Chapter 7 - Risks of Financial Inter Mediation

8/3/2019 Chapter 7 - Risks of Financial Inter Mediation

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Chapter 7: Risks of FinancialIntermediation

Business 4039


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Risks of Financial

Intermediation(in brokerage and asset transformation service delivery) Liquidity risk

interest rate risk

market risk credit risk

off-balance-sheet risk

foreign exchange risk

country and sovereign risk

actuarial risk

operating, technological, and systematic risk


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Interest Rate Risk The positive spread between borrowed funds and invested fundscan be threatened because of interest rate changes.if thematurity of the sources of funds does not equal the maturity ofuses:

source of funds is shorter term and the term the funds areinvested.. (refinancing risk)

the use of funds is shorter term than the source of funds(reinvestment rate risk)

whenever the FI faces refinancing or reinvestment rate riskit alsofaces MARKET VALUE risk, since interest rates help to determine themarket value of assets (inverse relationship)

Liabilities 1 year

Assets0

0

1 year

2 years


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Maturity

Matching

Addresses both interest rate and liquidity riskand thereforemarket value risk

however, this works against the role of the FI providing true

ACTIVE ASSETTRANSFORMATION services maturity-matching

doesnt work with equity investments

is only an approximation.duration matching is more accurate.


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Interest Rate Risk The risk that the returns on funds to be reinvested will fall below

the originally anticipated returns.

Assets 1 year

Liabilities0

0

2 years


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Market Risk

As traditional activities of the banks declines in relative proportions(deposit-taking and lending) other forms of activities have grow inimportance.

Especially trading . Actively investing in stocks, bonds, andderivative securitiesas a profit-center.

Market Risk is the risk that in active trading, the market value of thebanks asset(s) declines.

Example: derivative losses with the Baring Merchant Bank:

derivative trading on the Japanese Nikkei Stock Market Index


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Credit Risk

Is the likelihood that a borrower will default on a loanorthat the issuer of a bond that the FI has invested in, defaulton interest or principal repayment.

Default risk obviously, FIs are diversified investorstheir portfolio of

financial assets and portfolio of loans must be widelydiversified across industries, geographical regions andincome groups.

Firm-specific credit risk is the risk of default of theborrowing firm associated with the specific types ofproject risk undertaken by that firm.

Systematic credit risk is the risk of default associated withthe health of the general economy.


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Off-balance-s

heet Risk

Off-balance-sheet activity, by definition, does not appear onthe current balance sheet of the FI

commercial letter of credit is an irrevocable obligation to

make payment to a beneficiary of documents evidencingshipment of goods.

BAs -Bankers Acceptances

as the guarantorof such financial instruments, the Bankremains liable for payment, and there is always a chance that

the client may become insolvent, leaving the Bank withobligation to paybut without recourse.


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Foreign Exchange Risk

Mismatches between the amount of foreign currencydenominated assets and liabilities can lead to foreignexchange losses or gains depending on the relative movement

of the two currencies involved.

Foreign Assets 80 million pounds

Foreign Liabilities0

0

100 million pounds

A Net Short Asset Position in Pounds


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Foreign Exchange Risk

An FI that matches both the SIZE and MATURITIES of itsexposures in assets and liabilities of a given currency ishedged (immunized) against foreign currency, liquidity, and

interest rate risk.


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Country and Sovereign Risk

Is the risk of losses experienced by an FI due to changing, social,economic, or political factors specific to one country.

Hong Kong reverting to Chinese control.

Mexico, Argentina imposing restrictions on debt repayments ofdomestic corporationsetc.

Greece potentially defaulting on international loan obligations.


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Actuarial Risk Actuaries estimate future liabilities for insurance companies based on the

law of large numbers and using conservative financial forecastingassumptions.

Actuarial risk is the risk that those estimates turn out to be wrong.

Of course, actuaries, continually review their estimates as time moveson.they will identify actuarial surpluses and actuarial deficits infunds that are accumulating for the purpose of meeting a future liability.This this way the fund sponsor can be informed about their progresstoward their target terminal value, and can take action in advance toavoid a crisis.

Adverse selection is the tendency of those most at risk in a group to takeout insurance so that the insuring FI that priced the contract with respect

to the average in the group is faced with losses.

Moral Hazard is the risk that the insured (or beneficiary) will alter his orher behaviour after contracting in order to benefit from the contract.


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Operating/Technological/Systemic Risk

Efficient electronic payments/communications/data-base/information/processing systems form the back-bone of amodern FI

once in place, it is possible for the FI to add more services and servemore clients with little or no impact on the systems infrastructure ofthe FI

Economies of scale is the degree to which an FIs average unit costsof producing financial services fall as its output of servicesincreases.

Economies of scope is the degree to which an FI can generate costsynergies by producing multiple financial service products.

CorrespondentBanking is the provision of reciprocal bankingservices between pairs of FIs, often in two separate jurisdictions.


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Questions and

Problems

Ch

apter 7Risks of FinancialIntermediation


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Question 7 - 1What is the process ofasset transformation performed by afinancial institution? Why does this process often lead to thecreation ofinterest rate risk? What is interest rate risk?

Asset transformation by an FI involves purchasing primary assets andissuing secondary assets as a source of funds. The primary securitiespurchased by the FI often have maturity and liquidity characteristics thatare different from the secondary securities issued by the FI. Forexample, a bank buys medium- to long-term bonds and makes medium-term loans with funds raised by issuing short-term deposits.

Interest rate risk occurs because the prices and reinvestment income

ch

aracteristics of long-term assets react differently to ch

anges in marketinterest rates than the prices and interest expense characteristics ofshort-term deposits. Interest rate risk is the effect on prices (value) andinterim cash flows (interest coupon payment) caused by changes in thelevel of interest rates during the life of the financial asset.


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Question 7 - 2What is refinancing risk? How is refinancing risk part of interestrate risk? If an FI funds long-term fixed-rate assets with short-termliabilities, what will be the impact on earnings of an increase in therate of interest? A decrease in the rate of interest?

Refinancing risk is the uncertainty of the cost of a new source of fundsthat are being used to finance a long-term fixed-rate asset.

This risk occurs when an FI is holding assets with maturities greater thanthe maturities of its liabilities.

For example, if a bank has a ten-year fixed-rate loan funded by a 2-yeartime deposit, the bank faces a risk of borrowing new deposits, or

refinancing, at a higher rate in two years. Thus, interest rate increaseswould reduce net interest income. The bank would benefit if the rates fallas the cost of renewing the deposits would decrease, while the earningrate on the assets would not change. In this case, net interest incomewould increase.


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Question 7 - 3What is reinvestment risk? How is reinvestment risk part of interest raterisk? If an FI funds short-term assets with long-term liabilities, what will bethe impact on earnings of a decrease in the rate of interest? An increase inthe rate of interest?

Reinvestment risk is the uncertainty of the earning rate on the redeployment ofassets that have matured.

This risk occurs when an FI holds assets with maturities that are less than thematurities of its liabilities.

For example, if a bank has a two-year loan funded by a ten-year fixed-rate timedeposit, the bank faces the risk that it might be forced to lend or reinvest themoney at lower rates after two years, perhaps even below the deposit rates. Also,if the bank receives periodic cash flows, such as coupon payments from a bond or

monthly payments on a loan, these periodic cash flows will also be reinvested atthe new lower (orhigher) interest rates.

Besides the effect on the income statement, this reinvestment risk may cause therealized yields on the assets to differ from the a prioriexpected yields.


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Question 7 - 5How can interest rate risk adversely affect theeconomic or market value of an FI?

When interest rates increase (or decrease), the value of fixed-rate assetsdecreases (or increases) because of the discounted present value of the cashflows. To the extent that the change in market value of the assets differs fromthe change in market value of the liabilities, the difference is realized in theeconomic or market value of the equity of the FI.

For example, for most depository FIs, an increase in interest rates will causeasset values to decrease more than liability values. The difference will causethe market value, or share price, of equity to decrease.


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Question 7 6

c. Assuming that market interest rates increase 1 percent, the bond willhave a value of $9,446 at the end of year 1. What will be the marketvalue of the equity for the FI? Assume that all of the NII in part (a) isused to cover operating expenses or is distributed as dividends.

Cash $1,000 Certificate of deposit $10,000Bond $9,446 Equity $ 446Total assets $10,446 Total liabilities and equity $10,446

d. If market interest rates had decreased 100 basis points by the end ofyear 1, would the market value of equity be higher or lower than $1,000?

Why?

The market value of the equity would be higher ($1,600) because thevalue of the bond would be higher ($10,600) and the value of the CDwould remain unchanged.


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Question 7 6

e. What factors have caused the change in operatingperformance and market value for this firm?

The operating performance has been affected by the changesin the market interest rates that have caused thecorresponding changes in interest income, interest expense,and net interest income.

These specific changes have occurred because of the unique

maturities of the fixed-rate assets and fixed-rate liabilities.

Similarly, the economic market value of the firm has changedbecause of the effect of the changing rates on the marketvalue of the bond.


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Question 7 - 8Corporate bonds usually pay interest semiannually. Ifa company decided to change from semiannual toannual interest payments, how would this affect the

bonds interest rate risk?

The interest rate risk would increase as the bonds are beingpaid back more slowly and therefore the cash flows would beexposed to interest rate changes for a longer period of time.

Thus any change in interest rates would cause a larger inversechange in the value of the bonds.


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uestion 7 - 10Consider again the two bonds in problem (9). If theinvestment goal is to leave the assets untouched untilmaturity, such as for a childs education or for onesretirement, which of the two bonds has more interest rate

risk? What is the source of this risk?

In this case the coupon-paying bond has more interest rate risk. The zero-coupon bond will generate exactly the expected return at

the time of purchase because no interim cash flows will be realized.Thus the zero has no reinvestment risk.

The coupon-paying bond faces reinvestment risk each time a couponpayment is received. The results of reinvestment will be beneficial ifinterest rates rise, but decreases in interest rate will cause therealized return to be less than the expected return.


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Question 7 - 12

A bank invested $50 million in a two-year asset paying 10 percentinterest per annum and simultaneously issued a $50 million, one-year liability paying 8 percent interest per annum. What will bethe banks net interest income each year if at the end of the first

year all interest rates have increased by 1 percent (100 basispoints)?

Net interest income is not affected in the first year, but NII willdecrease in the second year.

Year 1 Year 2

Interest income $5,000,000 $5,000,000Interest expense $4,000,000 $4,500,000Net interest income $1,000,000 $500,000


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Question 7 - 13

What is market risk? How do the results of this risk surface in theoperating performance of financial institutions? What actions canbe taken by FI management to minimize the effects of this risk?

Market risk is the risk of price changes that affects any firm thattrades assets and liabilities.

The risk can surface because of changes in interest rates, exchangerates, or any other changes in the prices of financial assets that aretraded rather than held on the balance sheet.

Market risk can be minimized by using appropriate hedgingtechniques such as futures, options, and swaps, and by implementing

controls that limit the amount of exposure taken by market makers.


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Question 7 - 14

What is credit risk? Which types of FIs are moresusceptible to this type of risk? Why?

Credit risk is the possibility that promised cash flows may notoccur or may only partially occur.

FIs that lend money for long periods of time, whether as loansor by buying bonds, are more susceptible to this risk thanthose FIs that have short investment horizons.

For example, life insurance companies and deposit-takinginstitutions generally must wait a longer time for returns to berealized than money market mutual funds and property-casualty insurance companies.


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Question 7 - 15

What is the difference between firm-specificcredit riskand systematiccredit risk? How can an FI alleviate firm-specific credit risk?

Firm-specific credit risk refers to the likelihood that specific individual assets

may deteriorate in quality, while systematic credit risk involvesmacroeconomic factors that may increase the default risk of all firms in the

economy. Thus, if S&P lowers its rating on RIMs stock and if an investor is holding only

this particular stock, she may face significant losses as a result of thisdowngrading. However, portfolio theory in finance has shown that firm-specificcredit risk can be diversified away if a portfolio of well-diversified stocks isheld.

Similarly, if an FI holds well-diversified assets, the FI will face only systematiccredit risk that will be affected by the general condition of the economy. Therisks specific to any one customer will not be a significant portion of the FIsoverall credit risk.


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Question 7 - 16

Many banks and S&Ls that failed in the 1980s in the United States hadmade loans to oil companies in Louisiana, Texas, and Oklahoma. Whenoil prices fell, these companies, the regional economy, and the banks andS&Ls all experienced financial problems. What types of risk wereinherent in the loans that were made by these banks and S&Ls?

The loans in question involved credit risk. Although the geographic risk areacovered a large region of the United States, the risk more closelycharacterized firm-specific risk than systematic risk.

More extensive diversification by the FIs to other types of industries wouldhave decreased the amount of financial hardship these institutions had toendure.

Similarly, the failure of Northland Bank and Canadian Commercial Bank in the1980s was partially a result of their lending which was concentrated in westernCanadian oil and gas as well as real estate.


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Question 7 - 17

What is the nature of an off-balance-sheet activity? How does anFI benefit from such activities? Identify the various risks thatthese activities generate for an FI and explain how these risks cancreate varying degrees of financial stress for the FI at a later time.

Off-balance-sheet activities are contingent commitments to undertakefuture on-balance-sheet investments.

The usual benefit of committing to a future activity is the generation ofimmediate fee income without the normal recognition of the activityon the balance sheet. As such, these contingent investments may beexposed to credit risk (if there is some default risk probability),

interest rate risk (if there is some price and/or interest rate sensitivity)and foreign exchange rate risk (if there is a cross currencycommitment).


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Question 7 - 18

What is technology risk? What is the difference betweeneconomies ofscale and economies ofscope? How can theseeconomies create benefits for an FI? How can these economiesprove harmful to an FI?

Technology risk occurs when investment in new technologies doesnot generate the cost savings expected in the expansion in financialservices.

Economies of scale occur when the average cost of productiondecreases with an expansion in the amount of financial servicesprovided.

Economies of scope occur when an FI is able to lower overall costsby producing new products with inputs similar to those used for otherproducts. In financial service industries, the use of data from existingcustomer databases to assist in providing new service products is anexample of economies of scope.


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Question 7 - 19

What is the difference between technology risk andoperational risk? How does internationalizing thepayments system among banks increase operational

risk?

Technology risk refers to the uncertainty surrounding theimplementation of new technology in the operations of an FI.

For example, if an FI spends millions on upgrading its

computer systems but is not able to recapture its costsbecause its productivity has not increased commensurately orbecause the technology has already become obsolete, it hasinvested in a negative NPV investment in technology.


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Question 7 - 19

What is the difference between technology risk and operationalrisk? How does internationalizing the payments system amongbanks increase operational risk?

Operational risk refers to the failure of t

he back-room support operationsnecessary to maintain the smooth functioning of the operation of FIs, including

settlement, clearing, and other transaction-related activities. For example, computerized payment systems such as CHIPS, and SWIFT

allow modern financial intermediaries to transfer funds, securities, andmessages across the world in seconds of real time. This creates theopportunity to engage in global financial transactions over a short term in anextremely cost-efficient manner.

However, th

e interdependence of such

transactions also creates settlementrisk. Typically, any given transaction leads to other transactions as funds andsecurities cross the globe. If there is either a transmittal failure orhigh-techfraud affecting any one of the intermediate transactions, this could cause anunraveling of all subsequent transactions.


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Question 7 - 20

What two factors provide potential benefits to FIsthat expand their asset holdings and liabilityfunding sources beyond their domestic

economies?

FIs can realize operational and financial benefits from directforeign investment and foreign portfolio investments in twoways.

1. First, the technologies and firms across various economies differfrom each other in terms of growth rates, extent of development,etc.

2. Second, exchange rate changes may not be perfectly correlatedacross various economies.


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Question 7 - 21

What is foreign exchange risk? What does it mean for an FI to benet longin foreign assets? What does it mean for an FI to be netshortin foreign assets? In each case, what must happen to theforeign exchange rate to cause the FI to suffer losses?

Foreign exchange risk involves the adverse effect on the value of an FIsassets and liabilities that are located in another country when the exchangerate changes.

An FI is net long in foreign assets when the foreign currency-denominatedassets exceed the foreign currency denominated liabilities. In this case, an FIwill suffer potential losses if the domestic currency strengthens relative to theforeign currency when repayment of the assets will occur in the foreigncurrency.

An FI is net short in foreign assets when the foreign currency-denominatedliabilities exceed the foreign currency denominated assets. In this case, an FIwill suffer potential losses if the domestic currency weakens relative to theforeign currency when repayment of the liabilities will occur in the domesticcurrency.


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Question 7 - 23

If international capital markets are well integrated andoperate efficiently, will banks be exposed to foreignexchange risk? What are the sources of foreign

exch

ange risk for FIs?

If there are no real or financial barriers to international capitaland goods flows, FIs can eliminate all foreign exchange raterisk exposure.

Sources of foreign exchange risk exposure include

international differentials in real prices, cross-countrydifferences in the real rate of interest (perhaps, as a result ofdifferential rates of time preference), regulatory andgovernment intervention and restrictions on capitalmovements, trade barriers, and tariffs.


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Question 7 - 24

If an FI has the same amount of foreign assets andforeign liabilities in the same currency, has that FInecessarily reduced to zero the risk involved in these

international transactions? Explain.

Matching the size of the foreign currency book will noteliminate the risk of the international transactions if thematurities of the assets and liabilities are mismatched.

To the extent that the asset and liabilities are mismatched interms of maturities, or more importantly durations, the FI willbe exposed to foreign interest rate risk.


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Question 7 - 26

Assume that a bank has assets located in Londonworth 150 million on which it earns an average of8 percent per year. The bank has 100 million in

liabilities on which it pays an average of 6 percentper year. The current spot rate is 1.50/$.

a. If the exchange rate at the end of the year is 2.00/$, will thedollarhave appreciated or devalued against the mark?

The dollar will have appreciated, or conversely, the will havedepreciated.


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Question 7 26

Assume that a bank has assets located in London worth 150 million on which it earnsan average of 8 percent per year. The bank has 100 million in liabilities on which itpays an average of 6 percent per year. The current spot rate is 1.50/$.

b. Given the change in the exchange rate, what is the effect in dollars on the net interest incomefrom the foreign assets and liabilities? Note: The net interest income is interest income minus

interest expense.Measurement in Interest received = 12 millionInterest paid = 6 millionNet interest income = 6 millionMeasurement in $ before devaluationInterest received in dollars = $8 millionInterest paid in dollars = $4 million

Net interest income = $4 millionMeasurement in $ after devaluationInterest received in dollars = $6 millionInterest paid in dollars = $3 millionNet interest income = $3 million


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Question 7 26

Assume that a bank has assets located in London worth 150 million onwhich it earns an average of 8 percent per year. The bank has 100 millionin liabilities on which it pays an average of 6 percent per year. The currentspot rate is 1.50/$.

c. What is the effect of the exchange rate change on the value of assets andliabilities in dollars?

The assets were worth $100 million (150m/1.50) before depreciation, but afterdevaluation they are worth only $75 million. The liabilities were worth $66.67million before depreciation, but they are worth only $50 million after devaluation.Since assets declined by $25 million and liabilities by $16.67 million, net worthdeclined by $8.33 million using spot rates at the end of the year. c. What is

the effect of the exchange rate change on the value of assets and liabilities indollars?

The assets were worth $100 million (150m/1.50) before depreciation, but afterdevaluation they are worth only $75 million. The liabilities were worth $66.67million before depreciation, but they are worth only $50 million after devaluation.Since assets declined by $25 million and liabilities by $16.67 million, net worthdeclined by $8.33 million using spot rates at the end of the year.


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Question 7 - 27

Six months ago, Qualitybank, LTD., issued a US$100 million, one-year maturity CDdenominated in Euros. On the same date, US$60 million was invested in a -denominated loan and US$40 million was invested in a U.S. Treasury bill. The exchangerate six months ago was 1.7382/US$. Assume no repayment of principal, and anexchange rate today of 1.3905/US$.

a. What is the current value of the Euro CD principal (in US dollars and )?Today's principal value on the Euro CD is 173.82 and US$125m (173.82/1.3905).

b. What is the current value of the Euro-denominated loan principal (in US dollars and )?Today's principal value on the loan is DM104.292 and US$75 (104.292/1.3905).

c. What is the current value of the U.S. Treasury bill (in US dollars and )?

Today's principal value on the U.S. Treasury bill is US$40m and 55.62 (40 x 1.3905),although for a U.S. bank this does not change in value.

d. What is Qualitybanks profit/loss from this transaction (in US dollars and )?Qualitybank's loss is US$10m or 13.908.


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Question 7 - 28


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Question 7 - 29

What is country or sovereign risk? What remedy doesan FI realistically have in the event of a collapsingcountry or currency?

Country risk involves the interference of a foreign governmentin the transmission of funds transfer to repay a debt by aforeign borrower.

A lender FI has very little recourse in this situation unless the

FI is able to restructure the debt or demonstrate influence overthe future supply of funds to the country in question.

This influence likely would involve significant workingrelationships with the IMF and the World Bank.


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Question 7 - 32

What is liquidity risk? What routine operating factors allowFIs to deal with this risk in times of normal economicactivity? What market reality can create severe financialdifficulty for an FI in times of extreme liquidity crises?

Liquidity risk is the uncertainty that an FI may need to obtain largeamounts of cash to meet the withdrawals of depositors or otherliability claimants.

In times of normal economic activity, depository FIs meet cashwithdrawals by accepting new deposits and borrowing funds in theshort-term money markets.

However, in times ofharsh liquidity crises, the FI may need to sellassets at significant losses in order to generate cash quickly.


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Question 7 - 33

Why can insolvency riskbe classified as aconsequence or outcome of any or all of theother types of risks?

Insolvency risk involves the shortfall of capital intimes when the operating performance of theinstitution generates accounting losses.

These losses may be the result of one or more of

interest rate, market, credit, liquidity, sovereign,foreign exchange, technological, and off-balance-sheet risks.


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Question 7 - 34Discuss the interrelationships among the different sources of bank riskexposure. Why would the construction of a bank risk-management model tomeasure and manage only one type of risk be incomplete?

Measuring each source of bank risk exposure individually creates the falseimpression that they are independent of each other. For example, the interest rate

risk exposure of a bank could be reduced by requiring bank customers to take onmore interest rate risk exposure through the use of floating rate products.However, this reduction in bank risk may be obtained only at the possible expenseof increased credit risk. That is, customers experiencing losses resulting fromunanticipated interest rate changes may be forced into insolvency, therebyincreasing bank default risk. Similarly, off-balance sheet risk encompasses severalrisks since off-balance sheet contingent contracts typically have credit risk andinterest rate risk as well as currency risk. Moreover, the failure of collection andpayment systems may lead corporate customers into bankruptcy. Thus,technology risk may influence the credit risk of FIs.

As a result of these interdependencies, FIs have focused on developingsophisticated models that attempt to measure all of the risks faced by the FI at anypoint in time.


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Question 7 - 35


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Sample Question 1

The sales literature of a mutual fund claims that the fund has norisk exposure because it invests exclusively in default risk-freefederal government securities. Is this claim true? Why orWhy

not? Although the funds asset portfolio is comprised of default risk

free securities, the fund may still be exposed to risk if there issignificant interest rate risk exposure

for example, if interest rates increase significantly, the market value of the

funds Treasury security portfolio may decrease. Moreover, although it is

virtually impossible for the federal government to go bankrupt (at least in

terms of local currency where it can always print more money to meet its

obligations), in times of political or economic turmoil the government may

refuse to meet its debt obligations.


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Sample Question 2

This is a summary of the descriptive contents of the chapterbe sureto review.A. bank finances a $20 million 5-year fixed-rate commercial loan by selling 1-year

certificates of deposit. Liquidity, interest rate and credit risks exist.

B. An insurance company invests its policy premiums in a long-term municipal bond

portfolio. Liquidity, credit and actuarial risks exist. Interest rate risk may also exist

if the investment duration differs from the actuarial duration.

C. A German bank sells two-year fixed-rate notes to finance a two-year fixed-rate loanto a Polish entrepreneur. Credit and sovereign risks exist. If the note and the loan

are in different currencies, foreign exchange risk also exists.


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Sample Question 2 ...G. The bond dealer sold the Brazilian debt in question f. Assuming that the

sale is complete, no new risk is incurred. Note, however, that the funds

must be reinvested (or paid out to equity holders). This could be

considered a realization of liquidity risk.

H. A bank sells a package of its mortgage loans as mortgage-backed

securities. Liquidity and interest rate risks exist to the extent that the

bank must reinvest its cash, funded by deposits of a given maturity and

interest rate.

I. A bank funds its asset portfolio consisting of commercial loans by issuing

demand deposits. Liquidity and credit risks exist. If the commercial

loans are fixed rate, interest rate also exists.


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Sample Question 3Discuss how off-balance-sheet risk can encompass

several of the other eight sources of risk exposure.

Off-balance-sheet commitments are contingent claims andobligations that either increase or are used to mitigateother risks.

An LC brings the credit risk of the account party.

Risk of exercise of a guarantee by the beneficiary is aliquidity risk.

Interest rate and foreign exchange derivatives may be used

to hedge on balance sheet interest rate and foreignexchange exposure or, if there is no offsetting balancesheet position, increase those exposures.

Various derivatives are marketable securities traded indeep and liquid markets and constitute an important part ofmarket risk of the FI.


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Sample Question 3 .

Off-balance-sheet positions where the counterparty is inanother country contain a sovereign dimension in their creditrisks.

Derivatives are contingent claims. The value of some can becalculated according to actuarial pricing; hence, openpositions in such derivatives have actuarial risk.

Settlement of off-balance sheet obligations involves thepayment system and various inter- and intra- banktechnological risks.


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Sample Question 4Discuss how the availability of international computerized payments

systems creates both risk and opportunity.

Computerized payments systems such as Fedwire,Chips, and SWIFT

allow modern financial intermediaries to transfer funds, securities andmessages across the world in seconds of real time. This creates the

opportunity to engage in global financial transactions over the short

term in an extremely cost efficient manner.

However, the interdependence of such transactions also creates

settlement risk. Typically, any given transaction leads to othertransactions as funds and securities cross the globe. If there is either a

transmittal failure or high-tech fraud affecting any one of the

intermediate transactions, this could cause unravelling of all

subsequent transactions in the pyramid.


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Sample Question 5What are the sources of foreign exchange risk for FIs? If

international capital markets are well-integrated and operateefficiently, will banks be exposed to foreign exchange risk?

An FI is exposed to foreign exchange risk when its funds (liabilities) and its

investments (assets) are denominated in different currencies and no offsetting

off-balance-sheet position is taken.

FIs that are currently able to completely hedge their foreign exchange

exposure often choose not to in order to perform an active trading (ie. Position

taking) role.

International capital markets in most of the currencies in which this activity is

currently performed are well integrated, yet FIs still can make profits fromposition taking.

If all markets operated efficiently, then expected profits to open positions

taking would disappear, and all FIs would choose to be hedged on their

investments (relative to their funding) all of the time.


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Sample Question 6Discuss the interrelationships among the different sources of bank

risk exposure.

Measuring each source of bank risk exposure individually creates the false

impression that they are each independent.

For example, the banks interest rate risk exposure could be reducedby allowing bank customers to take on more interest rate riskexposure through the use of floating rate products. However, thisreduction in bank risk may be obtained only at the possible expenseof increased credit risk exposure. That is, customers experiencinglosses resulting from unanticipated interest rate changes may be

forced into insolvency, thereby increasing bank default riskexposure.

Off-balance-sheet risk encompasses other sources of risk since off-balance-sheet

contingencies typically entail credit risk, interest rate risk as well as currency risk.


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Sample Question 7If it were feasible, would it be optimal for banks to be totally free of

risk exposure?

No, such policy would prevent the bank from performing its intermediation

functions of risk pooling, asset transformation, and delegating monitoring.

In financial markets, there are higher returns to be had for assuming higher

risks.

Due to diversification opportunities and economies of scale and scope

available to large agents like an F.I., it can realize better returns for a given

level of risk in comparison to a small agent.


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Sample Question 8Banks have greater exposure to liquidity risk than do mutual

funds. Is this statement true? If so, why? If not, why not?

Banks issue demand deposits which can be withdrawn at full face value at any

time by the depositor.

Mutual funds must redeem shares upon demand by the investor.

However, the mutual fund does not guarantee payment at some face value.

Instead, the mutual fund redeems shares on the basis of net asset value, which

is simply the market value of the funds portfolio divided by the number of

shares outstanding.

Thus, if liquidity pressure forces the mutual fund to sell assets, any reductionin the value of those assets will be borne by the mutual fund investor.

Instead, if liquidity pressure forces the bank to sell assets, any reduction in the

face value of those assets will be borne by the banks shareholders, not the

depositor.


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Problem 7 - 1

There would be no impact on net interest income during thefirst year. However, net interest income would decrease inthe second year.

Yr. 1 Interest Income = $50m v .10 = $5.0 mYr. 1 Interest Expense = $50m v .08 = $4.0m

Yr. 1 Net Interest Income = $5.0m - $4.0m = $1.0m

Yr. 2 Interest Income = $50m v .10 = $5.0m

Yr. 2 Interest Expense = $50m v .09 = $4.5m

Yr. 2 Net Interest Income = $5.0m - $4.5m = $0.5m


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Problem 7 - 2Megabank Ltd., as US bank, issued a euro CD (i.e., a CD denominated in

euros) in the amount of 100 million. On the date of the issuance of the CD,the exchange rate was 1.00 = U.S. $1.10. It used the funds to invest 60million in a euro-denominated loan and 40 million in a US dollar treasury bill.Principal of the CD, the loan and the T-bill are still amortized when the euro

plunges to par (1.00 = U.S. $1.00).

Documents

Chapter 7 - Risks of Financial Inter Mediation