EOC solutions Chapter 19

EOC solutions Chapter 19 - Answers to Chapter 19 Questions...

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Answers to Chapter 19 Questions: 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 have short investment horizons. For example, life insurance companies and depository institutions generally must wait a longer time for returns to be realized than money market mutual funds and property-casualty insurance companies. 2. Firm-specific credit risk refers to the likelihood that individual assets may deteriorate in quality. Thus, if S&P lowers its rating on IBM stock and if an investor is holding only this particular stock, she will face significant losses as a result of this downgrading. However, as portfolio theory in finance has shown, firm-specific credit risk can be diversified away if a portfolio of well-diversified stocks is held. Similarly, if an FI holds well-diversified assets, that is, assets of varying quality, it will be left only with systematic credit risk, which will be affected by the general condition of the economy. 3. 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 example is closer to a demonstration of firm specific risk in that it would have been possible to diversify some of this risk away by making loans to firms less dependent on the oil industry in particular or the regional economy more generally. 4. Liquidity risk is the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at less than fair market prices. In times of normal economic activity, depository institutions meet cash withdrawals by accepting new deposits and borrowing funds in the short-term money markets. However, in times of harsh liquidity crises, the FI may need to sell assets at significant losses in order to generate cash quickly. 5. The most liquid asset of all is cash, which FIs can use directly to meet liability holders’ demands to withdraw funds. Although FIs limit their cash asset holdings because cash earns no interest, low cash holdings are generally not a problem. Day-to-day withdrawals by liability holders are generally predictable, and large FIs can normally expect to borrow additional funds to meet any sudden shortfalls of cash in the money and financial markets. At times, however, FIs face a liquidity crisis. For example, because of a lack of confidence in an FI or some unexpected need for cash, liability holders may be led to demand larger withdrawals than usual. When all, or many, FIs face abnormally large cash demands, the cost of purchased or borrowed funds rises and the supply of such funds becomes restricted. As a consequence, FIs may have to sell some of their less liquid assets to meet the withdrawal demands of liability holders. This results in a more serious liquidity risk, especially as some assets with “thin” markets generate
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