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Chapter 2 (1) 2.3 What risks does a bank take if it funds long-term loans with short-term deposits?The risk is that interest rates will rise so that, when deposits are rolled over, the bank has to pay a higher rate of interest. The rate received on loans will not change. The result will be a reduction in the bank’s net interest income 2.4 Suppose that an out-of-control trader working for DLC bank loses $7 million trading foreign exchange. What do you think will happen?DLC’s loss is more than its equity capital and it would probably be liquidated. The subordinated long-term debt holders would incur losses on their $5 million investment. The depositors should get their money back 2.5 What is meant by net interest income?The net interest income of a bank is interest received minus interest paid.
2.6 Which items on the income statement of DLC Bank in Section 2.2 are most likely to be affected by (a) credit risk, (b) market risk, and (c) operational risk?Credit risk primarily affects loan losses. Non-interest income includes trading gains and losses. Market risk therefore affects non-interest income. It also affects net interest income if assets and liabilities are not matched. Operational risk primarily affects non-interest expense.
2.16 Explain the moral hazard problems with deposit insurance. How can they be overcome?Deposit insurance makes depositors less concerned about the financial health of a bank. As a result, banks may be able to take more risk without being in danger of losing deposits. This is an example of moral hazard. (The existence of the insurance changes the behaviour of the parties involved with the result that the expected payout on the insurance contract is higher.) Regulatory requirements that banks keep sufficient capital for the risks they are taking reduce their incentive to take risks. One approach (used in the U.S.) to avoiding the moral hazard problem is to make the premiums that banks have to pay for deposit insurance dependent on an assessment of the risks they are taking.Chapter 5 (1) 5.1 What is the difference between a long forward position and a short forward position?When a trader enters into a long forward contract, she is agreeing to buy the underlying asset for a certain price at a certain time in the future. When a trader enters into a short forward contract, she is agreeing to sell the underlying asset for a certain price at a certain time in the future 5.2 Explain the difference between hedging, speculation, and arbitrage A trader is hedging when she has an exposure to the price of an asset and takes a position in a derivative to offset the exposure.In a speculation, a trader has no exposure to offset. She is betting on the future movements in the price of the asset. Arbitrage involves take a position in two or more different markets to lock in a profit.
5.3 What is the difference between entering into a long forward contract when the forward price is $50 and taking a long position in a call option with a strike price of $50?In the first case, the trader is obligated to buy the asset for $50, the trader does not have a choice. In the second case, the trader has an option to buy the asset for $50 (the trader does not have to exercise the option) 5.4 Explain carefully the difference between selling a call option and buying a put option Selling a call option involves giving someone else the right to buy an asset from you for a certain price. Buying a put option gives you the right to sell the asset to someone else 5.7 Suppose you write a put contract with a strike price of $40 and an expiration date in three months. The current stock price is $41, and the contract is on 100 shares. What have you committed yourself to? How much could you gain or lose?You have sold a put option. You have agreed to buy 100 shares of $40 per share if the party on the other side of the contract chooses to exercise the right to sell for this price. The option will be exercised only when the price of stock is below $40.Suppose, for example, that the option is exercised when the price is $30. You have to buy at $40 shares that are worth $30, you lose $10 per share, or $1,000 in total. If the option is exercised when the price is $20, you lose $20 per share, and so on. The worst that can happen is that the price of the stock declines to almost zero. You would lose $4,000.
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5.8 What is the difference between the over-the-counter market and the exchange-traded market? Which of the two markets do the following trade in: (a) a forward contract, (b) a futures contract, (c) an option, (d) a swap, (e) an exotic option?The OTC market is a telephone- and computer-linked network of financial institutions, fund managers, and corporate treasurers where two participants can enter into any mutually acceptable contract. An exchange-traded market is a market organized by an exchange where traders either meet physically or communicate electronically and the contracts that can be traded have been defined by the exchange.Chapter 12 (2)
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