Financial Risk Analysis Exam Review
Course Introduction
Financial Risk Analysis explores the fundamental concepts and methodologies used to identify, assess, and manage risks in the financial sector. The course covers topics including market risk, credit risk, operational risk, and liquidity risk, providing students with a thorough understanding of risk measurement techniques such as Value at Risk (VaR), stress testing, and scenario analysis. Emphasis is placed on quantitative modeling, regulatory frameworks, and practical applications relevant to banking, investment management, and corporate finance. Through a combination of case studies and analytical tools, students develop skills to evaluate financial risk and devise effective risk mitigation strategies in a dynamic global environment.
Recommended Textbook
Financial Institution Management 3rd Edition by Helen Lange
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Chapter 1: Why Are Financial Institutions Special
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Sample Questions
Q1) Which of the following statements is true regarding the percentage share of assets of financial institutions in Australia as of end June 2005?
A) The largest percentage of assets is held by money market corporations.
B) The largest percentage of assets is held by credit unions.
C) The largest percentage of assets is held by permanent building societies.
D) The largest percentage of assets is held by banks.
Answer: D
Q2) Net regulatory burden for FIs is higher because regulators may require the FI to:
A) hold more capital than what would be held without regulation.
B) produce less information than would be produced without regulation.
C) hold more debt than what would be held without regulation.
D) hold fewer reserves than they would without regulation.
Answer: A
Q3) Which of the following are areas of institution-specific specialness?
A) money supply transmission
B) payment services
C) intergenerational transfers
D) All of the listed options are correct.
Answer: D
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Page 3
Chapter 2: The Financial Services Industry: Depository
Institutions
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Sample Questions
Q1) ASIC stands for Australian Society of Inter-bank Cooperation and ASIC is responsible for market integrity and consumer protection across the financial system.
A)True
B)False
Answer: False
Q2) The term 'spread' refers to the difference between an FI's:
A) assets and liabilities.
B) liabilities and equity.
C) short-term lending rates and long-term lending rates.
D) lending and deposit rates.
Answer: D
Q3) In which way did building societies respond to the competitive pressures resulting from the deregulation of the banking system in the 1980s?
A) They engaged in mergers for efficiency and scale reasons.
B) They adopted improved technology.
C) They diversified their products and activities.
D) All of the listed options are correct.
Answer: D
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Chapter 3: The Financial Services Industry: Other Financial Institutions
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Sample Questions
Q1) Which of the following statements are true in the context of general insurance?
A) Loss rates on all general property policies are adversely affected by unexpected increases in inflation.
B) Long-tail losses arise where the peril occurs during a coverage period but a claim is not made until many years later.
C) Long-tail losses arise where the peril occurs during a coverage period but a claim is not made until many years later and loss rates are more predictable on low-severity high-frequency lines than on high-severity low-frequency lines.
D) Loss rates on all general property policies are adversely affected by unexpected increases in inflation, long-tail losses arise where the peril occurs during a coverage period but a claim is not made until many years later and loss rates are more predictable on low-severity high-frequency lines than on high-severity low-frequency lines.
Answer: D
Q2) Insurance companies are not subject to regulatory capital adequacy rules.
A)True
B)False
Answer: False
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Page 5
Chapter 4: Risk of Financial Institutions
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Sample Questions
Q1) The major source of risk exposure resulting from issuance of standby letters of credit is:
A) technology risk.
B) interest rate risk.
C)C.credit risk.
D) off-balance-sheet risk.
Q2) The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as:
A) liquidity risk.
B) reinvestment risk.
C) credit risk.
D) foreign exchange risk.
Q3) Unanticipated diseconomies of scale and scope are a result of:
A) technology risk.
B) interest rate risk.
C) foreign exchange risk.
D) credit risk.
Q4) Firm-specific credit risk can be eliminated by diversification.
A)True
B)False
Page 6
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Chapter 5: Interest Rate Risk Measurement: The Repricing Model
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Sample Questions
Q1) Which of the following statements is true?
A) An FI with a negative repricing gap expects interest rates to remain stable.
B) An FI with a negative repricing gap expects interest rates to rise.
C) An FI with a negative repricing gap expects interest rates to remain fall.
D) An FI with a negative repricing gap has not particular expectations regarding interest rate movements.
Q2) Which of the following statements is true?
A) Cheque accounts are a type of interest-sensitive asset.
B) Cheque accounts are a type of interest-sensitive liability.
C) There are strong arguments for and against the inclusion of cheque accounts as a type of interest-sensitive asset.
D) There are strong arguments for and against the inclusion of cheque accounts as a type of interest-sensitive liability.
Q3) Which of the following statements is true?
A) An FI with a repricing gap of zero is unsure about interest rate movements.
B) An FI with a repricing gap of zero expects interest rates to rise.
C) An FI with a repricing gap of zero expects interest rates to remain fall.
D) An FI with a repricing gap of zero does not measure and manage its interest rate exposures.
Page 7
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Chapter 6: Interest Rate Risk Measurement: the Duration
Model
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Sample Questions
Q1) Calculating modified duration involves:
A) dividing the value of duration by the change in the market interest rate.
B) dividing the value of duration by 1 plus the interest rate.
C) dividing the value of duration by discounted change in interest rates.
D) multiplying the value of duration by discounted change in interest rates.
Q2) Discuss the following proposition: While in theory duration matching allows an FI to immunise against interest rate risk, the reality is that it is too costly and too time-consuming to be useful.
Q3) Which of the following statements are incorrect?
A) Investing in a zero-coupon asset with a maturity equal to the desired investment horizon is one method of immunising against changes in interest rates.
B) Investing in a zero-coupon asset with a maturity equal to the desired investment horizon removes interest rate risk from the investment management process.
C) Buying a fixed-rate asset whose duration is exactly equal to the desired investment horizon immunises against interest
D) Using a fixed-rate bond to immunisea desired investment horizon means that the reinvested coupon payments are not affected by changes in market interest rates.
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Page 8
Chapter 7: Managing Interest Rate Risk Using Off Balance
Sheet Instruments
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Sample Questions
Q1) Partially hedging the gap or individual assets and liabilities is referred to as?
A) hedging arbitrarily
B) hedging selectively C) hedging partially D) hedging naively
Q2) Which of the following is an example of microhedging asset-side portfolio risk?
A) When an FI, attempting to lock in cost of funds to protect itself against a rise in short-term interest rates, takes a short position in futures contracts on CDs.
B) FI manager trying to pick a futures contract whose underlying deliverable asset is not matched to the asset position being hedged.
C) When an FI hedges a cash asset on a direct dollar-for-dollar basis with a forward or futures contract.
D) When an FI manager wants to insulate the value of the institution's bond portfolio fully against a rise in interest rates.
Q3) The Sydney Futures Exchange only offers cash-settled contracts.
A)True B)False
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Page 9
Chapter 8: Credit Risk I: Individual Loan Risk
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Sample Questions
Q1) The ___________ is an accrual class of a CMO that makes a payment to bondholders only when preceding CMO classes have been retired:
A) A Class
B) B Class
C) Z Class
D) R Class
Q2) Which of the following is not a factor that may tend to increase loan sales in the future?
A) There is an increased trend to apply credit ratings to loans offered for sale, increasing the attractiveness to secondary market purchasers.
B) Because of their special credit monitoring skills, FIs have a comparative advantage in making loans to below-investment grade companies and then selling the loan.
C) The trend toward marked-to-market accounting for assets makes bank loans more like securities so they may be easier to sell.
D) The risk-based capital requirements of the Bank for International Settlements give banks a strong incentive to sell housing loans to decrease their amount of risky assets.
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Chapter 9: Market Risk
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Sample Questions
Q1) What is meant by vertical offset?
A) The deduction of capital charges because long and short positions in the same maturity bucket but in different instruments more than offset each other.
B) The assignment of additional capital charges because long and short positions in the same maturity bucket but in different instruments cannot perfectly offset each other.
C) The deduction of capital charges because long and short positions in different maturity buckets but in the same instrument more than offset each other.
D) The assignment of additional capital charges because long and short positions in different maturity buckets but in the same instrument cannot perfectly offset each other.
Q2) Which of the following statements is true?
A) The relative illiquidity of a market reduces an FI's losses.
B) The relative illiquidity of a market exposes an FI to magnified losses.
C) The relative illiquidity of a market does not influence an FI's loss size.
D) None of the listed options are correct.
Q3) Why is market risk measurement important?
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11
Chapter 10: Credit Risk I: Individual Loan Risk
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Sample Questions
Q1) Assume that B = $200 000, r = 1 year, i = 7 per cent, d = 0.9, N(h<sub>1</sub>) = 0.174120 and N(h<sub>2</sub>) = 0.793323. Using Moody's KMV Credit Monitor Model, what is the required risk premium on the loan (round to two decimal places)?
A) 0.13 per cent
B) 0.91 per cent
C) 1.64 per cent
D) 6.30 per cent
Q2) Assume that f<sub>1</sub> = 13.50 per cent and c<sub>1</sub> = 17.40 per cent. Which of the following statements is true?
A) The expected default probability of repayment is 96.10 per cent.
B) The expected probability of repayment is 3.32 per cent.
C) The one-year rate expected on corporate securities one year into the future is 13.50 per cent.
D) The current one-year rate on corporate securities is 17.40 per cent.
Q3) In its simplest form the rate on a loan is set as the base lending rate plus a credit risk premium.
A)True
B)False
Q4) What are the major ideas behind KMV's Credit Monitor Model?
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Chapter 11: Credit Risk II: Loan Portfolio and Concentration
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Sample Questions
Q1) Which of the following is incorrect in relation to debt recovery rates?
A) Macro-economic factors are found to be significant in explaining recovery rates on defaulted bonds.
B) Macro-economic factors are found to be insignificant in explaining recovery rates on defaulted bonds.
C) Senior securities tend to have higher recovery rates than subordinated securities.
D) Industrial revenue bonds tend to have higher recovery rates than subordinated securities.
Q2) Which of the following statements is true?
A) According to KMV, default correlations tend to be low and lie between 0.002 and 0.15.
B) According to KMV, default correlations tend to be high and lie between 0.42 and 0.65.
C) According to KMV, default correlations vary and thus no particular range can be stated.
D) None of the listed options are correct.
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13
Chapter 12: Sovereign Risk
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Sample Questions
Q1) Which of these are major segments of the secondary market for LCD debt?
A) performing loans
B) sovereign bonds
C) non-performing loans
D) sovereign bonds, performing loans and non-performing loans
Q2) The term LIBOR stands for the London Interbank:
A) offered rate and is the rate charged on prime interbank loans on the Eurodollar market.
B) obligor rate and is the rate charged on prime interbank loans on the Eurodollar market.
C) offered rate and is the rate charged on interbank loans worldwide.
D) obligor rate and is the rate charged on interbank loans worldwide.
Q3) Debt repudiations were more common before WWII compared to now. A)True
B)False
Q4) LDC debt can be bought and sold in secondary markets.
A)True
B)False
Q5) What are the major advantages and disadvantages of using scoring models to assess country risk?
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Chapter 13: Foreign Exchange Risk
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Sample Questions
Q1) An FI acts defensively as a hedger to reduce FX exposure if it engages in the purchase and sale of foreign currencies for hedging purposes to offset customer or FI exposure in any given currency.
A)True
B)False
Q2) The interest rate parity theorem implies that while interest rates are hedged, the dollar return on foreign investments can be above or below the return on domestic investments.
A)True
B)False
Q3) Which of the following statements is true?
A) Holding less assets than liabilities in a given currency is referred to as a net short position.
B) Holding less assets than liabilities in a given currency is referred to a net long position.
C) Holding less assets than liabilities in a given currency is referred to as a gross short position.
D) Holding less assets than liabilities in a given currency is referred to as a gross long position.
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15
Chapter 14: Liquidity Risk
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Sample Questions
Q1) Which of the following is not a potential cause of liquidity risk for a DI?
A) A decrease in the DI's stock price caused by market factors.
B) An increase in requests to fund large amounts of loan commitments.
C) A decrease in the availability of short-term borrowed funds.
D) An increase in requests by depositors to withdrawal large amounts of deposits.
Q2) Which of the following is a way in which an FI can raise liquidity?
A) Sell liquid assets.
B) Borrow funds in money markets.
C) Use excess cash reserves over and above the amount held in its exchange settlement account with the RBA.
D) All of the listed options are correct.
Q3) What are the two main liquidity facilities available to Australian FIs to prevent financial disturbances occurring?
A) Deposit insurance and the discount window.
B) Intra-day repurchase agreement and overnight repurchase agreement.
C) Financing gap and the financing requirement.
D) Secondary credit and seasonal credit.
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Page 16
Chapter 15: Liability and Liquidity Management
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Sample Questions
Q1) Potential sources of liquidity include investment in:
A) housing loans.
B) new equipment.
C) short-term securities such as treasury notes and bank accepted bills.
D) housing loans and investment in bank accepted bills.
Q2) Which of the following are characteristics of a liquid asset?
A) The asset can be turned into cash quickly.
B) Turning the asset into cash will result in low transaction costs.
C) Turning the asset into cash will result in little or no loss in principal value.
D) All of the listed options are correct.
Q3) An FI offers a $2500 minimum balance investment savings account paying 4 per cent annual interest, and there are no service charges as long as the customer maintains the minimum balance. The customer maintains a balance of $5000, and averages 750 cheques per year. Each cheque has a processing cost to the FI of $0.15.
What is the annual gross interest return on this account to the customer?
A) $112.50
B) $100.00
C) $312.50
D) $212.50
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Page 17
Chapter 16: Off-Balance-Sheet Activities
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Sample Questions
Q1) Assume that the market value of assets is $120 and the market value of liabilities is $90. What is the bank's net worth?
A) $210
B) $30
C) -$30
D) None of the listed options are correct.
Q2) Standby letters of credit can be seen as direct competitors to loan commitments.
A)True
B)False
Q3) Which of the following statements is true?
A) The vega of an option is a measure of volatility risk.
B) The omega of an option is a measure of volatility risk.
C) The delta of an option is a measure of volatility risk.
D) The alpha of an option is a measure of volatility risk.
Q4) Explain how the use of forward and future contracts creates contingent credit risk for an FI.
Q5) Graphically explain the general set-up of a letter of credit transaction. In this context, explain why letters of credit are important.
Q6) Briefly explain how off-balance-sheet transactions can affect an FI's solvency.
Page 18
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Chapter 17: Technology and Other Operational Risk
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Q1) Losses on technological innovations and new technology could weaken an FI because scarce capital resources were invested in value-decreasing projects.
A)True
B)False
Q2) Which of the following observations concerning the production approach is true?
A) It views FIs' outputs of services as having three underlying inputs.
B) Labour and capital are the only inputs.
C) It views the output as being produced by labour, capital and the funds used to produce intermediated services.
D) Deposit costs are viewed as an input in the banking and non-banking deposit institutions.
Q3) Diseconomies of scope refers to the:
A) fall in an FI's average costs of production as its output increases.
B) increase in an FI's average costs of production as its output increases.
C) situation in which the costs of joint production of FI services are higher than they would be if they were produced independently.
D) ability of an FI to generate synergistic cost savings through joint use of inputs in producing multiple outputs.
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Chapter 18: Capital Management and Adequacy
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Sample Questions
Q1) Which of the following statements is true?
A) Potential exposure refers to the cost of replacing a derivative securities contract at today's prices.
B) Current exposure refers to the cost of replacing a derivative securities contract at today's prices.
C) Current exposure refers to the cost of replacing a derivative securities contract at the contract's maturity.
D) Potential exposure refers to the cost of replacing a derivative securities contract at the contract's maturity.
Q2) Which pillar of the Basel Accord requires quantitative disclosures for capital structure, capital adequacy and risk exposure so market participants are able to undertake a meaningful comparison of DIs and their risk-based performance?
A) Pillar 1
B) Pillar 2
C) Pillar 3
D) all pillars
Q3) What are the major differences between the Basel I and the Basel II approaches to capital regulation?
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