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Answer: The credit quality of QBCo's assets will not necessarily decrease from issuing new loans to corporations headquartered in Brazil.
## Explanation **A is correct.** The new corporate loans are collateralized by investment-grade sovereign securities. To a large extent, while sovereigns still bear some risk, they are reasonably liquid, low default risk, and are good risk mitigants. Thus, the bank's credit quality does not necessarily decrease with the issuing of new credits to local corporates. In addition, assuming the sovereign bonds used as collateral come from a number of countries, there may also be a diversification effect that will reduce QBCo's credit risk. **B is incorrect.** QBCo currently has a positive leverage-adjusted duration gap [(DA – DL)*(L/A)] = +1.0 > 0 (asset duration greater than leverage-adjusted liability duration), which poses a significant interest rate risk to the bank if interest rates rise. In that situation the bank's net worth will decline as assets will lose more value than the decrease in liabilities. To hedge the risk, the bank can shorten the duration of the assets by taking a short (not long) position in futures contracts (or options, or swaps). **C is incorrect.** There is insufficient information to determine with certainty that the trading book's VaR after the transaction will increase. We know that portfolio value will decrease (UK government bonds sold, and the proceeds are moved to the corporate loans), but we cannot determine the exact impact on VaR without knowing the specific risk characteristics of both positions. **D is incorrect.** The liquidity coverage ratio (LCR) measures the bank's ability to meet short-term liquidity needs. Since the bank is selling liquid UK government bonds and replacing them with less liquid corporate loans (even though they are collateralized), the LCR would likely decrease rather than increase.
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Quant Banking Corporation (QBCo) is a large financial institution based in Brazil. QBCo's core liquid assets include Brazil government bonds, cash, and foreign sovereign bonds. In addition to receiving deposits, QBCo raises funds by issuing secured short-term debt and unsecured long-term debt. The CRO of the bank is analyzing the investment committee's proposal to sell QBCo's holdings of UK government bonds and allocate the proceeds to extend new loans denominated in BRL to corporations headquartered in Brazil. The new loans would be held to maturity and fully collateralized by high quality foreign sovereign securities. The CRO estimates that UK government bonds currently account for approximately 15% of QBCo's total assets. The estimated mark-to-market values and average value-weighted durations of the bank's assets and liabilities before implementation of the proposal are given below:
| Market value | Average value-weighted duration | |
|---|---|---|
| Total assets | BRL 60 billion | 6 years |
| Total liabilities | BRL 50 billion | 6 years |
Assuming no change to the average value-weighted duration of assets, no other changes to QBCo's asset and liability structure, and all foreign exchange exposures are fully hedged, which of the following will be correct if the bank implements the new proposal?
A
The credit quality of QBCo's assets will not necessarily decrease from issuing new loans to corporations headquartered in Brazil.
B
QBCo should manage its leverage-adjusted duration gap by taking long positions in government bond futures to address the risk of rising interest rates.
C
The trading book VaR of QBCo will show significant increase.
D
The liquidity coverage ratio of QBCo will show significant increase.