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~~FN1024 ZB d0

This paper is not to be removed from the Examination Halls



UNIVERSITY OF LONDON FN1024 ZB


BSc degrees and Diplomas for Graduates in Economics, Management, Finance
and the Social Sciences, the Diplomas in Economics and Social Sciences and
Access Route


Principles of Banking and Finance


Friday, 16 May 2014 : 10:00 to 13:00


Candidates should answer FOUR of the following EIGHT questions: ONE from Section
A, ONE from Section B and TWO further questions from either section. All questions
carry equal marks.

A calculator may be used when answering questions on this paper and it must comply
in all respects with the specification given with your Admission Notice. The make and
type of machine must be clearly stated on the front cover of the answer book.





PLEASE TURN OVER
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SECTION A

Answer one question and no more than two further questions from this section.


1. (a) Explain the process of securitization carried out by banks and discuss the reasons why
banks may wish to engage in such a process. (12 marks)


(b) Discuss the causes and consequences of asset price bubbles in relation to US internet-
based company stocks in the late 1990s and the 2007/8 global financial crisis.
(13 marks)




2. (a) Discuss how asymmetric information can cause problems in financial markets.
(12 marks)


(b) Discuss the solutions aimed at reducing moral hazard in debt markets. (13 marks)




3. (a) Discuss the risks arising from both the banking book (intermediation business) and
trading book of banks. (8 marks)


(b) Examine how Value at Risk models can be used by a bank to manage its market risk
exposure. Discuss the problems with these models. (10 marks)


(c) Explain how interest rate risk can affect a bank. (7 marks)




4. (a) Discuss the role of market discipline in regulating banks. (6 marks)


(b) Discuss the reasons for the lender of last resort facility provided by central banks and
discuss the problems with the provision of this facility. (7 marks)


(c) Discuss the reasons for the proposed changes in capital regulation under Basel 3.
(12 marks)


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SECTION B

Answer one question and no more than two further questions from this section.


5. (a) Distinguish between income gap and duration gap analysis in managing interest rate
risk. Critically examine the limitations of each. (12 marks)



(b) Consider the following balance sheet of Valubank:

Assets () Duration Liabilities () Duration

Variable-rate
mortgages

1400 4.1 Money market
deposits
1000 1.3
Fixed-rate mortgages

1200 8.1 Savings deposits 3000 2.3
Commercial loans 4000 3.2 Variable-rate CDs
(>1 year)
1000 1.2
Physical capital 1400 Equity 3000


Total 8000 Total 8000


Calculate the impact of an increase in interest rates from 3% to 4% on the equity of
Valubank. (7 marks)



(c) Explain what a duration gap of zero implies for a bank and discuss why banks generally
do not operate with duration gaps of zero. (6 marks)

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6. (a) Discuss the empirical evidence on the risk-return relationship for the following US
securities: Treasury bills, Treasury bonds, large firm common stocks and small firm
common stocks. (8 marks)


(b) Consider the following information about two stocks, White and Black:

Stock Expected return Variance
White 8% 13
Black 3% 5

The correlation between the two securities returns is 0.2

Calculate the expected return and standard deviation of the following four portfolios:

Portfolio proportions (%)

Portfolio White Black
A 30 70
B 50 50
C 75 25
D 100 0
(4 marks)

(c) How can investors identify the best set of efficient portfolios of common stocks? What
does best mean? (4 marks)


(d) Discuss the benefits and limits to diversification in relation to investment in common
stocks. (5 marks)


(e) Consider the following portfolio composed of three stocks (A, B, C):

Stock Quantity Price () CAPM Beta
A 200 1.5 0.8
B 500 1.2 1.0
C 300 2.3 1.5

What is the CAPM beta of this portfolio? (4 marks)



7. (a) Theoretically derive the efficient market hypothesis. (7 marks)


(b) Explain what an excess return is in a financial market. Discuss the main predictions of
the efficient markets hypothesis. (6 marks)


(c) Explain weak form efficiency and discuss the empirical evidence in relation to this form
of efficiency. (12 marks)


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8. (a) Consider the following stocks:

Stock X is expected to pay a dividend 8 next year then 5 forever;

Stock Y is expected to pay a dividend of 4 next year, 3 in year 2, with dividend
growth expected to be 5% per annum thereafter.

If the required return on similar equities is 7%, calculate the price of each stock.
(6 marks)


(b) Discuss the problems of valuing common stocks, preferred stocks and corporate bonds.
(7 marks)


(c) Explain the Gordon growth model as a technique for the valuation of common stocks
and discuss what kind of stocks this model is more appropriate for valuing.
(6 marks)


(d) Explain the yield to maturity of a bond and explain why it is inversely related to the price
of the bond. (6 marks)





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