 0.5 per cent, from 4 to 3.5 per cent? Explain using basic gap analysis.
(Use the following assumptions for runoff cash flows: fixed-rate mortgages repaid
during the year: 15 per cent; proportion of savings deposits and variable-rate CDs
that are rate-sensitive: 15 per cent). (7 marks)

(c) Calculate the duration gap for Fairview Bank? Explain why a bank will normally
have a duration gap greater than zero. (6 marks)

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 8. (a) Explain the concept of Macaulay duration and explain the relationship
between Macaulay duration and:

(i) bond maturity

(ii) interest rates
(iii) bond coupon rate (7 marks)

(b) Calculate the price and Macaulay duration of a five-year 5% coupon bond
where the market interest rate is 5%. Assume the par value of the bond is
$1000 and coupons are paid annually. (6 marks)

(c) An investor decides to construct a bond portfolio made up of $20,000 in a

bond with a Macaulay duration of 5 years and $30,000 in a three-year zero-
coupon bond (par value = $1,000). What is the Macaulay duration of this bond
portfolio? (4 marks)

(d) Estimate, using modified duration, the change in the price of the five-year
5% coupon bond (described in part (b)) if the market interest rate decreases
from 5% to 4%. (4 marks)

(e) Explain why the modified duration measure only gives good estimates of
price changes when the change in the market interest rate being considered
is small. (4 marks)

END OF PAPER

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