THIS PAPER IS NOT TO BE REMOVED FROM THE EXAMINATION HALL

FN1024 ZA

BSc DEGREES AND GRADUATE DIPLOMAS IN ECONOMICS, MANAGEMENT,

FINANCE AND THE SOCIAL SCIENCES, THE DIPLOMA IN ECONOMICS AND
SOCIAL SCIENCES AND THE CERTIFICATE IN HIGHER EDUCATION IN SOCIAL
SCIENCES EXAMINATION

Principles of Banking and Finance

Friday 3 May 2019: 14:30 – 17:30

Time allowed: 3 hours

DO NOT TURN OVER UNTIL TOLD TO BEGIN

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.

A handheld calculator may be used when answering questions on this paper and it
must comply in all respects with the specification given with your Admission Notice.
The make and type of machine must be clearly stated on the front cover of the answer
book.



© University of London 2019

Page 1 of 7
UL19/0113
SECTION A

Candidates should answer ONE question and NO MORE THAN TWO further
questions from this section.

1.
(a) Explain, giving examples, the main risks affecting banks.
(10 marks)

(b) Explain the importance of capital in protecting a bank from becoming

insolvent.
(7 marks)

(c) Distinguish between reinvestment risk and refinancing risk for a bank. Give
examples of each.
(8 marks)

2. Discuss the main theories explaining why in an economy, most funds passing
from surplus units to deficit units go through financial intermediaries such as
banks.
(25 marks)

3.
(a) Describe the main functions of a financial system.
(9 marks)

(b) Distinguish between the following types of market:

(i) primary and secondary markets

(ii) exchange traded and over-the counter markets
(4 marks)

(c) An investor is considering investing in the following securities:

(i) Treasury bills – short term (money market), government debt

(ii) Corporate bonds – longer term (capital market) company debt
(iii) Common stocks – company equity with uncertain cash flow
(iv) Preferred stock – company equity with fixed cash flow

Page 2 of 7
UL19/0113
 Explain the main characteristics (including risk, return and maturity) of each
type of investment.
(12 marks)

4.
(a) Explain the risk-assets ratio underlying the Basel capital adequacy framework.
(8 marks)

(b) Discuss the problem of pro-cyclicality in capital regulation and explain how
Basel 3 aims to mitigate this.
(11 marks)

(c) Explain the differences between micro and macro prudential regulation of
banks.
(6 marks)

Page 3 of 7
UL19/0113
SECTION B

Candidates should answer ONE question and NO MORE THAN TWO further
questions from this section.

5. At the end of June 2019 a UK corporate bond has an annual coupon rate of 4%,
par (face) value of £5,000 and will mature in June 2023 (assume 4 years of
coupons). Similar UK bonds have an annual redemption yield of 5%.

(a) Using the data given above and assuming annual coupons, calculate the
value of the corporate bond.
(4 marks)

(b) Calculate the duration of the UK corporate bond assuming annual coupons.

(5 marks)

(c) Assume annual interest rates decrease by 1%. What will be the approximate
percentage change in the value of the UK bond assuming annual coupons
and annual discount rate?
(4 marks)

(d) Explain why the change in bond value, calculated in (c), is approximate.

(5 marks)

(e) Explain how interest rate risk affects bond investors.

(7 marks)

Page 4 of 7
UL19/0113
6. Consider the following information about two stocks, A and B:

Stock Expected return Standard Deviation

A 9% 6%
B 4% 2%

The correlation between the two securities returns is 0.4

(a) Calculate the expected return and standard deviation of the following three
portfolios:

Portfolio proportions (%)

Portfolio
A B
1 30 70
2 75 25
3 100 0

(5 marks)

(b) How can investors identify the best set of portfolios of common stocks? What
does ‘best’ mean?
(5 marks)

(c) Explain the impact of the correlation between securities returns on the
diversification benefits of combining securities in a portfolio (use a diagram to
illustrate).
(6 marks)

(d) Demonstrate how the introduction of a risk-free security allows us to identify

the optimal risky portfolio that all investors will choose to invest in, irrespective
of their risk preference.
(9 marks)

Page 5 of 7
UL19/0113
7. A firm is considering two investment projects, Y and Z. These projects are NOT
mutually exclusive. Assume the firm is not capital constrained. The initial costs
and cashflows for these projects are:
Y Z
0 -30,000 -25,000
1 17,000 10,000
2 17,000 10,000
3 12,000 15,000

(a) Using a discount rate of 10% calculate the net present value for each project.
What decision would you make based on your calculations?
(4 marks)

(b) How would your decision change if the discount rate used for calculating the
net present value is 20%?
(3 marks)

(c) Calculate an approximate IRR for each project. Assume the hurdle rate is
10%. What decision would you make based on your calculations?

(5 marks)

(d) Calculate the payback period for each project. The company looks to select
investment projects paying back in 2 years. What decision would you make
based on your calculations?
(2 marks)

(e) Discuss the advantages and disadvantages of the payback rule of investment
appraisal.
(4 marks)

(f) Explain the additivity property of the NPV method.

(6 marks)

Page 6 of 7
UL19/0113
8.

(a) Consider a three-factor Arbitrage Pricing Theory (APT) model for stock XYZ.

Factor Risk premium Sensitivity to each factor

Change in GDP 4% 0.5
Change in interest rate 1.5% 0.8
Change in exchange rate 2% 0.2

Assuming a risk-free rate of 4%, calculate the expected return of stock XYZ.

(4 marks)

(b) What are the assumptions of APT? What is the expected risk premium?

(11 marks)

(c) What are the main advantages/disadvantages of APT in comparison to the

CAPM?
(4 marks)

(d) Discuss the joint hypothesis problem in relation to empirically testing the
CAPM.
(6 marks)

END OF PAPER

Page 7 of 7
UL19/0113