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# 7 - Chapter Seven Risks of Financial Intermediation Chapter...

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Chapter Seven Risks of Financial Intermediation Chapter Outline Introduction Recall: What is risk? Probability of future loss associated with unanticipated or adverse changes in interest rates, market conditions, asset values, counterparty contractual violations, new technologies, fraud, foreign exchange rates, etc. Call this determinant for example X for the time being. Future returns are unknown, but we can make a guess E(R|X) the mean of a distribution, but that distribution also has a variance. X may be an interest rate, an exchange rate, a technology, etc. What is the risk associated with X? Z ~ N(0,1) = [0-E(R|X)]/ σ Risk Options E(R|X) σ (R|X) Pr(Loss|X) A 5.0% 5.0% 15.9% B 10.0% 9.0% 13.3% C 15.0% 12.0% 10.6% D 20.0% 15.0% 9.1% Distributions of Returns and Risk 0 1 2 3 4 5 6 7 8 9 -20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0% A B C D 1

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Note area under each curve from –infinity to zero is an estimate of the probability of loss given X. As X changes the mean and variance may change as well. As a result changes in X may affect the probability of loss – RISK! See also “IRR.xls.” Interest Rate Risk - risk incurred by an FI when maturities of it assets and liabilities are mismatched. Notice something about the definitions?...All start with xxxx is the risk. Market Risk –risk incurred in trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices. Credit Risk-risk that the promised cash flows from loans and securities held by FIs may not be paid in full. Firm-specific Credit Risk – risk of default of the borrowing firm associated with the specific types of project risk taken by that firm. Systematic Credit Risk – the risk of default associated with the general economy wide or macro conditions affecting all borrowers. Off-Balance-Sheet Risk – the risk incurred by an FI due to activities related to contingent assets and liabilities. Letter of credit – a credit guarantee issued by an FI fodr a fee on which payment is contingent on some future event occurring. Technology Risk – risk incurred by an FI when technological investments do not produce the anticipated cost savings. Operational Risk –the risk that existing technologocy or support systems may malfunction or break down. Foreign Exchange Risk – the risk that exchange rate changes can affect the value of an FI’s assets and liabilities located abroad. Country or Sovereign Risk – the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments. Liquidity Risk-risk that a sudden surge in liability withdrawals may leave an FI in a position of having to liquidate assets in a very short period of time and at low prices. Insolvency Risk-risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to liabilities.
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7 - Chapter Seven Risks of Financial Intermediation Chapter...

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