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
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, 24 May 2007 : 2.30pm to 5.30pm
Candidates should answer FOUR of the following TEN 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 2007 PLEASE TURN OVER
UL07/434
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 question from
Section B.
1. (a) Outline the structure of a developed financial system. (10 marks)
(b) What factors have caused the decline in the share of financial assets held by
banks in recent years? What are the main consequences for banks?
(15 marks)
2. (a) How does adverse selection influence the lending decisions of banks?
(7 marks)
(b) Discuss how to reduce/solve the problems arising from moral hazard.
(13 marks)
(c) Explain why loan contracts do not suffer from free-riding problems compared
to bonds or other public financing. (5 marks)
3. (a) How can bank regulation reduce the bank’s incentive to take risks?
(5 marks)
(b) Consider bank ABC that has the following balance sheet:
Assets (£) Liabilities (£)

Cash 20
Government bills 10 Deposits 65
Commercial loans 50 Capital 15
Total 80 Total 80
i. What is the gearing ratio of Bank ABC?

ii. What is the risk-asset ratio of Bank ABC?
(7 marks)
(c) Explain the risk-assets ratio under Basel 1 and discuss the main problems that
have been identified with it. How will it change under Basel 2?
(13 marks)
1 PLEASE TURN OVER
UL07/434
4. (a) What are (abnormal) excess returns? Can excess returns be earned in efficient
markets? (5 marks)
(b) Name and briefly describe the three types of market efficiency.
(6 marks)
(c) What is the empirical evidence in favour of and against the weak form of
market efficiency? (14 marks)
5. (a) Discuss the arguments for bank regulation. (13 marks)
(b) Explain the main implications of the presence of market-based versus bank-
based financial systems. (12 marks
SECTION B
Section A.
6. The following balance sheet is available (amounts in £ millions and duration in years)
for Bank International:
Amount Duration
Commercial loans 4,000 3.5
Mortgages 1,500 6.7
T-bonds 1,000 2.9
Deposits 5,500 2.3
Equity 1000
(a) What is the duration gap for Bank International? (7 marks)
(b) Why do banks use credit scoring models? What are the main families of credit
scoring models? How do these families differ? (9 marks)
(c) What is meant by market risk of banks? Discuss the main approaches to
market risk management. (9 marks)
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7. (a) Consider the following stocks:
• Stock One is expected to pay a dividend of £1 forever;
• Stock Two is expected to pay a dividend of £0.8 next year with dividend
growth expected to be 2% per annum thereafter.
If the required return on similar equities is 8%, calculate the price of each
stock. (6 marks)
(b) What are the cash flows available to an investor in stocks? Which security
(stock or bond) tends to be more volatile? Compare the problems of estimating
stock cash flows to estimating bond cash flows. (6 marks)
(c) Formally derive and discuss the dividend discount model used for the
valuation of common stocks. (9 marks)
(d) Describe the Gordon growth model. (4 marks)
8. At the end of June 2007 a UK corporate bond has an annual coupon rate of 3%, par
(face) value of £5,000 and will mature in June 2010. Similar UK government bonds
have an annual interest rate of 4%.
(a) Using the data given above and assuming semi-annual coupons, calculate
the value of the corporate bond. (6 marks)
(b) Calculate the duration of the UK corporate bond assuming annual coupons
and annual discount rate. (7 marks)
(c) Assume annual interest rates decrease by 0.75%. What will be the
approximate percentage change in the value of the UK bond assuming
annual coupons and annual discount rate? (4 marks)
(d) What is the difference between US Government bonds and notes? Why do 2-
year Treasury bonds typically have lower interest rates than 4-year Treasury
bonds? Why do corporate bonds have higher rates than government bonds?
(8 marks)
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UL07/434
9. (a) Explain how a bank can use duration gap analysis and income gap analysis to
manage interest rate risk. Critically discuss the problems associated with
income gap analysis. (13 marks)
(b) Consider the following balance sheet of Bank One:
Assets (£) Liabilities and Equity (£)

Variable-rate mortgages 15 Money market deposits 25
Fixed-rate mortgages 15 Savings deposits 25
Commercial loans 50 Variable-rate CD (>1 year) 10
Physical capital 20 Equity 40
Total 100 Total 100
What will be the net interest income at the year end if interest rates
decreased by 1 per cent, from 4.5 to 3.5 per cent? Explain using basic gap
analysis. (Use the following hypothesis on the runoff of cash flows:
fixed-rate mortgages repaid during the year: 15 per cent; proportion of
savings deposits and variable-rate CD that are rate-sensitive: 15 per cent).
(12 marks)
10. (a) Consider a three-factor Arbitrage Pricing Theory (APT) model.
Factor Risk premium Sensitivity to each factor

Change in GDP 4% 0.5
Change in interest rate 1.5% 0.8
Inflation ratio 2% 0.2
Assuming a risk-free rate of 4%, calculate the expected return of this

stock. (4 marks)
(b) What are the assumptions under the APT? What is the expected risk
premium? (11 marks)
(c) What are the main advantages/disadvantages of APT in comparison to the

CAPM? (4 marks)
(d) Discuss the empirical validation of the APT. (6 marks)
END OF PAPER
UL07/434
This paper is not to be removed from the Examination Halls
UNIVERSITY OF LONDON 279 0024 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, 24 May 2007 : 2.30pm to 5.30pm
Candidates should answer FOUR of the following TEN questions: ONE from Section A,
ONE from Section B and TWO further questions from either section. All questions carry
equal marks.
©University of London 2007 PLEASE TURN OVER
UL07/435
SECTION A
Section B.
1. (a) Outline the main functions of financial systems. (10 marks)
(b) What factors have caused the decline in the share of financial assets
held by banks in recent years? What are the main consequences for
banks? (15 marks)
2. (a) How does adverse selection influence the lending decisions of banks?
(7 marks)
(b) Discuss how to reduce/solve the problems arising from adverse selection.
(13 marks)
(c) Discuss how banks can reduce the adverse selection problem by asking the
borrower to provide collateral against the loan. Try to use an example.
(5 marks)
3. (a) How can bank regulation reduce the bank’s incentive to take risks?
(5 marks)
(b) Consider bank XYZ that has the following balance sheet:

Cash 20
Total 100 Total 100
i. What is the gearing ratio of Bank XYZ?

ii. What is the risk-asset ratio of Bank XYZ?
(7 marks)
(c) Explain the risk-assets ratio under Basel 1 and discuss the main problems that
have been identified with it. How will it change under Basel 2 ?
(13 marks)
1 PLEASE TURN OVER
UL07/435
4. (a) What are excess (abnormal) returns? Can excess returns be earned in
efficient markets? (5 marks)
(b) Name and briefly describe the three types of market efficiency.
(6 marks)
(c) What is the empirical evidence in favour of and against the weak form
of market efficiency? (14 marks)
5. (a) Discuss the arguments for bank regulation. (13 marks)
(b) Explain the main implications of the presence of market-based versus

bank-based financial systems. (12 marks
SECTION B
Section A.
6. The following balance sheet is available (amounts in £ millions and duration in

years) for Bank International:
Amount Duration
Mortgages 1,000 6.5
T-bonds 1,000 2.9
Deposits 5,500 2.5
Equity 500
(b) Why do banks use credit scoring models? What are the main families of credit
scoring models? How do these families differ? (9 marks)
(c) What is meant by market risk of banks? Discuss the main approaches
to market risk management. (9 marks)
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UL07/435
7. (a) Consider the following stocks:
• Stock Two is expected to pay a dividend of £4 next year with dividend growth
expected to be 3% per annum thereafter.
stock. (6 marks)
(b) Describe the characteristics of common stocks and preferred stocks.

What are the main differences between common stocks and preferred
stocks? (6 marks)
(d) Describe the zero growth model. (4 marks)
8. At the end of June 2007 a UK corporate bond has an annual coupon rate of 3%, par
(face) value of £5,000 and will mature in June 2010. Similar UK government bonds
have an annual interest rate of 3.5%.
(a) Using the data given above and assuming semi-annual coupons,
calculate the value of the corporate bond. (6 marks)
(b) Calculate the duration of the UK corporate bond assuming annual coupons and
annual discount rate. (7 marks)
(c) Assume annual interest rates decrease by 0.5%. What will be the approximate
percentage change in the value of the UK bond assuming annual coupons and
annual discount rate? (4 marks)
(d) What is the difference between US Government bonds and notes? Why do 2-
year Treasury bonds typically have lower interest rates than 4-year Treasury
bonds? Why do corporate bonds have higher rates than government bonds?
(8 marks)
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9. (a) Explain how a bank can use duration gap analysis and income gap analysis to
manage interest rate risk. Critically discuss the problems associated with

Variable-rate mortgages 10
Fixed-rate mortgages 10 Money market deposits 20
Commercial loans 45 Savings deposits 30
Total 80 Total 80
decreased by 0.5 per cent, from 4.5 to 4 per cent? Explain using basic gap
analysis. (Use the following hypothesis on the runoff of cash flows: fixed-rate
mortgages repaid during the year: 25 per cent; proportion of savings deposits
that are rate-sensitive: 25 per cent). (12 marks)
10. (a) Consider a three-factor Arbitrage Pricing Theory (APT) model.

Change in GDP 5% 1
Change in interest rate 1% 0.5
Inflation ratio 2.5% 0.2
Assuming a risk-free rate of 4%, calculate the expected return of this

stock. (4 marks)
premium? (11 marks)
(c) What are the main advantages/disadvantages of APT in comparison to

the CAPM? (4 marks)
END OF PAPER
UL07/435
24 Principles of banking and finance
Examiner’s report 2007

Zone A
General remarks
The 24 Principles of banking and finance examination paper tests
the understanding of a wide range of concepts and techniques in banking
and finance areas. Therefore students are expected to demonstrate
numerical competence as well as a thoughtful and clear writing style in
the discursive parts of each answer.
Section A contains general questions which cover the syllabus. Section B
questions test application: as such they generally include both numerical
and essay-based parts.
All the questions asked on the paper test topics covered in the Principles
of banking and finance syllabus; students are reminded that the
examination of this unit may test any aspect of the syllabus.
Students are encouraged to demonstrate their ability to identify links
between concepts presented in different chapters of the syllabus/subject
guide. In essay questions, in addition to depth of knowledge of the subject
matter, Examiners are looking for the ability to discuss and evaluate
arguments and to relate the knowledge to the question asked, as opposed
to simple repetition of factual information on a particular topic. One way
of helping to ensure that students have a clear, well-structured and
relevant argument is for them to spend a few minutes organising an
answer before they begin writing, and by not trying to fit a standard
answer to the question.
While some of the questions might appear to be technical, most of the
marks were awarded for providing the economic reasoning and
explanations. In order to get better marks in the future, students might
wish to spend more time studying the subject guide, focusing on both the
economic reasoning and some of the techniques/tools. Note that in
numerical questions (e.g. question 8), alternative hypotheses were equally
acceptable if students had been consistent in the different parts of the
question: in these cases the Examiners were flexible in the allocation of
marks.
From the allocation of marks, students should be able to identify the
importance and weighting of each part of the question. Therefore they
should devote an appropriate amount of time to each part, related to the
marks awarded.
More detailed comments, as well as a detailed marking scheme and the
relevant references to the pages of the subject guide, can be found in the
following pages.
6
Examination papers and Examiners’ reports 2007
Specific comments on questions

Question 1
(a) Outline the structure of a developed financial system. (10 marks)
Students may like to refer to page 13 of the subject guide. A good way to
tackle this question would be to critically analyse the entities that compose
a financial system. 2 marks were awarded for emphasising the need to
interpret the structure of a financial system in terms of its entities, and for
stating what these are. In particular, the Examiners would here be
expecting a balanced, essay-format discussion of the three entities that
compose the system:
• financial markets (2 marks)
• securities (3 marks)
• financial intermediaries (3 marks).
(b) What factors have caused the decline in the share of financial assets held
by banks in recent years? What are the main consequences for banks?
(15 marks)
Students may like to refer to page 60 of the subject guide. The Examiners
would expect students to begin with a clear definition of disintermediation
as the process of lenders and borrowers bypassing the banking system and
lending/borrowing directly (2 marks awarded for this).
Then students should go on to discuss this in more detail to show that
they understand the definition and have not simply learnt it from a book.
The Examiners would award marks for students who constructed clear
paragraphs which made the following points:
• Lenders look for higher-yielding assets and take their deposits out of
banks (2 marks).
• Borrowers issue securities directly into markets (2 marks) due to
lower cost (1 mark) and development of credit rating agencies
(1 mark).
• Development of securitisation allows other types of intermediaries to
originate loans and then bundle them to enable securities to be issued.
This lowers the advantages banks have in the loan markets (2 marks).
(1 mark also awarded for the definition of securitisation).
A good answer would then go on to discuss the consequences for banks
which include the growth in off-balance sheet activities – often facilitating
direct capital raising by firms (2 marks) and expansion into new riskier
areas of business (2 marks).
Question 2
(a) How does adverse selection influence the lending decisions of banks? (7
marks)
Students may like to refer to page 55 of the subject guide. A very good
answer to this question would be structured as an essay-style answer
which covered the following points:
• Adverse selection is a problem created by asymmetric information
(1 mark).
• The existence of asymmetric information means that lenders will lend
at a rate of interest reflecting average risk (as they cannot distinguish
between good and bad risks) (2 marks).
7
• This drives many good risk borrowers out of the market leaving
mainly poor risks (2 marks).
• Hence the borrowers who are more likely to want to borrow are poor
risks (1 mark).
• As a consequence lenders may decide not to lend (1 mark).
(b) Discuss how to reduce/solve the problems arising from moral hazard.
(13 marks)
Students may like to refer to page 58–59 of the subject guide. The
question asks for a discussion of the solutions to the moral hazard
problem. The Examiners were looking first for a brief explanation of the
four main solutions:
• Making debt contract incentive-compatible (i.e. align the incentives of
borrowers and lenders). Up to 3 marks awarded.
• Monitoring and enforcement of restrictive covenants. Discussion of the
four types of possible covenants and relevant examples. Up to 4 marks
awarded.
• Financial intermediaries. Problems arising from the use of covenants.
Mechanisms used by financial intermediaries to solve the incentive
problem and the free-rider problem. Use of screening and monitoring
– favoured by the existence of established long-term relationships – to
overcome moral hazard. Up to 6 marks awarded.
(c) Explain why loan contracts do not suffer from free-riding problems
compared to bonds or other public financing. (5 marks)
A good way to tackle this question would be to refer to the fact that bank
loans are private securities, not traded in the open financial market (2
marks). Therefore, investors are not able to observe the bank and bid up
the price of the loan to the point where the bank makes no profit on the
production of information (3 marks).
Question 3
(a) How can bank regulation reduce the bank’s incentive to take risks? (5 marks)
Students may like to refer to page 74 of the subject guide.
An outstanding answer to this question would state that bank regulations
can reduce the bank’s incentive to take risks by introducing restrictions on
asset holding and bank capital requirements (1 mark). In particular, the
answer would then need to indicate the mechanisms used by banks to
achieve this objective:
• restrictions on holding risky assets (i.e. ordinary shares, known in the
USA as common stocks) (1 mark)
• limitations on the amount of loans, in particular the categories of the
individual borrowers (1 mark)
• reduction of the risk of the loan portfolio by diversification (1 mark)
• maintenance of a sufficient level of bank capital (1 mark).
(b) Consider bank ABC that has the following balance sheet:
Cash 20
Total 80 Total 80
8
i. What is the gearing ratio of Bank ABC?

ii. What is the risk–asset ratio of Bank ABC? (7 marks)
The gearing ratio is the amount of deposits and external liabilities divided
by the bank’s total capital and reserves.
Gearing ratio = 4.3 (=65/15).
1 mark was awarded for correct definition; 1 mark for correct answer.
i. Risk-weighted assets are:
• Cash (20*0%) £0
• Government bills (10*0%) £0
• Loans (50*100%) £50
Total £50
ii. Risk–asset ratio = 15/50 = 30%
1 mark awarded for correct definitions; 2 marks for correct input data; 1
mark for correct answer on risk-weighted assets; 1 mark for correct
answer on risk–asset ratio.
(c) Explain the risk–assets ratio under Basel 1 and discuss the main problems
that have been identified with it. How will it change under Basel 2?
(13 marks)
Students may like to refer to pages 75–76 of the subject guide.
Students should begin by showing that they understand that risk–assets
ratio is the ratio of capital to risk-adjusted assets (1 mark).
Students would then be expected to explain the risk–assets ratio under
Basel 1. The Examiners would be expecting points to be made such as:
Capital is divided into tier 1 (issued share capital and disclosed
accumulated reserves) and tier 2 (medium- and long-term subordinated
debt + general provisions and unpublished profits) (2 marks were
awarded for this). The value of each category of asset is risk-adjusted in a
crude way according to its exposure to credit risk. Risk weights of 0, 20%,
50% and 100% are used. Off balance sheet items are also converted to
credit equivalents and then risk-weighted (3 marks). An additional 2
marks were awarded if examples were given. The minimum ratio required
by Basel 1 is 8% (1 mark). Individually negotiated with regulator (1
mark).
Students should then discuss the main problems associated with the
risk–assets ratio under Basel 1:
• 100% risk weight applied to all commercial non-bank loans. This
implies that it does not reward diversification (1 mark)
• relative risk weights may not reflect relative risks – can also lead to
misallocation of resources (1 mark)
• assumption of independence of risks (1 mark).
Students should finally explain that under ‘The New Basel Capital Accord’
(so-called Basel 2, effective from the end of 2006), although no change is
envisaged for the definition of capital, and the minimum capital coefficient
of 8% is also to remain unchanged, several changes have been introduced
with regard to the credit risk assessment. In particular, the present
risk–asset ratio will be modified by separating loans into different classes
according to their risk measured by credit ratings from rating agencies.
This overcomes the problem with the current risk–asset ratio, which treats
all loans as equally risky (2 marks).
9
Question 4
(a) What are (abnormal) excess returns? Can excess returns be earned in
Excellent students would answer that excess returns can be calculated as
the difference between the actual return on the market and the
equilibrium expected return.
The excess return at time t (RtX) is: where Rt = actual
return on the market at time t; E(Rt) = expected equilibrium return at
time t.
3 marks were awarded for providing the intuition as displayed above.
Students should then explain that in an efficient market, no investor can
make excess returns based on the available set of information. They can
only earn normal returns, which here means equilibrium returns. 2 marks
were awarded for providing this intuition.
(b) Name and briefly describe the three types of market efficiency. (6 marks)
An outstanding answer would analyse the three varieties of market
efficiency identified by Fama (1970) as follows:
• weak-form efficiency
• semi-strong-form efficiency
• strong-form efficiency.
1 mark was awarded for each definition of each information set (weak,
semi-strong, strong) (total 3 marks); 1 mark each for elaborating on each
information set (further comments, examples) (total 3 marks).
Students may like to refer to pages 147 and 151–152 of the subject guide.
The Examiners would expect students to begin with the explanation of the
empirical evidence in favour of the weak-form efficiency. The Examiners
would award marks for students who constructed clear paragraphs which
made the following points:
• Random walk behaviour of stock prices. Up to 3 marks awarded for an
explanation of this.
• Technical analysis. Overall empirical evidence shows that technical
analysis does not outperform the market, and that successful past
forecasting does not imply future market outperformance. This
evidence (as provided for example in Allen and Karjalainen, 1999)
supports the weak-form efficiency of financial markets. Students
should also refer to the researchers more favourable to technical
analysis (such as Brock, Lakonishok and LeBaron, 1992), whose
results do not support market efficiency in the weak-form.
Up to 4 marks awarded for showing a good understanding of the evidence
on technical analysis.
Students should then move to the investigation of the evidence against
weak-form efficiency. The Examiners would expect students to make the
following points:
• Calendar effects. Students should begin with a clear list of the possible
calendar effects, and then focus on the so-called ‘January effect’, which
10
shows that stocks returns are greater in January than in any other
month of the year. Students 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 4 marks awarded for showing a good understanding
of the calendar effects.
• Small firm effect and weak-form efficiency. Students should begin with
the definition of the phenomenon and then provide the empirical
evidence on the positive correlation of next period’s returns of small
firms’ stocks with previous returns even for weekly and monthly
periods (as shown in Lo and MacKinley, 1988). Students would then
be expected to explain the theories that could explain the small firm
effect (low liquidity of small firms or inappropriate measurement of
risk for small firm stocks, data-snooping, and actual weak inefficiency
in the USA in the 1970s and the 1980s). Up to 3 marks awarded for
showing a good understanding of the small firm effect.
Question 5
(a) Discuss the arguments for bank regulation. (13 marks)
The Examiners would be expecting a balanced, essay-format discussion
which included the main reasons for prudential regulation, which include:
• The fragility of banks – mainly due to their provision of liquidity to
the financial system (i.e. vulnerability to runs). A source of mitigation
of fragility is the role of banks in screening and monitoring borrowers
who cannot obtain direct finance from financial markets (6 marks).
• Systemic risk – the contagion effect exacerbated by asymmetric
information (2 marks).
• Depositor protection (2 marks).
Students would also be expected to explain the main consequences of
bank failures in the absence of any regulation (3 marks).
based financial systems. (12 marks)
A good answer would explain that essentially in market-based systems (US
and UK) – (1 mark for examples) in contrast to bank-based financial
systems (Germany and Japan) (1 mark for examples) – the financial
markets play a greater role in providing finance to firms (1 mark), the
relationship between banks and firms is not close (1 mark) and there is a
lower level of integration between bank and non-bank financial services (1
mark).
A better answer to this question would mention the following:
• The proportion of gross financial assets owned by pension funds is
higher (2 marks).
• Equity is a more important component of households’ asset portfolios
in market-based systems (2 marks).
• Moral hazard should be lower in bank-based financial systems (1
mark).
• Trend is towards market-based systems suggesting their superiority in
terms of capital allocation (2 marks).
11
SECTION B
Question 6
The following balance sheet is available (amounts in £ millions and duration in
Amount Duration
Mortgages 1,500 6.7
T-bonds 1,000 2.9
Deposits 5,500 2.3
Equity 1,000

Weighted asset duration = 3.5 × (4000/6500) + 6.7 × (1500/6500) + 2.9
× (1000/6500) = 4.15 years (2 marks)
Liability duration = 2.3 years (1 mark)
years
1 mark was awarded for correct equation; 1 mark for correct input data;
1 mark for good explanation; 1 mark for correct answer.
(b) Why do banks use credit scoring models? What are the main families of
credit scoring models? How do these families differ? (9 marks)
Students should begin with a clear definition of credit scoring models
which are models used to calculate the probability of borrower default or
to sort borrowers into default classes. Up to 2 marks awarded for giving a
clear definition.
Students should then explain the main approaches used to construct credit
scoring models: linear probability models and discriminant models
(1 mark would be awarded for this).
Linear probability models use data from past defaulters and non-defaulters
to identify those factors that explain why a borrower defaults. The
resulting model is then used to forecast the probability of a new borrower
default (2 marks).
Discriminant models divide borrowers into high or low default risk classes.
Students should then go on with the description of Altman’s discriminant
function as illustrated at page 89 of the subject guide (2 marks awarded
for the description). This definition should be followed by a critical
explanation of the problems associated with the discriminant model (up to
2 marks awarded for this).
Students may like to refer to pages 86 and 99 of the subject guide.
A good definition of market risk states that market risk is related to
changes in market-determined prices, interest rates and exchange rates.
This mainly affects a bank’s trading book which contains assets, derivatives
held for short periods (2 marks).
Greater importance for market risk due to increase in trading activities of
banks as banks have sought other sources of income to replace the income
from traditional intermediation business (2 marks).
12
The increasing relevance of market risk determined the development of

market risk management models, among which is the value-at-risk (VAR)
approach. There are three main internal models for calculating market risk
exposure, as developed by large commercial banks and investment banks:
a) RiskMetrics (or the variance/covariance approach); b) Historic
simulation; c) Monte Carlo simulation (2 marks).
Under the RiskMetrics model developed by J.P. Morgan, the value-at-risk is
the maximum estimated loss in the market value of a given position that
can be incurred if market conditions move adversely (1 mark). This can be
written as:
where:
Vx = market value of position x; dV/dP = price sensitivity of the position;
Äpi = adverse price movement over time i. (2 marks for providing the
equation and the explanation on the notation).
Question 7
(a) Consider the following stocks:
• Stock Two is expected to pay a dividend of £0.8 next year with
dividend growth expected to be 2% per annum thereafter.
If the required return on similar equities is 8%, calculate the price of
each stock. (6 marks)
The price today of Stock One is £12.5. (3 marks) The price of Stock
Two is £13.3 (3 marks).
(b) What are the cash flows available to an investor in stocks? Which
security (stock or bond) tends to be more volatile? Compare the
problems of estimating stock cash flows to estimating bond cash flows.
(6 marks)
Cash flows generated from stocks are dividends, cash flows generated
from bonds are interests (1 mark). Stocks tend to be more volatile
(1 mark). For explanations of the higher volatility (2 marks). Unlike
bonds, which have contractual cash flows (interest and principal
payments), common stocks have unspecified cash flows (2 marks).
Excellent students 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 expected return on a stock over the next year can be written as:
(7.11)
where: DIV1 = expected dividend to be paid at time 1; P0 = current

price of the stock; P1 – P0 = capital gain on the stock (1 mark).
Rearranging equation (7.11), we can predict the current price of a
stock in terms of forecasted dividends and expected price next year.
Formally, this is:
(7.12)
where: re = required annual rate on similar equity stocks (2 marks).
13
Equation (7.12) is the fundamental valuation formula. It represents a

market equilibrium condition: if it does not hold, stocks will be under-
priced or over-priced.
When we come to use this equation, we immediately realise that we must
estimate the price of the stock at time 1 in order find the value today.
However, future stock prices are not easy to determine. What does
determine future stock prices? (2 marks).
The answer is contained in the same equation (7.12). The expected price
at time t can be expressed as the expected dividends at time t+1 plus the
price at the end of year t+1. Therefore, in equation (7.12), P1 could be
replaced by (DIV2+P2)/(1+re):
(7.13)
The current price of a stock relates to the expected dividends for two years
(DIV1 and DIV2) plus the forecasted price at the end of year two (P2).
Accordingly, in equation (7.13), P2 could be expressed as
(DIV3+P3)/(1+re) (2 marks).
Can you see that we can look as far into the future as we like? If we
consider a period of N years, by extending equation (7.13) we predict the
current price of a stock in terms of dividends over N years and the price at
the end of year N (1 mark):
(7.14)
(1 mark was awarded for this equation)

(d) Describe the Gordon growth model. (4 marks)
Students would be expected to explain that under this model expected
dividends can be assumed to grow at a constant rate g per annum. To value
such a common stock we just use the present value formula of a growing
perpetuity (shown in part (a)). Up to 3 marks awarded for this explanation.
Students should then present the equation for the calculation of the price
under this model (1 mark for the equation and the relevant notation).
Question 8
At the end of June 2007 a UK corporate bond has an annual coupon rate of 3%,
par (face) value of £5,000 and will mature in June 2010. Similar UK government
bonds have an annual interest rate of 4%.
The semi-annual discount rate is 2% (=4/2). The 6 six-month coupon
payments are of £75 (=£150/2). The price becomes:
1 mark was awarded for correct calculation procedure; 2 marks for correct
formula; 2 marks for the correct input data into PV formula; 1 mark for
correct answer.
14
The discount rate is 4%. The duration would be:
T CF PV(CF) t x PV(CF)
1 150 144.231 144.231
2 150 138.683 277.366
3 5,150 4,578.331 13,734.99
4,861.25 14,156.59
D= 2.912133
2 marks were awarded for correct calculation scheme; 1 mark for correct
T values; 1 mark for correct CF values; 2 marks for correct DF values; 1
mark for correct duration calculation.
Following from (b):
1 mark was awarded for correct equation; 1 mark for correct input data;
1 mark for the correct sign of the answer; 1 mark for correct answer.
(d) What is the difference between US Government bonds and notes? Why do
2-year Treasury bonds typically have lower interest rates than 4-year
Treasury bonds? Why do corporate bonds have higher rates than government
bonds? (8 marks)
A good answer states that US Government notes have an original maturity
of one to ten years, while bonds have an original maturity of ten to twenty
years. Both government notes and bonds are free of default risk. (1 mark).
An excellent answer to ‘Why do 2-year Treasury bonds typically have
lower interest rates than 4-year Treasury bonds?’ needs to refer to how the
term to maturity influences the interest rate. Bonds with identical risk may
have different interest rates because of the difference in the time
remaining to maturity (2 marks). A yield curve plots the interest rates of
bonds with different maturity but the same risk. It describes the term
structure for a particular type of bond (2 marks). The yield curve can be:
upward (the long-term rates are above the short-term rates); flat (short-
and long-term interest rates are the same); and inverted (long-term
interest rates are below short-term interest rates) (1 mark).
The degree of risk of corporate bonds, which depends on the default risk
of the company, is higher than for government and municipal bonds. This
determines the presence of higher interest rates (2 marks).
Question 9
(a) Explain how a bank can use duration gap analysis and income gap analysis
to manage interest rate risk. Critically discuss the problems associated with
Excellent students should make the following points:
Banks to manage interest rate exposure, taking into account the effects of
changes in interest rates both on income and market value, can use
duration (1 mark).
15
In order to determine the effects of changes in interest rates on the market

value of assets and liabilities, and then calculate the impact on
shareholders’ net worth, bank managers can calculate the duration of all
assets and liabilities on their balance sheet. Alternatively, recalling the
additive property of duration, bank managers can determine the effects of
a change in interest rates on the market value of net worth by calculating
the average duration for assets and for liabilities and then using those
figures to estimate the effects of the change in interest rates (1 mark).
Students should then provide the formula for the calculation of the overall
duration gap (1 mark).
They should emphasise that if the durations of designated assets and
liabilities are matched (DURgap=0), then the duration gap on that part of
the balance sheet is said to be ‘immunised against unexpected changes in
interest rates’. Immunisation can be used to obtain a fixed yield for a given
period of time because both sides of the balance sheet are protected
against interest rate risk (1 mark).
Duration gap can be used to calculate the change in the market value of
net worth (DNW) as a percentage of total assets induced by a change in
interest rates. Students would be awarded 1 mark for providing the
relevant equation.
Students may like to refer to page 93 of the subject guide to explain
income gap analysis:
Under the income gap analysis (maturity approach), banks report the gap
in each maturity bucket, calculated as the difference between rate-
sensitive assets (RSA) and rate-sensitive liability (RSL) on their balance
sheets. This can be written as:
GAP = RSA – RSL (6.1) (1 mark)
A positive GAP implies sensitive assets > sensitive liabilities. The rise in
interest rates will cause a bank to have interest revenue rising faster than
interest costs; thus the net interest margin and income will increase. The
decline in interest rates will increase liabilities costs faster than assets
returns; as a consequence the net interest margin and income will
decrease (1 mark).
Bank managers can calculate the income exposure to changes in interest
rates in different maturity buckets, by multiplying GAP by the change in
the interest rate:
ΔI= GAP * ΔI (6.2)
where Δ I = change in the bank’s income; Δ I = change in interest rate (1
mark).
Finally students should explain the three main problems associated with
• It ignores market value effects of interest rates changes (1 mark).
• Even rate-insensitive assets and liabilities (whose interest rates are not
re-priced) actually have a component that is rate-sensitive (i.e. a
runoff cash flow). Examples of these items would be expected. Bank
managers can deal with this problem by identifying for each asset and
liability the estimated runoff cash flow, to be added to the value of the
rate-sensitive assets and liabilities (3 marks).
• It ignores the effects of the changes in interest rates on off-balance
sheet instruments (1 mark).
16

Variable-rate 15 Money market deposits 25
mortgages
Fixed-rate mortgages 15 Savings deposits 25
Commercial loans 50 Variable-rate CD (>1 year) 10
Total 100 Total 100
decreased by 1 per cent, from 4.5 to 3.5 per cent? Explain using basic gap
analysis. (Use the following hypothesis on the runoff of cash flows: fixed-
rate mortgages repaid during the year: 15 per cent; proportion of savings
deposits and variable-rate CD that are rate-sensitive: 15 per cent). (12
marks)
Three steps are needed to answer part (b).
i. To determine the amount of rate-sensitive assets:
Commercial loans £50
Fixed-rate mortgages (15%*15) £2.25
Variable-rate mortgages £15
£67.25
2 marks awarded for correct procedure; 1 mark for correct input data; 1
mark for correct answer.
ii. To determine the amount of rate-sensitive liabilities:
Money market deposits £25
Savings deposits (15%*25) £3.75
Variable-rate CD (15%*10) £1.5
£30.25
2 marks awarded for correct procedure; 1 mark for correct input data; 1
mark for correct answer.
iii. What happens when interest rates decrease by 0.5%?
Decrease in income on assets (=1%*67.25) £6.725
Decrease in payments on liabilities (=1%*30.25) £3.025
Decrease in net income £3.7
1 mark awarded for correct procedure; 1 mark for correct input data; 2
marks for correct answer.
Question 10
(a) Consider a three-factor Arbitrage Pricing Theory (APT) model.
Change in GDP 4% 0.5
Change in interest rate 1.5% 0.8
Inflation ratio 2% 0.2
Assuming a risk-free rate of 4%, calculate the expected return of this stock.
(4 marks)
Expected return = 4% + 4%*0.5 + 1.5%*0.8 + 2%*0.2 = 7.6%
2 marks awarded for correct equation; 1 mark for correct input data;
1 mark for correct answer.
17
premium? (11 marks)
An outstanding answer would first explain the economic meaning of each
of the four assumptions under the APT:
1. no arbitrage opportunities (2 marks)
2. returns of risky assets can be described by a factor model (1 mark)
3. financial markets are frictionless (i.e. there are no transaction costs or
related market frictions) (1 mark)
4. diversifiable risk does not exist (1 mark).
Excellent students should then mention that the key to the APT is that a
factor model with no arbitrage opportunities implies that assets with the
same factor sensitivities must offer the same expected returns in financial
market equilibrium (1 mark). Therefore the expected risk premium on an
individual asset (equal to the expected return on an individual asset minus
the risk-free rate) depends on the sum of the expected risk premium
associated with each factor multiplied by the asset sensitivity to each of
these factors (2 marks).
Students should provide the equation for the calculation of the expected
return on an individual asset (1 mark).
Finally students should emphasise the characteristics of the risk premium
(i.e., it is affected only by macroeconomic factors, and not by unique risk
and it varies in direct proportion to the asset’s sensitivity to the factor (2
marks).
CAPM? (4 marks)
An excellent answer would mention that the advantage of the APT is that
it does not require us to identify and measure the market portfolio
(solving most of the problems on the theoretical limitations of the CAPM).
The disadvantage is that it does not tell us what the underlying factors are
(unlike the CAPM, which collapses all the macroeconomic factors into the
market portfolio).
Empirical research is still in the early stages as regards the APT, and is not
as well developed as the literature on the CAPM (1 mark). Many studies
have been particularly interested in whether the APT explains the size
effect discussed about the CAPM. Although the evidence is not conclusive,
the majority of the studies (see among others: Chen, 1983; Chan, Chen
and Hsieh, 1985) find that the size effect becomes negligible in a multi-
factor framework (2 marks). Other studies focused on the identification of
the factors with significant effects on risk premiums. Chen, Roll and Ross
(1986) emphasise the relevance of growth in real GDP, interest spread and
changes in default spreads (2 marks).
An outstanding answer would include any specific reference to papers
cited in the subject guide (1 mark).
Notice
There is a correction sheet for the subject guide for 2007.
18
Examiner’s report 2007

Zone B
General remarks
The 24 Principles of banking and finance examination paper tests
the understanding of a wide range of concepts and techniques in banking
and finance areas. Therefore students are expected to demonstrate
numerical competence as well as a thoughtful and clear writing style in
the discursive parts of each answer.
Section A contains general questions which cover the syllabus. Section B
questions test application: as such they generally include both numerical
and essay-based parts.
All the questions asked on the paper test topics covered in the Principles
of banking and finance syllabus; students are reminded that the
examination of this unit may test any aspect of the syllabus.
Students are encouraged to demonstrate their ability to identify links
between concepts presented in different chapters of the syllabus/subject
guide. In essay questions, in addition to depth of knowledge of the subject
matter, Examiners are looking for the ability to discuss and evaluate
arguments and to relate the knowledge to the question asked, as opposed
to simple repetition of factual information on a particular topic. One way
of helping to ensure that students have a clear, well-structured and
relevant argument is for them to spend a few minutes organising an
answer before they begin writing, and by not trying to fit a standard
answer to the question.
While some of the questions might appear to be technical, most of the
marks were awarded for providing the economic reasoning and
explanations. In order to get better marks in the future, students might
wish to spend more time studying the subject guide, focusing on both the
economic reasoning and some of the techniques/tools. Note that in
numerical questions (e.g. question 8), alternative hypotheses were equally
acceptable if students had been consistent in the different parts of the
question: in these cases the Examiners were flexible in the allocation of
marks.
From the allocation of marks, students should be able to identify the
importance and weighting of each part of the question. Therefore they
should devote an appropriate amount of time to each part, related to the
marks awarded.
More detailed comments, as well as a detailed marking scheme and the
relevant references to the pages of the subject guide, can be found in the
following pages.
24
Specific comments on questions

SECTION A
Question 1
(a) Outline the main functions of financial systems. (10 marks)
A good way to tackle this question would be to first mention that the
essential economic function of financial systems is to channel funds from
units who have saved surplus funds (lender-savers) to units who have a
shortage of funds (borrower-spenders). 1 mark awarded for the
identification of this function. One further mark awarded for providing
examples of each type of agent.
The answer should then move to explain the reasons of the importance of
this channelling function: to facilitate lending and borrowing and to adjust
the composition of the lenders’ portfolios (6 marks).
Students should finally mention the provision of payment mechanisms and
thus the monetary function of a financial system (2 marks).
(b) What factors have caused the decline in the share of financial assets held by
banks in recent years? What are the main consequences for banks?
(15 marks)
Students may like to refer to page 60 of the subject guide. The Examiners
would expect students to begin with a clear definition of disintermediation
as the process of lenders and borrowers bypassing the banking system and
lending/borrowing directly (2 marks awarded for this).
Then students should go on to discuss this in more detail to show that
they understand the definition and have not simply learnt it from a book.
The Examiners would award marks for students who constructed clear
paragraphs which made the following points:
• Lenders look for higher-yielding assets and take their deposits out of
banks (2 marks).
• Borrowers issue securities directly into markets (2 marks) due to
lower cost (1 mark) and development of credit rating agencies (1
mark).
• Development of securitisation allows other types of intermediaries to
originate loans and then bundle them to enable securities to be issued.
This lowers the advantages banks have in the loan markets (2 marks).
(1 mark also awarded for the definition of securitisation).
A good answer would then go on to discuss the consequences for banks
which include the growth in off-balance sheet activities – often facilitating
direct capital raising by firms (2 marks) and expansion into new riskier
areas of business (2 marks).
Question 2
(a) How does adverse selection influence the lending decisions of banks?
(7 marks)
Students may like to refer to page 55 of the subject guide. A very good
answer to this question would be structured as an essay-style answer
which covered the following points:
• Adverse selection is a problem created by asymmetric information
(1 mark).
25
• The existence of asymmetric information means that lenders will lend

at a rate of interest reflecting average risk (as they cannot distinguish
between good and bad risks) (2 marks).
• This drives many good risk borrowers out of the market leaving
mainly poor risks (2 marks).
• Hence the borrowers who are more likely to want to borrow are poor
risks (1 mark).
• As a consequence lenders may decide not to lend (1 mark).
(b) Discuss how to reduce/solve the problems arising from adverse selection.
(13 marks)
Examiners awarded marks to students who covered the following points in
their answer:
• Private production and sale of information. Explanation of the
economic concept of free-rider. Impossibility for this mechanism to
solve adverse selection because of the free-rider problem. Up to 7
marks awarded.
• Government regulation through disclosure requirements. Impossibility
for this mechanism to solve the adverse selection problem. Up to 2
marks awarded.
• Financial intermediaries. They are a better solution than private
production of information (credit rating agencies) because they do not
face the free-rider problem. Up to 4 marks awarded.
(c) Discuss how banks can reduce the adverse selection problem by asking the
borrower to provide collateral against the loan. Try to use an example.
(5 marks)
A good way to tackle this question is to refer to the fact that banks reduce
the adverse selection problem by asking the borrower to provide collateral
against the loan. Collateral is property promised to the lender if the
borrower defaults (2 marks). Therefore it reduces the losses of the lender
in the event of a default (1 mark). A better answer would use an example
to explain the use of collateral (2 marks).
Question 3
(a) How can bank regulation reduce the bank’s incentive to take risks? (5 marks)
An outstanding answer to this question would state that bank regulations
can reduce the bank’s incentive to take risks by introducing restrictions on
asset holding and bank capital requirements (1 mark). In particular, the
answer would then need to indicate the mechanisms used by banks to
achieve this objective:
• restrictions on holding risky assets (i.e. ordinary shares, known in the
USA as common stocks) (1 mark)
• limitations on the amount of loans, in particular the categories of the
individual borrowers (1 mark)
• reduction of the risk of the loan portfolio by diversification (1 mark)
• maintenance of a sufficient level of bank capital (1 mark).
26
(b) Consider bank XYZ that has the following balance sheet:
Cash 20
Total 100 Total 100
i. What is the gearing ratio of Bank XYZ?
ii. What is the risk-asset ratio of Bank XYZ? (7 marks)
The gearing ratio is the amount of deposits and external liabilities divided
by the bank’s total capital and reserves.
Gearing ratio = 3 (=75/25).
1 mark was awarded for correct definition; 1 mark for correct answer.
i) Risk-weighted assets are:
• Cash (20*0%) £0
• Government bills (10*0%) £0
• Loans (70*100%) £70
Total £70
ii) Risk–asset ratio = 25/70 = 35.7%
1 mark awarded for correct definitions; 2 marks for correct input data; 1
mark for correct answer on risk-weighted assets; 1 mark for correct
answer on risk–asset ratio.
(c) Explain the risk–assets ratio under Basel 1 and discuss the main problems
that have been identified with it. How will it change under Basel 2?
(13 marks)
Students should begin by showing that they understand that risk–assets
ratio is the ratio of capital to risk-adjusted assets (1 mark).
Students would then be expected to explain the risk–assets ratio under
Basel 1. The Examiners would be expecting points to be made such as:
Capital is divided into tier 1 (issued share capital and disclosed
accumulated reserves) and tier 2 (medium- and long-term subordinated
debt + general provisions and unpublished profits) (2 marks were
awarded for this). The value of each category of asset is risk-adjusted in a
crude way according to its exposure to credit risk. Risk weights of 0, 20%,
50% and 100% are used. Off balance sheet items are also converted to
credit equivalents and then risk-weighted (3 marks). An additional 2
marks were awarded if examples were given. The minimum ratio required
by Basel 1 is 8% (1 mark). Individually negotiated with regulator
(1 mark).
Students should then discuss the main problems associated with the
risk–assets ratio under Basel 1:
• 100% risk weight applied to all commercial non-bank loans. This
implies that it does not reward diversification (1 mark)
• relative risk weights may not reflect relative risks – can also lead to
misallocation of resources (1 mark)
• assumption of independence of risks (1 mark).
Students should finally explain that under ‘The New Basel Capital Accord’
(so-called Basel 2, effective from the end of 2006), although no change is
envisaged for the definition of capital, and the minimum capital coefficient
27
of 8% is also to remain unchanged, several changes have been introduced

with regard to the credit risk assessment. In particular, the present
risk–asset ratio will be modified by separating loans into different classes
according to their risk measured by credit ratings from rating agencies.
This overcomes the problem with the current risk–asset ratio, which treats
all loans as equally risky (2 marks).
Question 4
(a) What are excess (abnormal) returns? Can excess returns be earned in
Excellent students would answer that excess returns can be calculated as
the difference between the actual return on the market and the
equilibrium expected return.
The excess return at time t (RtX) is: where Rt = actual
return on the market at time t; E(Rt) = expected equilibrium return at
time t.
3 marks awarded for providing the intuition as displayed above.
Students should then explain that in an efficient market, no investor can
make excess returns based on the available set of information. They can
only earn normal returns, which here means equilibrium returns. 2 marks
were awarded for providing this intuition.
(b) Name and briefly describe the three types of market efficiency. (6 marks)
An outstanding answer would analyse the three varieties of market
efficiency identified by Fama (1970) as follows:
• Weak-form efficiency.
• Semi-strong-form efficiency.
• Strong-form efficiency.
1 mark awarded for the definition of each information set (weak, semi-
strong, strong) (total 3 marks); 1 mark for elaborating on each
information set (further comments, examples) (total 3 marks).
Students may like to refer to pages 147 and 151–152 of the subject guide.
The Examiners would expect students to begin with the explanation of the
empirical evidence in favour of the weak-form efficiency. The Examiners
would award marks for students who constructed clear paragraphs which
made the following points:
• Random walk behaviour of stock prices. Up to 3 marks awarded for an
explanation of this.
• Technical analysis. Overall empirical evidence shows that technical
analysis does not outperform the market, and that successful past
forecasting does not imply future market outperformance. This
evidence (as provided for example in Allen and Karjalainen, 1999)
supports the weak-form efficiency of financial markets. Students
should also refer to the researchers more favourable to technical
analysis (such as Brock, Lakonishok and LeBaron, 1992), whose
results do not support market efficiency in the weak-form.
Up to 4 marks awarded for showing a good understanding of the evidence
on technical analysis.
28
Students should then move to the investigation of the evidence against

weak-form efficiency. The Examiners would expect students to make the
following points:
• Calendar effects. Students 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. Students 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 4 marks awarded for showing a good understanding
of the calendar effects.
• Small firm effect and weak-form efficiency. Students should begin with
the definition of the phenomenon and then provide the empirical
evidence on the positive correlation of next period’s returns of small
firms’ stocks with previous returns even for weekly and monthly
periods (as shown in Lo and MacKinley, 1988). Students would then
be expected to explain the theories that could explain the small firm
effect (low liquidity of small firms or inappropriate measurement of
risk for small firm stocks, data-snooping, and actual weak inefficiency
in the USA in the 1970s and the 1980s). Up to 3 marks awarded for
showing a good understanding of the small firm effect.
Question 5
(a) Discuss the arguments for bank regulation. (13 marks)
The Examiners would here be expecting a balanced, essay-format
discussion which included the main reasons for prudential regulation,
which include:
• The fragility of banks – mainly due to their provision of liquidity to
the financial system (i.e. vulnerability to runs). A source of mitigation
of fragility is the role of banks in screening and monitoring borrowers
who cannot obtain direct finance from financial markets (6 marks)
• Systemic risk – the contagion effect exacerbated by asymmetric
information (2 marks)
• Depositor protection (2 marks).
Students would also be expected to explain the main consequences of
bank failures in the absence of any regulation (3 marks).
based financial systems. (12 marks)
A good answer would explain that essentially in market-based systems (US
and UK) – (1 mark for examples) in contrast to bank-based financial
systems (Germany and Japan) (1 mark for examples) – the financial
markets play a greater role in providing finance to firms (1 mark), the
relationship between banks and firms is not close (1 mark) and there is a
lower level of integration between bank and non-bank financial services (1
mark).
A better answer to this question would mention the following:
• The proportion of gross financial assets owned by pension funds is
higher (2 marks).
• Equity is a more important component of households’ asset portfolios
in market-based systems (2 marks).
29
• Moral hazard should be lower in bank-based financial systems (1

mark).
• Trend is towards market-based systems suggesting their superiority in
terms of capital allocation (2 marks).
SECTION B
Question 6
The following balance sheet is available (amounts in £ millions and duration in
Amount Duration
Mortgages 1,000 6.5
T-bonds 1,000 2.9
Deposits 5,500 2.5
Equity 500

Weighted asset duration = 3.5 × (4000/6000) + 6.5 × (1000/6000) + 2.9
× (1000/6000) = 3.9 years (2 marks)
Liability duration = 2.5 years (1 mark)
years
1 mark awarded for correct equation; 1 mark for correct input data;
1 mark for good explanation; 1 mark for correct answer.
(b) Why do banks use credit scoring models? What are the main families of
credit scoring models? How do these families differ? (9 marks)
Students should begin with a clear definition of credit scoring models
which are models used to calculate the probability of borrower default or
to sort borrowers into default classes. Up to 2 marks awarded for giving a
clear definition.
Students should then explain the main approaches used to construct credit
scoring models: linear probability models and discriminant models (1
mark awarded for this).
Linear probability models use data from past defaulters and non-defaulters
to identify those factors that explain why a borrower defaults. The
resulting model is then used to forecast the probability of a new borrower
default (2 marks).
Discriminant models divide borrowers into high or low default risk classes.
Students should then go on with the description of Altman’s discriminant
function as illustrated at page 89 of the subject guide (2 marks awarded
for the description). This definition should be followed by a critical
explanation of the problems associated with the discriminant model (up to
2 marks awarded for this).
Students may like to refer to pages 86 and 99 of the subject guide.
A good definition of market risk states that market risk is related to
changes in market-determined prices, interest rates and exchange rates.
This mainly affects a bank’s trading book which contains assets, derivatives
held for short periods (2 marks).
30
Greater importance for market risk due to increase in trading activities of

banks as banks have sought other sources of income to replace the income
from traditional intermediation business (2 marks).
The increasing relevance of market risk determined the development of
market risk management models, among which is the value-at-risk (VAR)
approach. There are three main internal models for calculating market risk
exposure, as developed by large commercial banks and investment banks:
a) RiskMetrics (or the variance/covariance approach); b) Historic
simulation; c) Monte Carlo simulation (2 marks).
Under the RiskMetrics model developed by J.P. Morgan, the value-at-risk is
the maximum estimated loss in the market value of a given position that
can be incurred if market conditions move adversely (1 mark). This can be
written as:
where:
Vx = market value of position x; dV/dP = price sensitivity of the position;
Äpi = adverse price movement over time i. (2 marks for providing the
equation and the explanation on the notation).
Question 7
(a) Consider the following stocks:
• Stock Two is expected to pay a dividend of £4 next year with dividend
growth expected to be 3% per annum thereafter.
stock. (6 marks)
The price today of stock One is $55.6. (3 marks) The price of stock Two is
$66.7 (3 marks).
(b) Describe the characteristics of common stocks and preferred stocks. What
are the main differences between common stocks and preferred stocks? (6
marks)
Common stocks represent ownership interests in the firm. Common
stockholders receive dividends (when distributed), take capital gains (or
losses) when the stock price on the market increases (or decreases) and
have the right to vote (1 mark).
Preferred stocks are equity claims with limited ownership rights in
comparison to common stocks (1 mark). They differ from common stocks
in several ways:
a) Preferred stocks distribute a fixed constant dividend, which makes
them more similar to bonds than to common stocks (1 mark).
b) The price of preferred stocks is relatively stable, as the dividend is a
constant amount (1 mark).
c) Preferred stocks do not usually attribute voting rights (1 mark).
d) Preferred stockholders have a residual claim on assets and income left
over after creditors have been satisfied, but they have priority over
common stockholders (1 mark).
31
Excellent students 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 expected return on a stock over the next year can be written as:
(7.11)
where: DIV1 = expected dividend to be paid at time 1; P0 = current price

of the stock; P1 - P0 = capital gain on the stock. (1 mark)
Rearranging equation (7.11), we can predict the current price of a stock in
terms of forecasted dividends and expected price next year. Formally, this
is:
(7.12)
where: re = required annual rate on similar equity stocks (2 marks).

Equation (7.12) is the fundamental valuation formula. It represents a
market equilibrium condition: if it does not hold, stocks will be under-
priced or over-priced.
When we come to use this equation, we immediately realise that we must
estimate the price of the stock at time 1 in order find the value today.
However, future stock prices are not easy to determine. What does
determine future stock prices? (2 marks).
The answer is contained in the same equation (7.12). The expected price
at time t can be expressed as the expected dividends at time t+1 plus the
price at the end of year t+1. Therefore, in equation (7.12), P1 could be
replaced by (DIV2+P2)/(1+re):
(7.13)
The current price of a stock relates to the expected dividends for two years
(DIV1 and DIV2) plus the forecasted price at the end of year two (P2).
Accordingly, in equation (7.13), P2 could be expressed as
(DIV3+P3)/(1+re) (2 marks).
Can you see that we can look as far into the future as we like? If we
consider a period of N years, by extending equation (7.13) we predict the
current price of a stock in terms of dividends over N years and the price at
the end of year N (1 mark):
(7.14)
(1 mark was awarded for this equation)

(d) Describe the zero growth model. (4 marks)
Students were expected to explain that under this model assumes a
constant dividend stream (DIV = DIV1 = DIV2 =…= DIV∝). Thus the
valuation formula reduces to the equation for the present value of a
perpetuity (illustrated in part (a)). Up to 3 marks awarded for this
explanation.
Students should then present the equation for the calculation of the price
under this model (1 mark for the equation and the relevant notation).
32
Question 8
At the end of June 2007 a UK corporate bond has an annual coupon rate of 3%,
par (face) value of £5,000 and will mature in June 2010. Similar UK government
bonds have an annual interest rate of 3.5%.
The semi-annual discount rate is 1.75% (=3.5/2). The 6 six-month
coupon payments are of £75 (=£150/2). The price becomes:
1 mark awarded for correct calculation procedure; 2 marks for correct

formula; 2 marks for the correct input data into PV formula; 1 mark for
correct answer.
The discount rate is 3.5%. The duration would be:
T CF PV(CF) t × PV(CF)
1 150 144.928 144.928
2 150 140.027 280.054
3 5,150 4,645.005 13,935.02
4,929.96 14,360.00
D=2.912802
2 marks awarded for correct calculation scheme; 1 mark for correct T
values; 1 mark for correct CF values; 2 marks for correct DF values; 1
mark for correct duration calculation.
Following from (b):
1 mark for correct equation; 1 mark for correct input data; 1 mark for the
correct sign of the answer; 1 mark for correct answer.
(d) What is the difference between US Government bonds and notes? Why do
2-year Treasury bonds typically have lower interest rates than 4-year
Treasury bonds? Why do corporate bonds have higher rates than government
bonds? (8 marks)
A good answer states that US Government notes have an original maturity
of one to ten years, while bonds have an original maturity of ten to twenty
years. Both government notes and bonds are free of default risk. (1 mark).
An excellent answer to ‘Why do 2-year Treasury bonds typically have
lower interest rates than 4-year Treasury bonds?’ needs to refer to how the
term to maturity influences the interest rate. Bonds with identical risk may
have different interest rates because of the difference in the time
remaining to maturity (2 marks). A yield curve plots the interest rates of
bonds with different maturity but the same risk. It describes the term
structure for a particular type of bond (2 marks). The yield curve can be:
33
upward (the long-term rates are above the short-term rates); flat (short-
and long-term interest rates are the same); and inverted (long-term
interest rates are below short-term interest rates) (1 mark).
The degree of risk of corporate bonds, which depends on the default risk
of the company, is higher than for government and municipal bonds. This
determines the presence of higher interest rates (2 marks).
Question 9
(a) Explain how a bank can use duration gap analysis and income gap analysis
to manage interest rate risk. Critically discuss the problems associated with
Excellent students should make the following points:
Banks to manage interest rate exposure, taking into account the effects of
changes in interest rates both on income and market value, can use
duration (1 mark).
In order to determine the effects of changes in interest rates on the market
value of assets and liabilities, and then calculate the impact on
shareholders’ net worth, bank managers can calculate the duration of all
assets and liabilities on their balance sheet. Alternatively, recalling the
additive property of duration, bank managers can determine the effects of
a change in interest rates on the market value of net worth by calculating
the average duration for assets and for liabilities and then using those
figures to estimate the effects of the change in interest rates (1 mark).
Students should then provide the formula for the calculation of the overall
duration gap (1 mark).
They should emphasise that if the durations of designated assets and
liabilities are matched (DURgap=0), then the duration gap on that part of
the balance sheet is said to be ‘immunised against unexpected changes in
interest rates’. Immunisation can be used to obtain a fixed yield for a given
period of time because both sides of the balance sheet are protected
against interest rate risk (1 mark).
Duration gap can be used to calculate the change in the market value of
net worth (DNW) as a percentage of total assets induced by a change in
interest rates. Students would be awarded 1 mark for providing the
relevant equation.
Students may like to refer to page 93 of the subject guide to explain
Under the income gap analysis (maturity approach), banks report the gap
in each maturity bucket, calculated as the difference between rate-
sensitive assets (RSA) and rate-sensitive liability (RSL) on their balance
sheets. This can be written as:
GAP = RSA – RSL (6.1) (1 mark).
A positive GAP implies sensitive assets > sensitive liabilities. The rise in
interest rates will cause a bank to have interest revenue rising faster than
interest costs; thus the net interest margin and income will increase. The
decline in interest rates will increase liabilities costs faster than assets
returns; as a consequence the net interest margin and income will
decrease (1 mark).
Bank managers can calculate the income exposure to changes in interest
rates in different maturity buckets, by multiplying GAP by the change in
the interest rate:
34
ΔI= GAP * ΔI (6.2)

where Δ I = change in the bank’s income; Δ I = change in interest rate (1
mark).
Finally students should explain the three main problems associated with
• It ignores market value effects of interest rates changes (1 mark).
• Even rate-insensitive assets and liabilities (whose interest rates are not
re-priced) actually have a component that is rate-sensitive (i.e. a
runoff cash flow). Examples of these items would be expected. Bank
managers can deal with this problem by identifying for each asset and
liability the estimated runoff cash flow, to be added to the value of the
rate-sensitive assets and liabilities (3 marks).
• It ignores the effects of the changes in interest rates on off-balance
sheet instruments (1 mark).
Variable-rate mortgages 10
Fixed-rate mortgages 10 Money market deposits 20
Commercial loans 45 Savings deposits 30
Total 80 Total 80
decreased by 0.5 per cent, from 4.5 to 4 per cent? Explain using basic gap
analysis. (Use the following hypothesis on the runoff of cash flows: fixed-
rate mortgages repaid during the year: 25 per cent; proportion of savings
deposits that are rate-sensitive: 25 per cent). (12 marks)
Three steps are needed to answer part (b).
i. To determine the amount of rate-sensitive assets:
Commercial loans £45
Fixed-rate mortgages (25%*10) £2.5
Variable-rate mortgages £10
£57.5
2 marks were awarded for correct procedure; 1 mark for correct input
data; 1 mark for correct answer.
ii. To determine the amount of rate-sensitive liabilities:
Money market deposits £20
Savings deposits (25%*30) £7.5
£27.5
2 marks were awarded for correct procedure; 1 mark for correct input
data; 1 mark for correct answer.
iii. What happens when interest rates decrease by 0.5%?
Decrease in income on assets (=0.5%*57.5) £0.2875
Decrease in payments on liabilities (=0.5%*27.5) £0.1375
Decrease in net income £0.15
1 mark was awarded for correct procedure; 1 mark for correct input data;
2 marks for correct answer.
35
Question 10
(a) Consider a three-factor Arbitrage Pricing Theory (APT) model.
Change in GDP 5% 1
Change in interest rate 1% 0.5
Inflation ratio 2.5% 0.2
Assuming a risk-free rate of 4%, calculate the expected return of this stock.
(4 marks)
Expected return = 4% + 5%*1 + 1%*0.5 + 2.5%*0.2 = 10%
2 marks were awarded for correct equation; 1 mark for correct input data;
1 mark for correct answer.
(b What are the assumptions under the APT? What is the expected risk
premium? (11 marks)
An outstanding answer would first explain the economic meaning of each
of the four assumptions under the APT:
1. no arbitrage opportunities (2 marks)
2. returns of risky assets can be described by a factor model (1 mark)
3. financial markets are frictionless (i.e. there are no transaction costs or
related market frictions) (1 mark)
4. diversifiable risk does not exist (1 mark).
Excellent students should then mention that the key to the APT is that a
factor model with no arbitrage opportunities implies that assets with the
same factor sensitivities must offer the same expected returns in financial
market equilibrium (1 mark). Therefore the expected risk premium on an
individual asset (equal to the expected return on an individual asset minus
the risk-free rate) depends on the sum of the expected risk premium
associated with each factor multiplied by the asset sensitivity to each of
these factors (2 marks).
Students should provide the equation for the calculation of the expected
return on an individual asset (1 mark).
Finally students should emphasise the characteristics of the risk premium
(i.e., it is affected only by macroeconomic factors, and not by unique risk
and it varies in direct proportion to the asset’s sensitivity to the factor (2
marks).
CAPM? (4 marks)
An excellent answer would mention that the advantage of the APT is that
it does not require us to identify and measure the market portfolio
(solving most of the problems on the theoretical limitations of the CAPM).
The disadvantage is that it does not tell us what the underlying factors are
(unlike the CAPM, which collapses all the macroeconomic factors into the
market portfolio).
Empirical research is still in the early stages as regards the APT, and is not
as well developed as the literature on the CAPM (1 mark). Many studies
have been particularly interested in whether the APT explains the size
36
effect discussed about the CAPM. Although the evidence is not conclusive,
the majority of the studies (see among others: Chen, 1983; Chan, Chen
and Hsieh, 1985) find that the size effect becomes negligible in a multi-
factor framework (2 marks). Other studies focused on the identification of
the factors with significant effects on risk premiums. Chen, Roll and Ross
(1986) emphasise the relevance of growth in real GDP, interest spread and
changes in default spreads (2 marks).
An outstanding answer would include any specific reference to papers
cited in the subject guide (1 mark).
Notice
There is a correction sheet for the subject guide for 2007.
37

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UNIVERSITY OF LONDON 279 0024 ZA

Principles of Banking and Finance

Thursday, 24 May 2007 : 2.30pm to 5.30pm

©University of London 2007 PLEASE TURN OVER

1. (a) Outline the structure of a developed financial system. (10 marks)

Assets (£) Liabilities (£)

i. What is the gearing ratio of Bank ABC?

1 PLEASE TURN OVER

5. (a) Discuss the arguments for bank regulation. (13 marks)

(a) What is the duration gap for Bank International? (7 marks)

• Stock One is expected to pay a dividend of £1 forever;

(d) Describe the Gordon growth model. (4 marks)

3 PLEASE TURN OVER

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

Assets (£) Liabilities and Equity (£)

10. (a) Consider a three-factor Arbitrage Pricing Theory (APT) model.

Factor Risk premium Sensitivity to each factor

Assuming a risk-free rate of 4%, calculate the expected return of this

(c) What are the main advantages/disadvantages of APT in comparison to the

(d) Discuss the empirical validation of the APT. (6 marks)

UNIVERSITY OF LONDON 279 0024 ZB

Principles of Banking and Finance

Thursday, 24 May 2007 : 2.30pm to 5.30pm

©University of London 2007 PLEASE TURN OVER

1. (a) Outline the main functions of financial systems. (10 marks)

Assets (£) Liabilities (£)

i. What is the gearing ratio of Bank XYZ?

1 PLEASE TURN OVER

5. (a) Discuss the arguments for bank regulation. (13 marks)

(b) Explain the main implications of the presence of market-based versus

6. The following balance sheet is available (amounts in £ millions and duration in

(a) What is the duration gap for Bank International? (7 marks)

• Stock One is expected to pay a dividend of £5 forever;

(b) Describe the characteristics of common stocks and preferred stocks.

(d) Describe the zero growth model. (4 marks)

3 PLEASE TURN OVER

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

Assets (£) Liabilities and Equity (£)

10. (a) Consider a three-factor Arbitrage Pricing Theory (APT) model.

Factor Risk premium Sensitivity to each factor

Assuming a risk-free rate of 4%, calculate the expected return of this

(c) What are the main advantages/disadvantages of APT in comparison to

(d) Discuss the empirical validation of the APT. (6 marks)

Examiner’s report 2007

Specific comments on questions

i. What is the gearing ratio of Bank ABC?

(a) What is the duration gap for Bank International? (7 marks)

The increasing relevance of market risk determined the development of

where: DIV1 = expected dividend to be paid at time 1; P0 = current

where: re = required annual rate on similar equity stocks (2 marks).

Equation (7.12) is the fundamental valuation formula. It represents a

(1 mark was awarded for this equation)

In order to determine the effects of changes in interest rates on the market

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

Examiner’s report 2007

Specific comments on questions

• The existence of asymmetric information means that lenders will lend

of 8% is also to remain unchanged, several changes have been introduced