Chapter+04+Answers+to+end-of-chapter+questions

Chapter+04+Answers+to+end-of-chapter+questions - PART 2...

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PART 2 MEASURING RISK CHAPTER 4 RISKS OF FINANCIAL INTERMEDIATION Chapter outline Interest Rate Risk Market Risk Credit Risk Off-balance-sheet Risk Technology and Operational Risks Foreign Exchange Risk Country or Sovereign Risk Liquidity Risk Insolvency Risk Other Risks and the Interaction of Risks Instructor’s Resource Manual t/a Financial Institutions Management 2e by Lange, Saunders, 1
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Answers to end-of-chapter questions QUESTIONS AND PROBLEMS 1. What is the process of asset transformation performed by a financial institution? Why does this process often lead to the creation of interest rate risk ? What is interest rate risk? Asset transformation by an FI involves purchasing primary assets and issuing secondary assets as a source of funds. The primary securities purchased by the FI often have maturity and liquidity characteristics that are different from the secondary securities issued by the FI. For example, 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 characteristics of long-term assets react to changes in market interest rates differently from the prices and interest expense characteristics of short-term deposits. Interest rate risk is the effect on prices (value) and interim cash flows (interest coupon payment) caused by changes in the level of interest rates during the life of the financial asset. 2. What is refinancing risk ? How is refinancing risk part of interest rate risk? If an FI funds long-term fixed-rate assets with short-term liabilities, what will be the impact on earnings of an increase in the rate of interest? A decrease in the rate of interest? Refinancing risk is the uncertainty of the cost of a new source of funds that are being used to finance a long-term fixed-rate asset. This risk occurs when an FI is holding assets with maturities greater than the maturities of its liabilities. For example, if a bank has a 10-year fixed-rate loan funded by a two-year time deposit, the bank faces a risk of borrowing new deposits, or refinancing, at a higher rate in two years. Thus, interest rate increases would reduce net interest income. The bank would benefit if the rates fall as the cost of renewing the deposits would decrease, while the earning rate on the assets would not change. In this case, net 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 will be the impact on earnings of a decrease in the rate of interest? An increase in the rate of interest? Reinvestment risk is the uncertainty of the earning rate on the redeployment of assets
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This note was uploaded on 08/21/2009 for the course FINS 3630 taught by Professor Yip during the Three '09 term at University of New South Wales.

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Chapter+04+Answers+to+end-of-chapter+questions - PART 2...

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