Professional Documents
Culture Documents
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201516. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.
General remarks
Learning outcomes
At the end of the course and having completed the Essential reading and activities you should:
discuss why financial systems exist, and how they are structured
explain why the relative importance of financial intermediaries and financial markets is
different around the world, and how bank-based systems differ from market-based systems
understand why financial intermediaries exist, and discuss the role of transaction costs and
information asymmetry theories in providing an economic justification
explain why banks need regulation, and illustrate the key reasons for and against the
regulation of banking systems
discuss the main types of risks faced by banks, and use the main techniques employed by
banks to manage their risks
explain how to value real assets and financial assets, and use the key capital budgeting
techniques (Net Present Value and Internal Rate of Return)
explain how to value financial assets (bonds and stocks)
understand how risk affects the return of a risky asset, and hence how risk affects the value
of the asset in equilibrium under the fundamental asset pricing paradigms (Capital Asset
Pricing Model and Asset Pricing Theory)
discuss whether stock prices reflect all available information, and evaluate the empirical
evidence on informational efficiency in financial markets.
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FN1024 Principles of banking and finance
From the allocation of marks, you should be able to identify the importance and weighting of each
part of the question. Therefore, you should devote an appropriate amount of time to each part
related to the marks awarded.
The FN1024 Principles of banking and finance examination paper tests your understanding of
a wide range of concepts and techniques in the banking and finance areas. Therefore, you are
expected to demonstrate numerical competence as well as a thoughtful and clear writing style in the
discursive parts of each question.
All the questions asked in the examination are designed to test topics covered in the syllabus as
presented in the Regulations; the subject guide provides a framework for covering the syllabus and
directs you to the Essential reading. You are reminded that the examination for this course may test
any aspect of the syllabus.
This is a foundation course and you are expected to demonstrate your knowledge and understanding
of key concepts/terms in banking and finance.
Moreover, you are expected to demonstrate your knowledge of the relevant technical terminology.
Finally, you are encouraged to demonstrate your ability to identify links between concepts presented
in different chapters of the syllabus/subject guide. In essay questions, in addition to depth of
knowledge of the subject matter, the examiners are looking for your ability to discuss and evaluate
arguments and to relate knowledge to the question asked, as opposed to simple repetition of factual
information on a particular topic. One way of helping to ensure that you have a clear,
well-structured and relevant argument is to spend a few minutes organising your answer before you
begin writing, and by trying not to fit a standard answer to the question.
Please note that since 2010 examination marks have not generally been allocated to individual
points made in the answer. This is particularly relevant to Section A questions but also to the parts
of Section B questions where you have to explain a concept. Instead, the examiners will be looking
at the answer as a whole when allocating a mark. The examiners will be looking for evidence of an
overall understanding of the concept/issue being examined. Demonstrating your understanding can
come from providing relevant factual information, relevant examples and showing how the concept
relates to other concepts in the syllabus. This change in the approach to marking will reinforce the
point made in the paragraph above that simple repetition of material from the subject guide is
unlikely to be rewarded with a high mark.
While some of the questions might appear to be technical, most of the marks are awarded for
providing the economic reasoning and explanations. The examiners therefore recommend focusing
on both the economic reasoning and some of the techniques/tools as you work with the subject
guide. Note that in numerical questions alternative hypotheses are equally acceptable if you have
been consistent in the different parts of the question: in these cases the examiners are flexible in the
allocation of marks.
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Examiners commentaries 2016
Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons. The Examiners commentaries suggest ways of
addressing common problems and improving your performance. One particular failing is question
spotting, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.
We recognise that candidates may not cover all topics in the syllabus in the same depth, but you
need to be aware that the examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.
The syllabus can be found in the Course information sheet in the section of the VLE dedicated to
each course. You should read the syllabus carefully and ensure that you cover sufficient material in
preparation for the examination. Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers. Examination papers may legitimately
include questions on any topic in the syllabus. So, although past papers can be helpful during your
revision, you cannot assume that topics or specific questions that have come up in past examinations
will occur again.
If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.
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FN1024 Principles of banking and finance
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201516. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.
Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.
Section A
Answer one question and no more than two further questions from this section.
Question 1
(a) Examine the respective roles of transaction costs and asymmetric information in
accounting for intermediation through financial institutions.
(15 marks)
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Examiners commentaries 2016
(b) Explain how transaction costs and asymmetric information in credit markets
has changed in the last 20 years and assess the impact of these changes on
financial disintermediation.
(10 marks)
Question 2
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FN1024 Principles of banking and finance
Better answers would define what each of these information sets are and explain that the
wider information sets nest the less wide sets (for example, the semi-strong information set
nests the weak).
The implications of weak-form efficiency for investors are that investors cannot use
models/technical analysis based on past data to predict future prices.
The implications of semi-strong efficiency are that investors cannot use fundamental analysis
to try to pick undervalued securities.
The implications of strong form efficiency is that excess returns cannot be obtained by using
private information, for example superior forecasting ability.
Question 3
(a) Distinguish between liquidity and solvency in relation to a bank. Explain how a
bank could become insolvent and explain the role of capital and liquidity in
preventing insolvency.
(10 marks)
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Examiners commentaries 2016
(b) Critically evaluate the methods a bank can use to manage the credit risk it faces.
(15 marks)
Question 4
(a) Discuss the main reasons for regulating banks and examine the safety net
arrangements put in place in most banking systems.
(15 marks)
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FN1024 Principles of banking and finance
The main justification for regulation is to reduce systemic risk. However, this increases
costs, reduces competition and increases moral hazard. These problems can be minimised by
appropriately implemented regulations but they will always exist and therefore can be seen
as the price worth paying for low systemic risk.
Safety net arrangements are:
i. lender of last resort liquidity provision
ii. deposit insurance
iii. capital injections in times of crisis.
These arrangements increase moral hazard reduced by penal rates on liquidity support,
coinsurance arrangements (no longer) and supervision by the regulator.
(b) Distinguish between micro- and macro-prudential regulation and give examples
of how macro-prudential regulation might work in practice.
(10 marks)
Section B
Answer one question and no more than two further questions from this section.
Question 5
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Examiners commentaries 2016
(a) Assuming a discount rate of 8 per cent, what is the NPV of the two projects?
Based on the NPV criteria identify which projects you would accept and
explain why.
(5 marks)
(b) Examine the factors that a firm might consider in determining the discount rate
to use in the NPV calculation.
(4 marks)
(c) Calculate the IRR of each project. Using a hurdle rate equal to 8%, identify
which projects you would accept and explain why.
(5 marks)
(d) Calculate the payback period for each project. If the company only accepts
projects that pay back within 3 years, identify which projects you would accept
and explain why.
(3 marks)
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FN1024 Principles of banking and finance
(e) Compare and contrast the three investment appraisal methods used in parts
(a), (c) and (d).
(8 marks)
Question 6
(a) You have been asked by a friend to explain Markowitzs modern portfolio
theory (MPT). Outline the key features of MPT and explain the main benefits
of MPT for an investor (the use of diagrams in your answer is encouraged).
(12 marks)
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Examiners commentaries 2016
(c) Discuss the limitations of the Capital Asset Pricing Model (CAPM).
(7 marks)
Question 7
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FN1024 Principles of banking and finance
Zeta:
4 4(1.1) 4(1.1)2 [4(1.1)2 (1.04)/(0.09 0.04)]
P = + 2
+ 3
+ = 88.85.
1.09 (1.09) (1.09) (1.09)3
(b) Compare and contrast the characteristics of common stocks and preferred
stocks.
(6 marks)
(c) Formally derive and explain the dividend discount model used for the valuation
of common stocks.
(9 marks)
(d) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)
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Examiners commentaries 2016
Question 8
(b) A US Treasury bond has an annual coupon rate of 5%, par (face) value of
$1,000 and will mature in 5 years. Similar US Treasury bonds have a yield to
maturity of 6%.
Using the data given above and assuming semi-annual coupons, calculate the
value of the US Treasury bond.
(4 marks)
(d) Assume annual interest rates increase by 0.5%. Using the duration calculated in
(c), calculate the approximate percentage change in the value of the US bond
assuming annual coupons and annual discount rate?
(4 marks)
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FN1024 Principles of banking and finance
(e) Demonstrate, using a diagram, why the estimate of a bonds price change
obtained using modified duration will be an underestimate of the percentage
increase in the bond price when yields fall, and an overestimate of the
percentage decrease in the bond price when yields rise.
(5 marks)
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Examiners commentaries 2016
Important note
This commentary reflects the examination and assessment arrangements for this course in the
academic year 201516. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).
Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2011).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements if
none are available, please use the contents list and index of the new edition to find the relevant
section.
Candidates should answer FOUR of the following EIGHT questions: ONE from Section A, ONE
from Section B and TWO further questions from either section. All questions carry equal marks.
Section A
Answer one question and no more than two further questions from this section.
Question 1
(a) Outline the key features and implications of the Diamond model of banks as
delegated monitors.
(15 marks)
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FN1024 Principles of banking and finance
(b) Explain how transaction costs and asymmetric information in credit markets
has changed in the last 20 years and assess the impact of these changes on
financial disintermediation.
(10 marks)
Question 2
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Examiners commentaries 2016
Question 3
(a) Distinguish between liquidity and solvency in relation to a bank. Explain how a
bank could become illiquid and how attempts to rectify this situation by the
bank could lead it to become insolvent.
(10 marks)
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FN1024 Principles of banking and finance
(b) Critically evaluate the methods a bank can use to manage the liquidity risk it
faces.
(15 marks)
Question 4
(a) Discuss the causes, consequences and solutions of the too big to fail problem in
banking.
(15 marks)
(b) Distinguish between micro- and macro-prudential regulation and give examples
of how macro-prudential regulation might work in practice.
(10 marks)
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Examiners commentaries 2016
The greater interconnections between banks through the interbank market or securitisation
create greater risk of systemic failure.
Regulators place greater emphasis on macro-prudential regulation as the lessons of the
banking crisis of 2007/08 have shown that the systemic risk that emerged was due more to
macro-prudential type risks than to imprudent behaviour of individual institutions. Both
types of regulation matter but there is now a greater awareness of the contribution to
systemic risk from interconnections between banks and macro-risks. This has led in the UK
to the formation of the Financial Policy Committee with a specific remit to assess and
recommend policy actions to address macro-prudential risk.
Examples of implementation include introducing limits on mortgage lending to prevent a
housing market bubble, or the counter-cyclical capital buffer introduced through Basel 3.
Section B
Answer one question and no more than two further questions from this section.
Question 5
(a) Assuming a discount rate of 7 per cent, what is the NPV of the two projects?
Based on the NPV criteria identify which projects you would accept and
explain why.
(5 marks)
(b) Examine the factors that a firm might consider in determining the discount rate
to use in the NPV calculation.
(4 marks)
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FN1024 Principles of banking and finance
(c) Calculate the IRR of each project. Using a hurdle rate equal to the discount
rate, identify which projects you would accept and explain why.
(5 marks)
(d) Calculate the payback period for each project. Given the firm only accepts
projects that pay back within 3 years, identify which projects you would accept
and explain why.
(3 marks)
(e) Compare the reinvestment assumptions of the NPV and IRR methods.
(5 marks)
(f ) Explain why the NPV method leads to decisions that are consistent with the
objective of wealth maximization.
(3 marks)
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Examiners commentaries 2016
Question 6
(a) You have been asked by a friend to explain Markowitzs modern portfolio
theory (MPT). Outline the key features of MPT and explain the main benefits
of MPT for an investor (the use of diagrams in your answer is encouraged).
(12 marks)
Proportions (%)
Portfolio X Y
1 25 75
2 75 25
3 50 50
4 100 0
(6 marks)
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FN1024 Principles of banking and finance
(c) Discuss the Roll critique in relation to the empirical testing of the CAPM.
(7 marks)
Question 7
(b) Compare and contrast the valuation of common stocks with corporate bonds.
(6 marks)
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Examiners commentaries 2016
(c) Formally derive and explain the dividend discount model used for the valuation
of common stocks.
(9 marks)
(d) Discuss the limitations of the Gordon Growth model for the valuation of stocks.
(4 marks)
Question 8
(a) Explain the relationship between the price, coupon and yield to maturity of a
bond.
(6 marks)
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FN1024 Principles of banking and finance
(b) A US Treasury bond has an annual coupon rate of 4%, par (face) value of
$1,000 and will mature in 5 years. Similar US Treasury bonds have a yield to
maturity of 5%.
Using the data given above and assuming semi-annual coupons, calculate the
value of the US Treasury bond.
(4 marks)
(c) Calculate the Macaulay duration of the US Treasury bond assuming annual
coupons and an annual discount rate.
(6 marks)
(d) Assume annual interest rates increase by 0.5%. Using the duration calculated in
(c), calculate the approximate percentage change in the value of the US bond
assuming annual coupons and annual discount rate?
(4 marks)
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Examiners commentaries 2016
(e) Explain why the estimate of a bonds price change obtained using modified
duration will be an underestimate of the percentage increase in the bond price
when yields fall, and an overestimate of the percentage decrease in the bond
price when yields rise.
(5 marks)
25