review - Chapter 1 Risks common to financial institutions...

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Unformatted text preview: Chapter 1 Risks common to financial institutions • Interest rate risks stems from the mismatching of the maturity (the main component of duration) of the assets and liabilities held by the FIs • Market risk: potential changes in the value of assets held by FIs • Credit risk: holding securities with the potential of default • Foreign exchange risks: FIs holding foreign currency or securities denominated in a foreign currency • Liquidity risk: cost associated with the ability to sell securities to raise cash Use of Economic transactions by FIs • Provide a center where savers meet borrowers • Provide economies of scale • Issue financial claims that are more attractive to the household savers than the claims directly issued by corporations, asset transformation o FIs purchase primary securities issued by finance corporations, they finance these purchases by selling secondary securities to household investors and other sectors in the form of deposits and insurance • FIs monitor the corporations keeping agency costs to a minimum • Liquidity risk: FI securities have better liquidity than corporate securities Functions of FIs • Provide a brokerage function along with asset transformation function o Asset transformation: issuing deposits to buy primary securities • Provide transaction services and information spets • Enact monetary policy Primary Vs secondary securities • Primary o Financial claims issued by commercial corporations are invested in real assets • Secondary- FIs buy primary securities with money from savers o Savers indirectly buy the primary securities o The information and evaluation (ex-ante), monitoring, liquidity costs and price risk are reduced through the FI FIs as delegated monitors • Depositors delegate an FI to act as a monitor on their behalf by giving an FI the responsibility of deciding who should receive money and of ensuring that the borrower uses the money properly o The FI can collect more information more efficiently than the individual investors o This information signals to other participants in the market FI specialty areas • Information: FIs collect and process information more efficiently than other investors • Liquidity: FIs provide secondary claims to household savers that often have better liquidity characteristics than primary securities • Price risk: FIs provide secondary securities with lower price risk than primary securities since they are backed by a diversifies asset base • Economies of scale: FIs provide economies of scale in transaction costs because assets are purchased in larger amounts • Maturity intermediation: FIs provide maturity intermediation to the economy that allows the introduction of additional types of investment contracts such as mortgage loans that are finance with short term deposits Non-cash costs • Agency costs: when a manager does not act in the best interests of his shareholders o Free rider: it is hard for individuals to monitor the company so they let...
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This note was uploaded on 02/27/2008 for the course FNCE 4000 taught by Professor Gross,davi during the Fall '07 term at Colorado.

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review - Chapter 1 Risks common to financial institutions...

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