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Chapter 07 - Risks of Financial Institutions

Chapter Seven
Risks of Financial Institutions
True/False
7-1 Because the economies of the U.S. and other overseas countries have become more
integrated, the risks of financial intermediation have decreased.
Answer: F

7-2 Interest rate risk stems from the impact of both anticipated and unanticipated changes in
interest rates on FI profitability.
Answer: F

7-3 An FI is short-funded when the maturity of its liabilities is less than the maturity of its
assets.
Answer: T

7-4 An FI is exposed to reinvestment risk by holding longer-term assets relative to liabilities.


Answer: F

7-5 An FI that is short-funded faces the risk that the return of reinvesting assets could exceed
the cost of funding those assets.
Answer: F

7-6 Exactly matching the maturities of assets and liabilities will provide a perfect hedge
against interest rate risk for an FI.
Answer: F

7-7 Matching the maturities of assets and liabilities supports the asset transformation function
of FIs.
Answer: F

7-8 Funding a portion of assets with equity capital means that hedging risk does not require
perfect matching of the assets and liabilities.
Answer: T

7-9 Active trading of assets and liabilities creates market risk.


Answer: T

7-10 FIs typically are concerned about the value at risk of their trading portfolios.
Answer: T
7-1
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Chapter 07 - Risks of Financial Institutions

7-11 Market risk is present whenever an FI takes an open position and prices change in a
direction opposite to that expected.
Answer: T

7-12 FIs that make loans or buy bonds with long maturity liabilities are more exposed to
interest rate risk than FIs that make loans or buy bonds with short maturity liabilities.
Answer: F

7-13 The relationship of a limited or fixed upside return with a high probability and the
potential large downside loss with a small probability is an example of an asset’s credit
risk to an FI.
Answer: T

7-14 Credit risk stems from non-repayment or delays in repayment of either principal or
interest on FI assets.
Answer: T

7-15 Credit risk exposes the lender to the uncertainty that only interest payments may not be
received.
Answer: F

7-16 In the case where a borrower defaults on a loan, the FI may lose only a portion of the
interest payments and a portion of the principal that was loaned.
Answer: T

7-17 Historically credit card loans have had very low rates of default or credit risk when
compared to other assets that an FI may hold.
Answer: F

7-18 One method of guarding against credit risk is to assess a risk premium based on the
estimate of default risk exposure that a borrower carries.
Answer: T

7-19 Managerial monitoring efficiency and credit risk management strategies affect the shape
of the risk of the loan return distribution.
Answer: T

7-2
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Chapter 07 - Risks of Financial Institutions

7-20 Individuals have an advantage over FIs in that individuals more easily can diversify away
some of the credit risk of their asset portfolios.
Answer: F

7-21 Similar to loans, non-government bonds expose a lender to principal payment default
risk.
Answer: T

7-22 Effective use of diversification principles allows an FI to reduce the total default risk in a
portfolio.
Answer: T

7-23 Firm-specific credit risk can be eliminated by diversification.


Answer: F

7-24 Systematic credit risk can be reduced significantly by diversification.


Answer: F

7-25 An off-balance-sheet activity does not appear on the current balance sheet because it does
not involve holding a current primary claim or the issuance of a current secondary claim.
Answer: T

7-26 Off-balance-sheet risk occurs because of activities that do not appear on the balance
sheet.
Answer: T

7-27 Off-balance-sheet activities often affect the shape of an FIs current balance sheet through
the creation of contingent claims.
Answer: F

7-28 Contingent claims are assets and liabilities that will come into existence at a future time
often at the insistence of a customer or second party.
Answer: T

7-29 Off-balance-sheet activities have become an important source of fee income, even though
losses on these activities can cause a financial institution to fail.
Answer: T

7-3
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Chapter 07 - Risks of Financial Institutions

7-30 The objective of technological expansion is to achieve economies of scale at the expense
of diseconomies of scope.
Answer: F

7-31 Technology risk is the uncertainty that economies of scale or scope will be realized from
the investment in new technologies.
Answer: T

7-32 The mergers of Citicorp with Travelers Insurance is an example of an attempt to exploit
economies of scope.
Answer: T

7-33 Economies of scope involve the ability to lower the average cost of operations by
expanding the output of financial services.
Answer: F

7-34 Employee fraud is a type of operational risk to a financial institution.


Answer: T

7-35 The risk that a computer system may malfunction during the processing of data is an
example of operational risk.
Answer: T

7-36 Direct foreign investment and foreign portfolio investment both can be beneficial to an FI
because of imperfectly correlated returns with domestic investments.
Answer: T

7-37 Returns from domestic and foreign investments may not be perfectly correlated because
of different economic infrastructures and growth rates.
Answer: T

7-38 Foreign exchange risk is that the value of assets and liabilities may change because of
changes in the foreign exchange rate between two countries.
Answer: T

7-39 Foreign exchange risk is that the value of assets and liabilities may change because of
changes in the level of interest rates.
Answer: F
7-4
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Chapter 07 - Risks of Financial Institutions

7-40 Foreign exchange risk includes interest rate risk and credit risk as well as changes in the
foreign exchange rate between two countries.
Answer: F

7-41 An FI can hold assets denominated in a foreign country, but it cannot issue foreign
liabilities.
Answer: F

7-42 An FI is net long in foreign assets if it holds more foreign liabilities than foreign assets.
Answer: F

7-43 For an FI to exactly hedge the foreign investment risk, the foreign currency assets must
equal the foreign currency liabilities.
Answer: F

7-44 To be immunized against foreign currency and foreign interest rate risk, an FI should
match both the size and maturities of its foreign assets and foreign liabilities.
Answer: T

7-45 Sovereign risk involves the inability of a foreign corporation to repay the principal or
interest on a loan because of stipulations by the foreign government that are out of the
control of the foreign corporation.
Answer: T

7-46 Control of the future supply of funds available to a foreign country is one method to
ensure the repayment of an existing debt.
Answer: T

7-47 Unanticipated withdrawals by liability holders are a major part of liquidity risk.
Answer: T

7-48 A natural consequence of the effects of realized liquidity risk across several institutions is
the ability to recognize capital gains on the sale of assets in the attempt to generate cash.
Answer: F

7-49 During a liquidity crisis assets normally must be sold at a loss because of the rising
interest rates caused by financial institutions attempting to raise funds.
7-5
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Chapter 07 - Risks of Financial Institutions

Answer: T

7-50 A lower level of equity capital increases the risk of insolvency to a financial institution.
Answer: T

7-51 Many of the various risks faced by an FI often are interrelated with each other.
Answer: T

7-52 Event risks often cause sudden and unanticipated changes in financial market conditions.
Answer: T

7-53 General macroeconomic risks may affect all risks of a financial institution.
Answer: T

7-54 Foreign exchange rate risk occurs because foreign exchange rates are volatile and can
impact banks with exposed foreign assets and/or liabilities.
Answer: T
Multiple-Choice

7-55 Holding corporate bonds with fixed interest rates involves


a. default risk only.
b. interest rate risk only.
c. liquidity risk and interest rate risk only.
d. default risk and interest rate risk.
e. default and liquidity risk only.
Answer: D

7-56 Regulation limits FI investment in non-investment grade bonds (rated below Baa or non-
rated).What kind of risk is this designed to limit?
a. Liquidity risk.
b. Interest rate risk.
c. Credit risk.
d. Foreign exchange rate risk.
e. Off-balance sheet risk.
Answer: C

7-57 What type of risk focuses upon mismatched asset and liability maturities and durations?
7-6
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Chapter 07 - Risks of Financial Institutions

a. Liquidity risk.
b. Interest rate risk.
c. Credit risk.
d. Foreign exchange rate risk.
e. Off-balance sheet risk.
Answer: B

7-58 The asset transformation function potentially exposes the FI to


a. foreign exchange risk.
b. technology risk
c. operational risk
d. trading risk
e. interest rate risk.
Answer: E

7-59 Which function of an FI involves buying primary securities and issuing secondary
securities?
a. Brokerage.
b. Asset transformation.
c. Investment research.
d. Self-regulator.
e. Trading.
Answer: B

7-60 What type of risk focuses upon mismatched currency positions?


a. Liquidity risk.
b. Interest rate risk.
c. Credit risk.
d. Foreign exchange rate risk.
e. Off-balance sheet risk.
Answer: D

7-61 What type of risk focuses upon future contingencies?

a. Liquidity risk.
b. Interest rate risk.
c. Credit risk.
d. Foreign exchange rate risk.
e. Off-balance sheet risk.
7-7
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Chapter 07 - Risks of Financial Institutions

Answer: E

7-62 If the loans in the bank's portfolio are all negatively correlated, what will be the impact
on the bank's credit risk exposure?
a. The loans' negative correlations will decrease the bank's credit risk exposure
because lower than expected returns on some loans will be offset by higher than
expected returns on other loans.
b. The loans' negative correlations will increase the bank's credit risk exposure
because lower than expected returns on some loans will be offset by higher than
expected returns on other loans.
c. The loans' negative correlations will increase the bank's credit risk exposure
because higher returns on less risky loans will be offset by lower returns on riskier
loans.
d. The loans' negative correlations will decrease the bank's credit risk exposure
because higher returns on less risky loans will be offset by lower returns on riskier
loans.
e. There is no impact on the bank's credit risk exposure.
Answer: A

7-63 A mortgage loan officer is found to have provided false documentation that resulted in a
lower interest rate on a loan approved for one of her friends. The loan was subsequently
added to a loan pool, securitized and sold. Which of the following risks applies to the
false documentation by the employee?
a. Market risk.
b. Credit risk.
c. Operational risk.
d. Technological risk.
e. Sovereign risk.
Answer: C

7-64 A small local bank failed because a housing market collapse following the departure of
the areas largest employer. What type of risk applies to the failure of the institution?
a. Firm-specific risk.
b. Technological risk.
c. Operational risk.
d. Sovereign risk.
e. Insolvency risk.
Answer: E

7-8
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Chapter 07 - Risks of Financial Institutions

7-65 The risk that a German investor who purchases British bonds will lose money when
trying to convert bond interest payments made in pounds sterling into euros is called
a. liquidity risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange rate risk.
e. off-balance-sheet risk.
Answer: D

7-66 An FI that finances long-term fixed rate mortgages with short-term deposits is exposed to
a. increases in net interest income and decreases in the market value of equity when
interest rates fall.
b. decreases in net interest income and decreases in the market value of equity when
interest rates fall.
c. decreases in net interest income and decreases in the market value of equity when
interest rates rise.
d. increases in net interest income and decreases in the market value of equity when
interest rates rise.
e. increases in net interest income and increases in the market value of equity when
interest rates rise.
Answer: C

7-67 The risk that an investor will be forced to place earnings from a loan or security into a
lower yielding investment is known as
a. liquidity risk.
b. reinvestment risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: B

7-68 Matching the book is intended to protect the FI from


a. liquidity risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: B
7-9
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Chapter 07 - Risks of Financial Institutions

7-69 When the assets and liabilities of an FI are not equal in size, efficient hedging of interest
rate risk can be achieved by
a. increasing the duration of assets and increasing the duration of equity.
b. issuing more equity and reducing the amount of borrowed funds.

c. not exactly matching the maturities of assets and liabilities.


d. issuing more equity and investing the funds in higher-yielding assets.
e. efficient hedging cannot be achieved without the use of derivative securities.
Answer: C

7-70 Unanticipated diseconomies of scope are a result of


a. technology risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: A

7-71 An FI that finances a euro loan with U.S. dollar deposits is exposed to
a. technology risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: D

7-72 Matching the foreign currency book does not protect the FI from
a. sovereign country risk.
b. interest rate risk.
c. liquidity risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: A

7-73 The potential exercise of unanticipated contingencies can result in


a. technology risk.
b. interest rate risk.
c. credit risk.
7-10
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Chapter 07 - Risks of Financial Institutions

d. foreign exchange risk.


e. off-balance-sheet risk.
Answer: E

7-74 The asymmetric return distribution on risky debt exposes the FI to


a. technology risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: C

7-75 The major source of risk exposure resulting from issuance of standby letters of credit is
a. technology risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: E

7-76 Politically motivated limitations on payments of foreign currency may expose an FI to


a. sovereign country risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: A

7-77 The risk that a debt security's price will fall, subjecting the investor to a potential capital
loss is
a. credit risk.
b. political risk.
c. currency risk.
d. liquidity risk.
e. market risk.
Answer: E

7-78 The risk that interest income will increase at a slower rate than interest expense is
7-11
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Chapter 07 - Risks of Financial Institutions

a. credit risk.
b. political risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: E

7-79 The risk that borrowers are unable to repay their loans on time is
a. credit risk.
b. sovereign risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: A

7-80 The risk that many borrowers in a particular country fail to repay their loans is
a. credit risk.

b. sovereign risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: B

7-81 The risk that many depositors withdraw their funds at once is
a. credit risk.
b. sovereign risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: D

7-82 The risk that foreign governments may devalue their exchange rates is:
a. credit risk.
b. sovereign risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: C
7-12
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Chapter 07 - Risks of Financial Institutions

7-83 As commercial banks move from their traditional banking activities of deposit taking and
lending and shift more of their activities to trading, they are more subject to
a. credit risk.
b. market risk.
c. political risk.
d. sovereign risk.
e. liquidity risk.
Answer: B

7-84 An advantage FIs have over individual household investors is that they are able to
diversify away credit risk by holding a large portfolio of loans to different entities. This
reduces
a. firm-specific credit risk.
b. systematic credit risk.
c. interest rate risk.
d. market risk.
e. political risk.
Answer: A

7-85 A U.S. bank has €40 million in assets and €50 million in CDs. All other assets and
liabilities are in U.S. dollars. This bank is
a. net long €10 million.

b. net short €10 million.


c. neither short nor long in €.
d. net long -€10 million.
e. net short -€10 million.
Answer: B

7-86 Risk management for financial intermediaries deals with


a. controlling the overall size of the institution.
b. controlling the scope of the institution's activities.
c. limiting the geographic spread of the institution's offices.
d. limiting the mismatches on the institution's balance sheet.
e. complying scrupulously with all government regulations.
Answer: D

7-87 The U.S. dollar's decline against European currencies is


7-13
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Chapter 07 - Risks of Financial Institutions

a. potentially harmful for European banks only.


b. potentially harmful for U.S. banks only.
c. potentially harmful for those banks that have financed U.S. dollar assets with
liabilities denominated in European currencies.
d. potentially harmful for those banks that have financed European currency assets
with U.S. dollar liabilities.
e. irrelevant for global banks.
Answer: C

7-88 In which of the following situations would an FI be considered net long in foreign assets
if it has ¥100 million in loans?
a. ¥120 million in liabilities.
b. ¥80 million in liabilities.
c. ¥100 million in liabilities.
d. ¥110 million in liabilities.
e. Answers A and D only.
Answer: B

7-89 With regard to market value risk, rising interest rates


a. increase the value of fixed rate liabilities.
b. increase the value of fixed rate assets.
c. increase the value of variable-rate assets.
d. decrease the value of fixed rate liabilities.
e. decrease the value of variable-rate assets.
Answer: D

7-90 Which of the following situations pose a refinancing risk for an FI?
a. An FI issues $10 million of liabilities of one-year maturity to finance the purchase
of $10 million of assets with a two-year maturity.

b. An FI issues $10 million of liabilities of two-year maturity to finance the purchase


of $10 million of assets with a two-year maturity.
c. An FI issues $10 million of liabilities of three-year maturity to finance the
purchase of $10 million of assets with a two-year maturity.
d. An FI matches the maturity of its assets and liabilities.
e. All of the above.
Answer: A

7-14
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Chapter 07 - Risks of Financial Institutions

7-91 Which term refers to the risk that the cost of rolling over or re-borrowing funds will rise
above the returns being earned on asset investments?
a. Reinvestment risk.
b. Credit risk.
c. Refinancing risk.
d. Liquidity risk.
e. Sovereign risk.
Answer: C

7-92 Which term refers to the risk that interest income will decrease as maturing assets are
replaced with new, more current assets?
a. Credit risk.
b. Refinancing risk.
c. Reinvestment risk.
d. Liquidity risk.
e. Sovereign risk.
Answer: C

7-93 Which of the following would you typically find in the trading portfolio of an FI?
a. Cash, loans, and deposits.
b. Premises and equipment.
c. Relatively illiquid assets.
d. Assets held for long holding periods.
e. Bonds, equities, and derivatives.
Answer: E

7-94 The increased opportunity for a bank to securitize loans into liquid and tradable assets is
likely to affect which type of risk?
a. Sovereign risk.
b. Market risk.
c. Insolvency risk.
d. Technological risk.
e. Interest rate risk.
Answer: B

7-95 This risk of default is associated with general economy-wide or macro conditions
affecting all borrowers.
a. Systematic credit risk.
7-15
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Chapter 07 - Risks of Financial Institutions

b. Firm-specific credit risk.


c. Refinancing risk.
d. Liquidity risk.
e. Sovereign risk.
Answer: A

7-96 Which of the following observations is NOT true of a letter of credit?


a. It is a credit guarantee.
b. It is issued by an FI.
c. It is issued for a fee.
d. Payment on the letter is contingent on some future event occurring.
e. It appears on the FI’s current balance sheet.
Answer: E

7-97 The BIS definition: "the risk of loss resulting from inadequate or failed internal
processes, people, and systems or from external events,” encompasses which of the
following risks?
a. Credit risk and liquidity risk
b. Operational risk and technology risk
c. Credit risk and market risk
d. Technology risk and liquidity risk
e. Sovereign risk and credit risk
Answer: B

7-98 Which of the following refers to an FI’s ability to generate cost synergies by producing
more than one output with the same inputs?
a. Market intermediation.
b. Economies of scope.
c. Break-even point.
d. Economies of scale.
e. Business continuity plan.
Answer: B

7-99 The risk that an FI may not have enough capital to offset a sudden decline in the value of
its assets relative to its liabilities is referred to as
a. currency risk.
b. sovereign risk.
c. insolvency risk.
d. liquidity risk.
7-16
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Chapter 07 - Risks of Financial Institutions

e. interest rate risk.


Answer: C

7-100 Which of the following may occur when a sufficient number of borrowers are unable to
repay interest and principal on loans, thus causing an FI’s equity to approach zero?
a. Insolvency risk.
b. Sovereign risk.
c. Currency risk.
d. Liquidity risk.
e. Interest rate risk.
Answer: A

7-101 For an FI investing in risky loans or bonds, the probability is relatively less for which of
the following occurrences?
a. Repayment of principal and promised interest in full.
b. Partial default on interest payments.
c. Complete default on interest payments.
d. Partial default of the principal remaining on a loan.
e. Complete default on principal and interest.
Answer: E

7-102 Economies of scale refer to an FI’s ability to


a. lower its average costs of operations by expanding its output of financial services.
b. generate cost synergies by producing more than one output with the same inputs.
c. understand each risk and its interaction with other risks.
d. finance its assets completely with borrowed funds.
e. moderate the long-tailed downside risk of the return distribution.
Answer: A

Multiple Part Questions

Use the following information to answer questions the next five (5) questions:

A bank has liabilities of $4 million with an average maturity of two years paying interest
rates of 4 percent annually. It has assets of $5 million with an average maturity of 5 years
earning interest rates of 6 percent annually.
7-17
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Chapter 07 - Risks of Financial Institutions

7-103 To what risk is the bank exposed?


a. Reinvestment risk.
b. Refinancing risk.
c. Interest rate risk.
d. Answers A and C only.
e. Answers B and C only.
Answer: E

7-104 What is the bank’s net interest income for the current year?
a. $300,000.
b. $140,000.
c. $160,000.
d. $280,000.
e. $ 80,000.
Answer: B

7-105 What is the bank’s net interest income in dollars in year 3, after it refinances all of its
liabilities at a rate of 6 percent?
a. -$ 60,000.
b. -$140,000.
c. +$140,000.
d. +$ 60,000.
e. +$800,000.
Answer: D

7-106 What is the bank’s net interest income in dollars in year 3, after it refinances all of its
liabilities at a rate of 8 percent?
a. -$20,000.
b. -$10,000.
c. -$15,000.
d. +$20,000.
e. +$10,000.
Answer: A

7-107 What is the maximum interest rate that it can refinance its $4 million liability and still
break even on its net interest income in dollars?
a. 6.5 percent.
7-18
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Chapter 07 - Risks of Financial Institutions

b. 7.0 percent.
c. 7.5 percent.
d. 8.0 percent.
e. 8.5 percent.
Answer: C

Use the following information to answer the next three (3) questions:

A bank has 10 million British pounds (£) in one-year assets and £8 million in one-year
liabilities. In addition, it has one-year liabilities of 4 million euros (€). Assets are earning
8 percent and both liabilities are being paid at a rate of 8 percent. All interest and principal
will be paid at the end of the year.

7-108 What is the net interest income in dollars if the spot prices at the end of the year are
$1.50/£ and €1.65/$?
a. $46,060.61.
b. $320,000.
c. $1,200,000.
d. $266,666.67.
e. $720,000.
Answer: A

7-109 What is the net interest income in dollars if the spot prices at the end of the year are
$1.35/£ and €1.35/$ and the liabilities instead cost 7 percent instead of 8 percent?
a. $1,080,000.
b. $116,592.59.
c. $100,567.45.
d. $112,677.94.
e. $120,009.76.
Answer: B

7-110 What is the maximum that the € can appreciate and the bank still maintain a zero profit?
a. €1.30/$.
b. €1.33/$.
c. €1.35/$.
d. €1.50/$.
7-19
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Chapter 07 - Risks of Financial Institutions

e. €1.60/$.
Answer: B

7-20
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Friends Which Study Finance .

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