Banking & Finance: Core Concepts, Question Traps and a Worked Example
What you must understand
Candidates should be fluent in the time value of money, the distinction between nominal and effective rates, the structure of a bank balance sheet, and the role of capital and liquidity buffers. Know how the central bank's policy rate transmits through money-market rates to lending rates, and be able to explain credit risk, liquidity risk, and interest-rate risk separately. Understand the difference between a retail deposit, a wholesale funding line, and a bond issuance, and why maturity transformation creates fragility.
Traps that appear in questions
- APR versus effective annual rate. Questions often quote a nominal rate compounded monthly and ask for the true annual cost. Always convert: effective rate = (1 + i/n)^n - 1.
- Real versus nominal returns. If inflation is given, the real return is approximately nominal minus inflation, but the exact Fisher relationship is (1 + nominal) / (1 + inflation) - 1.
- Present value of an annuity due versus an ordinary annuity. Payments at the start of each period are worth more by one period of interest.
- Confusing capital with liquidity. Capital absorbs losses; liquidity meets cash outflows. A bank can be well capitalised and still fail on liquidity.
- Sign conventions in cash-flow questions. Inflows positive, outflows negative, applied consistently.
Worked example
A client borrows 20,000 at a nominal 12% per year compounded monthly, repaid over 24 equal monthly instalments. The monthly rate is 0.12/12 = 1%. The annuity factor is [1 - (1.01)^-24] / 0.01. Since (1.01)^24 is about 1.2697, the factor is (1 - 0.7876)/0.01 = 21.24. The instalment is 20,000 / 21.24, roughly 941.62 per month. The trap is quoting the total repaid (about 22,599) as if it were the cost; the true effective annual rate is (1.01)^12 - 1, about 12.68%, not 12%.
Rule of thumb
When a rate is quoted with a compounding frequency other than annual, convert to the effective annual rate before comparing products or answering cost questions.