FIN 320 STANDARD EXAM SHEET 2025/2026 QUESTIONS
AND SOLUTIONS GRADED A+ TIP
✔✔Is the Duration Gap of a typical bank positive or negative? Why? - ✔✔Positive
because most bank's main use of funds is long-term loans - their assets (mainly loans
and securities) have longer duration than their liabilities (deposits)
✔✔Positive Duration gap - ✔✔duration of banks assets is greater than duration of the
banks liabilities (increase in market interest rates = reduce the value of banks assets
more than the value of its liabilities - will decrease banks capital)
✔✔Negative Duration gap - ✔✔duration of liabilities is greater than duration of assets
✔✔Positive Duration GAP + increase in market rates= - ✔✔Bank Capital Decreases
✔✔Positive Duration GAP + decrease in market rates= - ✔✔Bank Capital Increases
✔✔Negative Duration GAP increase in market rates= - ✔✔Bank Capital Increases
✔✔Negative Duration GAP decrease in market rates= - ✔✔Bank Capital Decreases
✔✔Definition and main purpose of Derivatives - ✔✔Derivatives are an asset that
derives its economic value from an underlying asset, such as a stock or bond. They are
used to transfer risk.
✔✔Futures contracts - ✔✔Standardized contracts to buy or sell a specified amount of a
commodity or financial asset on a specific future date at a predetermined price. This
increases liquidity since the contract is standardized. Trade on exchanges, buyer or
seller of futures is trading with the exchange as the counterpart. Reduces information
costs. No payments are made initially between buyers and sellers when the contract is
agreed to.
✔✔Futures contract Settlement date/delivery date - ✔✔The prearranged future date for
the exchange is called the settlement date or the delivery date. On the settlement date
of the futures contract, the price of the futures contract must equal the price of the
underlying asset.
✔✔Underlying asset - ✔✔is the financial instrument (stocks, futures, commodity,
currency, index) on which a derivatives price is based
✔✔What happens to the price of a futures contract if the price of the underlying asset
goes up or down? - ✔✔The financial futures price moves with the market price of the
underlying financial instrument
,✔✔What is the price of a futures contract on the settlement date? - ✔✔Equals the price
of the underlying asset (today)
✔✔What are interest rate futures? What kind of interest rate futures did we use in our
example of bank hedging with futures? - ✔✔An interest rate future is a financial
derivative (a futures contract) with an interest-bearing instrument as the underlying
asset. It is a particular type of interest rate derivative. Examples include Treasury-bill
futures, Treasury-bond futures and Eurodollar futures.
✔✔Long interest rate futures and short interest rate futures positions: What are they
and how do their values change with the price and yield of the underlying asset? -
✔✔Long position- in interest rate futures contract represents a party that will buy an
interest bearing financial instrument on some future date at a prearranged price. They
benefit if the price of the underlying financial instrument increases, or if the interest rate
on the underlying financial instrument decreases.
Short position- in interest rate futures contract represents a party that will deliver (sell)
an interest-bearing financial instrument to a buyer on some future date at a
predetermined price, they benefit if the price of the underlying financial instrument
decreases, also benefit if the interest rate on the underlying financial instrument
increases.
✔✔Margin-What is it and why is it necessary? - ✔✔1. Put up money showing "skin in
the game"
- To reduce default risk, the exchange requires both the buyer and seller to place an
initial deposit called a margin requirement into a margin account (CBOT 0requires
deposits minimum of $1,100 x 100 notes instead of $1,000 x 100 notes ($110,000 face
value vs. $100,000)
✔✔Will a bank with variable-rate liabilities and fixed-rate assets hedge by being long
(buying) or short (selling) Eurodollar futures? - ✔✔Short Eurodollar futures (think price
will fall)
2. (Perfect hedge - one that eliminates all risk in a position or portfolio - buying flood
insurance because your house is prone to flooding)
- If a bank has variable-rate liabilities and fixed-rate assets, it's profits decline if interest
rates go up. That is because its interest expense (the interest it pays on deposits) goes
up, but its interest income (the interest it gets paid on loans) stays the same. So to
hedge this risk, a bank would have to enter into a futures position that benefits from a
rise in interest rates. (This way bank makes a profit on its futures position if rates
increase.) This would be a short position in an interest rate future. Since LIBOR is a
good proxy for the rate paid on bank deposits, the example in the handout has bank
taking a short position in Eurodollar futures.
✔✔Interest rate swaps - ✔✔Agreement between two counterparts to exchange periodic
interest rate payments over some future period, based on agreed amount of principal.
, ✔✔Notional principal - ✔✔Agreed amount of principal, called this because it is just used
as the basis for calculation, its not borrowed, lent, or exchanged
✔✔What is exchanged in an interest-rate swap? - ✔✔Fixed interest rate for payments
on a floating interest rate
✔✔How will a bank with variable-rate liabilities and fixed-rate assets hedge with an
interest-rate swap? Will they be a fixed-rate payer or a floating-rate payer? - ✔✔fixed
rate - To hedge a negative gap, the bank pays a fixed rate of interest out of the income
from its fixed-rate assets, and it receives a variable rate of interest which covers its
interest expense on variable-rate deposits.
✔✔Why do banks get the most regulation? - ✔✔Have the most systematic risk (market
risk - day to day fluctuation) towards the economy (our only way of accessing payment
system is through banks*)
✔✔Two reasons for government regulation of banks - ✔✔1. To help avoid a financial
crisis
2. Consumer protection
✔✔Solvency - ✔✔bank's net worth is > 0 (Assets-Liab > 0)
✔✔Insolvency - ✔✔(bank failure) bank's net worth is < 0 (Assets-Liab < 0)
✔✔Liquidity - ✔✔- bank has cash it needs to pay those who want to withdraw funds
✔✔Illiquidity - ✔✔bank does not have cash it needs to pay those who want to withdraw
funds
✔✔Current maximum deposit amount at a bank (per individual/entity) covered by FDIC
insurance - ✔✔$250,000
✔✔Advantages and disadvantages of Deposit Insurance - ✔✔Advantage of FDIC
insurance is that it helps financial stability. With FDIC insurance there are no longer
bank runs, contagion, etc. Meaning if one bank fails, people do not pull their deposits
out of other banks. As long as they are below the FDIC max insurance limit, they know
their money is safe.
- Disadvantage is moral hazard. People/banks act differently because they have
insurance/safety net. You don't investigate your bank's balance sheet for risky behavior
before choosing to bank there because FDIC protects you. The bank is able borrow lots
of money cheaply (via deposits) because FDIC insurance is available.
AND SOLUTIONS GRADED A+ TIP
✔✔Is the Duration Gap of a typical bank positive or negative? Why? - ✔✔Positive
because most bank's main use of funds is long-term loans - their assets (mainly loans
and securities) have longer duration than their liabilities (deposits)
✔✔Positive Duration gap - ✔✔duration of banks assets is greater than duration of the
banks liabilities (increase in market interest rates = reduce the value of banks assets
more than the value of its liabilities - will decrease banks capital)
✔✔Negative Duration gap - ✔✔duration of liabilities is greater than duration of assets
✔✔Positive Duration GAP + increase in market rates= - ✔✔Bank Capital Decreases
✔✔Positive Duration GAP + decrease in market rates= - ✔✔Bank Capital Increases
✔✔Negative Duration GAP increase in market rates= - ✔✔Bank Capital Increases
✔✔Negative Duration GAP decrease in market rates= - ✔✔Bank Capital Decreases
✔✔Definition and main purpose of Derivatives - ✔✔Derivatives are an asset that
derives its economic value from an underlying asset, such as a stock or bond. They are
used to transfer risk.
✔✔Futures contracts - ✔✔Standardized contracts to buy or sell a specified amount of a
commodity or financial asset on a specific future date at a predetermined price. This
increases liquidity since the contract is standardized. Trade on exchanges, buyer or
seller of futures is trading with the exchange as the counterpart. Reduces information
costs. No payments are made initially between buyers and sellers when the contract is
agreed to.
✔✔Futures contract Settlement date/delivery date - ✔✔The prearranged future date for
the exchange is called the settlement date or the delivery date. On the settlement date
of the futures contract, the price of the futures contract must equal the price of the
underlying asset.
✔✔Underlying asset - ✔✔is the financial instrument (stocks, futures, commodity,
currency, index) on which a derivatives price is based
✔✔What happens to the price of a futures contract if the price of the underlying asset
goes up or down? - ✔✔The financial futures price moves with the market price of the
underlying financial instrument
,✔✔What is the price of a futures contract on the settlement date? - ✔✔Equals the price
of the underlying asset (today)
✔✔What are interest rate futures? What kind of interest rate futures did we use in our
example of bank hedging with futures? - ✔✔An interest rate future is a financial
derivative (a futures contract) with an interest-bearing instrument as the underlying
asset. It is a particular type of interest rate derivative. Examples include Treasury-bill
futures, Treasury-bond futures and Eurodollar futures.
✔✔Long interest rate futures and short interest rate futures positions: What are they
and how do their values change with the price and yield of the underlying asset? -
✔✔Long position- in interest rate futures contract represents a party that will buy an
interest bearing financial instrument on some future date at a prearranged price. They
benefit if the price of the underlying financial instrument increases, or if the interest rate
on the underlying financial instrument decreases.
Short position- in interest rate futures contract represents a party that will deliver (sell)
an interest-bearing financial instrument to a buyer on some future date at a
predetermined price, they benefit if the price of the underlying financial instrument
decreases, also benefit if the interest rate on the underlying financial instrument
increases.
✔✔Margin-What is it and why is it necessary? - ✔✔1. Put up money showing "skin in
the game"
- To reduce default risk, the exchange requires both the buyer and seller to place an
initial deposit called a margin requirement into a margin account (CBOT 0requires
deposits minimum of $1,100 x 100 notes instead of $1,000 x 100 notes ($110,000 face
value vs. $100,000)
✔✔Will a bank with variable-rate liabilities and fixed-rate assets hedge by being long
(buying) or short (selling) Eurodollar futures? - ✔✔Short Eurodollar futures (think price
will fall)
2. (Perfect hedge - one that eliminates all risk in a position or portfolio - buying flood
insurance because your house is prone to flooding)
- If a bank has variable-rate liabilities and fixed-rate assets, it's profits decline if interest
rates go up. That is because its interest expense (the interest it pays on deposits) goes
up, but its interest income (the interest it gets paid on loans) stays the same. So to
hedge this risk, a bank would have to enter into a futures position that benefits from a
rise in interest rates. (This way bank makes a profit on its futures position if rates
increase.) This would be a short position in an interest rate future. Since LIBOR is a
good proxy for the rate paid on bank deposits, the example in the handout has bank
taking a short position in Eurodollar futures.
✔✔Interest rate swaps - ✔✔Agreement between two counterparts to exchange periodic
interest rate payments over some future period, based on agreed amount of principal.
, ✔✔Notional principal - ✔✔Agreed amount of principal, called this because it is just used
as the basis for calculation, its not borrowed, lent, or exchanged
✔✔What is exchanged in an interest-rate swap? - ✔✔Fixed interest rate for payments
on a floating interest rate
✔✔How will a bank with variable-rate liabilities and fixed-rate assets hedge with an
interest-rate swap? Will they be a fixed-rate payer or a floating-rate payer? - ✔✔fixed
rate - To hedge a negative gap, the bank pays a fixed rate of interest out of the income
from its fixed-rate assets, and it receives a variable rate of interest which covers its
interest expense on variable-rate deposits.
✔✔Why do banks get the most regulation? - ✔✔Have the most systematic risk (market
risk - day to day fluctuation) towards the economy (our only way of accessing payment
system is through banks*)
✔✔Two reasons for government regulation of banks - ✔✔1. To help avoid a financial
crisis
2. Consumer protection
✔✔Solvency - ✔✔bank's net worth is > 0 (Assets-Liab > 0)
✔✔Insolvency - ✔✔(bank failure) bank's net worth is < 0 (Assets-Liab < 0)
✔✔Liquidity - ✔✔- bank has cash it needs to pay those who want to withdraw funds
✔✔Illiquidity - ✔✔bank does not have cash it needs to pay those who want to withdraw
funds
✔✔Current maximum deposit amount at a bank (per individual/entity) covered by FDIC
insurance - ✔✔$250,000
✔✔Advantages and disadvantages of Deposit Insurance - ✔✔Advantage of FDIC
insurance is that it helps financial stability. With FDIC insurance there are no longer
bank runs, contagion, etc. Meaning if one bank fails, people do not pull their deposits
out of other banks. As long as they are below the FDIC max insurance limit, they know
their money is safe.
- Disadvantage is moral hazard. People/banks act differently because they have
insurance/safety net. You don't investigate your bank's balance sheet for risky behavior
before choosing to bank there because FDIC protects you. The bank is able borrow lots
of money cheaply (via deposits) because FDIC insurance is available.
