Chap021 - Chapter 21 Managing Liquidity Risk on the Balance...

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Chapter 21 - Managing Liquidity Risk on the Balance Sheet Answers to Chapter 21 Questions 1. Asset-side risk arises from transactions that result in a transfer of cash to some other asset. This could arise from the exercise of a loan commitment or a line of credit. Liability side risk arises from transaction whereby a creditor, depositor, or other claimholder demands cash in exchange for the claim. The withdrawal of funds from a bank is an example of such a transaction. 2. a. This bank is decreasing in size because less core deposits are being added to the bank than are being withdrawn.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%. If the distribution is normal, we can state with 95% confidence that the rate of decrease of deposits will be between 0% and 4% (plus or minus two standard deviations). b. If the bank has a net deposit drain, it needs to either increase its purchased liquidity (by borrowing funds or issuing equity) or reduce its stored liquidity. An institution can reduce its assets by drawing down on its cash reserves, selling securities, or calling back (or not renewing) its loans. It can increase liabilities by issuing more Federal funds, long-term debt, or new issues of equity. If a bank offsets the drain by increasing liabilities, the size of the firm remains the same. However, if it offsets the drain by reducing its assets, the size of the firm is reduced 3. They are likely to be positively related. During times when cash or credit is short, corporations may draw down their cash balances as well as using their lines of credit and loan commitments, thus reducing bank deposits and at the same time banks are obligated to lend out additional funds. 4. In the case of a bank, it could be due to a deposit drain caused by a bank run. For an insurance company, it could be caused by unusual losses. For a mutual fund, it might be the result of investors' cashing in their shares. 5. a. Assets (in millions) Liabilities Cash 15 Deposits 90 Other Assets 155 Borrowed Funds 40 170 Other liabilities 40 170 b. Assets(in millions) Liabilities Cash 30 Deposits 90 Other Assets 155 Borrowed Funds 55 185 Other liabilities 40 185 6. a. Cost of the drain = (8% - 6%) x $2 million = $40,000 The average size of the firm will be $8 million after the drain. 21-1
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Chapter 21 - Managing Liquidity Risk on the Balance Sheet b. Cost of the drain = (8% - 7.5%) x $2 million = $10,000 The average size of the firm will be $10 million after the drain. 7.a.
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Chap021 - Chapter 21 Managing Liquidity Risk on the Balance...

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