CH-8-9 Risk Management: Financial Futures, Options, Swaps, and other Hedging Tools – Bank Management and Financial Services : Exam Guide

This Document Contains Chapters 8 to 9 Chapter 8 Risk Management: Financial Futures, Options, Swaps, and other Hedging Tools Fill in the Blank Questions 1. A(n) _________ is an agreement between a buyer and a seller today which calls for the delivery of a particular security in exchange for cash at some future date for a set price. Answer: financial futures contract 2. A financial institution goes _________ in the futures market by selling a futures contract. Answer: short 3. A financial institution goes _________ in the futures market by buying a futures contract. Answer: long 4. _________ is the difference in interest rates (or prices) between the cash market and the futures market on an underlying security. Answer: Basis 5. The _________ is the fee the buyer must pay to be able to put securities to or to call securities away from the option writer. Answer: option premium 6. A(n) _________ allows the holder the right to either sell securities to another investor (put) or buy securities from another investor (call) for a set price before the expiration date. Answer: option 7. Futures contracts are _________ daily which means that the futures contracts settled each day as the market value of the futures contracts change. Answer: marked to market 8. Most options today are traded on a(n) _________. These options are standardized to make offsetting an existing position easier. Answer: organized exchange 9. A(n) _________ means that the buyer of the option contract is betting that the market price of the underlying security will decline in the future. Answer: put option 10. A(n) _________ means that the buyer of the option contract is betting that the market price of the underlying security will increase in the future. Answer: call option 11. A(n) _________ is where a borrower with a lower credit rating enters into an agreement with a borrower with a higher credit rating to exchange interest payments. Answer: quality swap 12. In an interest rate swap, the _________ or principal amount is not exchanged. Answer: notional 13. A(n) _________ is an interest rate swap which offsets the original interest rate swap agreement. Answer: reverse swap 14. In an interest rate swap agreement, _________ reduces the default risk. This is where the swap parties exchange only the net difference between interest payments owed. Answer: netting 15. A(n) _________ is a contract where two parties exchange interest payments in order to save money and hedge against interest rate risk. Answer: interest rate swap 16. A(n) _________ is an agreement between two parties where they agree to exchange different currencies. It is designed to reduce exchange rate risk. Answer: currency swap 17. A(n) _________ protects the holder from rising market interest rates. It sets the maximum interest rate that a lender can charge on the loan. Answer: interest rate cap 18. A(n) _________ protects the lender from falling interest rates. It is the minimum rate that the borrower must pay on a variable-rate loan. Answer: interest rate floor 19. A(n) _________ is where there is both a minimum and a maximum interest rate set on a loan. Answer: interest rate collar 20. In an interest-rate swap, the principal amount of the loan, usually called the _______, is not exchanged. Answer: notional amount 21. The category of derivative contract with the largest use by banks is __________. Answer: swaps 22. The _______ is the spread between the cash price and futures price of an underlying asset. Answer: basis 23. An interest-rate ________ would protect the swap party receiving a floating-rate payment in the swap. Answer: floor 24. An interest-rate _______ would protect the swap party receiving a fixed-rate payment and paying a floating-rate in a swap. Answer: cap 25. The combination of both a cap and floor is known as an interest-rate _________. Answer: collar 26. One reason that banks use derivatives is to generate important _________, money that does not come from interest earned on loans and securities. Answer: fee income 27. _________ are financial assets that derive their value from some underlying instrument. Answer: derivatives 28. The _________ largest banks account for more than 99 percent of derivatives activity in the U.S. Answer: 25 29. When an investor buys or sells a futures contract, they must deposit a(n) _________ when they first enter into the contract. Answer: initial margin 30. On the exchange floor, _________ execute orders received from the public to buy and sell the futures contract at the best possible price. Answer: floor brokers 31. The financial futures markets are designed to shift the risk of interest rate fluctuations from risk-averse investors to _________. Answer: speculators 32. Futures contracts can be traded _________, without the help of an organized exchange. Answer: over the counter 33. The _________ is determined by the clearing house and is used to the marked-to-market amount. Answer: settlement price (SETTLE) 34. The most actively traded futures contract in the world is the _________. It is traded on exchanges in Chicago, London, Tokyo, Singapore and elsewhere and allows investors the opportunity to hedge against market interest rate changes. Answer: three-month Eurodollar time deposit futures contract 35. The buyer of a call option has the right to buy from the writer of the option contract securities at the _________. Answer: exercise (or strike) price True/False Questions 36. One of the most popular methods of neutralizing duration gap risks is to buy and sell financial futures contracts. Answer: True 37. The financial futures markets are designed to shift the risk of interest rate fluctuations from risk-averse investors to speculators who are willing to accept and possibly profit from such risks. Answer: True 38. When a financial institution offers to sell financial futures contract, it is "going short" in futures and is agreeing to take delivery of certain kinds of securities on a stipulated date at a predetermined price. Answer: False 39. There are some significant limitations to financial futures as interest-rate hedging devices, among them is a special form of risk known as credit risk. Answer: False 40. An effective hedge is one where the positive or negative returns earned in the cash market are approximately offset by the profit or loss from futures trading. Answer: True 41. A hedging tool that provides "one-sided" insurance against interest rate risk is the interest rate option, which, like financial futures contracts, obligates the parties to the contract to either deliver or take delivery of securities. Answer: False 42. U.S. Treasury bond futures contracts call for the future delivery of U.S. T-bonds with minimum denominations of $100,000 and minimum maturities of 15 years. Answer: True 43. A futures hedge against interest-rate changes generally requires a bank to take an opposite position in the futures market from its current position in the cash market. Answer: True 44. The short hedge in financial futures contracts is most likely to be used in situations where a bank would suffer losses due to falling interest rates. Answer: False 45. The long hedge in financial futures contracts is most likely to be used in situations where a bank would suffer losses due to rising interest rates. Answer: False 46. The short hedge would usually be the correct choice if a bank is concerned about avoiding lower than expected yields from loans and security investments. Answer: False 47. A financial institution with a positive interest-sensitive gap and anticipating falling interest rates could protect against loss by covering the gap with a long hedge. Answer: True 48. A financial institution confronted with a negative interest-sensitive gap could avoid unacceptable losses from rising interest rates by covering the gap with a short hedge. Answer: True 49. The sensitivity of the market price of a financial futures contract depends upon the duration of the security to be delivered under the futures contract. Answer: True 50. In U.S. banking any gain or loss from futures trading must be "coincidental" to the main purpose of the trading – interest-rate hedging. Answer: True 51. If a U.S. bank's financial futures trading can be linked to a particular asset or liability position where it faces interest-rate risk exposure, that bank must take immediate recognition of any losses or gains it experiences from futures trading. Answer: False 52. According to the textbook the two principal uses of option contracts by banks are to protect the value of a bond portfolio or to hedge against interest-sensitive or duration gaps. Answer: True 53. Banks are generally writers (sellers) of put and call option contracts. Answer: False 54. The market value of a futures contract changes daily as the market price of the underlying security price changes. Answer: True 55. A futures contract is "marked to market" weekly to reflect the current market price of the contract. This means that one or the other party has to make a cash payment to the exchange at the end of each week. Answer: False 56. If a financial institution makes an offsetting sale and purchase of the same futures contract, it has no obligation either to deliver or take delivery of the contract. Answer: True 57. A bank will use a short hedge in the futures market to avoid higher borrowing costs or to protect against declining asset values. Answer: True 58. One of the significant disadvantages of using futures contracts to hedge against interest rate risk is the high commissions that must be paid to brokers. Answer: False 59. Basis risk is the difference in the interest rates (or prices) of the same security between the cash market and the futures market. Answer: True 60. In the typical quality swap a borrower with a positive duration gap is more likely to pay all or part of the other swap party's long-term interest rate. Answer: True 61. A currency swap is where two parties agree to exchange interest payments in order to hedge against interest rate risk. Answer: False 62. In most interest rate swaps netting reduces the default risk because the parties actually exchange only the difference in the interest payments. Answer: True 63. One advantage of an interest rate swap agreement is that the brokerage fees are very small. Answer: False 64. Unlike futures contracts, interest rate swap agreements have no basis risk. Answer: False 65. Interest rate caps protect the lender from falling interest rates. Answer: False 66. Interest rate floors protect the lender from falling interest rates. Answer: True 67. An interest rate collar sets both a minimum and a maximum interest rate on a variable rate loan agreement. Answer: True 68. Basis risk exists on interest rate swaps because the interest rate on the swap agreement may differ from the interest rate on assets and liabilities that the parties hold. Answer: True 69. A reverse swap is where the parties exchange the principal payments instead of the interest payments on loans. Answer: False 70. An interest-rate cap on a loan would protect the lender. Answer: False 71. Many banks are not only users of derivative products but also dealers. Answer: True 72. Most derivatives (measured by notional value) are traded on organized exchanges. Answer: False 73. An interest-rate cap will become more valuable as interest rates rise. Answer: True 74. Virtually all banks in the U.S. use derivative contracts to hedge their risks. Answer: False 75. The number of futures contracts needed to hedge a position increases as the bank's duration gap increases. Answer: True 76. A financial institution with a negative gap would like to receive the floating rate in an interest-rate swap. Answer: False Multiple Choice Questions 77. A financial institution with a negative gap could reduce the risk of loss due to changing interest rates by: A) Extending asset maturities B) Increasing short-term interest-sensitive liabilities C) Using financial futures or options contracts. D) All of the above. E) None of the above. Answer: D 78. If a bank has a positive gap, that is, if it is asset sensitive, the bank can hedge its interest-rate risk by which of the following activities: A) Reduce its asset maturities. B) Reduce maturities of its liabilities. C) Use a long hedge. D) All of the above. E) A and C only. Answer: E 79. A significant limitation to financial futures as an interest-rate hedging device is a special form of risk known as ___________ risk. Which of the following terms correctly completes the statement? A) Default B) Basis C) Credit D) Market E) None of the above. Answer: B 80. The realized return to a bank from a combined cash and futures market trading operation is composed of which of the following elements: A) Return earned in the cash market. B) Profit or loss from futures trading. C) Difference between the opening and closing basis between cash and futures markets. D) All of the above. E) B and C only. Answer: D 81. Advantages of trading financial futures to hedge interest-rate risk include which of the following: A) Only a fraction of the value of the contract must be pledged as collateral. B) Brokers' commissions are relatively low. C) There is no risk in trading futures contracts. D) All of the above. E) A and B only. Answer: E 82. An option buyer can: A) Exercise the option. B) Sell the option to another buyer. C) Allow the option to expire. D) All of the above. E) A and B only. Answer: D 83. A bank wishing to avoid higher borrowing costs would be most likely to use: A) A short or selling hedge in futures. B) A long or buying hedge in futures. C) A call option on futures contracts. D) B and C above. E) None of the above. Answer: A 84. A bank seeking to avoid lower than expected yields from loans and security investments would be most likely to use: A) A short or selling hedge in futures. B) A long or buying hedge in futures. C) A put option on futures contracts. D) B and C above. E) None of the above. Answer: B 85. The gain or loss to a bank from the use of a financial futures contract depends upon: A) The duration of the underlying security named in the futures contract B) The initial futures price C) The change expected in interest rates divided by 1 + the original interest rate. D) All of the above. E) None of the above. Answer: D 86. The number of futures contracts that a bank will need in order to fully hedge the bank's overall interest rate risk exposure and protect the bank's net worth depends upon (among other factors): A) The relative duration of bank assets and liabilities. B) The duration of the underlying security named in the futures contract. C) The price of the futures contract. D) All of the above. E) None of the above. Answer: D 87. A put option would most likely be used to: A) Protect fixed-rate loans and securities. B) Protect variable-rate loans and securities. C) Offset a positive interest-sensitive gap. D) Offset a negative interest-sensitive gap. E) None of the above. Answer: A 88. A call option would most likely be used to: A) Protect the value of fixed-rate loans and securities. B) Offset a negative interest-sensitive gap. C) Offset a positive duration gap. D) Offset a negative duration gap. E) None of the above. Answer: D 89. According to the textbook, the most popular option contracts used by banks today include: A) Federal Funds futures contracts. B) Eurodollar time deposit futures contracts. C) U.S. Treasury bond futures contract. D) All of the above. E) None of the above. Answer: D 90. A futures contract which calls for the delivery of a $100,000 T-bond with a minimum of 15 years to maturity is called a: A) U.S. Treasury bond futures contract B) One-month LIBOR futures contract C) Eurodollar time deposit futures contract D) Federal Funds futures contract E) None of the above Answer: A 91. A financial institution that sells a particular futures contract and later purchases the same contract back is executing: A) A long hedge B) A short hedge C) A sideways hedge D) An up-side-down hedge E) None of the above Answer: B 92. A financial institution that uses a long hedge is most likely: A) Trying to avoid higher borrowing costs B) Trying to avoid declining asset values C) Trying to avoid lower than expected yields on from loans and securities D) A and B above Answer: C 93. A bank that uses a short hedge is most likely: A) Trying to avoid higher borrowing costs B) Trying to avoid declining asset values C) Trying to avoid lower than expected yields on from loans and securities D) A and B above Answer: D 94. Suppose a bank has an asset duration of 5 years and a liability duration of 2.5 years. This bank has $1000 million in assets and $750 million in liabilities. They are planning on trading in a Treasury bond future which has a duration of 8.5 years and which is selling right now for $99,000 for a $100,000 contract. How many futures contracts does this bank need to fully hedge itself against interest rate risk? A) 3714 contracts B) 3125 contracts C) 2971 contracts D) 371 contracts E) None of the above Answer: A 95. A bank wishes to sell $350 million in new 30-day time deposits next month. Today interest rates are 7 percent. However, next month interest rates are expected to rise to 7.75 percent. What is the potential loss in profit for the month from this increase in interest rates? (Use a 360 day year) A) $27.125 million B) $24.500 million C) $.2188 million D) $2.625 million E) There is no potential loss from this increase Answer: C 96. A futures contract on a 30 day Eurodollar time deposit is currently selling at an IMM index of 95.75 percent. The IMM index on a 30 day Eurodollar time deposit for immediate delivery is 95.10 percent. What is the basis risk for the futures contract? A) 65 basis points B) –65 basis points C) 490 basis points D) 425 basis points E) There is no basis risk on this contract Answer: A 97. Suppose a T-Bond futures contract has a duration of 9 years and has a current market price of $98,750. Market interest rates are 6 percent today but are expected to rise to 7.5 percent. What is the change in this futures contract's market price from this change in interest rates? A) $12,577 B) -$12,577 C) $62,883 D) -$62,883 E) None of the above Answer: B 98. Suppose a Eurodollar time deposit futures contract has a duration of .5 years and has a current market price of $950,000. Market interest rates are 8.5 percent and are expected to fall to 7.5 percent. What is the change in this futures contract's market price from this change in interest rates? A) $4378 B) -$4378 C) $30,645 D) -$30,645 E) None of the above Answer: A 99. A financial institution that goes long in the futures market: A) Has the right to accept delivery of the underlying security at the contract price if they wish B) Has the right to make delivery of the underlying security at the contract price if they wish C) Is obligated to accept delivery of the underlying security at the contract price D) Is obligated to make delivery of the underlying security at the contract price Answer: C 100. A bank that goes short in the futures market: A) Has the right to accept delivery of the underlying security at the contract price if they wish B) Has the right to make delivery of the underlying security at the contract price if they wish C) Is obligated to accept delivery of the underlying security at the contract price D) Is obligated to make delivery of the underlying security at the contract price Answer: D 101. A financial institution that buys a put option: A) Has the right to accept delivery of the underlying security at the contract price if they wish B) Has the right to make delivery of the underlying security at the contract price if they wish C) Is obligated to accept delivery of the underlying security at the contract price D) Is obligated to make delivery of the underlying security at the contract price Answer: B 102. A bank that buys a call option: A) Has the right to accept delivery of the underlying security at the contract price if they wish B) Has the right to make delivery of the underlying security at the contract price if they wish C) Is obligated to accept delivery of the underlying security at the contract price D) Is obligated to make delivery of the underlying security at the contract price Answer: A 103. Interest rate hedging devices used by banks today include which of the following: A) Financial futures contracts. B) Interest-rate options contracts. C) Interest rate swaps. D) Interest rate caps, floors, and collars. E) All of the above. Answer: E 104. An interest rate swap is: A) A way to change a bank's exposure to interest rate fluctuations. B) A way to achieve lower borrowing costs. C) A way to convert from fixed rates to floating rates. D) A way to transform actual cash flows through the bank to more closely match desired cash flow patterns. E) All of the above. Answer: E 105. An interest rate collar: A) Combines a rate floor and a rate cap into one agreement. B) Ranges in maturity from a few days to a few weeks. C) Protects a lender from rising interest rates. D) All of the above. E) B and C only. Answer: A 106. An agreement where two parties agree to exchange different currencies is known as: A) An interest rate swap B) A currency swap C) A swaption D) A quality swap E) None of the above Answer: B 107. The part of an agreement which allows one or both parties to make certain changes to the agreement or eliminate the agreement is called: A) An interest rate swap B) A currency swap C) A swaption D) A quality swap E) None of the above Answer: C 108. An agreement where a party with a lower credit rating enters into an agreement to exchange interest payments with a borrower having a higher credit rating is known as: A) An interest rate swap B) A currency swap C) A swaption D) A quality swap E) None of the above Answer: D 109. Which of the following is an advantage of an interest rate swap agreement? A) Little or no basis risk B) Low brokerage fees C) Increased flexibility over other hedging techniques D) Little or no credit risk E) All of the above are advantages of interest rate swap agreements. Answer: C 110. Which of the following is a disadvantage of an interest rate swap agreement? A) Basis risk B) High brokerage fees C) Default risk D) Interest rate risk E) All of the above are disadvantages of interest rate swap agreements. Answer: E 111. Interest rate swaps: A) First developed in the 1980s B) Are one of the oldest interest rate hedging devices C) Allows for the exchange of different currencies by two parties D) Are rigid and inflexible E) Are none of the above Answer: A 112. Interest rate caps: A) First developed in the 1980s B) Are one of the oldest interest rate hedging devices C) Allow for the exchange of different currencies by two parties D) Protect lenders from falling interest rates E) B and D above Answer: B 113. The approximate percentage of banks who reportedly use derivative contracts is: A) 12% B) 25% C) 50% D) 75% E) 100% Answer: A 114. All of the following interest-rate futures contracts are traded on exchanges except: A) Eurodollar futures contract B) Treasury Bond futures contract C) Eurodollar time deposit futures contract D) Federal Funds futures contract E) Corporate Bond futures contract Answer: E 115. A bank with a duration gap of 2 years and total assets of $100 million uses a futures contract with a duration of .5 years and a price of $100,000 to hedge. The number of contracts that are needed is: A) 2000 B) 4000 C) 8000 D) 10,000 E) 20,000 Answer: B 116. The floating-rate payer in a swap may want to buy an interest-rate: A) Floor B) Cap C) Collar D) Option E) Neither a floor nor a cap Answer: B 117. When an investor first purchases or sells a futures contract, she must make a deposit to the exchange. This is called the: A) Initial margin B) Floor broker C) Settlement price D) Open interest E) Clearinghouse Answer: A 118. The person who executes orders in the futures market for the public is called the: A) Day trader B) Floor broker C) Bank examiner D) Speculator E) Scalper Answer: B 119. When contracts are marked to market at the end of each day, the amount that is used to determine this is called the: A) Initial margin B) Floor broker C) Settlement price D) Open interest E) Clearinghouse Answer: C 120. The number of contracts that have been established and not yet offset or exercised is called _________ by the Wall Street Journal. A) Initial margin B) Floor broker C) Settlement price D) Open interest E) Clearinghouse Answer: D 121. The amount of initial margin, the settlement price and other rules regarding trading futures contract are determined by: A) SEC B) Floor brokers C) Dealers D) Open interest E) Clearinghouse Answer: E 122. Julie Wells has found a Treasury Bond futures contract that has a duration of 8.5 years and is currently selling for $97,500. Interest rates are currently 8% and are expected to rise 1.5%. What is the change in this future contract’s price for this change in interest rates? A) $1462.50 B) $12,431.25 C) -$11,521.42 D) -$1462.50 E) -$12,431.25 Answer: C 123. The Kromwell Community Bank has an average duration for its asset portfolio of 6 years. It also has an average duration for its liability portfolio of 2.5 years. This bank has $ $500 million in total assets and $450 million in liabilities. The Kromwell Community Bank is thinking about hedging their risk by using a Treasury Bond futures contract with a duration of 7.5 years and a price of $98,000. How many futures contracts will the Kromwell Community Bank need use to hedge their risk? A) 2381 contracts B) 2551 contracts C) 3061 contracts D) 4464 contracts E) None of the above Answer: B 124. A Treasury Bond futures contract is selling in the market for $98,225 and has a duration of 8 years. The same Treasury Bond is selling in the cash market for $98,625 and has a duration of 8.25 years. What is the basis for this futures contract? A) $400 B) .25 years C) $28,156.25 D) $1600 E) None of the above Answer: A 125. What type of futures contract tends to accurately predict the consensus opinion as to actions to be taken by the Federal Open Market Committee in the future? A) U.S. Treasury Bond futures contract B) Eurodollar time deposit futures contract C) One month LIBOR futures contract D) Federal Funds futures contract E) All of the above Answer: D 126. Which of the following is one of the risks the OCC requires banks to measure and set limits on? A) Strategic risk B) Reputation risk C) Price risk D) Liquidity risk E) All of the above Answer: E 127. What is the objective of a fair value hedge? A) To offset the losses due to changes in the value of an asset or liability B) To reduce the risk associated with future cash flows C) To maximize future cash flows D) To maximize the value of an asset or minimize the value of a liability E) None of the above Answer: A 128. What is the objective of a cash flow hedge? A) To offset the losses due to changes in the value of an asset or liability B) To reduce the risk associated with future cash flows C) To maximize future cash flows D) To maximize the value of an asset or minimize the value of a liability E) None of the above Answer: B 129. Which of the following is a characteristic of a swap buyer? A) Prefers flexible, short-term interest rate B) Generally has a higher credit rating C) Often has a positive duration D) Generally has a large holding of short-term assets E) All of the above Answer: C 130. Which of the following is a characteristic of a swap seller? A) Prefers fixed-rate longer term loans B) Generally has a lower credit rating C) Often has a positive duration D) Generally has a large holding of short-term assets E) All of the above Answer: D 131. Which of the following is a characteristic of a swap buyer? A) They generally have a lower credit rating B) They prefer fixed rate longer term loans C) They often have a positive duration D) They generally have substantial holdings of longer term assets E) All of the above Answer: E 132. Which of the following is a characteristic of a swap seller? A) They generally have a higher credit rating B) They prefer flexible short-term interest rate C) They often have a negative duration D) They generally have large holdings of short-term assets E) All of the above Answer: E 133. A swap where the notional amount is constant is called: A) A quality swap B) A bullet swap C) An amortizing swap D) An accruing swap E) None of the above Answer: B 134. A swap where the notional amount declines over time is called: A) A quality swap B) A bullet swap C) An amortizing swap D) An accruing swap E) None of the above Answer: C 135. A swap where the notional amount accumulates over time is called: A) A quality swap B) A bullet swap C) An amortizing swap D) An accruing swap E) None of the above Answer: D 136. Which of the following is a difference between futures and forward contracts? A) Futures contracts are market-to-market daily, while forward contracts are not B) Buyers and sellers deal directly with each other on forward contracts but go through organized exchanges in futures contracts C) Futures contracts are standardized, forward contracts generally are not D) Forward contracts are generally more risky because no exchange guarantees the settlement of each contract if one or the other party to the contract defaults E) All of the above are differences between futures and forward contracts Answer: E 137. The daily settlement process that credits gains or deducts losses from a futures customer’s account is called: A) The variation margin B) Marking-to-market C) The initial margin D) The maintenance margin E) The notional value Answer: B 138. Assume that two firms, one considered a high credit risk (HCR) and the other a low credit risk (LCR), are considering an interest rate swap. Each can borrow at the following rates: An interest rate swap would be beneficial to both parties if: A) The LCR firm wants to borrow at the fixed rate and the HCR firm wants to borrow at the variable rate. B) The HCR firm wants to borrow at the fixed rate and the LCR firm wants to borrow at the variable rate. C) Both firms want to borrow at the variable rate. D) Both firms want to borrow at the fixed rate. E) An interest rate swap would be never beneficial in this situation. Answer: B Chapter 9 Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives Fill in the Blank Questions 1. When a bank sets aside a group of income-earning assets and then sells securities based upon those assets it is _________ those assets. Answer: securitizing 2. Often when loans are securitized they are passed on to a _________ who pools the loans and sells securities. Answer: special purpose entity 3. A(n) _________ allows a homeowner to borrow against the residual value of their residence. Answer: home equity loan 4. _________ allow the bank to generate fee income after they have sold a loan. The bank continues to collect interest and principal from the borrowers and passes these collections to the loan buyers. Answer: Servicing rights 5. In a _________ an outsider purchases part of a loan from the selling financial institution. Generally the purchaser has no influence over the terms of the loan contract. Answer: participation loan 6. A(n) _________ is a contingent claim of the bank that issues it. The issuing bank, in return for a fee, guarantees the repayment of a loan received by its customer or the fulfillment of a contract made by its customer to a third party. Answer: standby credit agreement 7. A(n) _________ occurs when two banks agree to exchange a portion or all of the loan repayments of their customers. Answer: credit swap 8. A(n) _________ guards against the losses in the value of a credit asset. It would pay off if the asset declines significantly in value or if it completely turns bad. Answer: credit option. 9. A(n) _________ combines a normal debt instrument with a credit option. It allows the issuer of the debt instrument to lower its loan repayments if some significant factor changes. Answer: credit linked note 10. The _________ of a standby letter of credit is a bank or other investor who is concerned about the safety of funds committed to the recipient of the standby letter of credit. Answer: beneficiary 11. A(n) _________ guarantees the swap parties a specific rate of return on their credit asset. Bank A may agree to pay the total return on the loan to Bank B plus any appreciation in the market value of the loan. In return Bank A will often get LIBOR plus a fixed spread plus any depreciation in the value of the loan. Answer: total return swap 12. The _________ is the party that is requesting a standby letter of credit. Answer: account party 13. The _________ is the bank or financial institution which guarantees the payment of the loan in a standby letter of credit. Answer: issuer 14. A(n) _________ is a loan sale where ownership of the loan is transferred to the buyer of the loan, who then has a direct claim against the borrower. Answer: assignment 15. Another type of loan sale is a(n) _________ which is a short dated piece of a longer maturity loan, entitling the purchaser to a fraction of the expected loan income. Answer: loan strip 16. A relatively new type of credit derivative is a CDO which stands for __________. Answer: collateralized debt obligation 17. Insurance companies are a prime __________ of credit derivatives. Answer: seller 18. A(n) _________ is an over-the-counter agreement offering protection against loss when default occurs on a loan or other debt instrument. Answer: credit derivative 19. A(n) _________ is related to the credit option and is usually aimed at lenders able to handle comparatively limited declines in value but wants insurance against serious losses. Answer: credit default swap 20. There has been an explosion in _________ in recent years. These instruments rest on pools of credit derivatives that mainly insure against defaults on corporate bonds. The creators of these instruments do not have to buy and pool actual bonds but can create these instruments and generate revenues from selling and trading in them. Answer: synthetic CDOs (Collateralized debt obligations) 21. A _________ rates the securities to be sold from a pool of securitized loans so that investors have a better idea of what the new securities are likely to be worth. Answer: credit rating agency 22. A(n) _________ is an assurance that investors will be repaid in the event of the default of the underlying loans in a securitization. These can be internal or external to the securitization process and lower the risk of the securities. Answer: credit enhancement 23. When the FHLMC creates CMOs they often use different _________ which each promise a different coupon rate and which have different maturity and risk characteristics. Answer: Tranches 24. Lenders can set aside a group of loans on their balance sheet, issue bonds and pledge the loans as collateral against the bonds in _________. These usually stay on the bank’s balance sheet as liabilities. Answer: Securitization 25. FNMA (Fannie Mae) and FHLMC (Freddie Mac) are examples of _________. They appear to have the unofficial backing of the federal government in the event of default. Answer: government sponsored enterprises (GSEs) True/False Questions 26. Securitization is designed to turn illiquid loans into liquid assets in the form of securities sold in the open market. Answer: True 27. Securitization has the added advantage of generating fee income for banks. Answer: True 28. Securitized assets cannot be removed from a bank's balance sheet until they mature. Answer: False 29. Securitization raises the level of competition for the best-quality loans among banks. Answer: True 30. Servicing rights on loans sold consist of the collection of interest and principal payments from borrowers and monitoring borrower compliance with loan terms. Answer: True 31. A loan sold by a bank to another investor with recourse means the bank has given the investor a call option on the loan. Answer: False 32. An account party will seek a bank's standby credit guarantee if the bank's fee for issuing the guarantee is less than the value assigned the guarantee by its beneficiary. Answer: True 33. Securitization tends to lengthen the maturity of a bank's assets. Answer: False 34. Securitized assets as a source of bank funds are subject to reserve requirements set by the Federal Reserve Board. Answer: False 35. Securitizations of commercial loans usually carry the same regulatory capital requirements for a bank as the original loans themselves. Answer: True 36. Most loans that banks sell off their balance sheets have minimum denominations of at least a million dollars. Answer: True 37. Most loans that banks sell off their balance sheets carry interest rates that usually are connected to long-term interest rates (such as the 30-year Treasury bond rate). Answer: False 38. In a participation loan the purchaser is an outsider to the loan contract between the financial institution selling the loan and the borrower. Answer: True 39. The buyer of a loan participation must watch both the borrower and the seller bank closely. Answer: True 40. Under an assignment ownership of a loan is transferred to the buyer, though the buyer still holds only an indirect claim against the borrower. Answer: False 41. Loan sales are generally viewed as risk-reducing for the selling financial institution. Answer: True 42. In a CMO, the different tiers (or tranches) of security purchasers face the same prepayment risk. Answer: False 43. A standby letter of credit substantially reduces the issuing bank's interest rate risk and liquidity risk. Answer: False 44. Securitization of loans can easily be applied to business loans since these loans tend to have similar cash flow schedules and comparable risk structures. Answer: False 45. The advantage of a credit swap is that it allows each bank in the swap to broaden its market area and spread out its credit risk on its loans. Answer: True 46. Bank use of credit derivatives is dominated by the largest banks. Answer: True 47. The credit derivatives market has grown nine-fold during the recent years. Answer: True 48. Banks are the principal sellers of credit derivatives. Answer: False 49. Banks are one of the principal buyers of credit derivatives. Answer: True 50. Insurance companies are one of the principal sellers of credit derivatives. Answer: True Multiple Choice Questions 51. Securitized assets carry a unique form of risk called: A) Default risk B) Inflation risk C) Interest-rate risk D) Prepayment risk E) None of the above Answer: D 52. Short-dated pieces of a longer-term loan, usually maturing in a few days or weeks, are called: A) Loan participations B) Servicing rights C) Loan strips D) Shared credits E) None of the above Answer: C 53. The party for whom a standby credit letter is issued by a bank is known as the: A) Account party B) Beneficiary C) Representative D) Credit Guarantor E) None of the above Answer: A 54. When a bank issues a standby credit guarantee on behalf of one of its customers, the party receiving the guarantee is known as the: A) Account party B) Beneficiary C) Obligator D) Servicing agent E) None of the above Answer: B 55. Securitization had its origin in the selling of securities backed by _____________ A) Credit card receivables B) Residential mortgage loans C) Computer leases D) Automobile loans E) Truck leases Answer: B 56. Loan-backed securities, which closely resemble traditional bonds, carry various forms of credit enhancements, which may include all of the following, EXCEPT: A) Credit letter guaranteeing repayment of the securities. B) Set aside of a cash reserve. C) Division into different risk classes. D) Early payment clauses. E) None of the above. Answer: D 57. In some instances, a bank will sell loans and agree to give the loan purchaser recourse to the seller for all or a portion of those loans that become delinquent. In this case, the purchaser, in effect, gets a: A) Call option. B) Put option. C) Forward contract. D) Futures contract E) None of the above. Answer: B 58. The key advantages of issuing standby letters of credit include which of the following: A) Letters of credit generate fee income for the bank. B) Letters of credit typically reduce the borrower's cost of borrowing. C) Letters of credit can usually be issued for a relatively low cost. D) The probability is low that the issuer of the letter of credit will be called upon to pay. E) All of the above. Answer: E 59. Banks that issue standby letters of credit may face which of the following types of risk? A) Prepayment risk. B) Interest-rate risk. C) Liquidity risk. D) All of the above. E) B and C only. Answer: E 59a. By agreeing to service any assets that are packaged together in the securitization process a bank can: A) Ensure the assets that are packaged and securitized remain in the package and are not sold off. B) Choose the best loans to go through the securitization process. C) Earn added fee income. D) Liquidate any assets it chooses. E) None of the above. Answer: C 60. The difference in interest rates between securitized loans themselves and the securities issued against the loans is referred to as: A) The funding gap B) Residual income. C) Service returns D) Security income E) None of the above Answer: B 61. If a credit letter is issued to backstop payments on loan-backed securities, the credit letter is a form of: A) Collateralized asset B) Residual income C) Direct loan obligation D) Credit enhancement E) None of the above Answer: D 62. Loan sales by banks are generally of two types: (a) participation loans; and (b) __________. The term that correctly fills in the blank above is: A) Assignments B) Recourse loans C) Direct loans D) Subscription loans E) None of the above. Answer: A 63. A standby credit letter is a (or an): A) Securitized strip B) Loan strip C) Contingent obligation D) Indirect loan E) None of the above. Answer: C 64. A bank that wants to protect itself from higher credit costs due to a decrease in its credit rating might purchase _________. A) A credit risk option B) A standby letter of credit C) A credit linked note D) A credit swap E) None of the above Answer: A 65. When two banks simply agree to exchange a portion of their customers' loan repayments, they are using: A) A credit option B) A standby letter of credit C) A credit linked note D) A credit swap E) None of the above Answer: D 66. A debt instrument which allows the issuer to lower its coupon payments if some significant factor changes is called: A) A credit option B) A standby letter of credit C) A credit linked note D) A credit swap E) None of the above Answer: C 67. Which of the following is a risk of using credit derivatives? A) Credit derivatives do not protect against credit risk exposure B) The partner in the swap or option contract may fail to perform C) Regulators may decide to lower the amount of capital needed for banks using these derivatives D) Regulators may decide that these derivatives make the bank more stable and efficient E) All of the above are risks of using credit derivatives Answer: B 68. A securitized asset where the asset used to back the securities is a loan based on the residual value of a homeowner's residence is called: A) A mortgage backed security B) A credit card backed security C) An automobile backed security D) A loan backed bond E) A home equity loan backed security Answer: E 69. A financial institution plans to issue a group of bonds backed by a pool of automobile loans. However, they fear that the default rate on the automobile loans will rise well above 4 percent of the portfolio – the projected default rate. The financial institution wants to lower the interest payments if the loan default rate rises too high. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: A 70. A bank is about to make a $50 million project loan to develop a new oil field and is worried that the petroleum engineer's estimates of the yield on the field are incorrect. The bank wants to protect itself in case the developer cannot repay the loan. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: B 71. A bank plans to offer new subordinated notes in the open market next month but knows that its credit rating is being reviewed by a credit rating agency. The bank wants to avoid paying sharply higher credit costs. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: C 72. A bank is concerned about excess volatility in its cash flows from some recent business loans it has made. Many of these loans have a fixed rate of interest and the bank's economics department has forecast a sharp increase in interest rates. The bank wants more stable cash flows. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: D 73. A bank has a limited geographic area. It would like to diversify its loan income with loans in other market areas but does not want to actually make loans in those areas because of their limited experience in those areas. Which type of credit derivative contract would you most recommend for this situation? A) Credit linked note B) Credit option C) Credit risk option D) Total return swap E) Credit swap Answer: E 74. A bank has a long term relationship with a particular business customer. However, recently the bank has become concerned because of a potential deterioration in the customer's income. In addition, regulators have expressed concerns about the bank's capital position. The business customer has asked for a renewal of its $25 million dollar loan with the bank. Which credit derivative can help this situation? A) Credit swap B) Loan sale C) Loan securitization D) Credit risk option E) Credit linked notes Answer: B 75. A bank has placed 5000 consumer loans in a package to be securitized. These loans have an annual yield of 15.25 percent. This bank estimates that the securities on these loans are priced to yield 10.95 percent. The bank expects 1.45 percent of the loans will default. Underwriting and advisory services will cost .25 percent and a credit guarantee if more loans default than expected will cost .35 percent. What is the residual income from this loan securitization? A) 3.70 percent B) 4.30 percent C) 2.25 percent D) 5.15 percent E) None of the above Answer: C 76. Bank use of credit derivatives is dominated by A) Community Banks B) The largest (over $1 billion) banks C) The retail banks D) None of the banks E) Banks do not use credit derivatives yet Answer: B 77. According to the text, in 2005 the securitization of loans reached: A) Million dollar market B) Billion dollar market C) Trillion dollar market D) Market unknown in value E) Small but growing market Answer: C 78. The principal sellers of credit derivatives include all of the following except: A) Insurance companies B) Securities dealers C) Fund management firms D) Banks E) None of the above Answer: D 79. The bank or other lender whose loans are pooled is called: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer Answer: A 80. Loans that are to be securitized pass to _________. This helps ensure that if the lender goes bankrupt it does not affect the credit status of the pooled loans. A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer Answer: B 81. Someone appointed to ensure that the issuer fulfills all the requirements of the transfer of the loans to the pool and provides all of the services promised to investors in the securities is called: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer Answer: C 82. Someone who collects the payments on the securitized loans and passes those payments on to the trustee is called: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer Answer: D 83. Investors in securitized loans normally receive added assurance that they will be repaid in the form of guarantees against default issued by: A) The originator B) The special purpose entity C) The trustee D) The servicer E) The credit enhancer Answer: E 84. When an issuer of securitized loans divides them into different risk classes or tranches, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above Answer: A 85. When an issuer of securitized loans includes a standby letter of credit with the securitized loans, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above Answer: B 86. When an issuer of securitized loans sets aside a cash reserve to cover loan defaults, they are providing an: A) Internal credit enhancement B) External credit enhancement C) Internal liquidity enhancement D) External liquidity enhancement E) None of the above Answer: A 87. Which of the following is an advantage of securitizing loans? A) Diversifying a lender’s credit risk exposure B) Reducing the need to monitor each individual loan’s payment stream C) Transforming illiquid assets into liquid securities D) Serving as a new source of funds for lenders and attractive investments for investors E) All of the above are advantages of securitizing loans Answer: E 88. Why are securitized loans often issued through a special purpose entity? A) Because the securitized loans often add risk to the bank and need to be held separately B) Because the securitized loans are not profitable for the bank and need to be held separately C) Because the special purpose entity might fail and this prevents the failure of the bank D) Because the bank might fail and this protects the credit status of the securitized loans E) All of the above Answer: D 89. A group of pooled loans used is expected to yield a return of 23%. The coupon rate promised to investors on securities issued against the pool of loans is 8%. The default rate on the pooled loans is expected to be 4.5%. The fee to compensate a servicing institution for collecting payments on the loans is 2%. Fees to set up credit and liquidity enhancements are 3%. The fee for providing advising how to set up the pool of securitized loans is 1%. What is the residual income on this pool of loans? A) 18.5% B) 9% C) 4.5% D) 2% E) None of the above Answer: C 90. The coupon rate promised investors on securities issued against a pool of loans is 6.5%. The default rate on the pool of loans is expected to be 3.5%. The fee to compensate a servicing institution for collecting payments on the loan is 2%. Fees to set up credit and liquidity enhancements are 5%. The residual income on this pool of loans is 7%. What is the expected yield on this pool of loans? A) 24% B) 12% C) 10% D) 6.5% E) None of the above Answer: A 91. In a collateralized mortgage obligation (CMO) a tranche: A) Promises a different return (coupon) to investors B) A liquidity enhancement C) Carries a different risk exposure D) A and C above E) All of the above Answer: D 92. What is one of the advantages of using loan-backed bonds? A) Loans used as collateral for the bonds can be sold before the maturity of the bonds B) Loan-backed bonds have longer maturities than deposits C) Banks do not have to meet regulatory capital requirements on loans used as collateral D) Banks can use less loans as collateral than the amount of bonds issued E) All of the above are advantages of loan-backed bonds Answer: B 93. What is one of the disadvantages of using loan backed bonds? A) The cost of funding often rises B) There is greater default risk on the bonds C) Loans used as collateral for the bonds must be held until the bonds reach maturity D) Loan backed bonds have shorter maturities than deposits E) All of the above are disadvantages of loan-backed bonds Answer: C 94. According to the textbook, what is the minimum size of the loan-backed securities offering that are likely to be successful? A) $1 million B) $10 million C) $25 million D) $50 million E) $1 trillion Answer: D 95. Which of the following is a concern regulators have about securitization? A) The risk of being an underwriter for asset-backed securities that cannot be sold B) The risk of acting as a credit enhancer and underestimating the need for loan-loss reserves C) The risk that unqualified trustees will fail to protect investors in asset-backed instruments D) The risk that loan servicers will be unable to satisfactorily monitor loan performance E) All of the above are concerns regulators have about securitization Answer: E 96. What prompted a surge in loan sales in the 1980s? A) A wave of corporate buyouts B) An increase in lesser developed country loans C) A loosening of government regulations D) An increase in international lending E) None of the above Answer: A 97. Why have the use of standby credit letters grown in recent years? A) The growth of bank loans sought by companies in recent years B) The decreased demand for risk reduction devices C) The high cost of standby credit letters in recent years D) The rapid growth of direct financing by companies E) All of the above Answer: D 98. Which of the following is true regarding regulatory rules for standby credit letters issued by banks? A) They must list the standby credit letter as a liability on their balance sheet B) They must count standbys as loans C) They do not have to apply the same credit standards for approving standbys as direct loans D) They can apply lower capital standards to standbys than loans Answer: B 99. Which of the following is true regarding regulatory rules for standby credit letters issued by banks? A) They must list the standby credit letter as a liability on their balance sheet B) They do not have to list standby credit letters when assessing the risk exposure to a single credit customer C) They must apply the same credit standards for approving standby credit letters as direct loans D) They can apply lower capital standards to standby credit letters than loans E) None of the above is true Answer: C 100. Regular collateralized debt obligations (CDO) have been surpassed by: A) Credit swaps B) Credit options C) Credit default swaps D) Total return swaps E) Synthetic collateralized debt obligations Answer: E 101. According to research, off-balance-sheet standby credit letters reduce risk by: A) Increasing diversification of assets B) Reducing the need for documentation C) Reducing probability of losses D) Avoiding capital requirements E) Increasing concentration of risk exposure Answer: A 102. What is the advantage of credit swaps for each partner? A) Broaden the number of markets B) Broaden the variety of markets from which they collect loan revenues and principal C) Spread out the risk in the loan portfolio D) Avoiding capital requirements E) A, B, and C Answer: E 103. What are the ways to reduce the risk of standby credit letters? A) Avoid renegotiating the terms of loans of SLC customers B) Specialize in SLCs issued by the same region and industry C) Sell participations in standbys in order to share risk with other lending institutions D) Do not count standbys as loans when assessing the bank’s risk exposure E) All of the above are the ways to reduce the risk Answer: C 104. The lesson(s) of the credit crisis of 2007-2009 is that the “bankruptcy remote” arrangement of the special-purpose entity (SPE): A) Reduces the need for securitization B) Eliminates the probability of bankruptcy of the originator institution C) May create problems if the underlying loans go bad in great numbers D) Eliminates the need for a trustee E) All of the above are correct Answer: C 105. The lesson from the credit crisis of 2007-2009 is that securitized assets and credit swaps are: A) Complex financial instruments B) Difficult to correctly value and measure in terms of risk exposure C) Affected by cyclically sensitive markets in which financial problems may spread and result in a financial contagion D) Possible to set in motion a financial contagion that cannot be easily stopped without active government intervention E) All of the above are correct Answer: E Test Bank for Bank Management and Financial Services Peter S. Rose, Sylvia C. Hudgins 9780073382432, 9780078034671