Ivan Paulinic, an analyst at a large wealth management firm, meets with his supervisor to discuss adding financial institution equity securities to client portfolios. Paulinic focuses on Vermillion Insurance (Vermillion), a property and casualty company, and Cobalt Life Insurance (Cobalt). To evaluate Vermillion further, Paulinic compiles the information presented in Exhibit 1.
Exhibit 1
Select Financial Ratios for Vermillion Insurance
Ratio | 2017 | 2016 |
Loss and loss adjustment expense | 59.1% | 61.3% |
Underwriting expense | 36.3% | 35.8% |
Combined | 95.4% | 97.1% |
Dividend | 2.8% | 2.6% |
In addition to the insurance companies, Paulinic gathers data on three national banks that meet initial selection criteria but require further review. This information is shown in Exhibits 2, 3, and 4.
Exhibit 2
Select Balance Sheet Data for National Banks—Trading: Contribution to Total Revenues
Bank | 2017 | 2013 | 2009 | 2005 |
N-bank | 4.2% | 7.0% | 10.1% | 8.9% |
R-bank | 8.3% | 9.1% | 17.0% | 7.9% |
T-bank | 5.0% | 5.0% | 11.9% | 6.8% |
Focusing on N-bank and T-bank, Paulinic prepares the following data.
Exhibit 3
2017 Select Data for N-bank and T-bank
N-bank | T-bank | ||||
2017 | 2016 | 2017 | 2016 | ||
Average daily trading VaR ($ millions) | 11.3 | 12.6 | 21.4 | 20.5 | |
Annual trading revenue/average daily trading VaR | 160× | 134× | 80× | 80× |
Paulinic investigates R-bank’s risk management practices with respect to the use of credit derivatives to enhance earnings, following the 2008 financial crisis. Exhibit 4 displays R-bank’s exposure over the last decade to credit derivatives not classified as hedges.
Exhibit 4
R-bank’s Exposure to Freestanding Credit Derivatives
Credit Derivative Balances | 2017 | 2012 | 2007 |
Notional amount ($ billions) | 13.4 | 15.5 | 305.1 |
All of the national banks under consideration primarily make long-term loans and source a significant portion of their funding from retail deposits. Paulinic and the rest of the research team note that the central bank is unwinding a long period of monetary easing as evidenced by two recent increases in the overnight funding rate. Paulinic informs his supervisor that:
Statement 1 | Given the recently reported stronger-than-anticipated macroeconomic data, there is an imminent risk that the yield curve will invert. |
Statement 2 | N-bank is very active in the 30-day reverse repurchase agreement market during times when the bank experiences significant increases in retail deposits. |
Q. Based only on Exhibit 3, Paulinic should conclude that:
- trading activities are riskier at T-bank than N-bank.
- trading revenue per unit of risk has improved more at N-bank than T-bank.
- compared with duration, the metric used is a better measure of interest rate risk.
Solution
B is correct. Trading revenue per unit of risk can be represented by the ratio of annual trading revenue to average daily trading value at risk (VaR) and represents a measure of reward-to-risk. The trading revenue per unit of risk improved at N-bank (from 134× to 160×) between 2016 and 2017, and there was no change at T-bank (80×). VaR can be used for gauging trends in intra-company risk taking.
I think “A” option should also be correct.
Option A is incorrect because we can interpret the VAR but we don’t have the net exposure on which we are taking the positions so we can’t comment about the risk involved.
Option B is correct because we have been given the ratio of Trading revenue by Trading VAR, which is Trading revenue per unit of risk, which has significantly improved for N bank from 134 to 160 which remaining constant for T bank at 80