What is the primary function of a bank?
To act as an intermediary in the transfer of funds between depositors and borrowers. What are the banking book and trading book?
The banking book is the bank’s portfolio of retail-related assets such as commercial loans, retail loans, mortgages and retail deposits. The trading book is the bank’s portfolio of tradable securities. How does a bank make money through the banking book?
By charging a higher rate of interest on loans than on deposits. List and briefly describe the different types of risk a bank faces. * Credit risk: The risk of loss due to a counterparty failure * Market risk: The risk of loss due to adverse movements in market rates * Operational loss: The risk of loss arising from external events or from inadequate or failed internal processes, systems or people. Also can be considered any loss not arising from credit or market risk. When was Basel I finalised, what risks did it deal with and what was its approach? Basel I was finalised in 1988. It dealt with credit risk, and involved the determination of a minimum capital requirement equal to 8% of total risk-weighted assets. When and how was Basel I amended?
Basel I was amended in 1996 to include a minimum capital requirement for market risk, based on a value at risk (VaR) calculation. What is VaR?
The maximum expected loss over a given time period at a certain confidence level. When was Basel II finalised and what were the two major differences from Basel I? Basel II was finalised in 2006. The major differences were:
* The minimum capital requirement for credit risk could be calculated using a Standardised Approach (SA) or Internal Ratings Based Approach (IRB). The SA is similar to the Basel I approach but allows for greater sensitivity to risk by using external credit ratings to determine risk-weights. With IRB, the bank uses its own calculations to determine risk-weights. * Basel II included a minimum capital requirement for operational risk Identify and briefly describe four types of financial instrument. * Debt instruments: Securities that involve interest payments * Equity instruments: Instruments representing a right to a share of the profits of the issuer * Foreign exchange instruments: Instruments which involve the exchange of funds in different currencies * Derivatives: Instruments which derive their value from the value of an underlying instrument or asset What are the four important characteristics of debt instruments? * Maturity
* Issuer credit rating
* Payment structure
What are the six important characteristics of options?
* Spot price of the underlying
* Time to maturity/expiration of the option
* Strike price
* Risk-free rate of return
* Volatility of the price of the underlying
* Whether it is a put or a call
What is the price of a call option most sensitive to?
Movements in the price of the underlying.
Identify and briefly describe six measures of market risk aside from VaR. * Basis Point Value (BPV): The change in the value of a portfolio due to a 1 basis point (0.01%) change in interest rates. It is applied to interest rate sensitive portfolios. * Delta: Change in the value of an options portfolio due to a 0.01% change in the price of the underlying. It is applied to options portfolios. * Gamma: The rate of change of delta. Applied to options portfolios. * Sensitivity analysis: The process of identifying which risk factors a portfolio is most sensitive to, by ranking them in order of their contribution to variability in the value of the portfolio. * Stress testing: The process of determining how much the value of a portfolio will change under extreme market conditions. It is usually applied by making extreme changes to the risk factors identified through sensitivity analysis. * Scenario analysis: The process of determining the impact on portfolio value of arbitrary situations that have occurred...
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