Introduction to Financial Systems
Exam Solutions
Course Introduction
Introduction to Financial Systems offers a comprehensive overview of the structure, functions, and significance of financial institutions and markets within modern economies. The course examines the roles of banks, non-bank financial intermediaries, and central banks in facilitating the flow of funds, supporting investment, and managing risks. Students will explore key concepts such as money creation, interest rates, financial regulation, and the impact of technology on financial systems. Through real-world examples and case studies, the course emphasizes the interconnectedness of domestic and global financial systems and their influence on economic stability and development.
Recommended Textbook
Financial Institutions Management 5th Canadian Edition by Anthony Saunders
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Page 2
Chapter 1: Why Are Financial Institutions Special
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Sample Questions
Q1) Commercial banks and finance companies have traditionally served the needs of the residential real estate market.
A)True
B)False
Answer: False
Q2) The passage of legislation to ensure that FIs are meeting the needs of their local communities is an example of entry regulation.
A)True
B)False
Answer: False
Q3) Which of the following is NOT a major function of financial intermediaries?
A)Brokerage services.
B)Asset transformation services.
C)Information production.
D)Management of the nation's money supply.
E)Administration of the payments mechanism.
Answer: D
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Chapter 2: Deposit-Taking Institutions
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Sample Questions
Q1) Which of the following is NOT an off balance sheet activity for Canadian banks?
A)Derivative contracts.
B)Loan commitments.
C)Standby letters of credit.
D)Trust services.
E)When-issued securities.
Answer: D
Q2) The use of off-balance-sheet activities and instruments will always reduce the risk to a bank.
A)True
B)False
Answer: False
Q3) Which of the following is the most important source of funds for credit unions?
A)Borrowings from the Bank of Canada.
B)Savings deposits from small consumers.
C)Repurchase agreements.
D)Interbank borrowing.
E)Wholesale deposits.
Answer: B
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Page 4
Chapter 3: Finance Companies
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Sample Questions
Q1) A company that specializes in making loans to the customers of a particular retailer or manufacturer would best be categorized as a
A)sales finance institution.
B)personal credit institution.
C)business credit institution.
D)lease finance company.
E)factoring company.
Answer: A
Q2) Compared to commercial banks, finance companies usually signal solvency and safety concerns by
A)holding higher leverage ratios.
B)holding lower capital-asset ratio.
C)holding less liquid long-term assets.
D)holding higher capital-asset ratio.
E)holding higher leverage ratios, and holding lower capital-asset ratio.
Answer: D
Q3) Finance companies generally have higher overhead than do commercial banks.
A)True
B)False
Answer: False
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Chapter 4: Securities, Brokerage, and Investment Banking
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Sample Questions
Q1) An investment banker agrees to underwrite an issue of 5 million shares of stock for NetChoice, Inc. on a best-efforts basis. The investment banker is able to sell 4.5 million shares for $31.00 per share and it charges NetChoice, Inc. $0.375 per share sold. If the investment bank were able to sell all 5 million shares for $35, how much money would NetChoice, Inc. receive?
A)$195,675,000.
B)$187,500,000.
C)$130,250,000.
D)$175,000,000.
E)$173,125,000.
Q2) Market making involves creating a primary market in a financial asset. A)True B)False
Q3) The revision of the Bank Act and other regulatory changes have been the cause of the increase in interindustry mergers of investment banks and securities firms since 1987. A)True B)False
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Chapter 5: Mutual Funds, Hedge Funds, and Pension Funds
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Sample Questions
Q1) Mutual funds often offer multiple share classes which differentiate between different methods of paying the sales loads and management fees.
A)True
B)False
Q2) Directed brokerage is a trading abuse where a mutual fund and a brokerage agree to promote sales of certain funds in exchange for orders of specific stocks and bonds.
A)True B)False
Q3) Historical evidence indicates that load funds perform better than no-load funds. A)True B)False
Q4) The return from investing in mutual funds can include dividends, gains from the sale of the mutual fund assets, and gains from the sale of the mutual fund shares. A)True
B)False
Q5) Equity mutual funds may contain common stock, but not preferred stock. A)True B)False
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Chapter 6: Insurance Companies
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Sample Questions
Q1) One reason for the recent decline in the expense ratio for PC insurers is an increased dependence on independent brokers to sell and distribute insurance policies.
A)True
B)False
Q2) By regulation, the payments on an annuity contract must stop when the annuity holder dies.
A)True
B)False
Q3) The surrender value of an insurance policy is
A)the expected payment commitment on existing policy contracts.
B)a fund established and held separately from the company's other assets.
C)the cash value paid to the policyholder if the policy is terminated before it matures.
D)the same as the endowment payout.
E)the price at which the company may repurchase the policy.
Q4) In recent years, the total assets of insurance companies in Canada have been decreasing.
A)True
B)False
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Chapter 7: Risks of Financial Institutions
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Sample Questions
Q1) Economically speaking, OBS activities are contractual claims that A)may or may not occur.
B)if the contingency does occur, the asset or liability is transferred onto the FI's balance sheet
C)impact the economic value of the equity.
D)if the contingency never occurs, there is virtually no economic meaning to the OBS activity.
E)All of these.
Q2) Historically credit card loans have had very low rates of default or credit risk when compared to other assets that an FI may hold.
A)True
B)False
Q3) Individuals have an advantage over FIs in that individuals more easily can diversify away some of the credit risk of their asset portfolios.
A)True
B)False
Q4) Systematic credit risk can be reduced significantly by diversification.
A)True
B)False
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Chapter 8: Interest Rate Risk I
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Sample Questions
Q1) Which theory of term structure states that long-term rates are equal to the geometric average of current and expected short-term rates plus a risk premium that increases with the maturity of the security?
A)The unbiased expectations theory.
B)The liquidity premium theory.
C)The loanable funds theory.
D)The market segmentation theory.
E)None of these.
Q2) For a given change in interest rates, fixed-rate assets with long-term maturities will have smaller changes in price than assets with shorter maturities.
A)True
B)False
Q3) For a given change in interest rates, the change in price for each additional year of maturity of a fixed-rate asset is smaller as the maturity increases.
A)True
B)False
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Chapter 9: Interest Rate Risk II
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Sample Questions
Q1) Setting the duration of the assets higher than the duration of the liabilities will exactly immunize the net worth of an FI from interest rate shocks.
A)True
B)False
Q2) The value for duration describes the percentage increase in the price of an asset for a given increase in the required yield or interest rate.
A)True
B)False
Q3) The immunization of a portfolio against interest rate risk means that the portfolio will neither gain nor lose value when interest rates change.
A)True
B)False
Q4) The rate of change in duration values is less than the rate of change in maturity. A)True
B)False
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Chapter 10: Credit Risk: Individual Loans
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Sample Questions
Q1) The amount of security or collateral on a loan and the interest rate or risk premium on a loan normally are negatively related.
A)True
B)False
Q2) Confidence Bank has made a loan to Risky Corporation. The loan terms include a default risk-free borrowing rate of 8 percent, a risk premium of 3 percent, an origination fee of 0.1875 percent, and a 9 percent compensating balance requirement. Required reserves are 6 percent. What is the expected or promised gross return on the loan?
A)11.19 percent.
B)11.90 percent.
C)12.29 percent.
D)12.02 percent.
E)12.22 percent.
Q3) The primary difficulty in arranging a syndicated loan is having all of the various lending and borrowing parties reach agreement on terms, rates, and collateral.
A)True
B)False
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Chapter 11: Credit Risk: Loan Portfolio and Concentration
Risk
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Sample Questions
Q1) In the use of modern portfolio theory (MPT), the sum of the credit risks of loans under estimates the risk of the whole portfolio.
A)True
B)False
Q2) Which model involves estimating the systematic loan loss risk of a particular sector or industry relative to the loan loss risk of an FI's total loan portfolio?
A)Credit Metrics.
B)Credit Risk +.
C)Loan loss ratio-based model.
D)KMV portfolio manager model.
E)Loan volume-based model.
Q3) In the past, data availability limited the use of sophisticated portfolio models to set concentration limits.
A)True
B)False
Q4) Included in the Moody's Analytics model are recovery rates on defaulted loans.
A)True
B)False
Page 13
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Chapter 12: Liquidity Risk
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Sample Questions
Q1) Asset-side liquidity risk may be a result of OBS lending commitments.
A)True
B)False
Q2) Abnormally large and unexpected deposit withdrawals can occur because of concerns by depositors about a bank's solvency relative to other banks.
A)True
B)False
Q3) During the financial crisis of 2008, liquidity problems were avoided as banks continued to provide lending to each other.
A)True
B)False
Q4) Core deposits represent a relatively short-term source of funds.
A)True
B)False
Q5) A contagious run, or bank panic, differs from a run on a bank in that a contagious run involves loss of faith in the entire banking system as opposed to just one bank.
A)True
B)False
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Page 14
Chapter 13: Foreign Exchange Risk
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Sample Questions
Q1) The foreign exchange market in Tokyo is the largest FX trading market.
A)True
B)False
Q2) The reason an FI receives a fee when purchasing foreign currencies to allow customers to complete international transactions is because the FI assumes some FX risk.
A)True B)False
Q3) The FX markets of the world have become one of the largest of all financial markets.
A)True
B)False
Q4) A positive net exposure position in FX implies that the FI is
A)net long in a currency and exposed to depreciation of the foreign currency.
B)net short in a currency and exposed to depreciation of the foreign currency.
C)net long in a currency and exposed to appreciation of the foreign currency.
D)net short in a currency and exposed to appreciation of the foreign currency.
E)neither long nor short in a currency.
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15
Chapter 14: Sovereign Risk
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Sample Questions
Q1) Under the doctrine of sovereign immunity, creditors cannot force repayment of the debt.
A)True
B)False
Q2) The Euromoney Index for a given country currently is based on the A)spread of the required interest rate on that country's debt over LIBOR.
B)a number of economic and political factors specifically weighted according to their relative importance in determining country risk problems.
C)a combined economic and political risk survey of economists and political analysts presented on a 100-point scale.
D)surveys of the loan officers of major multinational banks.
E)historical default rates of that country's loans.
Q3) In international finance, the investment ratio is determined by dividing the value of real investment by the A)total foreign exchange reserves.
B)real investment.
C)gross national product.
D)value of exports.
E)money supply.
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Page 16
Chapter 15: Market Risk
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Sample Questions
Q1) Price volatility of a bond can be estimated by multiplying the bond's modified duration by the adverse daily yield move.
A)True
B)False
Q2) Which of the following items is not considered to be an advantage of using back simulation over the Risk Metrics approach in developing market risk models?
A)Back simulation is less complex.
B)Back simulation creates a higher degree of confidence in the estimates.
C)Asset returns do not need to be normally distributed.
D)The correlation matrix does not need to be calculated.
E)A worst-case scenario value is determined by back simulation.
Q3) Which term defines the risk related to the uncertainty of an FI's earnings on its trading portfolio caused by changes, and particularly extreme changes in market conditions?
A)Interest rate risk.
B)Credit risk.
C)Sovereign risk.
D)Market risk.
E)Default risk.
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Page 17
Chapter 16: Off-Balance-Sheet Risk
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Sample Questions
Q1) Which of the following is true of the market price of an options contract over time?
A)It is set at time 0.
B)It is fixed over the life of the contract.
C)It changes based on the market value of the underlying asset.
D)It increases with time to expiration.
E)It is based on supply and demand.
Q2) Contingent credit risk occurs with the use of derivative products and involves the potential default by a counterparty.
A)True
B)False
Q3) One way to minimize contingent credit risk is to use derivative products sold on organized exchanges.
A)True
B)False
Q4) Credit derivatives allow FIs to hedge credit risk on individual assets, but not on portfolios of assets.
A)True
B)False
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Chapter 17: Technology and Other Operational Risks
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Sample Questions
Q1) Which of the following wholesale services offered by FIs to businesses allows the FI to combine the e-mail capabilities of the internet with the FIs ability to process payments electronically through the interbank payment networks?
A)Electronic data exchange.
B)E-commerce facilitation.
C)Electronic billing.
D)Electronic funds transfer.
E)Account reconciliation
Q2) As banks and other FIs increase the use of technology, an unintended consequence may be that
A)cost savings are seldom realized.
B)customers are driven away because they still want to interact with a person for certain transactions.
C)innovation of new products tends to take longer periods of time to attract new customers.
D)the marginal cost of adding new customers tends to increase at an increasing rate.
E)None of these.
Q3) A feature that records which checks have been paid by the FI.
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Chapter 18: Liability and Liquidity Management
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Q1) Which of the following is an outcome of a decrease in the reserve requirement ratio?
A)DTIs must hold more reserves against the transaction accounts on their balance sheets.
B)DTIs are able to lend a smaller percentage of their deposits.
C)Decreased credit availability in the economy.
D)A multiple contraction in deposits and a decrease in the money supply.
E)A multiplier effect on the supply of DTI deposits and thus, the money supply.
Q2) Property & casualty insurance companies can reduce their exposure to liquidity risk by diversifying coverage across different types of disasters.
A)True
B)False
Q3) In most countries, assets used to satisfy the liquid assets ratio may include liquid government securities. A)True
B)False
Q4) Savings accounts normally receive a lower interest rate than chequing accounts.
A)True
B)False
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20
Chapter 19: Deposit Insurance and Other Liability
Guarantees
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Sample Questions
Q1) Moral hazard at FIs may
A)result when actions and consequences are separated.
B)occur when interest rates are very high and volatile.
C)occur when commodity prices are very high and volatile.
D)be a consequence of strict regulatory supervision.
E)be a consequence of an erosion of family values.
Q2) The use of the option pricing model to determine the actuarially fair premium for deposit insurance indicates that the cost of the insurance should rely on both the asset quality and level of leverage of the DTI.
A)True
B)False
Q3) The contagion effect
A)stems from the positive correlation in FI returns.
B)results when interest rate risk increases credit risk and liquidity risk exposures.
C)occurs when liquidity risk problems at bad banks damages well-run banks.
D)occurs when a computer virus infects the computerized electronics payments systems.
E)is completely eliminated by government provided deposit insurance against bank runs.
Page 21
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Chapter 20: Capital Adequacy
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Sample Questions
Q1) From a regulatory perspective, what is the impact on book value capital of a 25 basis point decrease in interest rates if the FI is holding a year, fixed-rate, 11 percent annual coupon $100,000 par value bond?
A)A decrease of $250.
B)An increase of $250.
C)An increase of $2,023.
D)A decrease of $1,959.
E)No impact on capital since the book value is unchanged.
Q2) The Basic Indicator Approach in calculating capital to cover operational risk requires banks to hold 12 percent of total assets in capital to cover operational risk exposure. A)True
B)False
Q3) Market value accounting often is said to be difficult to implement because of the amounts of nontraded assets.
A)True
B)False
Q4) The benefits may not support the significant cost of developing and implementing new risk management systems.
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Chapter 21: Product and Geographic Expansion
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Sample Questions
Q1) Using lending power to coerce a customer to purchase or use the products sold by an affiliate.
Q2) The realization of revenue synergies from the acquisition of a bank may come
A)from expansion into less than fully competitive markets.
B)from acquiring a bank in a growing market.
C)through diversification of asset and liability mixes between the two banks.
D)All of these.
E)from acquiring a bank in a growing market, and through diversification of asset and liability mixes between the two banks.
Q3) The use of the Herfindahl-Hirschman Index (HHI) to measure market concentration is encouraged for banks because of the ease of separating banks from thrifts and insurance companies.
A)True
B)False
Q4) The purpose of the Foreign Bank Supervision Enhancement Act of 1991 was to extend federal authority over foreign banking organizations in the U.S.
A)True
B)False
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Chapter 22: Futures and Forwards
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Q1) A conversion factor often is used to determine the invoice price on a futures contract when a bond other than the benchmark bond is delivered to the buyer.
A)True
B)False
Q2) Which of the following indicates the need to place a hedge?
A)The price movement in the underlying cash asset cannot be forecasted perfectly.
B)The prices of the assets or liabilities are imperfectly correlated over time with the prices on the futures.
C)Basis risk prevents the minimum risk of the portfolio from reaching zero.
D)Treasury has been issuing more shorter-dated bonds to finance U.S. budget deficits.
E)Spot bonds and futures on bonds are traded in different markets.
Q3) Federal regulations in Canada allow derivatives to be used only by the 25 largest banks.
A)True
B)False
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24
Chapter 23: Options, Caps, Floors, and Collars
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Q1) The writer of a bond put option
A)receives a premium in return for standing ready to sell the bond at the exercise price.
B)receives a premium in return for standing ready to buy bonds at the exercise price.
C)pays a premium and has the right to sell the underlying bond at the agreed exercise price.
D)pays a premium and has the right to buy the underlying bond at the agreed exercise price
E)pays a premium and has the obligation to buy the underlying bond at the agreed exercise price
Q2) Identify a problem associated with using the Black-Scholes model to value bond options.
A)It assumes short-term interest rates are constant.
B)It assumes that commissions are charged.
C)It assumes fluctuating variance of returns on the underlying asset.
D)It assumes that the variance of bond prices is constant over time.
E)All of these.
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Chapter 24: Swaps
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Q1) When compared to swap and option contracts, credit risk exposure is greatest with a futures contract.
A)True
B)False
Q2) A credit union has funded 10 percent fixed-rate assets with variable-rate liabilities at LIBOR + 2 (L + 2) percent. A bank has funded variable-rate assets with fixed-rate liabilities at 6 percent. The bank's variable-rate assets earn LIBOR + 1 (L + 1) percent. The credit union and the bank have reached agreement on an interest-rate swap with the fixed-rate swap payment at 6 percent and the variable-rate swap payment at LIBOR. What will be the net after-swap cost of funds for the credit union if the cash market liabilities are included in the analysis?
A)Variable-rate at LIBOR.
B)Fixed-rate at 8 percent.
C)Fixed-rate at 1 percent.
D)Fixed-rate at 2 percent.
E)None of these.
Q3) A pure credit swap is similar to buying credit insurance.
A)True
B)False
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Page 26
Chapter 25: Loan Sales
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Q1) A distinction between distressed and non-distressed is usually made when selling highly leveraged transactions loans (HLTs).
A)True
B)False
Q2) Which of the following refers to a period when a borrower is unable to meet a payment obligation to lenders and other creditors?
A)Window.
B)Financial distress.
C)Foreclosure.
D)Recession.
E)Assignment.
Q3) Selling loans without recourse is a way for FIs to remove loans from their balance sheet for the purpose of reducing the cost associated with reserve requirements.
A)True
B)False
Q4) Loans originated by domestic Canadian banks cannot be sold to foreign banks.
A)True
B)False
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Chapter 26: Securitization Index
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Q1) The call option held by the residential mortgage holder is in the money when market interest rates are less than the interest rate on an existing mortgage.
A)True
B)False
Q2) In regard to a CMO, which of the following have the shortest average life with a minimum of prepayment protection?
A)Class A bonds.
B)Class B bonds.
C)Class C bonds.
D)Class Z bonds.
E)Class R bonds.
Q3) A mortgage pass-through strip security is a special type of collateralized mortgage obligation (CMO).
A)True B)False
Q4) The securities that form a NHA CMHC pass-through are Treasury bonds, bills, and notes.
A)True B)False
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