7 - Financial Institutions 2

7 - Financial Institutions 2 - Lecture 7 TOPIC 4 Financial...

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1 Derivatives and Securities Markets © HB, 2008 Lecture 7 TOPIC 4 Financial Institutions 2 © HB, 2008 Notes r TEST Next week, in H2-16 (our usual lecture room) on 19 September No tutorials next week Start at 2.10 pm but be seated by 2.00 pm As some additional time is likely to be available, plan to spend about one and half to two hours during the test. Please sit with gap of one seat, starting from the wall or aisle on your right as you face the front screens. Read what you can bring – writing implements, calculator, A- 4 one-sided sheet of notes. » Write answers on the test paper » Sample Test on course home page, with feedback and notes » Multiple choice questions in Learning Resources and at the textbook Web site » Covers Topics 1 to 4, including today’s lecture © HB, 2008 r Give an example and possible financial institution Amount of cash to pay Timing of cash to pay Example Institution Known Known Known Uncertain Uncertain Known Uncertain Uncertain Source: Fabozzi et al, 2002: 18-20 Cash flows may be uncertain and their timing is often not known precisely. Maturity structure of assets and liabilities and resulting cash flows do not always match. Nature of liabilities
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2 Derivatives and Securities Markets What risks do banks face? r Default risk Applies to: » Loans the bank has given. » Investments the bank makes. » These are assets of the bank. What can a bank do? Choose the assets! s Diversify portfolio of assets » Loans and investments can be diversified. » How can the bank diversify? How will risk be reduced? s Decide how much risk to take » Safe loans – charge low interest » Risky loans – charge higher interest » Credit granting procedures © HB, 2008 © HB, 2008 r Interest rate risk What is affected by this risk? » Both the bank’s assets and liabilities. Why? What can abank do? Manage its assets and liabilities » Reduce sensitivity of profits to changes in interest rates s Decide what assets and liabilities to have and how much s Match assets and liabilities In terms of their maturities, cash flows Example: Borrow short, lend long Raise $100m in short-term deposits by offering 5% p.a. Invest $100m in 15-year government bonds at 7% p.a. What happens to spread income? r Liquidity risk How does this risk arise? What can a bank do? s Manage cash flows to have enough cash to meet obligations – pay depositors and make loans s Match cash inflows and outflows s Sell securities that it owns when needed s Raise short term funds in the money market s Manage deposit base – attract additional deposits © HB, 2008
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3 Derivatives and Securities Markets © HB, 2008 r Operational risk Banks must have good internal controls . » Work culture
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7 - Financial Institutions 2 - Lecture 7 TOPIC 4 Financial...

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