Vce 2016-FRR Questions Latest

Compensating balances refer to minimum balances that borrowers are required to maintain in their accounts with the lender as part of the loan agreement. These balances benefit the bank by providing a stable source of funding and increasing the bank's interest rate margin and profitability. However, they do not directly influence the expected loss rate of the bank or improve capital structure by controlling obligor type and avoiding payment delays. These functions are not typically associated with compensating balances, which is why option C does not represent a benefit of compensating balances.

Adverse selection occurs when one party in a transaction has more or better information than the other party, often leading to the more informed party exploiting the situation. In this case, the bank customer chooses a mortgage with low initial payments, knowing she will have trouble making early payments. The bank, using standard default assumptions for ordinary mortgages, underestimates the risk of default, thus exposing itself to adverse selection, where the higher-risk borrowers are more likely to select this type of mortgage.

Chooser options give the holder the flexibility to decide whether the option will be a call or a put at a specific future date. This feature makes chooser options valuable in uncertain marketconditions, as the holder can choose the type of option that will be more beneficial depending on the market scenario at the decision point.

Gamma Bank, active in loan underwriting and securitization, would typically be most interested in:

Expected Loss:The anticipated average loss from defaults in the credit portfolio.

Unexpected Loss:The potential variability or deviation from the expected loss, critical for understanding the risk beyond average expectations.

Duration and factor sensitivities are more relevant to market risk rather than direct credit risk.

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