MGT411 Final Term Solved Subjective by Dua

Q43. What is the source of Trading risk, Credit risk and Liquidity risk? (3 marks)

Liquidity risk is the risk of a sudden demand for funds and it can come from both sides of a bank’s balance sheet (deposit withdrawal on one side and the funds needed for its off-balance sheet activities on the liabilities side If a bank cannot meet customers’ requests for immediate funds it runs the risk of failure; even with a positive net worth, illiquidity can drive it out of business

Trading risk:

Banks today hire traders to actively buy and sell securities, loans, and derivatives using a portion of the bank’s capital in the hope of making additional profits However, trading such instruments is risky (the price may go down instead of up); this is called trading risk or market risk Managing trading risk is a major concern for today’s banks, and bank risk managers place limits on the amount of risk any individual trader is allowed to assume Banks also need to hold more capital if there is more risk in their portfolio

Credit risk

This is the risk that loans will not be repaid and it can be managed through diversification and Credit-risk analysis Credit-risk analysis produces information that is very similar to the bond-rating systems and is done using a combination of statistical models and information specific to the loan applicant

Q44. "Monetary policy can be used to stabilize economy" Discuss (3 marks)

Monetary policy Control over the money supply and interest rates by a central bank or monetary authority to stabilize business cycles, reduce unemployment and inflation, and promote economic growth. Stability exists when fluctuations in prices, production, and employment have been eliminated. While stability for all aspects of the economy are important, monetary policy tends to be most concerned with price stability, that is, keeping the price level in check and eliminating inflation. Inflation erodes the purchasing power of financial wealth

Q45. Give an account of different components of aggregate demand? (3 marks)

Aggregate demand is divided into four components:

1. Consumption:

Consumption decisions often rely on borrowing, and the alternative to consumption is saving (Higher rates mean more saving).

2. Investment: · 3. Government purchases: · 4. Net exports:

As for net exports, when the real interest rate in a country rises, her financial assets become attractive to foreigners, causing local currency to appreciate, which in turn means more imports and fewer exports (lower net exports)

Aggregate Govt.’s Net Demand = Consumption + Investment + Purchases + Exports

Q46. Differentiate between the Foreign exchange risk and the Sovereign risk. (5 marks)

Foreign exchange risk

(The risk from unfavorable moves in the exchange rate) Banks manage their foreign exchange risk by attracting deposits denominated in the same currency as the loans and by using foreign exchange futures and swaps to hedge the risk

Sovereign risk

(The risk from a government prohibiting the repayment of loans) Banks manage sovereign risk by diversification, by refusing to do business in a particular country or set of countries, and by using derivatives to hedge the risk

Q47. Central bank can control the size of the monetary base. What are central bank monetary policy tools? Name them. (5 marks)

Central bank controls the quantity of reserves that commercial banks hold. Besides the quantity of reserves, the central bank can control either the size of the monetary base or the price of its components. The central bank has three monetary policy tools, or instruments:

What is it? Interest rate charged on overnight loans between banks How is it controlled? Supply of reserves adjusted through open market operations to meet expected demand at the target rate What is its impact? Changes interest rates throughout the economy

The discount rate:

What is it? Interest rate charged by the central bank on loans to commercial banks How is it controlled? Set as a premium over the target federal funds rate What is its impact? Provides short-term liquidity to bank in times of crisis and aids in controlling the federal funds rate

The reserve requirement:

Q43. Write down the categories of assets in the balance sheet of commercial banks. (3 marks)

1. Cash Items

2. Reserves

Includes cash in the bank’s vault and its deposits at the central bank Cash items in the process of collections Uncollected funds the bank expects to receive The balances of accounts that banks hold at other banks (correspondent banking) Because cash earns no interest, it has a high opportunity cost. So banks minimize the amount of cash holding

3. Cash items in process of collection · 4. Vault cash · 5. Securities

Stocks T-Bills Government and corporate bonds Securities are sometimes called secondary reserves because they are highly liquid and can be sold quickly if the bank needs cash

6. Secondary reserves

7. Loans

The primary asset of modern commercial banks; Business loans (commercial and industrial loans), Real estate loans, Consumer loans, Inter-bank loans, Loans for the purchase of other securities The primary difference among the various types of depository institutions is in the composition of their loan portfolios Commercial banks make loans primarily to business Savings and loans provide mortgages to individuals Credit unions specialize in consumer loans

Q44. How Central banks link tools to meet their objectives? (3 marks)

Central bank holds the capacity to force the market federal funds rate to equal the target rate all the time by participating directly in the market for overnight reserves, both as a