Q. 1: How can you differentiate between forward and future contracts?

Explain at least
five most important differences with self-created examples (examples should not be taken
from book, internet or other student’s papers). (Marks: 5)

Forward contract Future contract

An arrangement between two parties to buy or
sell an asset (which can be of any nature) at a
pre-agreed future point in time at a specified
price.
Price fixed
Settlement is on maturity date
Low level of regulation and oversight on
settlement
Traded on Public Exchanges
Not Standardized
Difficult to terminate
Less liquid no margin payments
Example;
Farmer who harvests a certain corn and is
unsure of its price 4 months down the line. In
this case, the farmer can enter into a forward
contract with a certain third party by locking
in the price at which he would sell his corn in
the upcoming 4 months.
Contract traded on a future exchange, to buy
or sell an underlying instrument at a specific
date in the future, at a specified price.
Price Change with time
Settlement is on daily basis
Low risk of not fulfilling obligations, due to
regulation and oversight
Private contract between two parties
Standardized
Not Difficult to terminate
More liquid and requires margins
The price of petrol going up and down Since
petrol or gas is such a huge expense for so
many companies, often they don't want to
deal with the unpredictability of petrol prices,
so they'll buy futures contracts to protect
against rising prices
E.g. gold , bonds etc.

Q. 2: Explain, with the help of your own created numerical example, the concept of “Basis
risk” and the reasons for its occurrence?

“ Out of 100% , remaining risk is basis risk”

Basis Risk is a type of organized risk that arises where perfect hedging is not possible.
Explanation:
The risk that the futures price might not move in normal, steady correlation with the price of the
underlying asset, and that this variation in the basis may deny the effectiveness of a hedging
strategy employed to minimize a trader’s exposure to potential loss is basis risk. The price
difference between the cash price and the futures price may either widen or narrow.
Price in cash - Price of futures contract = Basis
Reason:
Basis risk occurs when a hedge is imperfect, so that losses in an investment are not exactly offset
by the hedge.
Example :
CDS) are often used to hedge the changes in the credit quality of a bond. But CDS prices may
not perfectly track changes in the price of the bond. 
Numerical:
As an example,
the current spot price of silver = $2290
price of gold in the May silver futures contract = $2295,
basis = $5.00.

Q. 3: Explain the concept of short hedging and long hedging in future contracts with
suitable self-created numerical examples? (Marks: 5)

Short hedge: ( sale now buy later)

Hedging strategy used by producers to fix the price of a product or commodity to be delivered
sometime in the future is the short hedge. 
Numerical:
The petrol producer can hedge with the following transactions:
Sep 17 : Short 1000 August futures contracts on petrol
sep 17: Close out futures position
Suppose spot price on sep17 proves to be $55.
Gain in futures: $59-55 = $4million.
Sales in spot market = $ 55m - Net = $55+ $4 = $59million
Effective price = $ 59 million/1 million barrels = $59/b 6

Long hedge (buy now sale later):

An investment strategy where one comprises in taking a long position in a future contract.
Numerical:
now: Take a long position in 5 sep futures contracts on zinc sep 17
Close out the position.
Suppose that the price of zinc on sep 17 = 425 cents.
Gain in futures: (4.25-4.20)*100,000= $5000
Buying cost in spot: $ 425,000 - Net outcomes: ($425,000) + 5000= (420,000)
Effective price:=420 cents per pound 9

Q. 4: What do we mean by short and long position of a financial institution in foreign

currency trading? Explain the concept while developing your own hypothetical balance
sheet of a financial institution. (Marks: 5)
“In a long (buy) position, the investor is hoping for the price to rise and in short position a
drop in the price of the security”

A long position is made when the trader buys a currency e.g  he or she will buy the base
currency which is british pound and sell counter currency which is Euro.
Short position is kept when trader sells any currency in the expectating it will depreciate. For
example, an individual selling British pounds and buying EUROS in the foreign exchange
market.

Balance sheet example :

assests Lia
U.S. loans ($) $100 U.S. CDs $200
million million
U.K. loans (£) $100
million

By selling both the pound loan principal and interest forward one year at the known forward
exchange rate at the beginning of the year, the FI could hedge itself against losses on its pound
loan position due to changes in the dollar–pound exchange rate over the succeeding year.

Q. 5: What is FX exposure of a financial institution and how it can be used to manage the
currency trading risk? Explain the concept with a self-created numerical example. (Marks:
5)

FX Risk Exposure
The risk affiliated with the rates of exchange that changes regularly and can have a negative
effect on the financial dealings denominated in some foreign currency rather than the domestic
currency.

Example:
Transaction exposure. Swiss Cruises (SC), a Swiss firm, sells cruise packages to U.S. customers
priced in USD. SC also has several U.S. suppliers that price in USD.

Explanation:
Exposure to a foreign currency can be measured by DEAR.
Formula:
Dollar loss/gain in currency i
= [Net exposure in foreign currency measured in U.S. $] × Volatility of the
 foreign exchange rate

The possibility of an investment’s value may decrease due to changes in the relative value of the
involved currencies.

Numerical:
Swiss Cruises. SC has sold cruise packages to a U.S. wholesaler for USD= 2.5 million.
SC has bought petrol for USD= 1.5 million.
T=30 days.
St = 1.45 CHF/USD.
(USD 2,500,000 - USD 1,500,000) x 1.45 CHF/USD
= CHF 1,450,000.

Numerical:

Currency Assets Liabilities FX Bought FX Sold

Euro (€) $125 000 $50 000 $10 000 $15 000
British pound (£) 50 000 22 000 15 000 20 000
Japanese yen (¥) 75 000 30 000 12 000 88 000

Net exposure in euros = (Assets + FX Bought) – (Liabilities + FX Sold) = $70 000.

If assets are greater than liabilities, an appreciation of the foreign exchange rates will generate a
gain = $70 000 x 0.01 = $7000.

Q. 6: Prepare a balance sheet of a bank and explain and calculate the following from this balance
sheet: (Marks: 5)
Tier I and Tier II
Risk weighted assets
Tier I ratio and total capital ratio

National bank balance sheet

Assets Liability
Cash 0% 20 common stock $60
Items in process 20% 10 retained earing$10
Commercial loans A rated 50% 70 preferred stock 10
Premises 100% 108 Convertible bonds 15
Commercial loans 150% 10 Subordinate bonds 15
Reserve for loans (10) PS non qualifying 15

Tier 1= 60+10+10=80
P.S= 60*1.25%=15
Tier II= 15+15+15=45
Risk weighted average= (20%*10)+(50%*70)+(100%*108)+(10*150%)=160m
Reserve for losses=160m*1.25%=2m
Tier II= 2m+45=47
Tier I= 80/160=0.5
Total tier= (80+47)/160=0.79

Explanation:
Since the minimum Tier I capital ratio required is 4 percent and the minimum risk-based capital
ratio required is 8 percent so the national bank in this example has low adequate capital under
both capital requirement formulas.

Q. 7: Use the balance sheet you prepare for question number 6, and add some amount of
loan loss reserve, long term debentures and qualifying cumulative perpetual preferred
stock in your balance sheet. Now calculate and explain that how much from the above
three categories you can use for the calculation of Tier I and Tier II capital ratios? (Marks:
4)

Assets Liability
Cash 0% 20 common stock $60
Items in process 20% 10 retained earing$10
Commercial loans A rated 50% 70 preferred stock 10
Premises 100% 108 Convertible bonds 15
Commercial loans 150% 10 Subordinate bonds 15
Reserve for loans (10) PS non qualifying 15
Tier 1= 60+10+10=80
P.S= 60*1.25%=15
Tier II= 15+15+15=45
Risk weighted average= (20%*10)+(50%*70)+(100%*108)+(10*150%)=160m
Reserve for losses=160m*1.25%=2m
Tier II= 2m+45=47
Tier I= 80/160=0.5
Total tier ratio = (80+47)/160=0.79 not well capitilize

Explanation:
 Total of Tier II is limited to 100 percent of Tier I
 Total risk based capital ratio Total capita > 8%
 Tier I core capital ratio > 4%
 Subordinated debt and intermediate-term preferred stock are limited to 50
percent of Tier I

Since the minimum Tier I capital ratio required is 4 percent and the minimum risk-based capital
ratio required is 8 percent so the national bank in this example has low adequate capital under
both capital requirement formulas.

Q. 8: Second National Bank has the following balance sheet (in millions) and risk weights:
(Marks: 8)

Cash (0%) $ 10 Deposits $60

Mortgage loans (50%) $ 40 Money market borrowing 38
Consumer loans (100%) $ 60 Subordinate debt ( 5 years) 5
Loan Loss Reserves $ 7 Equity 2
Qualifying preferred stock 5

a) What is the risk adjusted on balance sheet assets of the bank as defined under the
Basel ll or lll?
b) Does the bank have enough capital to meet the Basel requirements? If not what
minimum Tier I or total capital does it need to meet the requirement?
c) If mortgage homeowners pay back $4 million and the bank use the proceeds to build
new ATM, how this transaction affects the value of Tier l and total capital ratio?
d) If bank issues $1 million in non-qualifying perpetual stock and lends to other FI
with AAA+ credit rating, how this transaction will affect the Capital and Capital
ratios?
May be im wrong

In this question I think incomplete data was

provided to us due to which im unable to calculate
the capital ratios with reference to (book question
19)

PTO
Q. 9: NatWest bank UK has purchased a 12 million one year Euro loan that pays 12
percent interest annually. The spot rate for Euro is €1.11/₤ (British pound). NatWest
has funded this loan by accepting a US $ denominated deposit for the equivalent
amount and maturity at an annual rate of 10 percent. The current spot rate of US
dollar is ₤0.81/$. (Marks: 8)

a. What is the net interest income earned in British pounds on this one year
transaction if the spot rates at the end of the year are €1.21/₤ and ₤0.95/$?
b. What should be the US$ to ₤ spot rate in order for the bank to earn a net
interest margin of 5 percent?
c. Does your answer to part (b) imply that the British pound should appreciate or
depreciate against the US$?
d. What is the total effect on net interest income and principal of this transaction
given the end-of-year spot rates in part (a)?

PTO