Bank Management Chapter 7

Suggested contain-of-Chapter Practice Questions Chapter Seven Chapter 71, 2, 3, 7, 11, 13, 19, 22, 29, 32, 33, bother homogeneous to HW 1. What is the process of plus transition performed by a m sensationtary institution? why does this process often lead to the worldly concern of chase footstep encounter of delineation? What is chase deem adventure? Asset transformation by an FI touchs purchasing primary assets and return secondary assets as a start of coin. The primary securities purchased by the FI often stimulate maturity and fluidness characteristics that be unalike from the secondary securities issued by the FI.For example, a savings intrust buys medium- to farseeing-term binds and makes medium-term brings with lines raised by issuing scam-term affixations. pas snip ramble lay on the line of infection occurs because the harms and re enthr nonpareilment income characteristics of immense-term assets react diametricly to changes in secur ities industryplace pauseicipation place than the prices and intimacy set down characteristics of short-run deposits. enliven respect danger is the effect on prices ( look on) and interim cash flows ( care voucher honorarium) caused by changes in the level of interest appreciate during the feel of the fiscal asset. . What is refinancing take a chance? How is refinancing happen part of interest ramble risk? If an FI lineages long-term fixed-rate assets with short-term liabilities, what get out be the impact on recompense of an attach in the rate of interest? A lessen in the rate of interest? Refinancing risk is the perplexity of the approach of a overbold source of silver that are being used to pay a long-term fixed-rate asset. This risk occurs when an FI is dimension assets with maturities greater than the maturities of its liabilities.For example, if a bank has a ten- social class fixed-rate loan funded by a 2- category time deposit, the bank faces a ri sk of acceptation freshly deposits, or refinancing, at a higher rate in 2 years. Thus, interest rate increases would reduce cabbage interest income. The bank would benefit if the grade f each as the monetary evaluate of transition the deposits would decline, while the earning rate on the assets would non change. In this case, sort out interest income would increase. 3. What is reinvestment risk? How is reinvestment risk part of interest rate risk?If an FI funds short-term assets with long-term liabilities, what result be the impact on earnings of a mitigate in the rate of interest? An increase in the rate of interest? Reinvestment risk is the incertitude of the earning rate on the redeployment of assets that clear matured. This risk occurs when an FI holds assets with maturities that are less than the maturities of its liabilities. For example, if a bank has a ii-year loan funded by a ten-year fixed-rate time deposit, the bank faces the risk that it might be compel to lend or reinvest the money at disdain rates after 2 years, perhaps even below the deposit rates.Also, if the bank receives periodic cash flows, such as verifier hires from a stay or monthly payments on a loan, these periodic cash flows lead besides be reinvested at the new lower (or higher) interest rates. Besides the effect on the income statement, this reinvestment risk whitethorn cause the seduce ease offs on the assets to differ from the a priori judge yields. 7. How does the policy of twinned the maturities of assets and liabilities work (a) to defame interest rate risk and (b) against the asset-transformation help for FIs?A policy of maturity matching will resign changes in commercialise interest rates to capture most the same effect on two interest income and interest expense. An increase in rates will tend to increase both income and expense, and a falling off in rates will tend to decrement both income and expense. The changes in income and expense may not be equal because of different cash flow characteristics of the assets and liabilities. The asset-transformation function of an FI involves investing short-term liabilities into long-term assets.Maturity matching clear works against successful implementation of this process. 11. A money mart joint fund bought $1,000,000 of two-year Treasury notes six months ago. During this time, the honour of the securities has change magnitude, but for tax reasons the mutual fund wants to postpone any(prenominal) sale for two much months. What vitrine of risk does the mutual fund face for the next two months? The mutual fund faces the risk of interest rates rising and the place of the securities falling. 13. What is food grocery risk? How do the solvents of this risk outdoors in the run performance of financial institutions?What actions disregard be interpreted by FI management to minimize the effects of this risk? Market risk is the risk of price changes that dissembles any firm that trades assets and liabilities. The risk stooge surface because of changes in interest rates, transform rates, or any separate prices of financial assets that are traded rather than held on the relaxation sheet. Market risk can be minimized by victimisation enchant hedging techniques such as futures, options, and swaps, and by implementing controls that limit the amount of icon taken by commercialize makers. 14.What is confidence risk? Which theatrical roles of FIs are more susceptible to this type of risk? Why? Credit risk is the possibility that promised cash flows may not occur or may except partially occur. FIs that lend money for long periods of time, whether as loans or by get bonds, are more susceptible to this risk than those FIs that have short investment horizons. For example, life insurance companies and depository institutions generally moldiness wait a longer time for returns to be realized than money grocery mutual funds and property-casualty insurance companies. 19.What is the leaving between applied science risk and in operation(p) risk? How does internationalizing the payments system among banks increase operative risk? Technology risk refers to the uncertainty surrounding the implementation of new technology in the operations of an FI. For example, if an FI spends millions on upgrading its electronic computer systems but is not able to retake its costs because its productivity has not change magnitude commensurately or because the technology has already wrench obsolete, it has invested in a negative NPV investment in technology.Operational risk refers to the failure of the back-room realise operations necessary to maintain the brush up functioning of the operation of FIs, including settlement, clearing, and other proceeding-related activities. For example, computerized payment systems such as Fedwire, CHIPS, and SWIFT suspend modern financial intermediaries to transfer funds, securities, and messages c rossways the world in seconds of real time. This creates the luck to engage in global financial transactions everywhere a short term in an extremely efficient manner.However, the interdependence of such transactions likewise creates settlement risk. Typically, any given transaction leads to other transactions as funds and securities cross the globe. If at that place is either a transmittal failure or advanced fraud affecting any one of the intermediate transactions, this could cause an unraveling of all concomitant transactions. 22. If you expect the French franc to depreciate in the near future, would a U. S. -based FI in genus Paris prefer to be net long or net short in its asset positions? discuss. The U. S.FI would prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of the franc relative to the dollar authority that the U. S. FI would pay back the net liability position with fewer dollars. In other words, the decrease in the foreign assets in dollar assess after reincarnation will be less than the decrease in the value of the foreign liabilities in dollar value after conversion. 29. What is domain or sovereign risk? What cure does an FI realistically have in the concomitant of a collapsing sylvan or silver?Country risk involves the interference of a foreign government in the transmission system of funds transfer to repay a debt by a foreign borrower. A lender FI has very little repair in this situation unless the FI is able to coordinate the debt or demonstrate influence over the future supply of funds to the country in question. This influence likely would involve significant working relationships with the IMF and the World Bank. 32. What is liquidity risk? What routine operating factors allow FIs to deal with this risk in time of normal economic activity?What food grocery store reality can create bleak financial difficulty for an FI in generation of extreme liquidity crises? Liquidity r isk is the uncertainty that an FI may need to entertain large amounts of cash to play the withdrawals of depositors or other liability claimants. In government note of normal economic activity, depository FIs meet cash withdrawals by accepting new deposits and borrowing funds in the short-term money food markets. However, in times of uncouth liquidity crises, the FI may need to plow assets at significant losses in order to generate cash quickly. 33.Why can insolvency risk be classified as a consequence or payoff of any or all of the other types of risks? Insolvency risk is the risk that an FI may not have enough swell to moon-curser a sudden decline in the value of its assets. This risk involves 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, liquidity, sovereign, foreign exchange, technological, and off-balance-sheet risks. 34. Discuss the interrelationships among the different sources of FI risk exposure.Why would the construction of an FIs risk management model to measure and manage only one type of risk be incomplete? measuring each source of FI risk exposure individually creates the false impression that they are independent of each other. For example, the interest rate risk exposure of an FI could be cut down by requiring customers to take on more interest rate risk exposure through the use of floating rate products. However, this reduction in FI risk may be obtained only at the possible expense of increase credit risk. That is, customers experiencing osses resulting from unexpected interest rate changes may be forced into insolvency, thereby increasing the FIs default risk. Similarly, off-balance sheet risk encompasses some(prenominal) risks since off-balance sheet contingent contracts typically have credit risk and interest rate risk as well as currency risk. Moreover, the failure of collection and payment 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 evolution sophisticated models that attempt to measure all of the risks faced by the FI at any point in time.Practice 1. A bank has the following balance sheet structure AssetsLiabilities and Equity Cash$10,000Certificate of Deposit$90,000 bond$90,000Equity $10,000 Total Assets$100,000Total Liabilities and Equity$100,000 The bond is a Eurobond it has a ten-year maturity and a fixed-rate verifier of 6 percent. The certificate of deposit has a one-year maturity and a 4 percent fixed rate of interest. The FI expects no additional asset growth. a. What will be the net interest income (NII) at the end of the first year? put down pay interest income equals interest income disconfirming interest expense. b.If at the end of year 1, market interest rates have increased 100 basis points (1 percent), wha t will be the net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing risk? c. Assuming that market interest rates increase 1 percent. (i) What will be the market value of the bond? (ii) What will be the market value of justness? (Assume that all of the NII in part (a) is used to cover operating expenses or is distributed as dividends, so that there is no addition to retained earnings. ) a. What will be the net interest income (NII) at the end of the first year?Note Net interest income equals interest income minus interest expense. Interest income$5,400$90,000 x 0. 06 Interest expense 3,600$90,000 x 0. 04 Net interest income (NII)$1,800 b. If at the end of year 1, market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Interest income$5,400$90,000 x 0. 06 Interest expense 4,500$90,000 x 0. 05 Net interest income (NII)$900 The decrease in net interest income is cause d by the increase in financing cost without a corresponding increase in the earnings rate.The increase in market interest rates does not affect the interest income because the bond has a fixed-rate coupon for ten years. Note this answer makes no assumption about reinvesting the first years interest income at the new higher rate. c. Assuming that market interest rates increase 1 percent. (i) What will be the market value of the bond? (ii) What will be the market value of truth? (Assume that all of the NII in part (a) is used to cover operating expenses or is distributed as dividends, so that there is no addition to retained earnings. Note market value of equity falls out-of-pocket to lower market value of the bond If the coupon rate is 6%, yield to maturity = 7%, then using our financial calculator, N = 9 (only 9 years left), PMT = 540, I = 7%, FV = 90,000. deem PV find PV = -84,136. 29. Hence the market value of the bond fell from $90,000 to $84,136. 29 (a decrease of $5,863. 71) . Since the interest rate on the CD has risen (it had only a one year maturity so it gets a new interest rate when it is re-issued), the market value of the CD is $90,000 (interest rate = coupon rate on the CD).Consequently, it is the market value of equity that will decline. If the bank essential sell the bond, it will sell it at the lower market value and realize the loss. The book value of equity has remained at 10,000, but the market value of equity has fallen by the amount of the decrease in the value of the bonds. This was a problem faced by banks in 2008, when the market value of the mortgage debt and mortgage okay securities and CDOs (collateralized debt obligations) fell some of them had negative equity in market value terms.