Section 1: Multiple Choice Questions.

1. The repricing gap approach calculates the gaps in each maturity bucket by subtracting the
a. current assets from the current liabilities.
b. long term liabilities from the fixed assets.
c. rate sensitive assets from the total assets.
d. rate sensitive liabilities from the rate sensitive assets.
e. current liabilities from tangible assets.
2. Which of the following statements is true?
a. An increase in interest rates leads to an increase in the market value of financial
securities.
b. Value of longer term securities decreases at a diminishing rate for increases in interest
rates.
c. Value of longer term securities increases at an increasing rate for any decline in
interest rates.
d. The shorter the maturity of a fixed income asset or liability, the greater the fall in
market value for any given interest rate increase.
e. The longer the maturity of a fixed income asset or liability, the greater the fall in
market value for any given interest rate decrease.
3. A positive repricing gap implies that an increase in interest rates will cause
interest income.
a. no change

in net

b. a decrease
c. an increase
d. an unpredictable change
e. Either A or B.
4. If interest rates decrease 50 basis points for an FI that has a gap of +$5 million, the expected
change in net interest income is
a. + $2,500. b. +
$25,000.
c. + $250,000. d. $250,000.
e. - $25,000.
5. Can an FI immunize itself against interest rate risk exposure even though its maturity gap is not
zero?

a. Yes, because with a maturity gap of zero the change in the market value of assets
exactly offsets the change in the market value of liabilities.
b. No, because with a maturity gap of zero the change in the market value of assets
exactly offsets the change in the market value of liabilities.
c. Yes, because the maturity model does not consider the timing of cash flows.
d. No, because the timing of cash flows is relevant to immunization against interest rate
risk exposure.
e. No, because a representative bank will always have a positive maturity gap.
6. Which of the following is indicated by high numerical value of the duration of an asset?
a. Low sensitivity of an asset price to interest rate shocks.
b. High interest inelasticity of a bond.
c. High sensitivity of an asset price to interest rate shocks.
d. Lack of sensitivity of an asset price to interest rate shocks.
e. Smaller capital loss for a given change in interest rates.
7. Immunizing the balance sheet to protect equity holders from the effects of interest rate risk
occurs when
a. the maturity gap is zero.
b. the repricing gap is zero.
c. the duration gap is zero.
d. the effect of a change in the level of interest rates on the value of the assets of
the FI is exactly offset by the effect of the same change in interest rates on the
liabilities of the FI.
e. after-the-fact analysis demonstrates that immunization coincidentally occurred.

Section 2: Quantitative problems. You MUST show your work in this

section
1. Consider a six-year, $1,000 par value, zero-coupon bond yielding 8 percent.
a. What is the duration of this bond?

6 years
b. If interest rates increase to 9 percent, what is the amount of error (Pduration Pmarket) in
the price estimate using the duration relationship versus the true bond price
determined in the market?

-$1.11
c. What is the convexity factor (CX) for this bond?

36
d. What is the change in price caused by convexity in the duration-convexity model
for an interest rate increase to 9 percent?

$1.134
2. City bank has six-year zero coupon bonds with a total face value of $20 million.
The current market yield on the bonds is 10 percent.
a. What is the modified duration of these bonds?

5.45 years

b. What is the price volatility if the maximum potential adverse move in yields is
estimated at 20 basis points?

-1.09%
c. What is the daily earnings at risk (DEAR) of this bond portfolio?

-$123,055.32
d. What is the 10-day VAR assuming the daily returns are independently distributed?

-$389,135.09

3. The following represents two yield curves.

Maturit
y

Pure

B-rated Corporate Bond

Discount

Yields (Pure Discount

1 year

Treasury
3 percent

Bonds)
6 percent

2 year

6 percent

10 percent

20 year

12 percent

17 percent

a. What is the implied probability of repayment on one-year B-rated debt?

97.17 percent
b. What rate is expected on a one-year B-rated corporate bond in one year? (Hint: Use
the implied forward rate.)

14.15 percent
c. What spread is expected between the one-year maturity B-rated bond and the oneyear Treasury bond in one year?

5.06 percent
d. What is the expected probability of default in year 2 of two-year maturity B-rated
debt?

4.43 percent
e. What is the probability that two-year B-rated corporate debt will be fully repaid?

92.9 percent

Section 3: Short Answer Questions.

1. Explain under what conditions and for what types of fixed income products duration may
be an inadequate immunization tool.

2. When and why did weaknesses arise in the U.S. financial system in the period leading up
to 2008?