Short Answer (5 points each)
1.
Cheung Kong issues a new 5 year US dollar bond which it sells directly to a trader at the Bank of America in exchange for a check. This transaction occurs in the: a.
Primary Market, Derivative Market, and Over-the-Counter market b.
Secondary Market, Derivative Market and Cash Market c.
Auction Market, Primary Market, and Derivative Market d.
Over-the-Counter Market, Primary Market and Cash Market e.
Over-the-Counter Market, Derivative Market and Secondary Market
2.
We see that for a 10-period coupon bond, the current yield is greater than the
D coupon rate. This implies: a.
The price is higher than the face value and the yield to maturity is higher than the current yield. b.
The price is higher than the face value and the yield to maturity is lower than the current yield. c.
The price is lower than the face value and the yield to maturity is higher than the current yield. d.
The price is lower than the face value and the yield to maturity is lower than the current yield.
3.
Assume that uncovered interest parity and the expectations theory of the term structure are true. The yield on 1 year HK dollar bonds is 5% and the yield on 1 year
Singapore dollar bonds is 10% indicating that the market expects a positive appreciation rate of the HK dollar (relative to the Singapore dollar) over the next coming year. The yield on a 2 year HK dollar bond is 8% and the yield on a 2 year Singapore dollar bond is
C
10%. The appreciation rate is the growth rate of the exchange rate. The market expects a.
the interest rates on HK dollar bonds to be greater than 5% next year and the appreciation rate of the HK dollar to be positive in the next coming year and negative in the subsequent year. b.
the interest rate on HK dollar bonds to be greater than 5% next year and the appreciation rate of the HK dollar to be negative in the next coming year and positive in the subsequent year. c.
the interest rates on HK dollar bonds to be less than 5% next year and the appreciation rate of the HK dollar to be positive in the next coming year and negative in the subsequent year. d.
the interest rate on HK dollar bonds to be less than 5% next year and the appreciation rate of the HK dollar to be negative in the next coming year and positive in the subsequent year.
A

4.
We see that in the United States there is a high-tech investment boom coupled with a large government budget deficit. From the Hong Kong dollar loanable funds market perspective, we should observe: a.
An increase in the supply of loanable funds in HK and an increase in bond yields. b.
An increase in the supply of loanable funds in HK and a decrease in bond yields. c.
A decrease in the supply of loanable funds in HK and an increase in bond yields. d.
A decrease in the supply of loanable funds in HK and a decrease in bond yields
Verbal Answers
5.
(10 points) Name 4 strategies (under the categories of Asset Management) for managing credit risk i.
Credit-Risk Analysis – A loan officer manages banks relationship with borrowers. Loan officers may have some specialization with certain industries or businesses. Loan officers also use credit scoring systems which use statistical data to measure default probabilities and charge interest rate commensurate with risk. ii.
Monitoring – Loan agreements may contain restrictions on borrower behavior or value of assets. Loan officers monitor behavior and may recall loans if covenants are violated. iii.
Collateral – Loans identify physical assets which may be taken by the bank in case of default. iv.
Long-term Relationships – Banks often have relationships with certain businesses which reduces information problems. Relationships have value to businesses which they are loathe to jeopardize by engaging in moral hazard behavior. v.
Diversification – Banks can limit the likelihood of default by reducing exposure to a particular borrower or class of borrower. vi.
Credit Rationing – During recessions, adverse selection may dominate bond markets and banks may restrict bad loans.
6.
(5 points) Explain in 3 sentences or less the difference between Primary Reserves and Secondary reserves.
Primary reserves are the first source that banks use to provide liquidity to their customers and include vault cash and clearing balances/reserves at the central bank. Secondary reserves are government securities which can be sold quickly to provide additional security.
C

7.
(5 points) Explain in 3 sentences or less the difference between core deposits and managed liabilities.
Core deposits are retail funds raised by individual depositors through checking accounts, savings deposits and small time deposits. Managed liabilities are raised wholesale through large CD’s, time deposits, bonds and borrowings from banks. Core deposits are more stable and have lower interest costs while managed liabilities can be raised more quickly but only at a high interest cost.
8.
(10 points) A bank lends $10 million dollars to a customer by crediting their checking account. The customer uses the funds to buy government securities from the same bank. Sketch these transactions with a T-account.
+ 10 Loan
- 10 Securities
+ 10 Checking Deposits
- 10 Checking Deposits
Calculations
9.
(10 points) See the attached Consolidated Balance Sheets and Consolidated Profit and Loss Accounts for DBS (Hong Kong). Calculate the ROA, ROE, and Equitly
Multiplier for this Bank.
Equity
Profits
Assets
15856216 ROA
2007410 ROE
162704682 EM
0.012338
0.126601
10.26126

10.
(10 points) A borrower can issue a 3 year discount bond with a face value of 100 and sell it for a price of 60. Calculate the yield to maturity for the discount bond.
Alternatively, the borrower could issue a coupon bond with a face value of 60. What coupon would the bond issuer have to offer to sell the coupon bond at a price of 60, assuming that the market demands a yield to maturity for the coupon bond that was equal to the yield to maturity of the discount bond?
Return
Coupon
18.56%
11.137866

11.
(20 points) Assume that the bond market is restricted to 1 year discount bonds with face value equal to 100. There are two types of borrowers in the bond market: risky borrowers (“lemons”) and non-risky borrowers (“cream puffs). Fifty percent of borrowers are known to be lemons and fifty percent of borrowers are known to be creampuffs. Savers are willing to pay 90 for a lemon bond and 95 for a cream puff bond.
Lemon borrowers are willing to borrow if they can pay a yield no greater than 15% and creampuff borrowers will issue bonds if they can pay a yield no greater than 6%.
Assume borrowers and savers are equally good bargainers, so that the price of bonds is midway between the maximum price that savers are willing to pay for a bond and the minimum price that borrowers are will to expect.
A.
If there is perfect information and borrowers and savers can easily distinguish between lemon and creampuff bonds, what will be the price at which lemon and creampuff bonds will be sold?
Lemon
Creampuff
Price of Sellers
86.95652174
94.33962264
Price of Buyers
90
95
Middle Price
88.47826087
94.66981132
B.
Assume that savers and borrowers cannot distinguish between lemon and creampuff bonds and savers are willing to pay (at most) the expected value of a bond that is equally likely to be a lemon or creampuff. What will be the price that savers will be willing to pay for a bond of unknown type?
92.5
C.
Assume asymmetric information. Is the price that savers will pay for a bond greater than or less than the minimum price that issuers of a creampuff bond will be willing to accept? Will any creampuff bonds be sold? What price will prevail for a lemon bond?
The price that savers will be willing to pay for a bond of unknown type is 92.5 which is less than the minimum price that a creampuff borrower will accept. All creampuff borrowers will leave the market and everyone will know that the market is one of Lemons so the price will be 88.478.

12. (10 points) Some bonds have maturities with dates as long as 70 years. Calculate the present value of a T = 70 year bond with a discount factor = 10% (i=.10), a face value of
100 and a coupon rate of 8%. Compare this with the present value of a consol that pays a coupon of 8 forever (T =
∞) assuming the same discount factor.
The value of a coupon bond is
C i


1
 
1
T

 
FACE
 
T
. When T = 70, i = .1 and C = 8, this is 80.02532457. When T =
∞, i = .1 and C = 8, this is 80. Almost the same value.