Chapter 19 - Types of Risks Incurred by Financial Institutions
Answers to Chapter 19 Questions
Firm-specific credit risk refers to the likelihood that individual assets may deteriorate in
quality. Thus, if S&P lowers its rating on IBM stock and if an investor is holding only this
particular stock, she will face significant losses as a result of this downgrading. However, as
portfolio theory in finance has shown, firm-specific credit risk can be diversified away if a
portfolio of well-diversified stocks is held. Similarly, if an FI holds well-diversified assets, that
assets of varying quality, it will be left only with systematic credit risk, which will be
affected by the general condition of the economy.
This was principally credit risk, but the main issue is whether this represents systematic credit
risk or firm specific credit risk. It would seem that this example is closer to a demonstration of
firm specific risk in that it would have been possible to diversify some of this risk away by
making loans to firms less dependent on the oil industry in particular or the regional economy
Refinancing risk occurs when an FI is holding assets with maturities greater than its liabilities.
For example, if a bank has a ten-year loan funded by a 2-year time deposit, it faces a risk of
borrowing deposits at a higher rate in two years. It could also benefit if the rates fall.
Reinvestment risk occurs when an FI holds assets with maturities lower than its liabilities. For
example, if a bank has a two year loan funded by a ten year time deposit, it faces the risk that it
might be forced to lend
the money at lower rates after two years, perhaps even below the deposit
rates. Thus, if an FI has short-term liabilities funding long term assets, interest rate increases will
reduce net interest income.
4. Although the fund's asset portfolio is comprised of default (or credit) risk free securities, it is
still exposed to interest rate risk. For example, if interest rates increase significantly, the market
value of the fund's Treasury security portfolio may decrease. Moreover, although it is virtually
impossible for the federal government to go bankrupt (at least in terms of local currency, where
it always can print more money to meet its obligations), in times of political or economic
turmoil, the government may refuse to meet its debt obligations.
Market value risk refers to the possibility of a change in the underlying value of an asset. In
the context of this chapter, it refers to the changing of the value of a fixed income security as
interests rates change. The change in value occurs because of a change in the discounted present
value of cash flows as interests rates rise and fall.