1. What risks does a bank take if it funds long-term loans with short-term deposits?

The main risk is that interest rates will rise so that, when deposits are rolled over, the bank has to pay a
higher rate of interest. The rate received on loans will not change. The result will be a reduction in the
bank’s net interest income.
When a bank funds long-term loans with short-term deposits, it exposes itself to interest rate risk. The
primary risk is that interest rates may rise by the time the short-term deposits mature and need to be
renewed. If this happens, the bank will have to offer higher interest rates to attract new deposits. However,
the interest income from the long-term loans remains fixed, as those loan agreements typically lock in rates
for the duration of the loan. This mismatch between rising funding costs and stable income reduces the
bank’s net interest margin, which is a key component of profitability. In extreme cases, if the cost of funds
exceeds the return on loans, the bank could even incur losses. Additionally, this maturity mismatch can also
impact the bank’s liquidity and stability, especially in volatile market conditions.

When a bank funds long-term loans with short-term deposits, it faces several risks, especially interest rate
risk. This is because the maturities of the bank's loans (long-term) and its deposits (short-term) don’t
match, which creates various types of risks:

1. Interest Rate Risk:

• What it is: This occurs when interest rates rise. Since the bank’s long-term loans usually have fixed
interest rates, the income from these loans doesn’t change. However, the bank’s short-term
deposits are subject to rolling over at market rates, which can rise when interest rates increase.

• Impact: As interest rates increase, the bank must pay higher interest on the short-term deposits,
but the income from its long-term loans remains the same. This reduces the bank’s net interest
income (NII), which is the difference between the interest income from loans and the interest
expense on deposits. A decrease in NII means less profit for the bank.

2. Liquidity Risk:

• What it is: Liquidity risk arises because short-term deposits need to be renewed often. If the bank
cannot attract enough new deposits or if there’s a sudden withdrawal of deposits (for example, if
depositors take out their money), the bank may not have enough cash to fund its long-term loans.

• Impact: This mismatch between the bank’s short-term funding and long-term loans creates a
situation where the bank might not be able to meet its obligations without borrowing more or
selling assets, which could be costly. A lack of liquidity can lead to financial distress and, in extreme
cases, a bankrupt.

2. Explain the terms “private placement” and “public offering.” What is the difference
between “best efforts” and “firm commitment” for a public offering?
A private placement is a new issue of securities that is sold to a small number of large institutional
investors. A public offering is a new issue of securities that is offered to the general public. In a best efforts
deal, the investment bank does as well as it can to place securities with investors, but does not guarantee
that they can be sold. In a firm commitment deal, the investment bank agrees to buy the securities from
the issuing company for a particular price and attempts to sell them in the market for a higher price.

There are a number of different types of arrangement between the investment bank and the corporation
1. Private Placement:
A company sells its securities directly to a small group of large institutional investors (like institutions or
wealthy individuals), not to the public.

Example:
A startup raises $5 million by selling shares to a few venture capital firms without going through the stock
market.

2. Public Offering:
A company offers its securities to the general public, usually through a stock exchange.

Example:
When Facebook went public in 2012, it sold shares to anyone who wanted to buy through the IPO (Initial
Public Offering).

3. Best Efforts:
An investment bank agrees to try to sell as many securities as possible but doesn’t guarantee the full
amount will be sold.

Example:
A small biotech company hires an underwriter to help raise $10 million. The underwriter tries their best but
only sells $7 million worth of shares.

4. Firm Commitment:
An investment bank agrees to buy all the securities from the company and resell them to the public—
guaranteeing the company gets all its money.

Example:
A large bank underwrites a $100 million IPO for a tech company and buys all the shares, taking the risk of
selling them later.

3. Give three examples of the conflicts of interest in a large bank. How are conflicts of
interest handled?

There are many potential conflicts of interest between commercial banking, securities services, and
investment banking when they are all conducted under the same corporate umbrella. For example:
1. When asked for advice by an investor, a bank might be tempted to recommend securities that the
investment banking part of its organization is trying to sell. When it has a fiduciary account (i.e., a customer
account where the bank can choose trades for the customer), the bank can “stuff” difficult-to-sell securities
into the account.
2. A bank, when it lends money to a company, often obtains confidential information about the company.
It might be tempted to pass that information to the mergers and acquisitions arm of the investment bank
to help it provide advice to one of its clients on potential takeover opportunities.
3. Suppose a commercial bank no longer wants a loan it has made to a company on its books because the
confidential information it has obtained from the company leads it to believe that there is an increased
chance of bankruptcy. It might be tempted to ask the investment bank to arrange a bond issue for the
company, with the proceeds being used to pay off the loan. This would have the effect of replacing its loan
with a loan made by investors who were less well-informed.
The passage explains how different parts of a large bank—like commercial banking, investment banking,
and brokerage services—can have conflicts of interest when working under the same company.
To prevent these unfair practices, banks set up "Chinese walls"—rules and systems to keep information
from flowing between departments
 Here’s a simplified summary:

Conflict of interest happens when one part of the bank acts in a way that benefits itself but may hurt
clients or other parts of the bank.

For example, the investment banking arm may want to sell certain securities, so the brokerage
recommends them to clients even if they’re not a good investment.

The commercial banking arm might use private information from loan clients to help the investment bank
advise others—this is unfair.

Or, if a bank knows a company is in trouble, it may try to push risky loans onto outside investors through
bond issues.

To prevent these unfair practices, banks set up "Chinese walls"—rules and systems to keep information
from flowing between departments.

In short: Big banks can face ethical problems when their departments share information or promote
products for self-interest. “Chinese walls” help keep things fair and separate.

4. Explain the moral hazard problems with deposit insurance. How can they be
overcome?

Moral hazard is the risk that the existence of insurance will cause the policyholder to behave differently than he or
she would without the insurance. This different behavior increases the risks and the expected payouts of the
insurance company. As a result of a government-sponsored deposit insurance plan, a bank takes more risks because
it knows that it is less likely to lose depositors because of this strategy. Insurance companies have traditionally dealt
with moral hazard in property-casualty and health insurance in a number of ways. Typically there is a deductible. This
means that the policyholder is responsible for bearing the first part of any loss. Sometimes there is a co-insurance
provision in a policy. The insurance company then pays a predetermined percentage (less than 100%) of losses in
excess of the deductible. In addition there is nearly always a policy limit (i.e., an upper limit to the payout). The effect
of these pro visions is to align the interests of the policyholder more closely with those of the insurance company

Deposit insurance makes depositors less concerned about the financial health of a bank. As a result, banks may be
able to take more risk without being in danger of losing deposits. This is an example of moral hazard. The existence of
the insurance changes the behavior of the parties involved with the result that the expected payout on the insurance
contract is higher.

For example, they could increase their deposit base by offering high rates of interest to depositors and use the funds
to make risky loans. Without deposit insurance, a bank could not follow this strategy because their depositors would
see what they were doing, decide that the bank was too risky, and withdraw their funds. With deposit insurance, it
can follow the strategy because depositors know that, if the worst happens, they are protected under FDIC.

Regulatory requirements that banks keep sufficient capital for the risks they are taking reduce their incentive to take
risks. One approach (used in the U.S.) to avoiding the moral hazard problem is to make the premiums that banks
have to pay for deposit insurance dependent on an assessment of the risks they are taking.

5. PROBLEM SOLVING: Sensitivity of bank assets to interest rates

6. Explain how CoCos bonds work. Why are they attractive to banks?
Contingent Convertible Bonds, commonly known as CoCos or Enhanced Capital Notes (ECNs), are hybrid
financial instruments that combine features of debt and equity.
They are designed to automatically convert into equity or absorb losses when a predetermined trigger
event occurs, typically related to the issuer's financial health.
How CoCo Bonds Work:
CoCo bonds are characterized by two main components:
1. Trigger Activation: This is a predefined event that initiates the conversion of the bond into equity or the
absorption of losses. Triggers can be based on specific financial metrics, such as the issuer's capital ratio
falling below a certain threshold, or they can be activated at the discretion of regulatory authorities.
2. Loss-Absorption Mechanism: Once the trigger is activated, the bond either converts into equity or its
principal is written down, thereby absorbing losses. This mechanism helps stabilize
the issuer's financial position during times of distress. The concept of CoCo bonds emerged as a tool for
crisis management in the banking industry, particularly following the 2007-2008 financial crisis.
They serve as a means for banks to bolster their capital buffers without immediate dilution of existing
shareholders.
Why CoCo Bonds Are Attractive to Banks:
CoCo bonds offer several advantages to banks:
• Regulatory Capital Compliance: CoCos can be counted towards a bank's regulatory capital requirements,
specifically Additional Tier 1 (AT1) capital, under frameworks like Basel III.
• Cost-Effective Capital: They provide a cost-effective way for banks to raise capital, as the interest
payments on CoCos are typically lower than those on traditional debt instruments, and they can be
suspended without triggering a default.
•Automatic Loss Absorption: In times of financial stress, CoCos automatically convert to equity or absorb
losses, reducing the need for external bailouts and enhancing financial stability.
• Investor Appeal: For investors, CoCos offer higher yields compared to other debt instruments,
compensating for the higher
risk associated with their loss-absorption features.
Overall, CoCo bonds serve as a strategic financial instrument for banks, balancing the need for capital
adequacy with investor returns.

Why are they attractive to banks?

CoCos bonds offer banks a strategic way to strengthen their capital base. CoCos are also cost-effective—
interest payments are lower than traditional debt and can be suspended without default. In times of
financial stress, they automatically convert to equity or absorb losses, reducing the need for government
bailouts. This loss-absorbing feature enhances financial stability while still appealing to investors
with higher yields.

7. Consider two bonds that have the same coupon, time to maturity, and price. One is a
B-rated corporate bond. The other is a CAT bond. An analysis based on historical data
shows that the expected losses on the two bonds in each year of their life is the
same. Which bond would you advise a portfolio manager to buy and why?
The CAT bond has very little systematic risk. Whether a particular type of catastrophe occurs is
independent of the return on the market. The risks in the CAT bond are to some extent diversified away by
the other investments in the portfolio. A B-rated bond does have systematic risk so that less of its risks are
diversified away. It is likely therefore that the CAT bond is a better addition to the portfolio.
CAT (catastrophe) bonds tend to carry minimal systematic risk because the occurrence of natural disasters
or other specified catastrophic events is generally uncorrelated with broader market movements. This
makes them relatively insulated from the ups and downs of the overall economy. As a result, the unique
risks associated with CAT bonds can be more easily diversified when included in a larger, well-balanced
investment portfolio. In contrast, traditional high-yield bonds, such as B-rated bonds, typically exhibit
higher levels of systematic risk, as their performance is more closely tied to macroeconomic conditions and
market fluctuations. Consequently, their risks are less easily diversified. From a portfolio construction
perspective, instruments like CAT bonds can offer valuable diversification benefits and may serve as
effective tools for enhancing risk-adjusted returns.

Both bonds have the same coupon rate, time to maturity, and price, and historical data suggests that
their expected annual losses are identical. However, the key difference lies in the type of risk they carry.
1. B-Rated Corporate Bond:
o This bond carries systematic risk, meaning its default probability is influenced by overall
economic conditions.
o If the economy enters a recession, the issuing company’s financial health may deteriorate,
increasing the likelihood of default.
o Since systematic risk cannot be diversified away, investors in the corporate bond remain
exposed to economic downturns.
2. CAT (Catastrophe) Bond:
o CAT bonds are linked to natural disasters (e.g., hurricanes, earthquakes). The probability of
these events occurring is largely independent of financial market movements.
o This means that even during a market crash, the likelihood of default on a CAT bond remains
unchanged unless a catastrophe happens.
o Because natural disasters are unrelated to the economy, the risks in a CAT bond can be
diversified away when combined with other financial assets in a portfolio.
Which Bond Is a Better Investment?
Since a B-rated corporate bond has systematic risk that cannot be diversified away, it poses a greater threat
to overall portfolio stability. In contrast, a CAT bond’s risks are largely uncorrelated with financial markets,
making it an effective way to diversify the portfolio.
For a portfolio manager focused on risk management and diversification, the CAT bond is the better choice
because:
• It reduces exposure to market downturns.
• It offers the same expected losses as the corporate bond while contributing less overall risk to the
portfolio.
Thus, even if both bonds have similar individual risk levels, the CAT bond is more attractive when
considering the overall portfolio impact.

8. What is the difference between term life insurance and whole life insurance?
Term life insurance lasts a fixed period (e.g., five years or ten years). The policyholder pays premiums. If the
policyholder dies during the life of the policy, the policyholder’s beneficiaries receive a payout equal to the principal
amount of the policy. Whole life insurance lasts for the whole life of the policyholder. The policyholder pays
premiums (usually the same each year), and the policyholder’s beneficiaries receive a payout equal to the principal
amount of the policy when the policyholder dies. There is an investment element to whole life insurance because the
premiums in early years are high relative to the expected payout in those years. (The reverse is true in later years.)
Term life insurance (sometimes referred to as temporary life insurance) lasts a predetermined number of
years. If the policyholder dies during the life of the policy, the insurance company makes a payment to the specified
beneficiaries equal to the face amount of the policy. If the policyholder does not die during the term of the policy, no
payments are made by the insurance company.

The policyholder is required to make regular monthly or annual premium payments to the insurance company for the
life of the policy or until the policyholder’s death (whichever is earlier). The face amount of the policy typically stays
the same or declines with the passage of time. One type of policy is an annual renewable term policy. In this, the
insurance company guarantees to renew the policy from one year to the next at a rate reflecting the policyholder’s
age without regard to the policyholder’s health.
A common reason for term life insurance is a mortgage. For example, a person aged 35 with a 25-year mortgage
might choose to buy 25-year term insurance (with a declining face amount) to provide dependents with the funds to
pay off the mortgage in the event of his or her death.

Whole life insurance (sometimes referred to as permanent life insurance) provides protection for the life of
the policyholder. The policyholder is required to make regular monthly or annual payments until his or her death. The
face value of the policy is then paid to the designated beneficiary.

In the case of term life insurance, there is no certainty that there will be a payout, but in the case of whole life
insurance, a payout is certain to happen providing the policyholder continues to make the agreed premium
payments. The only uncertainty is when the payout will occur. Not surprisingly, whole life insurance requires
considerably higher premiums than term life insurance policies. Usually, the payments and the face value of the
policy both remain constant through time. Policyholders can often redeem (surrender) whole life policies early or use
the policies as collateral for loans. When a policyholder wants to redeem a whole life policy early, it is sometimes the
case that an investor will buy the policy from the policyholder for more than the surrender value offered by the
insurance company. The investor will then make the premium payments and collect the face value from the
insurance company when the policyholder dies.

9. Explain the meaning of variable life insurance and universal life insurance.
Variable life insurance is whole life insurance where the policyholder can specify how the funds generated
in early years (the excess of the premiums over the actuarial cost of the insurance) are invested. There is a
minimum payout on death, but the payout can be more than the minimum if the investments do well.
Universal life insurance is whole life insurance where the premium can be reduced to a specified minimum
level without the policy lapsing. The insurance company chooses the investments (generally fixed income)
and guarantees a minimum return. If the investments do well, the return provided on the policyholder’s
death may be greater than the guaranteed minimum.
Variable Life Insurance Variable life (VL) insurance is a form of whole life insurance where the surplus
premiums discussed earlier are invested in a fund chosen by the policyholder. This could be an equity fund,
a bond fund, or a money market fund. A minimum guaranteed payout on death is usually specified, but the
payout can be more if the fund does well. Income earned from the investments can sometimes be applied
toward the premiums. The policyholder can usually switch from one fund to another at any time.

Universal Life Universal life (UL) insurance is also a form of whole life insurance. The policyholder can
reduce the premium down to a specified minimum without the policy lapsing. The surplus premiums are
invested by the insurance company in fixed income products such as bonds, mortgages, and money market
instruments. The insurance company guarantees a certain minimum return, say 4%, on these funds. The
policyholder can choose between two options. Under the first option, a fixed benefit is paid on death;
under the second option, the policyholder’s beneficiaries receive more than the fixed benefit if the
investment return is greater than the guaranteed minimum. Needless to say, premiums are lower for the
first option.

10. Explain how CAT bonds work.

The derivatives market has come up with a number of products for hedging catastrophic risk. The most
popular is a catastrophe (CAT) bond. This is a bond issued by a subsidiary of an insurance company that
pays a higher-than-normal interest rate. In exchange for the extra interest, the holder of the bond agrees to
cover payouts on a particular type of catastrophic risk that are in a certain range. Depending on the terms
of the CAT bond, the interest or principal (or both) can be used to meet claims. Suppose an insurance
company has a $70 million exposure to California earthquake losses and wants protection for losses over
$40 million. The insurance company could issue CAT bonds with a total principal of $30 million. In the event
that the insurance company’s California earthquake losses exceeded $40 million, bond holders would lose
some or all of their principal. As an alternative, the insurance company could cover the same losses by
making a much bigger bond issue where only the bondholders’ interest is at risk. Yet another alternative is
to make three separate bond issues covering losses in the range $40 to $50 million, $50 to $60 million, and
$60 to $70 million, respectively
CAT bonds typically give a high probability of an above-normal rate of interest and a low-probability of a
high loss. Why would investors be interested in such instruments? The answer is that the return on CAT
bonds, like the longevity bonds considered earlier, have no statistically significant correlations with market
returns.2 CAT bonds are therefore an attractive addition to an investor’s portfolio. Their total risk can be
completely diversified away in a large portfolio. If a CAT bond’s expected return is greater than the risk-free
interest rate (and typically it is), it has the potential to improve risk-return trade-offs.
CAT bonds (catastrophe bonds) are an alternative to reinsurance for an insurance company that has taken
on a certain catastrophic risk (e.g., the risk of a hurricane or an earthquake) and wants to get rid of it. CAT
bonds are issued by the insurance company. They provide a higher rate of interest than risk-free bonds.
However, the bondholders agree to forgo interest, and possibly principal, to meet any claims against the
insurance company that are within a prespecified range.

11.What is the difference between a defined benefit and a defined contribution pension
plan
A defined contribution plan is a plan where the contributions of each employee
(together with contributions made by the employer for that employee) are kept in a
separate account and invested for the employee. When retirement age is reached, the
accumulated amount is usually converted into an annuity. In a defined benefit plan, all
contributions for all employees are pooled and invested. Employees receive a pre-
defined pension that is based on their years of employment and final salary. At any given
time, a defined benefit plan may be in surplus or in deficit.

In a defined benefit plan, the pension that the employee will receive on retirement is
defined by the plan. Typically, it is calculated by a formula that is based on the number of
years of employment and the employee’s salary.
For example, the pension per year might equal the employee’s average earnings per year
during the last three years of employment multiplied the number of years of
employment multiplied by 2%. The employee’s spouse may continue to receive a (usually
reduced) pension if the employee dies before the spouse. In the event of the employee’s
death while still employed, a lump sum is often payable to dependents and a monthly in
come may be payable to a spouse or dependent children.

In a defined contribution plan, the employer and employee contributions are invested
on behalf of the employee. When employees retire, there are typically a number of
options open to them. The amount to which the contributions have grown can be
converted to a lifetime annuity. In some cases, the employee can opt to receive a lump
sum instead of an annuity.
 The key difference between a defined contribution and a defined benefit plan is that, in
the former, the funds are identified with individual employees. An account is set up for
each employee and the pension is calculated only from the funds contributed to that
account. By contrast, in a defined benefit plan, all contributions are pooled and
payments to retirees are made out of the pool. In the United States, a 401(k) plan is a
form of defined contribution plan where the employee elects to have some portion of
his or her income directed to the plan (with possibly some employer matching) and can
choose between a number of investment alternatives (e.g., stocks, bonds, and money
market instruments).

12. A life insurance company offers whole life and annuity contracts. In
which contracts does it have exposure to (a) longevity risk, (b) mortality
risk?
Annuity contracts have exposure to longevity risk. Life insurance contracts have exposure to
mortality risk.

A life insurance company faces different types of biometric risks depending on the type of
product it offers. These include mortality risk and longevity risk, both of which arise from
uncertainty about human lifespans.

(a) Longevity Risk – Annuity Contracts:

In annuity contracts, the life insurance company commits to making regular payments to an
individual until their death. The primary risk for the insurer in this scenario is longevity risk,
which is the risk that annuitants live longer than expected. If annuitants live significantly
beyond the mortality assumptions used in pricing the contract, the insurer will have to
continue making payments for a longer period than anticipated. This increases the total
payout and can negatively affect the profitability of the contract. As John Hull outlines, this
is a key concern in the management of life and pension portfolios because it introduces the
risk of underestimating future liabilities.

(b) Mortality Risk – Whole Life Insurance Contracts:

In whole life insurance contracts, the insurer promises to pay a death benefit upon the
policyholder’s death. The risk here is mortality risk, which is the risk that the policyholder
dies sooner than expected. If death occurs earlier than the actuarial models predicted, the
insurer must pay the death benefit earlier, potentially before sufficient premiums have been
collected to fully fund it. This results in financial loss for the insurer. As described by Hull,
this type of risk affects the insurer’s liability management and is a central component of
pricing and reserving strategies for life insurance products.

In summary:
Annuity contracts expose insurers to longevity risk (risk of policyholders living longer than
expected).Whole life insurance contracts expose insurers to mortality risk (risk of
policyholders dying sooner than expected).

13. What is the difference between an open-end and closed-end mutual fund?
An investor in a long-term mutual fund owns a certain number of shares in the fund. The
most common type of mutual fund is an open-end fund. This means that the total number
of shares outstanding goes up as investors buy more shares and down as shares are
redeemed. Mutual funds are valued at 4 p.m. each day. This involves the mutual fund
manager calculating the market value of each asset in the portfolio so that the total value of
the fund is determined. This total value is divided by the number of shares outstanding to
obtain the value of each share. The latter is referred to as the net asset value (NAV) of the
fund. Shares in the fund can be bought from the fund or sold back to the fund at any time.

Closed-end funds are like regular corporations and have a fixed number of shares
outstanding. The shares of the fund are traded on a stock exchange. For closed-end funds,
two NAVs can be calculated. One is the price at which the shares of the fund are trading.
The other is the market value of the fund’s portfolio divided by the number of shares
outstanding. The latter can be referred to as the fair market value. Usually a closed end
fund’s share price is less than its fair market value. A number of researchers have
investigated the reason for this. Research by Ross (2002) suggests that the fees paid to fund
managers provide the explanation.4

In conclusion the number of shares of an open-end mutual fund increases as investments

in the fund increase and decreases as investors withdraw their funds. A closed-end fund is
like any other corporation with a fixed number of shares that trade.

14. Problem solving: Mutual funds, capital gain

15. What is an index fund? How is it created?
An index fund is a fund that is designed so that its value tracks the performance of an
index such as the S&P500. It can be created by buying all the stocks (or a representative
subset of the stocks) that underlie the index. Sometimes futures contracts on the index are
used. Some funds are designed to track a particular equity index. The tracking can most
simply be achieved by buying all the shares in the index in amounts that reflect their
weight. For example, if IBM has 1% weight in a particular index, 1% of the tracking
portfolio for the index would be invested in IBM stock. Another way of achieving tracking
is to choose a smaller portfolio of representative shares that has been shown by research
to track the chosen portfolio closely. Yet another way is to use index futures. One of the
first index funds was launched in the United States on December 31, 1975, by John Bogle
to track the S&P 500. It started with only $11 million of assets and was initially ridiculed as
being “un-American” and “Bogle’s folly.” However, it has been hugely successful and has
been renamed the Vanguard 500 Index Fund. The assets under administration reached
$100 billion in November 1999. How accurately do index funds track the index? Two
relevant measures are the tracking error and the expense ratio. The tracking error of a
 fund can be defined as either the root mean square error of the difference between the
fund’s return per year and the index return per year or as the standard deviation of this
difference.2 The expense ratio is the fee charged per year, as a percentage of assets, for
administering the fund
An index fund is designed to track a particular equity index, such as the S&P
500 or the FTSE 100. These funds aim to replicate the performance of a specific
market index by investing in the same stocks that make up that index.
How is an Index Fund Created?
The tracking of the index can be achieved in a few different ways:
1. Full Replication:
This method involves buying all the shares in the index, with each stock
being bought in amounts proportional to its weight in the index. For example, if
a stock like IBM has a 1% weight in the index, 1% of the tracking portfolio
would be invested in IBM stock.
2. Sampling:
Another method of tracking is to select a smaller portfolio of representative
shares that have been shown, through research, to track the chosen index
closely. This approach reduces the number of stocks needed in the portfolio
while still closely following the performance of the index.
3. Using Index Futures:
An alternative method is to use index futures, which are contracts that allow
the fund to gain exposure to the index’s performance without having to buy
the underlying stocks. This approach provides a way to track the index
more efficiently.
16. What are the advantages of an exchange-traded fund over (a) an open-
end mutual fund and (b) a closed-end
An exchange-traded fund (ETF) that tracks an index is created when an
institutional investor deposits a portfolio of shares that is designed to track the
index and receives shares in the ETF. Institutional investors can at any time
exchange shares in the ETF for the underlying shares held by the ETF, or vice
versa. The advantages over an open-end mutual fund that tracks the index are
that the fund can be traded at any time, the fund can be shorted, and the fund
does not have to be partially liquidated to accommodate redemptions. The
advantage over a closed-end mutual fund is that there is very little difference
between the ETF share price and the net asset value per share of the fund.

a) An Open-End Mutual Fund?

An ETF has the following advantages over an open-end mutual fund that tracks
an index:
 1. ETFs can be traded at any time during the trading day, just like a stock.
(Open-end funds are only priced and traded once at the end of the day.)
2. ETFs can be shorted, meaning investors can profit from a decline in the
ETF’s price.
(Open-end funds usually cannot be shorted.)
3. ETFs do not need to be partially liquidated to meet redemptions.
(Open-end funds must sell assets when investors want to withdraw money,
which can affect fund performance.)

(b) A Closed-End Mutual Fund?

The key advantage of an ETF over a closed-end mutual fund is:
• ETFs trade very close to their net asset value (NAV), because institutional
investors can exchange ETF shares for the underlying assets.
(Closed-end funds can trade at significant discounts or premiums to NAV.)

17. Explain the meanings of the terms hurdle rate, high-water mark clause,
and clawback clause when used in connection with the incentive fees of
hedge funds.
Hurdle rate is the minimum return necessary for an incentive fee to be
applicable. High-water mark refers to the previous losses that must be recouped
before incentive fees are applicable. Clawback refers to investors being able to
use some of the past incentive fees they have paid as an offset to current losses.

Hurdle Rate: The hurdle rate is the minimum rate of return that a hedge fund must achieve
before it can charge an incentive fee to investors. If the fund’s performance does not exceed
this threshold, no incentive fees are earned, regardless of overall profits. This ensures that
investors only pay performance fees when returns exceed a predetermined acceptable
level.

High-Water Mark Clause: The high-water mark ensures that a hedge fund only earns
incentive fees on new profits. If the fund experiences a loss, it must first recover those
losses and surpass the previous peak value (the high-water mark) before any performance
fees can be charged again. This protects investors from paying fees on recovered losses and
aligns the interests of fund managers and investors.

Clawback Clause: A clawback clause allows for the return of previously paid incentive fees if
the fund underperforms in subsequent periods. This is typically used in private equity or
longer-term hedge fund structures to ensure that managers do not retain incentive fees if
the fund ultimately fails to deliver sustained positive performance. It serves as an investor
protection mechanism to ensure fairness over the entire investment horizon.
 18. Problem solving: Hedge funds, incentive fee
19. Please explain importance of tracking error
How accurately do index funds track the index? Two relevant measures are the tracking
error and the expense ratio. The tracking error of a fund can be defined as either the root
mean square error of the difference between the fund’s return per year and the index
return per year or as the standard deviation of this difference.
Tracking error quantifies the divergence between a portfolio’s returns and those of its
benchmark, serving as a measure of the portfolio’s active risk. Hull explains that tracking
error is crucial for assessing the effectiveness of active portfolio management strategies. A
low tracking error indicates that the portfolio closely follows its benchmark, which is typical
for passive investment strategies. Conversely, a higher tracking error suggests a significant
deviations due to active management decisions, such as security selection or market
timing.
By monitoring tracking error, investors and risk managers can evaluate whether the
additional risks taken by the returns achieved. This assessment aids in determining the
value added by active management compared to passive strategies.
In summary, Hull underscores tracking error as an essential tool for measuring active
management performance and ensuring that portfolio deviations from benchmarks are
intentional and potentially beneficial.

20. Why do you think the increase in house prices during the 2000 to 2007
period is referred to as a bubble?
There was a short-term imbalance between supply and demand because many people were
persuaded to take out mortgages that they could not afford.

The increase in house prices from 2000 to 2007 is considered a bubble because the surge
was largely driven by unsustainable and speculative factors rather than economic
fundamentals. Lenders issued risky mortgages to subprime borrowers, many of whom were
persuaded to take out loans they couldn't afford. This artificially inflated demand and drove
prices higher.

Financial innovations like mortgage-backed securities allowed lenders to pass on risk,

further fueling excessive lending. Many buyers assumed prices would keep rising, leading to
speculative purchases. When interest rates increased and defaults rose, prices collapsed,
exposing the gap between real value and inflated prices—hallmarks of a housing bubble.

1. Demand was artificially high: Many people were convinced to take out risky loans
(like subprime mortgages) that they couldn't afford. This created an artificial increase in
demand for homes, which pushed prices up.
2. Supply didn't match demand: Lenders were willing to give out loans even to those
who were unlikely to repay them, thinking home prices would keep rising and they wouldn't
lose money.
3. Unsustainable price increases: As more people took out loans they couldn’t pay back,
house prices became unrealistically high. The supply of homes was not keeping up with
demand, which caused prices to rise quickly.
4. Bubble burst: Eventually, home prices became too high for most people to afford, and
many homeowners defaulted on their loans. When this happened, demand fell sharply, and
the prices of homes crashed, causing a collapse in the market.

21. In what ways are the risks in the tranche of an ABS different from the
risks in a similarly rated bond?
Often a tranche is thin and the probability distribution of the loss is quite different from
that on the bond. If a loss occurs, there is a high probability that it will be 100%. A 100%
loss is much less likely for a bond.

Even if a tranche of an Asset-Backed Security (ABS) and a corporate bond have the same
credit rating, the risks are different. This is mainly because of the structure and size of the
tranche.
• Tranches are often thin, meaning they only absorb a small slice of losses from the
overall pool of assets.
• Because of this, the probability distribution of losses is very different from that of a
bond.
Hull explains that:
"If a loss occurs, there is a high probability that it will be 100%."
This means that:
• For a tranche, if things go wrong, it’s very likely that the entire tranche gets wiped out
(a 100% loss).
• For a similarly rated bond, a 100% loss is much less likely. Bondholders might lose
some money, but not necessarily all of it.

So, the key difference is:

Tranche = small chance of loss, but if it happens, likely to lose everything.
Bond = more gradual loss potential, total loss is rare.
Even if an ABS tranche and a corporate bond have the same credit rating, their risks
can be very different:

Loss potential: ABS tranches, especially the lower ones, can lose everything quickly if things
go wrong, while corporate bonds usually lose value more gradually.

Default linkages: ABS risk depends on how connected the underlying assets are—if many
default together, even top-rated tranches can be hit. Corporate bonds are less affected by
this kind of correlation.

Rating swings: ABS ratings can drop fast with small changes in asset performance, while
bond ratings tend to move more slowly.
Complexity: ABS structures are complicated, with layers of payments and protections, while
bonds are simpler and easier to understand.

So, the same credit rating doesn't always mean the same type or level of risk.

22.What is a waterfall in a securitization?

The waterfall defines how the interest and principal cash flows from the underlying
portfolio are distributed to the tranches. In a typical arrangement, interest cash flows are
first used to pay the most senior tranche its promised return on its outstanding principal.
The cash flows (if any) that are left over are used to provide the next most senior tranche
with its promised return on its outstanding principal, and so on. Principal cash flows are
usually used first to repay the most senior tranche, then the next most senior tranche, and
so on. The equity tranche receives principal and interest payments only when more senior
tranches have been paid.
Sure! Here's a simple and concise explanation:
A waterfall defines how the interest and principal cash flows from the underlying loan
portfolio are distributed to different tranches in a securitization.
In a typical waterfall arrangement:
• Interest cash flows are first used to pay the most senior tranche its promised return
on the amount of principal still owed.
• Any remaining interest is then used to pay the next most senior tranche, and so on.
• Principal repayments are also used first to repay the most senior tranche, then the
next, and so on.
• The equity tranche (the riskiest one) gets interest and principal payments only if all
the more senior tranches have been paid.
This structure makes sure that senior investors are protected and get paid first, while
junior tranches take losses first if the underlying loans don’t perform well.
In a waterfall structure, money from a pool of loans (interest and principal) is paid out to
investors in a specific order, from the safest to the riskiest:
1. Interest goes first to the most senior tranche (least risky), then to the next, and so on.
2. Principal repayments also go first to the senior tranche, then down the line.
3. The equity tranche (most risky) only gets paid if all the senior tranches have been fully
paid.
This setup protects senior investors and puts more risk on junior ones—they’re the first to
lose money if loans go bad.
23. Explain the influence of an increase in default correlation on (a) the risks
in the equity tranche of an ABS and (b) the risks in the senior tranches of
an ABS.
As default correlation increases, the senior tranche of an ABS becomes more risky because
it is more likely to suffer losses. The equity tranche becomes less risky as the default
correlation increases. To understand this, note that in the when there is perfect correlation
(and assuming no recoveries), all tranches have the same loss experience because either (a)
all companies default or (b) no companies default. As we move toward the perfect
correlation situation, the tranches become more similar so that the senior tranche becomes
more risky and the equity tranche becomes less risky.
Correlation. measures how two things move together. In finance, default correlation refers
to how likely it is that two or more borrowers will default at the same time.

In an Asset-Backed Security (ABS), loans are divided into tranches:

1.The senior tranche is the safest—it gets paid first and takes losses last.
2.The equity tranche is the riskiest—it takes losses first.
Now, as default correlation increases:
Defaults happen together more often.If defaults are perfectly correlated, either everyone
pays or everyone defaults.In that case, all tranches are exposed to the same risk:The senior
tranche becomes riskier because it can now suffer large losses if all borrowers default
together.The equity tranche becomes less risky because it's no longer taking frequent, small,
isolated defaults—it either loses everything or nothing, just like the other tranches.So,
higher correlation "flattens" the risk across tranches, making the senior riskier and the
equity slightly less so.
An ABS (Asset-Backed Security) is like a tower made of blocks (called tranches).
Equity tranche is at the bottom – it takes the first hit if loans go bad.Senior tranche is at the
top – it only loses money if many loans go bad.
Now, let’s talk about default correlation — it means how likely companies are to fail
together.
Low correlation = companies fail independently. A few fail here and there.
→ Only the bottom (equity) gets hit. Senior is safe.
High correlation = companies fail together. Either most survive or most fail.
→ If they all fail, even the senior gets hit.
→ If none fail, even the equity is safe.
So As correlation goes up:
The senior tranche becomes riskier (more chance it gets hit).
The equity tranche becomes safer (more chance it avoids loss).

Simple Example:
Say there are 10 companies. You invest in 3 tranches:
Equity: Takes first 3 losses
Mezzanine: Takes next 3 losses
Senior: Takes final 4 losses
Case 1: Low correlation
3 companies default (random ones)
Only equity loses → Senior is very safe

Case 2: High correlation

Either 0 or all 10 companies default together.If all default → Everyone loses, even senior.If
none default → No one loses, even equity.So, with high correlation, equity has more chance
to avoid loss, and senior has more chance to suffer loss.
 24. How is an ABS CDO created? What was the motivation to create ABS CDOS?
How is an ABS CDO created?
An ABS CDO (Asset-Backed Security Collateralized Debt Obligation) is created by taking
the mezzanine tranches (medium-risk portions) from several ABSs (which are made
from subprime mortgages) and bundling them together into a new security. This new
security is then sliced again into tranches:
Senior (AAA-rated)
Mezzanine
Equity (high-risk)

Why was it created? (Motivation)

Investors easily bought the safe (AAA-rated) tranches of regular subprime ABSs.High-
risk equity tranches were often kept by the bank or sold to hedge funds.But mezzanine
tranches were hard to sell.So, financial engineers repackaged those hard-to-sell mezzanine
tranches into new ABS CDOs to create more AAA-rated securities, making them easier to
sell to investors.

Why is this a problem?

This process stacked risk on top of risk, but still managed to produce AAA-rated
securities. It made the system look safer than it really was, contributing to the 2008
financial crisis.
25. Explain how the liquidity coverage ratio and the net stable funding ratio
are defined.
The liquidity coverage ratio (LCR) is the ratio of high-quality liquid assets to net cash outflows during a
stressed period of 30 days. The net stable funding ratio (NSFR) is the ratio of a weighted sum of the items
on the “liabilities and net worth” side of the balance sheet divided by a weighted sum of the items on the
“assets” side of the balance sheet.

1.Liquidity Coverage Ratio (LCR); and

2. Net Stable Funding Ratio (NSFR) The LCR focuses on a bank’s ability to survive a 30-day period of
liquidity disruptions. It is defined as:

The NSFR focuses on liquidity management over a period of one year. It is defined as:

1. Liquidity Coverage Ratio (LCR):

This measures a bank’s ability to handle a short-term liquidity crisis. It’s the ratio of high-quality liquid
assets (like cash or government bonds) to the bank’s expected cash outflows over the next 30 days during
stress. A higher ratio means the bank is better prepared to survive sudden cash needs.
2. Net Stable Funding Ratio (NSFR):

This measures a bank’s long-term stability. It’s the ratio of stable funding sources (like long-term deposits
and equity) to the funding needed for its assets and off-balance sheet activities. A higher ratio shows the
bank is less reliant on short-term funding and better positioned for long-term strength.

26. Problem solving: Sensitivity of bank assets to interest rates

27. Explain how an overnight indexed swap works.
An overnight indexed swap (OIS) is a swap where a fixed interest rate for a period is exchanged for the
geometric average of overnight rates during the period.The relevant overnight rates are the rates in the
government-organized interbank market where banks with excess reserves lend to banks that need to
borrow to meet their reserve requirements. In the United States, the overnight borrowing rate in this
market is known as the fed funds rate. The effective fed funds rate on a particular day is the weighted
average of the overnight rates paid by borrowing banks to lending banks on that day. This is what is used in
the OIS geometric average calculations. If during a certain period a bank borrows at the overnight rate
(rolling the loan and interest forward each day), it pays the geometric average of the overnight interest
rates for the period. Similarly, if it lends at the overnight rate every day, it receives the geometric average of
the overnight rates for the period. An OIS therefore allows overnight borrowing or lending to be swapped
for borrowing or lending at a fixed rate for a period of time. The fixed rate is referred to as the OIS rate.

28. Explain why the LIBOR-OIS spread is a measure of stress in financial

markets.
The LIBOR-OIS spread is a measure of the reluctance of banks to lend to each other.

A key indicator of stress in the banking system is the LIBOR-OIS spread. This is the amount by which the
three-month London Interbank Offered Rate (LIBOR) exceeds the three-month overnight indexed swap
(OIS) rate. As discussed, the former is the rate of interest at which a bank will extend unsecured credit to
an AA-rated bank for a term of three months. → This means the interest rate a bank charges another
highly-rated (AA-rated) bank when giving a short-term loan without any collateral. The loan period is three
months. This is known as an unsecured loan because no assets are pledged as security. The latter is the
rate of interest at which funds can be borrowed by a bank for three months by using overnight
borrowings at the fed funds rate of interest in conjunction with a swap which converts the overnight
borrowing to three-month borrowing →This is the interest rate a bank pays to borrow money for three
months. To do this, the bank first borrows money overnight at the Fed funds rate, then uses a financial tool
called a swap to turn it into a three-month loan. Banks can in theory borrow at the three-month OIS rate
and lend the funds to an AA-rated bank at the three-month LIBOR rate of interest. The LIBOR-OIS spread is
therefore a credit spread that compensates lenders for the possibility that an AA-rated bank might default
during a three-month period. In normal market conditions, the LIBOR-OIS spread is less than 10 basis
points (annualized). The larger the LIBOR-OIS spread, the greater the reluctance of banks to lend to each
other.

29. Problem solving: Bond pricing, duration calculation

 30. How are "Modified duration" and "convexity" defined?

Modified Duration

Modified duration adjusts Macaulay duration to reflect different compounding periods. When
yield y is compounded annually, divide Macaulay duration by 1+y. If interest is compounded m
times a year, divide by 1+y/m. Modified duration measures the percentage change in bond price
for a 1% change in yield.

For large yield changes, the bonds behave differently. For example bond X has more curvature in
a relationship with yields than bond Y. A factor known as convexity measures this curvature and
can be used to improve the relationship between bond prices and yields. Convexity shows how the
duration of a bond changes as interest rates change. It accounts for the fact that the price-yield
curve is not a straight line, but curved. So, while duration estimates how much a bond’s price will
change for a small change in interest rates, convexity adjusts this estimate to be more accurate for
larger rate changes.

Mathematically, Hull defines convexity (C) as:

In simple terms: higher convexity means the bond is less affected by interest rate changes, and its
price will fall less when rates rise and rise more when rates fall.

31. Problem solving: Impact of interest rate changes on bond portfolio

32. Please explain yield curve and inverted type of yield curve
In finance, the yield curve is a graph which depicts how the yields on debt instruments –
such as bonds – vary as a function of their years remaining to maturity. Typically, the graph's
horizontal or x-axis is a time line of months or years remaining to maturity, with the shortest
maturity on the left and progressively longer time periods on the right. The vertical or y-axis
depicts the annualized yield to maturity.
Those who issue and trade in forms of debt, such as loans and bonds, use yield curves to
determine their value. Shifts in the shape and slope of the yield curve are thought to be
related to investor expectations for the economy and interest rates.
 In finance, an inverted yield curve is a yield curve in which short-term debt instruments
(typically bonds) have a greater yield than longer term bonds. An inverted yield curve is an
unusual phenomenon; bonds with shorter maturities generally provide lower yields than
longer term bonds.
To determine whether the yield curve is inverted, it is a common practice to compare the
yield on the 10-year U.S. Treasury bond to either a 2-year Treasury note or a 3-
month Treasury bill. If the 10-year yield is less than the 2-year or 3-month yield, the curve is
inverted

33. Please explain yield curve and flat type of yield curve
In finance, the yield curve is a graph which depicts how the yields on debt instruments
– such as bonds – vary as a function of their years remaining to maturity. Typically, the
graph's horizontal or x-axis is a time line of months or years remaining to maturity, with
the shortest maturity on the left and progressively longer time periods on the right. The
vertical or y-axis depicts the annualized yield to maturity.
Those who issue and trade in forms of debt, such as loans and bonds, use yield curves
to determine their value. Shifts in the shape and slope of the yield curve are thought to
be related to investor expectations for the economy and interest rates.

The flat yield curve is a yield curve with little difference between short-term and long-
term rates for bonds of the same credit quality, typically Treasurys. This flattening of
what is, by definition, usually a curve is often seen during transitions between normal
and inverted curves. A normal yield curve slopes upward
A flat yield curve means investors get about the same return on short-term
investments as long-term ones. When short and long-term bonds offer very similar
yields, there is usually little benefit in holding the longer-term instrument; the investor
does not gain any more returns for the risk or opportunity costs of holding longer-term
securities.2
 For example, a flat yield curve on U.S. Treasury bonds is one in which the yield on a
two-year bond is 5% and the yield on a 30-year bond is 5.1%.
34. Please explain Value at Risk concept
Definition of Var:

Value at risk (VaR) is a measure of the risk of loss of investment/capital. It estimates how
much a set of investments might lose (with a given probability), given normal market
conditions, in a set time period such as a day. VaR is typically used by firms and regulators in
the financial industry to gauge the amount of assets needed to cover possible losses.
When using the value at risk measure, we are interested in making a statement of the
following form: “We are X percent certain that we will not lose more than V dollars in time
T.” The variable V is the VaR of the portfolio. It is a function of two parameters: the time
horizon, T, and the confidence level, X percent. It is the loss level during a time period of
length T that we are X% certain will not be exceeded. VaR can be calculated from either the
probability distribution of gains during time T or the probability distribution of losses during
time T. (In the former case, losses are negative gains; in the latter case, gains are negative
losses.) For example, when T is five days and X=97, VaR is the loss at the 3rd percentile of the
distribution of gains over the next five days. Alternatively, it is the loss at the 97th percentile
of the distribution of losses over the next five days. More generally, when the distribution of
gains is used, VaR is equal to minus the gain at the(100−X)th percentile of the distribution as
illustrated inFigure12.1. When the distribution of losses is used, VaR is equal to the loss at
the Xth percentile of the distribution as indicated inFigure12.2
 FIGURE 12.2 Calculation of VaR from the Probability Distribution of the Loss in the Portfolio Value
Gains are negative losses; confidence level is X%; VaR level is V.

35. Please explain Expected Shortfall

A measure that can produce better incentives for traders than VaR is expected short fall
(ES). This is also sometimes referred to as conditional value at risk, conditional tail
expectation, or expected tail loss. Whereas VaR asks the question: “How bad can things
get?” ES asks: “If things do get bad, what is the expected loss?” ES, like VaR, is a function of
two parameters: T (the time horizon) and X (the confidence level). It is the expected loss
during time T conditional on the loss being greater than the Xth percentile of the loss
distribution. For example, suppose that X = 99, T is 10 days, and the VaR is $64 million. The
ES is the average amount lost over a 10-day period assuming that the loss is greater than
$64 million.
Setting an ES rather than a VaR limit for traders makes it less likely that they will be able
take the sort of position indicated by Figure 12.4. Also, as shown in the next section, ES has
better properties than VaR in that it always recognizes the benefits of diversification. One
disadvantage is that it does not have the simplicity of VaR and as a result is more difficult to
understand. Another is that it is more difficult to back-test a procedure for calculating ES
than it is to back-test a procedure for calculating VaR. (Back-testing, as will be explained
later, is a way of looking at historical data to test the reliability of a particular methodology
for calculating a risk measure.)

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