GARP 2016-FRR - Financial Risk and Regulation (FRR) Series

Bonds and loans are fundamentally different in their legal structures and treatment. Bonds are typically issued in the public markets and are subject to securities laws and regulations, while loans are generally private agreements between a borrower and a lender.

Both instruments can be used to estimate credit capital under Basel II provisions, so option C is incorrect.

The pricing drivers for bonds and loans can overlap significantly, such as interest rates and credit risk, so option B is not the core difference.

Both bonds and loans can be subject to credit counterparty regulations, making option D incorrect.

When Delta Bank sells off the lower-risk portions of its credit portfolio, it retains the higher-risk residual pieces. This process inherently increases the risk associated with the remaining portfolio because the lower-risk assets, which provided a cushion, are no longer part of the portfolio. As the risk increases, the potential return on these higher-risk assets also increases to compensate for the additional risk taken on by the bank. Consequently, this higher risk and potential return increase the bank's return on equity (ROE), as the bank is now leveraging more volatile assets that have higher potential returns.

References

Verified information on risk and return from the document ​

The Black-Scholes model does not require discrete future stock prices as an input. Instead, it uses the current price of the underlying asset, the option’s strike price, time to maturity, risk-free interest rate, and the volatility of the underlying asset. The model assumes that the price of the underlying asset follows a continuous stochastic process and not discrete intervals.

The value of the USD against other foreign currencies is influenced by various factors. An increase in the US current account surplus (D) would likely strengthen the value of the USD. This is because a current account surplus indicates that the US is exporting more goods and services than it is importing, leading to higher demand for the USD by foreign buyers who need it to pay for US exports. This increased demand for the USD relative to other currencies results in an appreciation of the USD.

The formula to estimate a partial change in an option's price based on the change in the underlying asset's price is primarily dependent on the option's Delta. Delta represents the sensitivity of the option's price to changes in the price of the underlying asset. Therefore, the most straightforward and widely used formula to estimate this partial change is:

Partial change in option price=Δ×Change in underlying pricePartial change in option price=Δ×Change in underlying price

This formula directly utilizes Delta to measure the immediate rate of change in the option's price relative to a small change in the underlying asset's price. The other options involving Gamma are more complex and not typically used for simple partial changes.

When an asset manager for a large mutual fund engages in forward exchange transactions traded in a clearinghouse system, the primary risks that arise are exchange rate risk and credit risk. Exchange rate risk is inherent in any foreign exchange transaction due to potential fluctuations in the currency's value over time. Credit risk is also significant as it involves the possibility that the counterparty may default on their contractual obligations.

When a credit analyst evaluates spreads in loans, they focus on compensating for costs such as the marginal cost of funds provided, overhead costs of maintaining the loan, and inherent risks of lending to the borrower. However, the opportunity cost of the risk-adjusted marginal cost of capital is not typically considered directly in the spreads. The opportunity cost generally refers to the potential returns from alternative investments, which isn't a direct component of loan spread calculations.

To determine the appropriate interest rate to charge, Alpha Bank needs to cover the risk-free rate, the spread, and the expected loss due to default. The formula used is: Risk-free rate + Spread + (Probability of Default x Loss Given Default). Substituting the given values: 6% (risk-free rate) + 3% (spread) + (0.02 x 0.50) = 6% + 3% + 1% = 10%.

From the bank's point of view, repricing the retail debt portfolio introduces risks primarily related to fluctuations in interest rates and bank spreads. When interest rates change, the cost of funds for the bank can fluctuate, which affects the interest margins (bank spreads). Additionally, the repricing of existing debt to match current market rates introduces direct exposure to interest rate volatility. Therefore, the risks associated with fluctuations in these areas are III. Interest rates and IV. Bank spreads.

Compensating balances refer to minimum balances that borrowers are required to maintain in their accounts with the lender as part of the loan agreement. These balances benefit the bank by providing a stable source of funding and increasing the bank's interest rate margin and profitability. However, they do not directly influence the expected loss rate of the bank or improve capital structure by controlling obligor type and avoiding payment delays. These functions are not typically associated with compensating balances, which is why option C does not represent a benefit of compensating balances.