Chapter%207%20Problem_Solutions

Chapter%207%20Problem_Solutions - Chapter 07 - Risks of...

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Chapter Seven Risks of Financial Institutions Solutions for End-of-Chapter 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 differently to changes in market interest rates than the prices and interest expense characteristics of short-term deposits. Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched. 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 risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments. 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 ten-year fixed- rate loan funded by a 2-year time deposit, the bank faces a risk in that new deposits may only be obtained, and the loans refinanced, at a higher rate in two years. These interest rate increases would reduce net interest income. The bank would benefit if interest rates fall as the cost of renewing the deposits would decrease, while the interest rate earned on the loan 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 risk that the returns on funds to be reinvested will fall below the cost of funds. This risk occurs when an FI holds assets with maturities that are shorter than the maturities of its liabilities. For example, if a bank has a two-year loan funded by a ten-year fixed- rate time deposit, the bank faces the risk that it might be forced to lend or reinvest the money at lower rates after two years, perhaps even below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at the new lower (or higher) interest rates. Besides the
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Chapter%207%20Problem_Solutions - Chapter 07 - Risks of...

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