Answers to Chapter 19
Questions:
1. Credit risk is the risk that promised cash flows from loans and securities held by FIs may not be paid in full. FIs
that lend money for long periods of time, whether as loans or by buying bonds, are more susceptible to this risk than
2. 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
3. This was principally credit risk, but the main issue is whether this represents systematic credit risk or firm
4. Liquidity risk is the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very
5. The most liquid asset of all is cash, which FIs can use directly to meet liability holders’ demands to withdraw
funds. Although FIs limit their cash asset holdings because cash earns no interest, low cash holdings are generally
not a problem. Day-to-day withdrawals by liability holders are generally predictable, and large FIs can normally
6. Asset transformation by an FI involves purchasing primary assets and issuing secondary assets as a source of
7. 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
8. 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
9. Although the fund’s asset portfolio is comprised of default (or credit) risk free securities, it is still exposed to
10. When interest rates increase (or decrease), the value of fixed-rate assets decreases (or increases) because of the
discounted present value of the cash flows. To the extent that the change in market value of the assets differs from
11. A policy of maturity matching will allow changes in market interest rates to have approximately the same effect
on both interest income and interest expense. An increase in rates will tend to increase both income and expense, and
13. The zero coupon bond would have more interest rate risk. Since the entire cash flow from the zero coupon is not
received until the bond matures, the entire cash flow is exposed to interest rate changes over the entire life of the
14. In this case the coupon-paying bond has more interest rate risk. The zero-coupon bond will generate exactly the
expected return at the time of purchase because no interim cash flows will be realized. Thus, the zero-coupon bond
16. Off-balance-sheet activities are contingent commitments to undertake future on-balance-sheet investments. The
17. Foreign exchange risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities
denominated in non-domestic currencies. An FI is net long in foreign assets when the foreign currency-denominated
18. FIs can realize operational and financial benefits from direct foreign investment and foreign portfolio
19. The U.S. FI would prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of
20. Matching the size of the foreign currency book will not eliminate the risk of the international transactions if the
21. In this case, the insurance company is worried about the value of the British pound falling. If this happens, the
22. If the franc is expected to depreciate, an FI loses if it is net long in assets (i.e., it has more assets denominated in
23. Country risk is the risk that repayments to foreign lenders or investors may be interrupted because of
24. Technology risk refers to the uncertainty surrounding the implementation of new technology in the operations of
an FI. For example, if an FI spends millions on upgrading its computer systems but is not able to recapture its costs
because its productivity has not increased commensurately or because the technology has already become obsolete,
it has invested in a negative NPV investment in technology.
26. 1. a, b
2. a, b
27. Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its
28. Measuring each source of FI risk exposure individually creates the false impression that they are independent of
each other. For example, the interest rate risk exposure of an FI could be reduced by requiring customers to take on
more interest rate risk exposure through the use of floating-rate products. However, this reduction in FI risk may be
Problems:
The change in NII is the result of refinancing risk. Refinancing risk occurs when the cost of rolling over the CD
liability occurs at the new higher 7% rate. Reinvestment risk is not incurred in this example. Reinvestment risk is
when the cash earned on the assets is reinvested at a lower interest rate. This did not occur in this case.
e. The operating performance has been affected by the changes in the market interest rates that have caused the
3. There would be no impact on net interest income during the first year. However, net interest income would
decrease in the second year:
Before Devaluation
After Devaluation
Thus, the devaluation of the euro reduced net interest margin by $1 million.
c. The assets before depreciation were worth $100 million (€150m/1.50) but after devaluation they are worth $75
million. The liabilities were worth $66.67 million but are now worth $50 million. Since assets declined by $25
million and liabilities by $16.67 million, net worth declined by $8.33 million using current spot rates.
5. At Issue Date:
Today:
a. Today’s principal value on the Euro CD is £153.82 and $129.21m (153.82/1.1905).
6. a. Beginning of the Year
End of Year