Deck 16: Off-Balance-Sheet Activities

Question 1

Which of the following statements is true?

A) A forward contract is a standardised contract between two parties to deliver and pay for an asset in the future.
B) A forward contract is a non-standardised contract between two parties to deliver and pay for an asset in the future.
C) A forward contract is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.
D) A forward contract is a non-standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.

Answer 1

B

Question 2

Which of the following statements is true?

A) Large increases in the value of the OBS assets can render an FI economically insolvent.
B) Large increases in the value of the OBS liabilities will not render an FI economically insolvent as the liabilities are only contingent.
C) Large increases in the value of the OBS liabilities will not render an FI economically insolvent as the net worth of the institution will not be affected.
D) Large increases in the value of the OBS liabilities can render an FI economically insolvent.

Answer 2

D

Question 3

Which of the following are typical off-balance sheet activities undertaken by Australian banks?

A) futures contracts and forward contracts
B) direct credit substitutes.
C) commitments.
D) All of the listed options are correct.

Answer 3

D

Question 4

Contingent assets and liabilities are assets and liabilities off the balance sheet that:

A) produce positive or negative future cash flows for an FI.
B) can be used in contingency situations, that is, they serve as a fall-back position.
C) potentially can produce positive or negative future cash flows for an FI.
D) None of the listed options are correct.

Question 5

Which of the following statements is true?

A) A futures contract is a standardised contract between two parties to deliver and pay for an asset in the future.
B) A futures contract is a non-standardised contract between two parties to deliver and pay for an asset in the future.
C) A futures contract is a standardised contract guaranteed by organised exchanges to deliver and pay for an asset in the future.
D) A futures contract is a non-standardised contract b guaranteed by organised exchanges to deliver and pay for an asset in the future.

Question 6

Which of the following statements is true?

A) Economically speaking, contingent assets and liabilities are contractual claims that might or might not impact on the economic value of a bank.
B) Economically speaking, contingent assets and liabilities are contractual claims that do not impact on the economic value of a bank.
C) Economically speaking, contingent assets and liabilities are contractual claims that directly impact on the economic value of a bank.
D) Economically speaking, contingent assets and liabilities are contractual claims that indirectly impact on the economic value of a bank.

Question 7

Letters of credit are:

A) contingent guarantees sold by an FI to underwrite the trade or commercial performance of the buyer of the guarantee.
B) another word for cheques.
C) guarantees bought by an FI because they are convinced by the issuer's commercial performance.
D) reminders sent by FIs to customers who have outstanding debit balances.

Question 8

Which of the following statements is true?

A) In its simplest form, the traditional valuation calculates an FI's net worth as the market value of assets less the market value of liabilities.
B) In its simplest form, traditional valuation calculates an FI's net worth as the market value of assets plus the market value of liabilities.
C) In its simplest form, traditional valuation calculates an FI's net worth as the market value of liabilities less the market value of assets.
D) None of the listed options are correct.

Question 9

The delta of an option refers to the change in the value of an:

A) option for a large unit change in the price of the underlying security.
B) option for a small unit change in the price of the underlying security.
C) underlying security for a small unit change in the price of the option.
D) underlying security for a large unit change in the price of the option.

Question 10

Assume that a bank's market value of assets is $200, the market value of its contingent assets is $50, the market value of its liabilities is $180 and the market value of its contingent liabilities is $60. What is the value of this bank's net worth?

A) $200 + $180 - $50 - $60 = $270
B) $180 - $200 + $50 + $60 = $90
C) $200 - $180 + $50 - $60 = $10
D) $200 - $180 - $50 + $60 = $30.

Question 11

Which of the following statements is true?

A) The delta of an option can be calculated as the option's price divided by the price of the underlying security.
B) The delta of an option can be calculated as the change in the option's price divided by the change in the price of the underlying security.
C) The delta of an option can be calculated as the price of the underlying security divided by the price of the option.
D) The delta of an option can be calculated as the change in the price of the underlying security divided by the change in the price of the option.

Question 12

Which of the following statements is true?

A) The variable spread between a lending rate and a borrowing rate, or between any two interest rates or prices is called basis risk.
B) The variable spread between a lending rate and a borrowing rate, or between any two interest rates or prices is called spread risk.
C) The variable spread between a lending rate and a borrowing rate, or between any two interest rates or prices is called interest spread risk.
D) The variable spread between a lending rate and a borrowing rate, or between any two interest rates or prices is called funding risk.

Question 13

Assume that the market value of assets is $120 and the market value of liabilities is $90. What is the bank's net worth?

A) $210
B) $30
C) -$30
D) None of the listed options are correct.

Question 14

Including on-balance-sheet and off-balance-sheet activities, a bank's net worth is calculated as:

A) (A-L) + (CA-CL)
B) (A-L) - (CA-CL)
C) (L-A) + (CA-CL)
D) (L-A) - (CA-CL)

Question 15

Which of the following are included in commitments and non-market related items?

A) direct credit substitutes and trade performance related items
B) swaps and options.
C) future contracts.
D) None of the listed options are correct.

Question 16

The change in the value of an option for a small unit change in the price of the underlying security is called the:

A) alpha of an option.
B) gamma of an option.
C) beta of an option.
D) delta of an option.

Question 17

Which of the following statements is true?

A) Back-end fee is the fee imposed on the used component of a loan commitment.
B) Back-end fee is the fee imposed at the beginning of a loan contract.
C) Back-end fee is the fee imposed on the unused component of a loan commitment.
D) Back-end fee is the fee imposed at the end of a loan contract.

Question 18

The term 'recourse' refers to the ability to put an asset or loan back to the seller should the:

A) asset need to be entirely written off.
B) credit quality of that asset improve.
C) buyer not need the asset any longer.
D) credit quality of that asset deteriorate.

Question 19

An off-balance sheet asset is an item that:

A) moves on to the asset side of the balance sheet when a contingent event occurs.
B) is off the balance sheet as it is not part of the FI's core operations.
C) is off the balance sheet as the FI does not wish to reveal its existence.
D) is off the balance sheet as it neither has an impact on the risk or profitability of the FI.

Question 20

Where are the contingent items disclosed in the financial statements?

A) On the assets side of the balance sheet.
B) On the liabilities side of the balance sheet.
C) As footnotes to financial statements.
D) In the income statement.

Question 21

Which of the following is true of an 'adverse material change in conditions clause' used in a loan commitment?

A) It allows the FI to cancel or reprice a loan commitment.
B) It protects the lender against takedown risk.
C) It protects the lender against basis risk.
D) Exercise of the clause helps defaulted borrowers.

Question 22

Which of the following statements is true?

A) For an in-the-money call option the price of the underlying security is below the option's exercise price.
B) For an in-the-money call option the price of the underlying security is equal to the option's exercise price.
C) For an in-the-money call option the price of the underlying security exceeds the option's exercise price.
D) The answer to the question depends on the type of the call option.

Question 23

Which of the following statements is true?

A) The measure used to measure the change in delta as the underlying security price varies is called vega.
B) The measure used to measure the change in delta as the underlying security price varies is called alpha.
C) The measure used to measure the change in delta as the underlying security price varies is called beta.
D) None of the listed options are correct.

Question 24

Which of the following statements is true?

A) An FI that issues a documentary letter of credit to one of its customers implicitly believes that the customer's credit standing is not sufficiently high enough to engage in international transactions.
B) An FI that issues a documentary letter of credit to one of its customers implicitly assumes the borrower's credit risk.
C) An FI that issues a documentary letter of credit to one of its customers has created a contingent asset.
D) None of the listed options are correct.

Question 25

Which of the following is a reason why the default risk of a futures contract is assumed to be less than that of a forward contract?

A) Forward contracts are classified as exotic derivatives.
B) Margin requirements on futures.
C) More flexibility as the buyer can decide whether or not to exercise the contract at maturity.
D) None of the listed options are correct as the default risk of a futures contract is generally considered to be higher than that of a forward contract.

Question 26

Which of the following statements is true?

A) When issued trading can expose FIs to future interest rate risk.
B) When issued trading can expose FIs to future credit risk.
C) When issued trading can expose FIs to future liquidity risk.
D) When issued trading can expose FIs to future default risk.

Question 27

Assume a bank makes a loan commitment to the value of $10m at a fixed interest rate of 10 per cent p.a. for a period of one year. Assume the borrower only uses 50 per cent of the provided funds over the course of the year. If the bank charges a back-end fee of 0.5 per cent, what is the additional revenue the bank would generate?

A) None, unless the loan is prepaid early.
B) $2500
C) $25 000
D) $5000

Question 28

Settlement in case of 'when issued' (WI) trading must be completed on:

A) the date on which the counterparties agree.
B) Tuesday.
C) Wednesday.
D) Thursday.

Question 29

Which of the following statements is true?

A) In general, default risk on OTC contracts decreases with the time to maturity of the contract and the fluctuation of underlying prices, interest rates or exchange rates.
B) In general, default risk on OTC contracts increases with the time to maturity of the contract and the fluctuation of underlying prices, interest rates or exchange rates.
C) In general, default risk on OTC contracts is independent of the time to maturity of the contract and the fluctuation of underlying prices, interest rates or exchange rates.
D) OTC contracts are generally free of default risk.

Question 30

Which of the following statements is true?

A) The vega of an option is a measure of volatility risk.
B) The omega of an option is a measure of volatility risk.
C) The delta of an option is a measure of volatility risk.
D) The alpha of an option is a measure of volatility risk.

Question 31

Which of the following contingent risks are most likely to be created if a bank provides a loan commitment?

A) interest rate risk and credit risk
B) draw-down risk
C) aggregate funding risk
D) All of the listed options are correct.

Question 32

Assume a bank grants a loan commitment at an interest rate of 10 per cent p.a. and the risk premium on the loan is 2 per cent. The bank charges borrowers an upfront fee on the whole commitment of 0.25 per cent and a back-end fee on any unused proportion of the loan of 0.5 per cent. The compensating balance is 10 per cent and so are reserve requirements. Assume that the average draw-down of the loan is 80 per cent over the time of the loan commitment. What is the promised return on the loan commitment (round to two decimals)?

A) 12.00 per cent
B) 12.75 per cent
C) 13.23 per cent
D) 13.67 per cent

Question 33

The vega of an option measures:

A) interest rate risk.
B) volatility risk.
C) off-balance sheet risk.
D) price elasticity.

Question 34

Which of the following statements is true?

A) Draw-down risk is a type of liquidity risk.
B) Draw-down risk is a type of investment risk.
C) Draw-down risk is a type of credit risk.
D) Draw-down risk is a type of economic risk.

Question 35

Which of the following statements is true?

A) The default risk in futures contracts is considered to be less than that of forward contracts because of daily marking to market of futures.
B) The default risk in futures contracts is considered to be less than that of forward contracts because of margin requirements on futures that act as a security bond and because of default guarantees by the future exchange itself.
C) The default risk in futures contracts is considered to be less than that of forward contracts because of price limits that spread out over times of extreme price fluctuations.
D) All of the listed options are correct.

Question 36

Back-end fees are charged as a certain percentage of:

A) commitment size and loan taken down.
B) utilised portion of commitment size.
C) unused portion of commitment size.
D) interest payable on the loan commitment.

Question 37

Which of the following statements is true?

A) In general, the relationship between the value of an option and the underlying value of a security is non-linear.
B) For an out-of-the money call option the price of the underlying security is less than the option's exercise price.
C) Using the delta method to derive the market value of an option is at best an approximation and to deal with the non-linearity of option pay-offs, some analysts consider an option's gamma too.
D) All of the listed options are correct.

Question 38

How do you interpret a delta of 0.30?

A) A delta of 0.30 means that a one-cent change in the price of the underlying asset of the option leads to a 0.30 cent change in the price of the option.
B) A delta of 0.30 means that a ten-cent change in the price of the underlying asset of the option leads to a 0.30 cent change in the price of the option.
C) A delta of 0.30 means that a one-dollar change in the price of the underlying asset of the option leads to a 0.30 cent change in the price of the option.
D) A delta of 0.30 means that a one-dollar change in the price of the underlying asset of the option leads to a 30 per cent change in the price of the option.

Question 39

Takedown or draw-down risk in a loan commitment exposes the FI to:

A) immediate liquidity risk.
B) basis and spread risk.
C) externality effects.
D) future liquidity risk.

Question 40

Assume a bank has bought a call option on bonds with a notional value of $200. Further assume that and that the delta of the option is calculated at 0.45. What is the contingent asset value (round to two decimals)?

A) $200 / 0.45 = $444.44
B) $200 $\times$ 0.45 = $90.00
C) ($200 / 0.45) / 100 = $4.44
D) ($200 $\times$ 0.45) / 100 = $0.90

Question 41

The delta of an option is always greater than one.

Question 42

Under an interest rate cap, in return for a fee the seller promises to compensate the buyer should interest rates remain under a certain level.

Question 43

Standby letters of credit can be seen as direct competitors to loan commitments.

Question 44

Basis risk refers to the variable spread between a lending rate and a borrowing rate, or between any two interest rates or prices

Question 45

Which of the following situation is similar to the externality effect?

A) Exercising an adverse material change in conditions clause as a last resort, thereby cancelling or repricing a loan commitment.
B) Increase in the cost of funds above normal levels while many FIs scramble for funds to meet their commitments to customers during a credit crunch.
C) In a loan commitment, the borrower takes down only part of the funds over the specified time-period.
D) The buyer of a commercial letter of credit fails to perform as promised under a contractual obligation.

Question 46

FIs may issue standby letters of credit to cover contingencies that are potentially more severe, less predictable and not necessarily trade related.

Question 47

An exporter demands a letter of credit in order to:

A) guarantee safe delivery of goods to the importer.
B) guarantee receipt of payment from the importer upon receipt of the goods.
C) protect against adverse changes in foreign exchange rates.
D) ascertain the creditworthiness of the importer.

Question 48

Which of the following is an out-of-the-money counterparty?

A) Counterparty in a loan commitment contract.
B) FI that trades in securities prior to their actual issue.
C) Counterparty that is currently at an advantage in terms of cash flows.
D) Counterparty that is currently at a disadvantage in terms of cash flows

Question 49

Which of the following are correct about off-balance sheet activities?

A) They provide a key source of interest income for many FIs.
B) By hedging against on-balance-sheet interest rate, FX and credit risks, OBS derivative instruments actually reduce FI overall insolvency risk.
C) Higher regulatory costs on derivative instruments may cause FIs to over-hedge resulting in a decrease in FI insolvency risk.
D) All of the listed options are correct.

Question 50

Conceptually, a swap contract can be viewed as a succession of forward contracts.

Question 51

In the early 1980s:

A) banks increased their off-balance-sheet activities to avoid regulatory taxes.
B) banks decreased their off-balance-sheet activities to avoid regulatory costs.
C) banks decreased their off-balance-sheet activities to avoid competition from nonbank banks.
D) banks increased their off-balance-sheet activities to avoid competition from nonbank banks.

Question 52

If a future credit crunch occurs, a loan commitment may expose the FI to:

A) credit risk.
B) interest rate risk.
C) sovereign country risk.
D) funding risk.

Question 53

The 'face value of an OBS item' is also referred to as the notional value.

Question 54

An Adverse material changes in conditions clause is included in loan commitments to protect the FI against:

A) funding risk.
B) interest rate risk.
C) takedown risk.
D) credit risk.

Question 55

Off-balance-sheet items are:

A) items omitted from the short form balance sheet.
B) contingent assets and liabilities.
C) exceptionally risky assets and liabilities.
D) foreign (off shore) assets and liabilities.

Question 56

What is seen as a possible reason behind restricted supply of spot loans to borrowers during a credit crunch?

A) Expansionary monetary policy actions of the Reserve Bank of Australia.
B) FI's increased aversion toward lending during tight monetary conditions.
C) Low aggregate demand from borrowers to take down loan commitments.
D) Decrease in cost of funds.

Question 57

The default risk of a futures contract is less than that of a forward contract.

Question 58

Redraw facilities are included in the category 'commitments and other non-market related items'.

Question 59

Off-balance sheet activities contributed to the 2008 global financial crisis with increasing financial market solvency risk exposure caused by:

A) loans sold with recourse had contingent liability implications for FIs when these loans went 'bad'.
B) sub-prime mortgages and OBS securities backed by these mortgages peaked prior to the mortgage market collapse.
C) the market for derivatives was opaque and 'trades' complex leading to counterparty risk where firms dealt directly with each other
D) All of the listed options are correct.

Question 60

The current market value of an off-balance-sheet item is determined by finding the current market value of the underlying item.

Question 61

As compared to LCs, SLCs typically are used to cover contingencies that potentially are more severe and which may not be trade related.

Question 62

Explain how the use of forward and future contracts creates contingent credit risk for an FI.

Question 63

Graphically explain the general set-up of a letter of credit transaction. In this context, explain why letters of credit are important.

Question 64

Briefly explain how off-balance-sheet transactions can affect an FI's solvency.

Question 65

Interest rate risk is part of the loan commitment contingent risk because of the uncertainty of changes in interest rates before the borrower exercises his option to borrow.