Give brief definitions/answers to the following questions:

a) What is interest rate risk? How is refinancing risk different from financing risk?.
b) What is market risk, and why is it relevant for banks?.
c) Name a few activities typical for an investment bank?.
d) How can individual credit risk be handled?
e) What is meant by off balance sheet risks? Give two examples.
f)
g) Banks acting as asset transformers?
h) What is RAROC and what is the purpose of using it?
i) What is interest rate risk? How is refinancing risk different from reinvestment risk?
j) How can a financial institution handle loan portfolio risk? (give examples)
k) What is meant by off balance sheet risks? Give two examples of off-balance sheet risk. .
l) Bank run
m) Lender of last resort
n) Deposit insurance
o) Moral Hazard
p) Systemic banking crisis
q) The interest rate as a function of supply and demand for loanable funds
r)
s) FRA
t) Financial institutions enable a smooth flow of funds from household saves to
corporate users. Explain what financial intermediaries do that households find too
costly or too difficult to do on their own?
u) Explain credit rationing
v) What are agency costs?

There are many types of financial crises, at least five different. Define each of them and
exemplify with short empirical illustration from various countries. .

Use relevant theories for the yield curves and explain the following:
a) Why is the more recent yield curves lower than what the curves a year ago? What can
have happened?
b) Why is the recent yield curve so flat in the beginning, then steeper and then flatting
out again?
c) Why are the long-term yields so much higher in Spain?
d) The recent yield curve for Spain shows that i) the yield for a three-year bond is 3.5%, ii)
the yield for a four-year bond is 4% and iii) the yield for a five year bond is 4.5%. What
is the expected one-year interest rate in Spain four years from now (assume no
additional risk premiums)?
e) Briefly explain the differences between forwards, futures and options
f) What is meant by a cap and a floor?
g) Explain what is a yield curve, and why might it change upwards.
h) Explain what is meant by financial institutions acting as asset transformers?
i) Explain what is meant by financial institutions performing delegated monitoring?
j) Explain briefly why financial institutions require special laws and regulations compared
to other sectors of the economy?


Estudiar nmero 1 y 2 enteros
8. Why are FIs among the most regulated sectors in the world? When is net regulatory
burden positive?
FIs are required to enhance the efficient operation of the economy. Successful financial
institutions provide sources of financing that fund economic growth opportunities that
ultimately raise the overall level of economic activity. Moreover, successful financial
institutions provide transaction services to the economy that facilitate trade and wealth
accumulation
Chapter 3
2. What is the adverse selection problem? How does adverse selection affect the profitable
management of an insurance company?

The adverse selection problem occurs because customers who are most in need of insurance
are most likely to acquire insurance. However, the premium structure for various types of
insurance typically is based on an average population proportionately representing all
categories of risk. Thus, the existence of a proportionately larger share of high-risk customers
may cause the premium revenue received by the insurance provider to underestimate the
revenue needed to cover the insured liabilities and to provide a reasonable profit for the
insurance company.
Chapter 4
1. Explain how securities firms differ from investment banks. In what ways are they financial
intermediaries?
Securities firms specialize primarily in the purchase, sale, and brokerage of securities, while
investment banks primarily engage in originating, underwriting, and distributing issues of
securities. In more recent years, investment banks have undertaken increased corporate
finance activities such as advising on mergers, acquisitions, and corporate restructuring. In
both cases, these firms act as financial intermediaries in that they bring together economic
units who need money with those units who wish to invest money.
Both segments have undergone substantial structural changes in recent years. Some of the
most recent consolidations include the acquisition of Bears Stearns by J.P. Morgan Chase, the
bankruptcy of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America.
Indeed, as discussed later in the chapter, the investment banking industry has seen the failure
or acquisition of all but two of its major firms (Goldman Sachs and Morgan Stanley) and these
two firms converted to commercial bank holding companies in 2008.
2. What are the key activity areas for securities firms? How does each activity area assist in
the generation of profits and what are the major risks for each area?
a) Investing: Securities firms act as agents for individuals with funds to invest by establishing
and managing mutual funds and by managing pension funds. The securities firms generate fees
that affect directly the revenue stream of the companies.
b) Investment Banking: Investment banks specialize in underwriting and distributing both
debt and equity issues in the corporate market. New issues can be placed either privately or
publicly and can represent either a first issued (IPO) or a secondary issue. Secondary issues of
seasoned firms typically will generate lower fees than an IPO. In a private offering the
investment bank receives a fee for acting as the agent in the transaction. In best-efforts public
offerings, the firm acts as the agent and receives a fee based on the success of the offering.
The firm serves as a principal by actually takes ownership of the securities in a firm
commitment underwriting. Thus, the risk of loss is higher. Finally, the firm may perform similar
functions in the government markets and the asset-backed derivative markets. In all cases, the
investment bank receives fees related to the difficulty and risk in placing the issue.
c) Market Making: Security firms assist in the market-making function by acting as brokers to
assist customers in the purchase or sale of an asset. In this capacity the firms are providing
agency transactions for a fee. Security firms also take inventory positions in assets in an effort
to profit on the price movements of the securities. These principal positions can be profitable
if prices increase, but they can also create downside risk in volatile markets.
d) Trading: Trading activities can be conducted on behalf of a customer or the firm. The
activities usually involve position trading, pure arbitrage, risk arbitrage, and program trading.
Position trading involves the purchase of large blocks of stock to facilitate the smooth
functioning of the market. Pure arbitrage involves the purchase and simultaneous sale of an
asset in different markets because of different prices in the two markets. Risk arbitrage
involves establishing positions prior to some anticipated information release or event. Program
trading involves positioning with the aid of computers and futures contracts to benefit from
small market movements. In each case, the potential risk involves the movements of the asset
prices, and the benefits are aided by the lack of most transaction costs and the immediate
information that is available to investment banks.
e) Cash Management: Cash management accounts are checking accounts that earn interest
and may be covered by FDIC insurance. The accounts have been beneficial in providing full-
service financial products to customers, especially at the retail level.
f) Mergers and Acquisitions: Most investment banks provide advice to corporate clients who
are involved in mergers and acquisitions. This activity has been extremely beneficial from a fee
standpoint during the 1990s and 2000s.
g) Back-Office and Other Service Functions: Security firms offer clearing and settlement
services, research and information services, and other brokerage services on a fee basis.

3. What is the difference between an IPO and a secondary issue?
An IPO is the first time issue of a companys securities, whereas a secondary offering is a new
issue of a security that is already offered.

What is the process of asset transformation performed by a financial institution? Why does
this process often lead to the creation of interest rate risk? What is interest rate risk?

Asset transformation by an FI involves purchasing primary assets and issuing secondary assets
as a source of funds. The primary securities purchased by the FI often have maturity and
liquidity characteristics that are different from the secondary securities issued by the FI. For
example, a bank buys medium- to long-term bonds and makes medium-term loans with funds
raised by issuing short-term deposits.
Interest rate risk occurs because the prices and reinvestment income characteristics of long-
term assets react differently to changes in market interest rates than the prices and interest
expense characteristics of short-term deposits. Interest rate risk is the effect on prices (value)
and interim cash flows (interest coupon payment) caused by changes in the level of interest
rates during the life of the financial asset.
How does a policy of matching the maturities of assets and liabilities work (a) to minimize
interest rate risk and (b) against the asset-transformation function for FIs?
What is market risk? How does this risk affect the operating performance of financial
institutions?
Market risk is the risk of price changes that affects any firm that trades assets and liabilities.
The risk can surface because of changes in interest rates, exchange rates, or any other prices of
financial assets that are traded rather than held on the balance sheet. Market risk can be
minimized by using appropriate hedging techniques such as futures, options, and swaps, and
by implementing controls that limit the amount of exposure taken by market makers.

What is credit risk?
Credit risk is the possibility that promised cash flows may not occur or may only partially occur.
FIs that lend money for long periods of time, whether as loans or by buying bonds, are more
susceptible to this risk than those FIs that have short investment horizons. For example, life
insurance companies and depository institutions generally must wait a longer time for returns
to be realized than money market mutual funds and property-casualty insurance companies.

What is country or sovereign risk? What remedy does an FI realistically have in the event of a
collapsing country or currency?
Country risk involves the interference of a foreign government in the transmission of funds
transfer to repay a debt by a foreign borrower. A lender FI has very little recourse in this
situation unless the FI is able to restructure the debt or demonstrate influence over the future
supply of funds to the country in question. This influence likely would involve significant
working relationships with the IMF and the World Bank.
What is the repricing gap? In using this model to evaluate interest rate risk, what is meant by
rate sensitivity? On what financial performance variable does the repricing model focus?
Explain.
What is meant by cash flow (or cash flows), and in what way is the concept different from
cash flows in accounting?
Cash flow refers to actual money (cash) in minus actual money out during a specified period. In
accounting are measured from accounting statements and they are not always identical to real
cash flows. Accounting standards, when looking at historical data will to some degree distorted
measured cash flows.

What is mean by risk-free interest rates and risk-free bonds? And are they really risk-free?
Risk-free bonds refer to default free bonds. If you buy this type of bond and hold it to maturity
there is a nearly 100% certainty that you will receive the nominal value of that bond. However,
the bond is not risk-free, since the value will go up and down with the interest rate until the
maturity. Finally, the nominal value of the bond is determined in nominal terms, so the real
value (and the purchasing power of the nominal value) will change with inflation.

ECB Eurostat IMFBloombergs
d) Certificate of deposits : document financier que acredita la propiedad e mercancas o bienes
depositados en el almacen que lo emite.
e) Commercial Paper : isntrumento empresarial utilizado para una estrategia de despliegue
para obtener financiacion a largo plazo con un coste inferior. Se coloca a inversores, son de
corto plazo.
f) TBill : bono emitido por el Departamento de Tesoro de USA. Instrumentos de deuda
utilizados por el gobierno para financiar los servicios gubernamentales. Cuando hay dficit el
gobierno tiene que recaudar capital y lo hace asi.
h) YTM: es la tasa de retorno obtenida por comprar un bono al precio actual del Mercado y se
mantiene a la madurez. Rendimiento al vencimiento es el ndice para medir el atractivo de los
bonos. Cuando el precio del bono es bajo el rendimiento es alto y viceversa. Indicador de
buena medida para el retorno de la inversin prevista de un enlace.
i) Yield curve : la relacion entre el tipo de inters y el plazo de vencimiento de un bono,
prstamo o cualquier otra deuda. Mide el movimiento de las tasas de renta fija basado en la
fecha de su vencimiento, prediciendo el futuro de los tipos de inters y las condiciones
econmicas.
j) Implicit forward rate : representa una tasa que es la diferencia entre la tasa de inters y el
tipo de cambio spot asociado con una inversin especfica. Se calcula restando el presente o el
tipo de capbio spot de la tasa de termion o de futuros.