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Final Exam 2012, questions

Treasury Management (Monash University)

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Monash University
Semester Two Final Examination 2012
Faculty of Business and Economics

EXAM CODE: AFW3651

TITLE OF PAPER: TREASURY MANAGEMNET
EXAM DURATION: 3 hours writing time
READING TIME: 10 minutes

THIS PAPER IS FOR STUDENTS STUDYING AT: (office use only - tick where applicable)
 Berwick  Clayton  Peninsula  Distance Education  Other (specify)
 Caulfield  Gippsland  Sunway  Open Learning

During an exam, you must not have in your possession, a book, notes, paper, electronic device/s,
calculator, pencil case, mobile phone or other material/item which has not been authorised for the
exam or specifically permitted as noted below. Any material or item on your desk, chair or person will
be deemed to be in your possession. You are reminded that possession of unauthorised materials in an
exam is a discipline offence under Monash Statute 4.1.

No examination papers are to be removed from the room.

AUTHORISED MATERIALS
CALCULATORS  YES  NO
OPEN BOOK  YES  NO
SPECIFICALLY PERMITTED ITEMS  YES  NO
if yes, item permitted is:

This exam paper consists three (3) sections printed on Eleven (11) pages. Section A consist fifteen (15)
compulsory MCQ questions, Section B consist four (4) questions and section C consist four (4) questions
to be attempted. PLEASE CHECK BEFORE COMMENCING. This is a FINAL paper and CLOSED BOOK
examination.

Candidates must complete this section if required to write answers within this paper

STUDENT ID __ __ __ __ __ __ __ __ DESK NUMBER __ __ __ __

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Section A (30 marks)

Answer ALL questions (15 x 2 = 30 marks) in this section. For each question, select the
BEST answer of the choices provided. All answers must be written on the first page of the
answer book.

1. Experience economies of scale when:

A. Banks marginal costs increase as total costs decrease.

B. Total costs decrease as output decreases.

C. Total costs increase as output increases.

D. Average unit costs increase as output increases.

E. Average unit costs decrease as output increases.

2. Duration:

A. Is always greater than maturity.

B. Rises as the coupon payment rises.

C. Measures how bond prices change with changes in maturity.

D. Is a measure of total return.

E. Is a measure of how price sensitive a bond is to a change in interest rates.

3. What is the Macaulay’s duration of a 10 year zero-coupon bond with a face value of
$1,000 and a market rate of 8%, compounded annually is:

A. 10 years

B. 11 years

C. 12 years

D. 13 years

E. None of the above

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4. A bond’s Macaulay duration is 7.95 years. If the current annual interest rate is 7%, what
is the modified duration of this bond?

A. 7.00 years

B. 7.88 years

C. 7.43 years

D. 7.95 years

E. 8.51 years

5. A bank buys a $10,000 Treasury bill with a maturity of 1 year. Current market rates are
8%. If interest rates rise to 8.25%, what is the approximate change in the price of the T-
bill?

A. -0.02%

B. -0.23%

C. -2.31%

D. -23.15%

E. -231.15%

6. If a bank has a negative GAP, a decrease in interest rates will cause interest income to
__________, interest expense to__________, and net interest income to __________.

A. Increase, Increase, Increase

B. Increase, Decrease, Increase

C. Increase, Increase, Decrease

D. Decrease, Decrease, Decrease

E. Decrease, Decrease, Increase

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7. When an interest-bearing security is the underlying asset for a futures contract, it is called:

A. A forward contract.

B. An interest rate futures.

C. A commission futures.

D. A speculative futures.

E. An interest rate swap.

8. A bank anticipates it will need to borrow funds in the Eurodollar market in the future. It
hedges by selling futures contracts. If rates decline, which of the following is true?

A. The bank will profit on the futures contract.

B. The bank will profit in the cash market.

C. The bank will have locked in a low cost of borrowing.

D. The bank will lose in the cash market.

E. A. and D.

9. Financial futures are:

A. A commitment between two parties to trade a financial instrument at a certain rate at a

specified time in the future.

B. A call option on a standardized asset at a certain price at a specified time in the future.

C. A put option on a standardized asset at a certain price at a specified time in the future.

D. A commitment between two parties on the price of a standardized financial asset with
the final settlement specified time in the future.

E. B. and C.

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10. There is a short-run trade-off between a bank’s liquidity and _______.

A. Asset quality

B. Profitability

C. Discount window borrowing

D. All of the above

E. A & B. only

11. In an interest rate swap, the notional principle:

A. Is the difference in the fixed and floating interest rates.

B. Is the difference in the fixed and floating interest payments.

C. Is used to calculate the FRA basis.

D. Is used to calculate the value of the interest payments.

E. Is used to calculate the hedge ratio.

12. A bank estimates that their average balance on demand deposit accounts is $2,500, net of
float. Each account costs the bank $175 per year in processing costs. The bank collects
an average of $5 per month on each account in service charges. Assume reserve
requirements are 10%. What is the net cost of an average demand deposit?

A. 4.5%

B. 4.8%

C. 5.1%

D. 6.8%

E. 7.0%

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13. The earnings change ratio:

A. Is defined as yield on rate-sensitive liabilities divided by the yield on rate-sensitive

assets.
B. Measures how the yield on an asset is assumed to change given a 1% change in some
base rate.
C. Measures the change in net interest income for a given change in some base rate.

D. All of the above.

E. A. and C.

14. A bank is currently exactly meeting its reserve requirements of 10%. If the bank has a
deposit inflow of $10,000,000, what is the impact on its required reserve position?

A. It now has excess reserves in the amount of $9,000,000.

B. It now has excess reserves in the amount of $10,000,000.

C. It is now deficient $1,000,000 in required reserves.

D. It is now deficient $9,000,000 in required reserves.

E. There would be no impact on the bank's required reserves.

15. Which of the following allows a security's cash flows to change when interest rates
change?

A. Modified duration

B. Macaulay's duration

C. Effective duration

D. Balance sheet duration

E. Income statement duration

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Section B (35 marks)

Answer ALL questions in this section

Question 1

Discuss the statement “The relationship between GAP and net interest income is too
simplistic.”
(5 marks)

Question 2 (2008)

(a) Explain the investment strategies a securities portfolio manager can pursue.
(b) If interest rates are expected to fall and an active maturity management approach is
adopted, what portfolio readjustments are appropriate? Explain your answer.
(5+5=10 marks)

Question 3

(a) What are derivative instruments and how are these instruments used by future traders?
(b) Discuss the difference between a future contract and a forward contract.
(5+5=10 marks)

Question 4

(a) Define and explain the process of securitization

(b) Discuss how securitization can help the treasury department of a bank in the
management of the bank’s asset and liability.
(5+5=10 marks)

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Section C (35 marks)

Answer ALL questions in this section

Question 1

Martian bank has organized its 100 branch network into loan branches and deposit taking
branches. However, there was much discontent by the branch staff when a profitability
performance based measurement linking to staff bonus was introduced in the beginning of
2012. The dissatisfaction is centered on the failure by the Treasury Department to compensate
the deposit branches to reflect their effort, contribution and cost in soliciting deposits, leading
to losses for the branches.
The Asset and Liability Committee (ALCO) has directed the Treasury Department of Martian
Bank to come up with an appropriate mechanism to charge/compensate the branches to reflect
their true performance.

The loan and deposit data for Martian Bank as at 30/6/2012 are as follows

Value Rates
Total Branch loans $ 10.0 billion Lending Rate 8.5 % p.a
Total Deposits from Deposit Branches $ 10.0 billion Deposit Rate 3.5 % p.a

(i) Define and explain the mechanism that would be employed by the Treasury
Department to overcome the dissatisfaction?

(ii) Construct a charge/compensation mechanism based on the data provided above with
a 2 % spread for the deposit branches, 1.0 % gain for the treasury department and
2.0 % spread for the loan branches.

(iii) Explain the outcome of this mechanism in relation to the initial dissatisfaction by the
deposit branches.
(3+6+1=10 marks)

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Question 2

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 on a notional principle of USD$ 10.0 million.
Each can borrow at the following rates:

Fixed Rate Floating Rate

LCR 8.0 % Libor + 1.0 %
HCR 12.0 % Libor + 2.5 %

Both companies have independently called on your bank to construct a swap transaction
which will meet their needs in the most efficient way for each. Assuming that HCR needs a
fixed rate and LCR prefer a floating rate loan. The bank as an intermediary charges a
commission of 0.5 %.

Answer the following question (a) – (d).

(a) In which debt market does HCR have a comparative advantage over LCR?

(b) How would an interest rate swap be beneficial to both parties?

(c) Construct a transaction that will solve the needs of all parties. What are their
respective borrowing costs?

(d) Explain what kind of security is this?

(1+1+6+2= 10 marks)

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Question 3

Question3 requires the use of the following bank information in the Table below

Market Duration Liabilities Market Duration

Assets Rate Rate
value (Years) and Equity Value (Years)

Time
Cash $ 200
Deposits $ 600 2.0 % 1.500

Loans $ 800 8.0 % 3.750 CDs $ 500 4.5 % 3.125

T-Bonds $ 250 4.0 % 7.250 Equity $ 150

Total $ 1,250 $ 1, 250

(a) What is the weighted average duration of assets?

(b) What is the bank’s duration gap?

(c) What is the bank’s expected economic net interest income?

(d) If interest rates rise 1% for all assets and liabilities, what is the approximate expected
change in the economic value of equity?

(e) What is your conclusion of duration gap.

(2+2+2+2+2=10 marks)

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Question 4

A small bank is planning to issue A$20 million in 90-day negotiable certificates of deposit
(NCDs) in three months. Forecasts of interest rate movements over the next few months are
mixed, so the manager decides to use 90-day bank-bill futures contracts to hedge against the
exposure. The bank-bill futures contracts are currently traded at 93.67. The manager estimates
that the rate currently required on the NCDs is 6.1% per annum. Three months later, when the
bank closes out its futures position, the contracts are trading at 92.80 and the bank issues
NCDs at a rate of 7.30% per annum. (Contract size = $1,000,000/contract.)

(a) Calculate the effective interest cost to the bank on this short-term debt (show all
calculations).

(b) Is this a perfect hedge? Why?

(4+1=5 marks)

END OF THE EXAMINATION

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