FINC 6016 Financial Instruments and Markets

Final Exam Guide

* The final exam for FINC6016 Financial Instruments and Markets will be held on Thursday, November 13, 2014 at 1:50 pm. Please check the location for your specific exam on the Sydney Student section of the University of Sydney website. Note that there are multiple venues for the final exam due to the large class size – you may not have the same room as other students in the class. * The final exam is worth 50% of your total mark for the course. It will last for three hours, plus ten minutes reading time. You are allowed a non-alphanumeric calculator for the exam (which will be checked). Please ensure that you bring your student ID card as well. The formula sheet you will receive is attached to the end of the exam. * The exam consists of two parts * Part A: 45 Multiple Choice Questions, worth a total of 15 marks. These questions cover material from later portion of semester only (since the second multiple choice mid-term examination), but there will be obvious benefits to understanding material from earlier in the course.. * Part B: 5 short-answer questions with multiple parts, worth a total of 35 marks. These cover material mainly from the second half of the course, but an understanding of some parts of the first half of the subject would help (particularly the management of financial institutions, capital accords and the problems with Basel II, and duration gaps, duration measurement, and understanding how short-term financing affects institutions engaged in long-term lending). * To focus your study, please ensure that you have covered at least the following issues and material: * Short-term debt, medium to long-term debt. Please explore in detail the sections on Trade Credit in the lecture notes, as well as leasing, bond pricing, P-notes, Bank Accepted Bills, and other institutional details of the markets for paper. * Securitisation, and the role of the various counterparties in the transaction. What are the advantages and disadvantages of securitisation? What is the role of the Special purpose vehicle? How are the Special purpose vehicles funded? Are these really off the balance sheet of the ‘sponsoring bank?’ Understanding liquidity backstops in this context. Why had securitisation grown so much in the lead-up to the financial crisis? Why the role of credit-enhancements have been controversial? The various tranches in CDOs and how the service manager functions. Difficulties around the economic value of structured finance. Why Credit Rating Agencies are considered partially responsible for the crisis. How hard was their job? Were the overly optimistic or intentionally inaccurate due to agency problems or other reasons. * Some material on risk management. It is important that we understand the notion of operational risk, business risk, financial risk, technological risks etc and the general risk-management process. This is essentially as discussed in Pillar 2 of the Basel II capital accords, but it is probably worth a look. * Examining the financial crisis (as in, based on the lecture slides and the paper by Brunnermeier and Adrian and Shin). You should understand the process by which the housing market in the United States became overheated – as in the low interest rate environment and the how the market for lending led to many borrowers being able to obtain credit that would have previously been locked out. For example, regulations imposed by government to mandate lending to minorities, predatory lending due to mortgage originators bearing only pipeline risk, lax screening of borrowers due to the advent of securitization, regulatory arbitrage, and the growth of structured finance products all contributed to this process. * You should examine the role of credit rating agencies (the paper we discussed in class by Coval, Jurek, and Stafford might also provide you with a valuable examination of this) in the financial crisis. This builds on the ideas of “Rating at the Edge” and the fact that the credit rating agencies were paid by the issuer to rate CDOs and similar products. * Margin Spirals, Haircut Spirals, and Loss Spirals. Examine what they are and how they arise (market conditions that lead to these occurring, and what can lead to the spiral persisting). For example, why do lenders refuse to roll over short-term debt finance, or why might a financial institution need to sell of a large amount of assets at fire-sale prices in order to reduce their leverage ratio? Why is it a problem to raise equity in depressed markets? * The notion of market liquidity and funding liquidity – as in, one of the key components of the subject. How are the two related? How do we measure market liquidity (spreads, depth, resiliency) and why is this important? What leads to funding liquidity being more available or less available? How can it dry up suddenly? What is meant by precautionary hoarding, adverse selection and naïve extrapolation of volatility in this context? What measures are taken with regards to the haircuts required and how these are measured (why is common equity important in this context?) Do lenders take advantage of temporary liquidity shortfalls to purchase assets or increase their amount of lending? What is used as collateral in repo financing? * Problems that can arise due to a lack of transparency (ie. The over-the-counter derivatives problem / network and gridlock risk). How these might be overcome with centralised clearing operations – for example the complexity that arose due to counterparties being unsure of the exposures of one bank to another bank that has suffered losses. Understanding systemic risk in this context. * The run on Northern Rock (ie the lecture notes, paper by Shin and associated material available online provide useful sources). Why was Northern Rock at risk when it came to the bank run? What made it special among the UK banks? How did it grow the asset side of the balance sheet so much? How was the growth in loans funded? How did the run arise? What was ironic about seeing retail depositors lined up outside the branch? How the funding liquidity froze up, even though Northern Rock was not particularly exposed to sub-prime mortgage lending? * What are some of the lessons that we have learned in light of the financial crisis for capital requirements / market regulation? What were the failings of Basel II and proposed changes in light of this? Why is the management of liquidity and leverage important, even though it does not appear specifically in the Basel II accords (supervisory role notwithstanding). * What were some of the loopholes that were in Basel II and why capital regulation might be somewhat responsible for the financial crisis (leading to the growth in ‘originate and distribute’ models of commercial banking). Why certain firms are excluded from regulation, and why certain firms are discriminated against when it comes to capital requirements. What is the problem with procylicality in the banking sector and how this can be managed (if it can be managed)? * What are the ways that a bank can fail? Differentiate these from one another and explain how banks can carefully manage these conflicting risks. Why the regulatory role of bank supervision is both important and difficult. How we might ensure that similar financial crises will not arise. Should we allow banks to fail?

FORMULA SHEET: