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Chapter 19 - Types of Risks Incurred by Financial Institutions

Chapter Nineteen
Answers to Chapter 19
1. Credit risk is the risk that promised cash flows from loans and securities held by FIs may not
be paid in full. FIs that lend money for long periods of time whether as loans or by buying
bonds are more susceptible to this risk than those FIs that ha!e short in!estment hori"ons. For
e#ample life insurance companies and depository institutions generally must wait a longer time
for returns to be reali"ed than money market mutual funds and property-casualty insurance
$. Firm-specific credit risk refers to the likelihood that indi!idual assets may deteriorate in
%uality. Thus if &'( lowers its rating on I)* stock and if an in!estor is holding only this
particular stock she will face significant losses as a result of this downgrading. +owe!er as
portfolio theory in finance has shown firm-specific credit risk can be di!ersified away if a
portfolio of well-di!ersified stocks is held. &imilarly if an FI holds well-di!ersified assets that
is assets of !arying %uality it will be left only with systematic credit risk which will be affected
by the general condition of the economy.
,. This was principally credit risk but the main issue is whether this represents systematic credit
risk or firm specific credit risk. It would seem that this e#ample is closer to a demonstration of
firm specific risk in that it would ha!e been possible to di!ersify some of this risk away by
making loans to firms less dependent on the oil industry in particular or the regional economy
more generally.
-. .i%uidity risk is the risk that a sudden surge in liability withdrawals may re%uire an FI to
li%uidate assets in a !ery short period of time and at less than fair market prices. In times of
normal economic acti!ity depository institutions meet cash withdrawals by accepting new
deposits and borrowing funds in the short-term money markets. +owe!er in times of harsh
li%uidity crises the FI may need to sell assets at significant losses in order to generate cash
/. 0sset transformation by an FI in!ol!es purchasing primary assets and issuing secondary
assets as a source of funds. The primary securities purchased by the FI often ha!e maturity and
li%uidity characteristics that are different from the secondary securities issued by the FI. For
e#ample 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 rein!estment income characteristics of long-term
assets react differently to changes in market interest rates than the prices and interest e#pense
characteristics of short-term deposits. Interest rate risk is the risk incurred by an FI when the
maturities of its assets and liabilities are mismatched.
Chapter 19 - Types of Risks Incurred by Financial Institutions
1. Refinancing risk is the risk that the cost of rolling o!er or reborrowing funds will rise abo!e
the returns being earned on asset in!estments. This risk occurs when an FI is holding assets with
maturities greater than the maturities of its liabilities. For e#ample if a bank has a ten-year fi#ed-
rate loan funded by a $-year time deposit the bank faces a risk in that new deposits may only be
obtained and the loans refinanced at a higher rate in two years. These interest rate increases
would reduce net interest income. The bank would benefit if interest rates fall as the cost of
renewing the deposits would decrease while the interest rate earned on the loan would not
change. In this case net interest income would increase.
2. Rein!estment risk is the risk that the returns on funds to be rein!ested will fall below the cost
of funds. This risk occurs when an FI holds assets with maturities that are shorter than the
maturities of its liabilities. For e#ample if a bank has a two-year loan funded by a ten-year fi#ed-
rate time deposit the bank faces the risk that it might be forced to lend or rein!est the money at
lower rates after two years perhaps e!en below the deposit rates. 0lso if the bank recei!es
periodic cash flows such as coupon payments from a bond or monthly payments on a loan these
periodic cash flows will also be rein!ested at the new lower 3or higher4 interest rates. )esides the
effect on the income statement rein!estment risk may cause reali"ed yields on assets to differ
from the a priori e#pected yields.
5. 0lthough the fund6s asset portfolio is comprised of default 3or credit4 risk free securities it is
still e#posed to interest rate risk. For e#ample if interest rates increase significantly the market
!alue of the fund6s Treasury security portfolio may decrease. *oreo!er although it is !irtually
impossible for the federal go!ernment to go bankrupt 3at least in terms of local currency where it
always can print more money to meet its obligations4 in times of political or economic turmoil
the go!ernment may refuse to meet its debt obligations.
9. 7hen interest rates increase 3or decrease4 the !alue of fi#ed-rate assets decreases 3or
increases4 because of the discounted present !alue of the cash flows. To the e#tent that the
change in market !alue of the assets differs from the change in market !alue of the liabilities the
difference is reali"ed in the economic or market !alue of the e%uity of the FI. For e#ample for
most depository institutions an increase in interest rates will cause asset !alues to decrease more
than liability !alues. The difference will cause the market !alue or share price of e%uity to
18. 0 policy of maturity matching will allow changes in market interest rates to ha!e
appro#imately the same effect on both interest income and interest e#pense. 0n increase in rates
will tend to increase both income and e#pense and a decrease in rates will tend to decrease both
income and e#pense. The changes in income and e#pense may not be e%ual because of different
cash flow characteristics of the assets and liabilities. The asset-transformation function of an FI
in!ol!es in!esting short-term liabilities in long-term assets. *aturity matching clearly works
against successful implementation of this process.
11. The interest rate risk would increase as the bonds are being paid back more slowly and so
the cash flows would be e#posed to interest rate changes for a longer period of time.
Chapter 19 - Types of Risks Incurred by Financial Institutions
1$. The "ero coupon bond would ha!e more interest rate risk. &ince the entire cash flow from the
"ero coupon is not recei!ed until the bond matures the entire cash flow is e#posed to interest rate
changes o!er the entire life of the pro9ect. The coupon paying bond returns its cash flows sooner
e#posing less of them to interest rate changes. In this sense the coupon paying bond :pays back:
sooner. 0 more formal e#planation of the interest rate risk inherent in the two bonds will be
presented in the ne#t chapter after students ha!e learned about duration.
1,. In this case the coupon-paying bond has more interest rate risk. The "ero-coupon bond will
generate e#actly the e#pected return at the time of purchase because no interim cash flows will
be reali"ed. Thus the "ero-coupon bond has no rein!estment risk. The coupon-paying bond faces
rein!estment risk each time a coupon payment is recei!ed. The results of rein!estment will be
beneficial if interest rates rise but decreases in interest rate will cause the reali"ed return to be
less than the e#pected return.
1-. The mutual fund faces the risk of interest rates rising and the !alue of the securities falling.
1/. ;ff-balance-sheet acti!ities are contingent commitments to undertake future on-balance-
sheet in!estments. The usual benefit of committing to a future acti!ity is the generation of
immediate fee income without the normal recognition of the acti!ity on the balance sheet. 0s
such these contingent in!estments may be e#posed to credit risk 3if there is some default risk
probability4 interest rate risk 3if there is some price and<or interest rate sensiti!ity4 and foreign
e#change rate risk 3if there is a cross currency commitment4.
11. Foreign e#change risk is the risk that e#change rate changes can affect the !alue of an FI=s
assets and liabilities denominated in non-domestic currencies. 0n FI is net long in foreign assets
when the foreign currency-denominated assets e#ceed the foreign currency-denominated
liabilities. In this case an FI will suffer potential losses if the domestic currency strengthens
relati!e to the foreign currency when repayment of the assets will occur in the foreign currency.
0n FI is net short in foreign assets when the foreign currency-denominated liabilities e#ceed the
foreign currency-denominated assets. In this case an FI will suffer potential losses if the
domestic currency weakens relati!e to the foreign currency when repayment of the liabilities will
occur in the domestic currency.
12. FIs can reali"e operational and financial benefits from direct foreign in!estment and foreign
portfolio in!estments in two ways. First the technologies and firms across !arious economies
differ from each other in terms of growth rates e#tent of de!elopment etc. &econd e#change
rate changes may not be perfectly correlated across !arious economies.
15. If there are no real or financial barriers to international capital and goods flows FIs can
eliminate all foreign e#change rate risk e#posure. &ome sources of foreign e#change risk
e#posure are> international differentials in real prices cross-country differences in the real rate of
interest 3perhaps as a result of differential rates of time preference4 regulatory and go!ernment
inter!ention and restrictions on capital mo!ements trade barriers and tariffs.
Chapter 19 - Types of Risks Incurred by Financial Institutions
19. The ?.&. FI would prefer to be net short 3liabilities greater than assets4 in its asset position.
The depreciation of the franc relati!e to the dollar means that the ?.&. FI would pay back the net
liability position with fewer dollars. In other words the decrease in the foreign assets in dollar
!alue after con!ersion will be less than the decrease in the !alue of the foreign liabilities in dollar
!alue after con!ersion.
$8. *atching the si"e of the foreign currency book will not eliminate the risk of the international
transactions if the maturities of the assets and liabilities are mismatched. To the e#tent that the
asset and liabilities are mismatched in terms of maturities or more importantly durations the FI
will be e#posed to foreign interest rate risk.
$1. In this case the insurance company is worried about the !alue of the )ritish pound falling. If
this happens the insurance company would be able to buy fewer dollars with the )ritish pounds
recei!ed. This would happen if the e#change rate rose to say 1.55<@ since now it would take
more )ritish pound to buy one dollar.
$$. If the franc is e#pected to depreciate an FI loses if it is net long in assets 3i.e. it has more
assets denominated in francs than liabilities4. +owe!er if it is net short in assets a depreciation
of the franc will benefit the FI. This is because the fall of the assets in dollar !alue after
con!ersion will be lower than the fall in the !alue of its liabilities.
$,. Country risk is the risk that repayments to foreign lenders or in!estors may be interrupted
because of restrictions inter!ention or interference from foreign go!ernments. 0 lender FI has
!ery little recourse in this situation unless the FI is able to restructure the debt or demonstrate
influence o!er the future supply of funds to the country in %uestion. This influence likely would
in!ol!e significant working relationships with the I*F and the 7orld )ank.
$-. Technology risk refers to the uncertainty surrounding the implementation of new technology
in the operations of an FI. For e#ample if an FI spends millions on upgrading its computer
systems but is not able to recapture its costs because its producti!ity has not increased
commensurately or because the technology has already become obsolete it has in!ested in a
negati!e A(B in!estment in technology.
;perational risk refers to the failure of the back-room support operations necessary to
maintain the smooth functioning of the operation of FIs including settlement clearing and other
transaction-related acti!ities. For e#ample computeri"ed payment systems such as Fedwire
C+I(& and &7IFT allow modern financial intermediaries to transfer funds securities and
messages across the world in seconds of real time. This creates the opportunity to engage in
global financial transactions o!er a short term in an e#tremely cost-efficient manner. +owe!er
the interdependence of such transactions also creates settlement risk. Typically any gi!en
transaction leads to other transactions 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 an unra!eling of all subse%uent transactions.
Chapter 19 - Types of Risks Incurred by Financial Institutions
$/. Aeither. The costs as a percent of assets ha!e increased from 1/.,5C to 19.--C for )ank 1.
This represents diseconomies of scale.
$1. 1. a b
$. a b
,. a d e
-. a b c d e f
/. a c
1. a b d e
2. a b c
$2. Insol!ency risk is the risk that an FI may not ha!e enough capital to offset a sudden decline
in the !alue of its assets. This risk in!ol!es the shortfall of capital in times when the operating
performance of the institution generates accounting losses. These losses may be the result of one
or more of interest rate market credit li%uidity so!ereign foreign e#change technological and
off-balance-sheet risks.
$5. *easuring each source of FI risk e#posure indi!idually creates the false impression that they
are independent of each other. For e#ample the interest rate risk e#posure of an FI could be
reduced by re%uiring customers to take on more interest rate risk e#posure through the use of
floating-rate products. +owe!er this reduction in FI risk may be obtained only at the possible
e#pense of increased credit risk. That is customers e#periencing losses resulting from
unanticipated interest rate changes may be forced into insol!ency thereby increasing the FI=s
default risk. &imilarly off-balance-sheet risk encompasses se!eral risks since off-balance-sheet
contingent contracts typically ha!e credit risk and interest rate risk as well as currency risk.
*oreo!er the failure of collection and payment systems may lead corporate customers into
bankruptcy. Thus technology risk may influence the credit risk of FIs. 0s a result of these
interdependencies FIs ha!e focused on de!eloping sophisticated models that attempt to measure
all of the risks faced by the FI at any point in time.
1. a. Interest income @1888 @18888 # 8.18
Interest e#pense 188 @18888 # 8.81
Aet interest income 3AII4 @-88
b. Interest income @1888 @18888 # 8.18
Interest e#pense 288 @18888 # 8.82
Aet interest income 3AII4 @,88
The change in AII is the result of both rein!estment and refinancing risk.
c. Cash @1888 Certificate of deposit @18888
)ond @9--1 D%uity @ --1
Total assets @18--1 Total liabilities and e%uity @18--1
Chapter 19 - Types of Risks Incurred by Financial Institutions
d. The market !alue of the e%uity would be higher 3@11884 because the !alue of the bond
would be higher 3@181884 and the !alue of the CE would remain unchanged.
e. The operating performance has been affected by the changes in the market interest rates that
ha!e caused the corresponding changes in interest income interest e#pense and net interest
income. These specific changes ha!e occurred because of the uni%ue maturities of the fi#ed-rate
assets and liabilities. &imilarly the economic or market !alue of the firm has changed because of
the effect of the changing rates on the market !alue of the bond.
$. a. D#pected interest income> 3@/8m # .184 F 3@/8m # .824 G @5./m.
D#pected interest e#pense> 3@28m # .814 F 3@$8m # .814 G @/.-m
D#pected net interest income> @ 5./m - @/.-m G @,.1m.

b. 0fter the $88 basis point interest rate increase net interest income declines to
3/8m3.1$4 F /8m3.8244 - 328m3.854 F $8m3.8144 G @9./m - @1.5m G @$.2m a decline of @8.-
,. There would be no impact on net interest income during the first year. +owe!er net interest
income would decrease in the second year>
Hear 1 interest income G @/8m # .18 G @/.8m
Hear 1 interest e#pense G @/8m # .85 G @-.8m
Aet interest income @1.8m
Hear $ interest income G @/8m # .18 G @ /.8m
Hear $ interest e#pense G @/8m # .89 G @ -./m
Aet interest income @ 8./m J @1.8m
-. a. The dollar appreciated against the euro. It takes more euros to buy a dollar.
b. Interest recei!ed in Duro G Duro1$ million
Interest paid G Duro 1 million
Aet interest margin G Duro 1 million
)efore Ee!aluation
Interest recei!ed in dollars G @5 million
Interest paid in dollars G @- million
Aet interest margin G @- million
0fter Ee!aluation
Interest recei!ed in dollars G @1 million
Interest paid in dollars G @, million
Aet interest margin G @, million
Thus the de!aluation of the euro reduced net interest margin by @1 million.
Chapter 19 - Types of Risks Incurred by Financial Institutions
c. The assets before depreciation were worth @188 million 3Duro 1/8m<1./84 but after
de!aluation they are worth @2/ million. The liabilities were worth @11.12 million but are now
worth @/8 million. &ince assets declined by @$/ million and liabilities by @11.12 million net
worth declined by @5.,, million using current spot rates.
/. At Issue ate:
Eollar Transaction Balues K Transaction Balues
3in millions4 3in millions4
)ritish @18 Duro @188 )ritish K9$.$9 LDuro K1/,.5$
loan CE loan CE
?.&. @-8 ?.&. K11./,
T-bill T-bill
@188 @188 K1/,.5$ K1/,.5$
Eollar Transaction Balues K Transaction Balues
3millions of dollars4 3millions of K 4
)ritish @22./$ Duro @1$9.$1 )ritish K9$.$9 Duro K1/,.5$
loan CE loan CE
?.&. @-8 ?.&. K-2.1$
T-bill T-bill
@112./$ @1$9.$1 K1,9.91 K1/,.5$
a. Today6s principal !alue on the Duro CE is K1/,.5$ and @1$9.$1m 31/,.5$<1.198/4.
b. Today6s principal !alue on the loan is K9$.$9 and @22./$ 39$.$9<1.198/4.
c. Today6s principal !alue on the ?.&. Treasury bill is @-8m and K-2.1$ 3-8 # 1.198/4. 0lthough
for a ?.&. bank this does not change in !alue.
d. Mualitybank6s loss is @11.19m or K1,.91.
1. a. )eginning of the Hear
(rice of )ond G &F58NO1-31<31 F .854
4P<.85Q F &F1888<31 F .854
G &F1888
;n a financial calculator> A G 18 I G 5 (*T G 58 FB G 1888 GR (B G &F1888

Dnd of Hear
(rice of )ond G &F58NO1-31<31 F .184
4P<.18Q F &F1888<31 F .184
G &F55-.5$
;n a financial calculator> A G 9 I G 18 (*T G 58 FB G 1888 GR (B G &F55-.5$
.oss to &wiss in!estor 3&F55-.5$ F &F58 - &F18884<@1888 G -,./$C.

b. (rice beginning of year G &F1888 # .11112 G @111.12
(rice at end of year G &F55-.5$ # .2-82- G @1//.-$
Chapter 19 - Types of Risks Incurred by Financial Institutions
Interest recei!ed at end of year G &F58 # .2-82- G @/9.$1
Sain to ?.&. in!estor G 3@1//.-$ F @/9.$1 - @111.124<@111.12 G F2.$8C.
Thus the &wiss in!estor who was e#posed to interest rate risk faced a loss of ,./$C. +owe!er
the ?.&. in!estor faced both interest rate and foreign e#change risk. In the case of the latter the
appreciation of the &wiss franc helped to moderate the interest rate loss. It could ha!e resulted in
a bigger loss to the ?.&. in!estor if the &wiss franc had depreciated against the dollar.