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Finance
Q:
A bank is about to make a $50 million project loan to develop a new oil field and is worried that the petroleum engineer's estimates of the yield on the field are incorrect. The bank wants to protect itself in case the developer cannot repay the loan. Which type of credit derivative contract would you most recommend for this situation?
A) Credit linked note
B) Credit option
C) Credit risk option
D) Total return swap
E) Credit swap
Q:
Briefly explain how EPS-Operating Income analysis helps determine the capital structure of a firm?
Q:
A financial institution plans to issue a group of bonds backed by a pool of automobile loans. However, they fear that the default rate on the automobile loans will rise well above 4 percent of the portfolio the projected default rate. The financial institution wants to lower the interest payments if the loan default rate rises too high. Which type of credit derivative contract would you most recommend for this situation?
A) Credit linked note
B) Credit option
C) Credit risk option
D) Total return swap
E) Credit swap
Q:
Briefly discuss some of the applications of the law of conservation of value.
Q:
A securitized asset where the asset used to back the securities is a loan based on the residual value of a homeowner's residence is called:
A) A mortgage backed security
B) A credit card backed security
C) An automobile backed security
D) A loan backed bond
E) A home equity loan backed security
Q:
Explain the concept of "value additivity."
Q:
Which of the following is a risk of using credit derivatives?
A) Credit derivatives do not protect against credit risk exposure
B) The partner in the swap or option contract may fail to perform
C) Regulators may decide to lower the amount of capital needed for banks using these derivatives
D) Regulators may decide that these derivatives make the bank more stable and efficient
E) All of the above are risks of using credit derivatives
Q:
State the law of conservation of value.
Q:
A debt instrument which allows the issuer to lower its coupon payments if some significant factor changes is called:
A) A credit option
B) A standby letter of credit
C) A credit linked note
D) A credit swap
E) None of the above
Q:
Explain the concept of arbitrage.
Q:
When two banks simply agree to exchange a portion of their customers' loan repayments, they are using:
A) A credit option
B) A standby letter of credit
C) A credit linked note
D) A credit swap
E) None of the above
Q:
The firm's debt beta is usually approximately 1.0.
Q:
A bank that wants to protect itself from higher credit costs due to a decrease in its credit rating might purchase _________________________ .
A) A credit risk option
B) A standby letter of credit
C) A credit linked note
D) A credit swap
E) None of the above
Q:
The firm's asset beta is usually higher than the firm's equity beta.
Q:
A standby credit letter is a (or an):
A) Securitized strip
B) Loan strip
C) Contingent obligation
D) Indirect loan
E) None of the above.
Q:
Loan sales by banks are generally of two types: (a) participation loans; and (b)__________. The term that correctly fills in the blank above is:
A) Assignments
B) Recourse loans
C) Direct loans
D) Subscription loans
E) None of the above.
Q:
MM's proposition is violated when the firm, by imaginative design of its capital structure, can offer some financial service that meets the need of such a clientele.
Q:
Since the expected rate of return on debt is less than the expected rate of return on equity, the weighted average cost of capital declines as more debt is issued.
Q:
If a credit letter is issued to backstop payments on loan-backed securities, the credit letter is a form of:
A) Collateralized asset
B) Residual income
C) Direct loan obligation
D) Credit enhancement
E) None of the above
Q:
The difference in interest rates between securitized loans themselves and the securities issued against the loans is referred to as:
A) The funding gap
B) Residual income.
C) Service returns
D) Security income
E) None of the above
Q:
The beta of the firm is equal to the weighted average of the betas on its debt and equity under the assumption of no taxes.
Q:
By agreeing to service any assets that are packaged together in the securitization process a bank can:
A) Ensure the assets that are packaged and securitized remain in the package and are not sold off.
B) Choose the best loans to go through the securitization process.
C) Earn added fee income.
D) Liquidate any assets it chooses.
E) None of the above.
Q:
Expected return on assets depends on several factors including the firm's capital structure.
Q:
Banks that issue standby letters of credit may face which of the following types of risk?
A) Prepayment risk.
B) Interest-rate risk.
C) Liquidity risk.
D) All of the above.
E) B and C only.
Q:
Investors require higher returns on levered equity than on equivalent unlevered equity.
Q:
Financial leverage increases the expected return and risk of the shareholder.
Q:
The key advantages of issuing standby letters of credit include which of the following:
A) Letters of credit generate fee income for the bank.
B) Letters of credit typically reduce the borrower's cost of borrowing.
C) Letters of credit can usually be issued for a relatively low cost.
D) The probability is low that the issuer of the letter of credit will be called upon to pay.
E) All of the above.
Q:
According to Proposition II, the cost of equity increases as more debt is issued, but the weighted average cost of capital remains unchanged.
Q:
In some instances, a bank will sell loans and agree to give the loan purchaser recourse to the seller for all or a portion of those loans that become delinquent. In this case, the purchaser, in effect, gets a:
A) Call option.
B) Put option.
C) Forward contract.
D) Futures contract
E) None of the above.
Q:
Loan-backed securities, which closely resemble traditional bonds, carry various forms of credit enhancements, which may include all of the following, EXCEPT:
A) Credit letter guaranteeing repayment of the securities.
B) Set aside of a cash reserve.
C) Division into different risk classes.
D) Early payment clauses.
E) None of the above.
Q:
Modigliani and Miller Proposition II states that the rate of return required by the shareholders increases, steadily, as the firm's debt-equity ratio increases.
Q:
Securitization had its origin in the selling of securities backed by _____________
A) Credit card receivables
B) Residential mortgage loans
C) Computer leases
D) Automobile loans
E) Truck leases
Q:
According to Modigliani and Miller Proposition II, the rate of return required by the debt holders increases as the firm's debt-equity ratio increases.
Q:
When a bank issues a standby credit guarantee on behalf of one of its customers, the party receiving the guarantee is known as the:
A) Account party
B) Beneficiary
C) Obligator
D) Servicing agent
E) None of the above
Q:
Modigliani and Miller Proposition I states that the market value of any firm is independent of its capital structure.
Q:
The party for whom a standby credit letter is issued by a bank is known as the:
A) Account party
B) Beneficiary
C) Representative
D) Credit Guarantor
E) None of the above
Q:
The "law of conservation of value" is not applicable to the mix of debt securities.
Q:
Short-dated pieces of a longer-term loan, usually maturing in a few days or weeks, are called:
A) Loan participations
B) Servicing rights
C) Loan strips
D) Shared credits
E) None of the above
Q:
Value additivity does not hold good when assets are split up.
Q:
Securitized assets carry a unique form of risk called:
A) Default risk
B) Inflation risk
C) Interest-rate risk
D) Prepayment risk
E) None of the above
Q:
The firm's mix of long-term securities used to finance its assets is called the firm's capital structure.
Q:
Lenders can set aside a group of loans on their balance sheet, issue bonds and pledge the loans as collateral against the bonds in . These usually stay on the banks balance sheet as liabilities.
Q:
A firm's equity beta is 1.2 and its debt is risk free. Given a .7 debt to equity ratio, what is the firm's asset beta?
A. .7
B. 1.0
C. 1.2
D. 0
Q:
A firm's return on assets is estimated to be 12% and the cost of the firm's debt is 7%. Given a .7 debt to equity ratio, what is the levered cost of equity?
A. 7%
B. 12%
C. 13.6%
D. 15.5%
Q:
When the FHLMC creates CMOs they often use different which each promise a different coupon rate and which have different maturity and risk characteristics.
Q:
A(n) is an assurance that investors will be repaid in the event of the default of the underlying loans in a securitization. These can be internal or external to the securitization process and lower the risk of the securities.
Q:
According to the graph of WACC for Union Pacific, the following is (are) true:
I) cost of equity is an increasing function of the debt-equity ratio.
II) cost of debt is an increasing function of the debt-equity ratio.
III) weighted average cost of capital (WACC) is a decreasing function of the debt-equity ratio.
A. I only
B. I and II only
C. III only
D. I, II and III
Q:
A rates the securities to be sold from a pool of securitized loans so that investors have a better idea of what the new securities are likely to be worth.
Q:
Given the following data for U&P Company: Debt (D) = $100 million;
Equity (E) = $300 Million; rD = 6%; rE = 12% and TC = 30%.
Calculate the after-tax weighted average cost of capital (WACC):
A. 10.5%
B. 15%
C. 10.05%
D. 9.45%
Q:
There has been an explosion in in recent years. These instruments rest on pools of credit derivatives that mainly insure against defaults on corporate bonds. The creators of these instruments do not have to buy and pool actual bonds but can create these instruments and generate revenues from selling and trading in them.
Q:
The after-tax weighted average cost of capital (WACC) is given by: (Corporate tax rate = TC )
A. WACC = (rD)(D/V) + (rE)(E/V)
B. WACC = (rD)(D/V) +[(rE )(E/V)/(1 - TC)]
C. WACC = [(rD)(D/V) + (rE)(E/V)]/(1 - TC)
D. WACC = (rD)(1 - TC)(D/V) + (rE)(E/V)
Q:
A(n) is related to the credit option and is usually aimed at lenders able to handle comparatively limited declines in value but wants insurance against serious losses.
Q:
Minimizing the weighted average cost of capital (WACC) is the same as:
A. Maximizing the market value of the firm
B. Maximizing the book value of the firm
C. Maximizing the profits of the firm
D. Maximizing the liquidating value of the firm
Q:
If beta of debt is zero, then the relationship between equity beta and asset beta is given by:
A. equity beta = 1 + [(Beta of assets)/(debt-equity ratio)]
B. equity beta = (1 - Debt-equity ratio)(beta of assets)
C. equity beta = (1 + Debt-equity ratio)(beta of assets)
D. None of the above
Q:
Insurance companies are a prime __________ of credit derivatives.
Q:
The M & M Company is financed by $10 million in debt (market value) and $40 million in equity (market value). The cost of debt is 10% and the cost of equity is 20%. Calculate the weighted average cost of capital assuming no taxes.
A. 18%
B. 20%
C. 10%
D. None of the above
Q:
A relatively new type of credit derivative is a CDO which stands for __________________.
Q:
The M&M Company is financed by $4 million (market value) in debt and $6 million (market value) in equity. The cost of debt is 5% and the cost of equity is 10%. Calculate the weighted average cost of capital. (Assume no taxes.)
A. 10%
B. 15%
C. 8%
D. None of the above
Q:
Which of the following is true?
A. bD > bA > bE
B. bE > bA > bD
C. bA > bE > bD
D. None of the above is true
Q:
Another type of loan sale is a(n) _________________________ which is a short dated piece of a longer maturity loan, entitling the purchaser to a fraction of the expected loan income.
Q:
A(n) _________________________ is a loan sale where ownership of the loan is transferred to the buyer of the loan, who then has a direct claim against the borrower.
Q:
Generally, which of the following is true?
A. rE < rD < rA
B. rD < rA < rE
C. rE < rA < rD
D. None of the above is true
Q:
The __________________ is the bank or financial institution which guarantees the payment of the loan in a standby letter of credit.
Q:
Generally, which of the following is true? (b = beta)
A. bD < bA < bE
B. bE < bA < bD
C. bA < bE < bD
D. None of the above is true
Q:
The ________________________ is the party that is requesting a standby letter of credit.
Q:
Generally, which of the following is true?
A. rD > rA > rE
B. rE > rD > rA
C. rE > rA > rD
D. None of the above is true
Q:
A(n) _________________________ guarantees the swap parties a specific rate of return on their credit asset. Bank A may agree to pay the total return on the loan to Bank B plus any appreciation in the market value of the loan. In return Bank A will often get LIBOR plus a fixed spread plus any depreciation in the value of the loan.
Q:
The asset beta of a levered firm is 1.1. The beta of debt is 0.3. If the debt equity ratio is 0.5, what is the equity beta? (Assume no taxes.)
A. 1.5
B. 1.1
C. 0.3
D. None of the above
Q:
The _________________________ of a standby letter of credit is a bank or other investor who is concerned about the safety of funds committed to the recipient of the standby letter of credit.
Q:
The equity beta of a levered firm is 1.2. The beta of debt is 0.2. The firm's market value debt to equity ratio is 0.5. What is the asset beta if the tax rate is zero?
A. 1.2
B. 0.73
C. 0.2
D. None of the above
Q:
A(n) _________________________ combines a normal debt instrument with a credit option. It allows the issuer of the debt instrument to lower its loan repayments if some significant factor changes.
Q:
The beta of an all equity firm is 1.2. If the firm changes its capital structure to 50% debt and 50% equity using 8% debt financing, what will be the beta of the levered firm? The beta of debt is 0.2. (Assume no taxes.)
A. 1.2
B. 2.2
C. 2.4
D. None of the above
Q:
A(n) __________________ guards against the losses in the value of a credit asset. It would pay off if the asset declines significantly in value or if it completely turns bad.
Q:
For a levered firm, return on equity (rE) is equal to:
A. rE = rA
B. rE = rA + (D/E) * [rA - rB]
C. rE = rA + (D/(D + E)) [rA - rB]
D. None of the above
Q:
A(n) _________________________ occurs when two banks agree to exchange a portion or all of the loan repayments of their customers.
Q:
For a levered firm, beta of equity (bE) is equal to:
A. bE = bA
B. bE = bA + (D/E) * [bA - bD]
C. bE = bA + (D/(D + E)) [bA - bD]
D. None of the above
Q:
A(n) _________________________ is a contingent claim of the bank that issues it. The issuing bank, in return for a fee, guarantees the repayment of a loan received by its customer or the fulfillment of a contract made by its customer to a third party.
Q:
A firm has a debt-to-equity ratio of 1. Its (levered) cost of equity is 16%, and its cost of debt is 8%. If there were no taxes, what would be its cost of equity if the debt-to-equity ratio were zero?
A. 8%
B. 10%
C. 12%
D. 14%
Q:
In a _________________________ an outsider purchases part of a loan from the selling financial institution. Generally the purchaser has no influence over the terms of the loan contract.
Q:
If a firm is unlevered and has a cost of equity capital 9%, what would the cost of equity be if the firms became levered at a debt-equity ratio of 2? The expected cost of debt is 7%. (Assume no taxes.)
A. 15.0%
B. 16.0%
C. 14.5%
D. 13%