Question

Question ci Global stock markets slump due to worry on global economic depression under prevalence of COVID-19. Therefore, fund companies face tremendous redemption demand from their investors. To order to meet the redemption demand, fund companies have to sell large amount of risky assets (e.g. corporate and government bonds) and commodities (e.g. gold). It leads to further drop on financial assets' prices. Meanwhile, investors demand for the U.S. dollars as a “safe heaven” in the volatile financial market. U.S. Dollar Index, representing the exchange rate of the U.S. dollars relative to other major currencies, hit the 3-year high since early 2017. Besides, it is noticed that the market is lacking loanable fund supply amid increasing risk of financial market. A global strategist in an investment bank claimed that many oil exploration companies do not have sufficient cashflow for repaying interests of the bonds issued before as they are on the edge of bankruptcy after recent tumble in oil price. Therefore, they increase their borrowings from banks for daily operation by using the existing lines of credit. Various banks are considering whether to impose constraints for lending those companies so as to control their risks. Required: (a) Identify and explain THREE risks faced by banks regarding to the use of existing lines of credit by oil exploration companies. (6 marks) (b) Some fund companies plan to forbid fund redemption requested by fund investors. Explain the rationale behind. (3 marks) (C) It is noticed that many U.S. banks have overseas operations. (i) Identify and explain briefly TWO motives for overseas expansion. (4 marks) (ii) Explain how these banks were affected by recent change on exchange rate of the U.S. dollars. (2 marks)

Answer 1

Ans a)

Risks Faced by banks regarding to use of an existing line of credit by oil exploration companies :

1. Global crash in Oil Price: Due to COVID - 19 situation demand for oil goes down drastically leading crash in oil price.
2. The recent settlement of Oil price contracts in negative prices leading to suppliers are paying buyers for the cost of holding. Uncertainty / volatility of oil price leading to in upcoming days leading to a huge loss for oil exploration companies
3. Inventories are almost full for major oil-importing countries leading very small demand generation in the future also.

Ans b)

Some companies forbid fund redemption request by fund investors because

• Fund redemption request stopped because Fund house always maintain a particular percentage of the fund as a cash reserve to manage redemption request. Most of the Funds invested incorporate or govt bonds/shares etc. If funds invested in corporate bonds those come a particular lock-in period or maturity. So if redemption requests are more than a cash / liquid reserve fund house will not be in a position to honor the request instantly. To honor this request they have to sell invested bonds in open market quite lesser price which will bring down return ratio. So during COVID - 19 situations Some companies forbid fund redemption requests by fund investors.

Ans c)

i) Motives for overseas expansion of us banks

• The higher Interest rate in the overseas market - Improve the profitability of firms.
• Being USD one of the reserve currency - US banks having advantages in facilitating international transactions and gains huge commission through that.

ii) How Banks are affected by the recent change in the exchange rate

• Volatility of exchange rates increases dramatically in recent times. Secondly future price or price related to Options/ swap market changing dramatically. Which leads to a huge fluctuation in Hedging cost.