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17 - Chapter Seventeen Liquidity Risk Chapter Outline...

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Chapter Seventeen Liquidity Risk Chapter Outline Introduction Causes of Liquidity Risk Liquidity Risk at Depository Institutions Liability-Side Liquidity Risk Asset-Side Liquidity Risk Measuring a DI’s Liquidity Exposure Liquidity Risk, Unexpected Deposit Drains, and Bank Runs Bank Runs, the Discount Window, and Deposit Insurance Liquidity Risk and Life Insurance Companies Liquidity Risk and Property-Casualty Insurers Mutual Funds Summary 200
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Solutions for End-of-Chapter Questions and Problems: Chapter Seventeen 1. How does the degree of liquidity risk differ for different types of financial institutions? Depository institutions are the FIs most exposed to liquidity risk. Mutual funds, pension funds, and PC insurance companies are the least exposed. In the middle are life insurance companies. 2. What are the two reasons liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance sheet? What is meant by fire-sale prices? Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI. Asset-side risk arises from transaction that result in a transfer of cash to some other asset, such as the exercise of a loan commitment or a line of credit. Liability-side risk arises from transactions whereby a creditor, depositor, or other claim holder demands cash in exchange for the claim. The withdrawal of funds from a bank is an example of such a transaction. A fire-sale price refers to the price of an asset that is less than the normal market price because of the need or desire to sell the asset immediately under conditions of financial distress. 3. What are core deposits? What role do core deposits play in predicting the probability distribution of net deposit drains? Core deposits are those deposits that will stay with the bank over an extended period of time. These deposits are relatively stable sources of funds and consist mainly of demand, savings, and retail time deposits. Because of their stability, a higher level of core deposits will increase the predictability of forecasting net deposit drains from the bank. 4. The probability distribution of the net deposit drain of a DI has been estimated to have a mean of 2 percent and a standard deviation of 1 percent. Is this DI increasing or decreasing in size? Explain. This DI is decreasing in size because less core deposits are being added to the bank than are being withdrawn. On average, the rate of decrease of deposits is 2 percent. If the distribution is normal, we can state with 95 percent confidence that the rate of decrease of deposits will be between 0 percent and 4 percent (plus or minus two standard deviations).
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