EFI 1

Question 1

1.1 - Question 1

What are five risks common to all financial institutions?

Answer 1

Five risks common to all financial institutions include:
1) CREDIT risk (default of assets)

2) INTEREST RATE risk caused by maturity mismatches between assets and liabilities
3) LIQUIDITY risk (liability withdrawal)
4) UNDERWRITING risk (for example through the sale of securities or the issue of various types of credit guarantees)
5) OPERATING risks due to the use of real resources (labour and technology)

Question 2

1.1 - Question 2

Explain how economic transactions between household savers of funds and corporate users of funds would occur in a world without financial institutions.

Answer 2

In a world without FIs the users of corporate funds in the economy would have to directly approach the household savers of funds in order to satisfy their borrowing needs.
In this economy, the level of fund flows between household savers and the corporate sector is likely to be quite low. There are several reasons for this. Once they have lent money to a firm by buying its financial claims, households need to monitor, or check, the actions of that firm. They must be sure that the firm’s management neither steals nor wastes the funds on any projects with low or negative net present values.
Such monitoring actions are extremely costly for any given household because they require considerable time and expense to collect sufficiently high-quality information relative to the size of the average household saver’s investments. Given this, it is likely that each household would prefer to leave the monitoring to others. In the end, little or no monitoring would be done. The resulting lack of monitoring would reduce the attractiveness and increase the risk of investing in corporate debt and equity.
The net result would be an imperfect allocation of resources in an economy

Question 3

1.1 - Question 3

Identify and explain three economic disincentives that would dampen the flow of funds between household savers of funds and corporate users of funds in an economic world without financial institutions.

Answer 3

Investors generally are averse to directly purchasing securities because of:

1) Monitoring costs;
2) Liquidity costs; and
3) Price risk.

Monitoring the activities of borrowers requires extensive time, expense, and expertise. As a result, households would prefer to leave this activity to others, and by definition, the resulting lack of monitoring would increase the riskiness of investing in corporate debt and equity markets. The long-term nature of corporate equity and debt securities would likely eliminate at least a portion of those households willing to lend money, as the preference of many for near-cash liquidity would dominate the extra returns which may be available. Finally, the price risk of transactions on the secondary markets would increase without the information flows and services generated by high volume.

Question 4

1.1 - Question 4

Identify and explain the two functions FIs perform that would enable the smooth flow of funds from household savers to corporate users.

Answer 4

FIs serve as conduits between users and savers of funds by providing a brokerage function and by engaging in an asset transformation function.

When acting as a pure broker, an FI acts as an agent for the saver by providing information and transaction services. For example, full-service securities firms like Merrill Lynch carry out investment research and make investment recommendations for their retail (household) clients as well as conduct the purchase or sale of securities at better prices and with greater efficiency than household savers could achieve by trading on their own.

This efficiency results in reduced costs of trading, or economies of scales. Similarly, independent insurance brokers identify the best types of insurance policies household savers can buy to fit their savings and retirement plans. In fulfilling a brokerage function, the FI plays an extremely important role by reducing transaction and information costs or imperfections between households and corporations. Thus, the FI encourages a higher rate of savings than would otherwise exist.

The asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations. Thus, FIs take on the costs associated with the purchase of securities.

Question 5

1.1 - Question 5

In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?

Answer 5

Funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI.

Question 6

1.1 - Question 6

Explain how financial institutions act as delegated monitors. What secondary benefits often accrue to the entire financial system because of this monitoring process?

Answer 6

By putting excess funds into financial institutions, individual investors give to the FIs the responsibility of deciding who should receive the money and of ensuring that the money is used properly by the borrower. This agglomeration of funds resolves a number of problems.

First, the large FI now has a much greater incentive to collect information and monitor actions of the firm because it has far more at stake than does any small individual household. In a sense, small savers have appointed the FI as a delegated monitor to act on their behalf. Not only does the FI have a greater incentive to collect information, the average cost of collecting information is lower. Such economies of scale of information production and collection tend to enhance the advantages to savers of using FIs rather than directly investing themselves.

Second, the FI can collect information more efficiently than individual investors. The FI can use this information to create new products, such as commercial loans, that continually update the information pool. Thus, a richer menu of contracts may improve the monitoring abilities of FIs. This more frequent monitoring process sends important informational signals to other participants in the market, a process that reduces information imperfection and asymmetry between the ultimate providers and users of funds in the economy.

In conclusion, by acting as a delegated monitor and as an information producer, FIs reduce the degree of information imperfection and asymmetry between the ultimate suppliers and users of funds in the economy.

Question 7

1.1 - Question 7

What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?

Answer 7

1) FIs collect and process information more efficiently than individual savers.
2) FIs provide secondary claims to household savers which often have better liquidity characteristics than primary securities such as equities and bonds.
3) By diversifying the asset base FIs provide secondary securities with lower price risk conditions than primary securities.
4) FIs provide economies of scale in transaction costs because assets are purchased in larger amounts.
5) FIs provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts, such as mortgage loans, that are financed with short-term deposits.

Question 8

1.1 - Question 14

What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial institutions?

Answer 8

If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities through on- and off-balance sheet hedging activities and flexible access to the financial markets.

A dimension of FIs’ ability to reduce risk by diversification is that they can better bear the risk of mismatching the maturities of their assets and liabilities than can small household savers. Thus, FIs offer maturity intermediation services to the rest of the economy. Specifically, through maturity mismatching, FIs can produce long-term contracts, such as long-term, fixed-rate mortgage loans to households, while still raising funds with short-term liability contracts.

By investing in a portfolio of long- and short-term assets that have variable- and fixed-rate components, the FI can reduce maturity risk exposure by using liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options, swaps, and other derivative products.

Question 9

2.1 - Question 7

How do finance companies make money? What risks does this process entail? How do these risks differ for a finance company versus a commercial bank?

Answer 9

Finance companies make a profit by borrowing money at a rate lower than the rate
at which they lend. This is similar to a commercial bank, with the primary difference being the source of funds, principally deposits for a bank, and money and capital market borrowing for a finance company.

The principal risk in relying heavily on public debt as a
source of financing involves the continued depth of the commercial paper and other debt
markets.

As experienced during the financial crisis of 2008-2009, economic recessions
can affect these markets more severely than the effect on deposit drains in the commercial banking sector. In addition, the riskier customers may have a greater impact on the finance companies.

Question 10

2.1 - Question 8

Why do finance companies face less regulation than do commercial banks? How does this advantage translate into performance advantages? What is the major
performance disadvantage?

Answer 10

By not accepting deposits, the need is eliminated for regulators to evaluate the potentially adverse safety and soundness effects of a finance company failure on the economy.
The performance advantage involves the avoidance of dealing with the heavy regulatory burden, but the disadvantage is the loss of the use of a relatively
cheaper source of deposit funds.

However, because of the impact that non-bank FIs,
including finance companies, had on the U.S. economy during the financial crisis and as a result of the need for the Federal Reserve to rescue several non-bank FIs, regulators proposed that non-bank FIs receive more oversight.

Question 11

2.2 - Question 3

What are the key activity areas for investment banks and securities firms? How does each activity area assist in the generation of profits and what are the major risks for each area?

Answer 11

The major activity areas of security firms are:

1) INVESTMENT BANKING. Investment banks specialise in underwriting and distributing both debt and equity issues in the corporate market. New issues can be placed either privately or publicly and can represent either an initial public offering (IPO) of debt or
equity or a secondary issue. Secondary issues of seasoned firms typically will generate lower fees than an IPO. Securities underwritings can be undertaken through either public offerings or private offerings. In a private offering the investment bank receives a fee for acting as the agent in the transaction. In best-efforts public offerings, the bank acts as the agent and receives a fee based on the success of the offering.
In a firm commitment underwriting, the bank acts as a principal, purchasing the securities from the issuer at one price and seeking to place them with public
investors at a slightly higher price. Thus, the risk of loss is higher. Finally, the bank may perform similar functions in the government markets and the asset-backed derivative markets. In all cases, the investment bank receives fees related to the difficulty and risk in placing the issue.

2) VENTURE CAPITAL. A difficulty for new and small firms in obtaining debt financing from commercial banks is that commercial banks (CBs) are generally not willing or able to make loans to new companies with no assets and business history. In this case, new and small firms often turn to investment banks (and other firms) that make venture capital investments to get capital financing as well as advice. Venture capital is a
professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other
owners.

3) MARKET MAKING. Security firms assist in the market-making function by acting as brokers to assist customers in the purchase or sale of an asset. Market making can involve either agency or principal transactions. Agency transactions are two-way
transactions on behalf of customers, for example, acting as a stockbroker or dealer for a fee or commission. In principal transactions, the market maker seeks to profit on the price movements of securities and takes either long or short inventory positions for its
own account. These principal positions can be profitable if prices increase, but they can also create downside risk in volatile markets.

4) TRADING. Trading activities can be conducted on behalf of a customer or the firm. The activities usually involve position trading, pure arbitrage, risk arbitrage, programme trading, stock brokerage, and electronic brokerage.
Position trading involves the purchase of large blocks of stock to facilitate the smooth functioning of the market.
Pure arbitrage involves the purchase and simultaneous sale of an asset in different markets because of different prices in the two markets. Risk arbitrage involves establishing positions prior to some anticipated information release or event.
Programme trading involves positioning with the aid of computers and futures contracts to benefit from small market movements.
In each case, the potential risk involves the movements of the asset prices, and the benefits are aided by the lack of most transaction costs and the immediate information that is available to investment banks.
Stock brokerage involves the trading of securities on behalf of individuals whowant to transact in the money or capital markets.
Electronic brokerage, offered bymajor brokers, involves direct access, via the Internet, to the trading floor, therefore bypassing traditional brokers.

5) INVESTING. Securities firms act as agents for individuals with funds to invest by
establishing and managing mutual funds and by managing pension funds. The
securities firms generate fees that affect directly the revenue stream of the
companies.

6) CASH MANAGEMENT. Cash management accounts are checking accounts that earn
interest and may be covered by FDIC insurance. The accounts have been beneficial in
providing full-service financial products to customers, especially at the retail level.

7) MERGERS AND AQUISITIONS. Most investment banks provide advice to corporate
clients who are involved in mergers and acquisitions.

8) BACK-OFFICE AND OTHER SERVICE FUNCTIONS. Security firms offer clearing and settlement services, research and information services, and other brokerage services on a fee basis.

Question 12

2.2 - Question 6

What are the risk implications to an investment bank from underwriting on a best-efforts
basis versus a firm commitment basis?
If you operated a company issuing stock for the first time, which type of underwriting would you prefer? Why? What factors may cause you to choose the alternative?

Answer 12

In a best efforts underwriting, the investment bank acts as an agent of the company
issuing the security and receives a fee based on the number of securities sold.

With a firm commitment underwriting, the investment bank acts as a principal, purchasing the
securities from the company at a negotiated price and selling them to the investing public at what it hopes will be a higher price. Thus, the investment bank has greater risk with the firm commitment underwriting, since the investment bank will absorb any adverse price movements in the security before the entire issue is sold.

Factors causing preference to the issuing firm include general volatility in the market, stability and maturity of the financial health of the issuing firm, and the perceived appetite for new issues in the market place.

The investment bank will also consider these factors when negotiating the fees and/or pricing spread in making its decision regarding the offering process.

Question 13

2.2 - Question 11

What is venture capital?

Answer 13

Venture capital is a professionally managed pool of money used to finance new and often high-risk firms.

Venture capital is generally provided by investment institutions or private individuals willing to back an untried company and its managers in return for an
equity investment in the firm.

Venture capital firms do not make outright loans. Rather,they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners.

As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and sometimes even help in recruiting senior managers
for the firm. They also generally expect to be fully informed about the firm’s operations, any problems, and whether the joint goals of all of the firm’s owners are being met.

Question 14

3.1 - Question 1

What is a mutual fund?
In what sense is it a financial institution?

Answer 14

A mutual fund represents a pool of financial resources obtained from individuals and companies, which is invested in the money and capital markets.

This process represents another method for economic savers to channel funds to companies and
government units that need extra funds.

Question 15

3.1 - Question 3

What are the economic reasons for the existence of mutual funds;

What benefits do mutual funds provide for investors?

Why do individuals rather than corporations hold most mutual funds?

Answer 15

One major economic reason for the existence of mutual funds is the ability to achieve diversification through risk pooling for small investors.

By pooling investments from a large number of small investors, fund managers are able to hold well-diversified portfolios of assets.

In addition, managers can obtain lower transaction costs because of the volume of transactions, both in dollars and numbers, and they benefit from research,
information, and monitoring activities at reduced costs.

Many small investors are able to gain benefits of the money and capital markets by using mutual funds. Once an account is opened in a fund, a small amount of money can be invested on a periodic basis.
In many cases, the amount of the investment would be
insufficient for direct access to the money and capital markets.

On the other hand, corporations are more likely to be able to diversify by holding a large bundle of individual
securities and assets, and money and capital markets are easily accessible by direct investment.

Further, an argument can be made that the goal of corporations should be to maximise shareholder wealth, not to be diversified.

Question 16

3.1 - Question 4

How is the net asset value (NAV) of a mutual fund determined? What is meant by the term marked-to-market daily?

Answer 16

Net Asset Value (NAV) is the market value of each ownership share of the mutual fund.

The total market value of the fund is determined by summing the total value of each asset in the fund. The value of each asset can be found by multiplying the number of shares of the asset by the corresponding price of the asset. Dividing this total fund value
by the number of shares in the mutual fund will give the NAV for the fund.

The NAV is calculated at the end of each daily trading session, and thus reflects anyadjustments in value caused by:

a) changes in value of the underlying assets;
b) dividend distributions of the companies held; or
c) changes in ownership of the fund.

This process of daily recalculation of the NAV is called marking-to-market.

Question 17

3.1 - Question 7

What is the difference between open-end and closed-end mutual funds?
Which type of fund tends to be more specialised in asset selection?
How does a closed-end fund provide another source of return from which an investor may either gain or lose?

Answer 17

Open-end funds allow shares to be purchased and redeemed according to investor demand. The NAV of open-ended funds is determined only by changes in the value of the assets owned.

In closed-end funds, the number of shares of the fund is fixed. If investors need to redeem their shares, they sell them to another investor.
Thus, the demand for the fund shares can provide another source of return for the investors as the
market price of the fund may exceed the NAV of the fund. Closed-end funds, such as real estate investment trusts, tend to be more specialised.

Question 18

3.1 - Question 10

What is a hedge fund and how is it different from a mutual fund?

Answer 18

Hedge funds are a type of investment pool that solicits funds from (wealthy) individuals and other investors (e.g., commercial banks) and invests these funds on
their behalf.

Hedge funds are similar to mutual funds in that they are pooled investment vehicles that accept investors’ money and generally invest it on a collective basis.

Hedge funds are, however, not subject to the numerous regulations that apply to mutual funds for the protection of individuals, such as:

• regulations requiring a certain degree of liquidity;
• regulations requiring that mutual fund shares be redeemable at any time;
• regulations protecting against conflicts of interest;
• regulations to ensure fairness in the pricing of funds shares;
• disclosure regulations; and
• regulations limiting the use of leverage.

Further, hedge funds do not have to disclose their full activities to third parties. Thus, they offer a high degree of privacy for their investors.

Historically, hedge funds avoided regulations by limiting the number of investors to less
than 100 individuals, who must be deemed “accredited investors”. To be accredited, an investor must have a net worth of over $1 million or have an annual income of at least $200,000 ($300,000 if married).
These stiff financial requirements allowed hedge
funds to avoid regulation under the theory that individuals with such wealth should be able to evaluate the risk and return on their investments.

Because hedge funds have been exempt from many of the rules and regulations
governing mutual funds, they can use aggressive strategies that are unavailable to mutual
funds, including:

• short selling;
• leveraging;
• programme trading;
• arbitrage; and
• derivatives trading.

Question 19

3.2 - Question 1

What is the primary function of an insurance company? How does this function
compare with the primary function of a depository institution?

Answer 19

The primary function of an insurance company is to provide protection from adverse events.
Insurance companies accept premium payments in exchange for compensation in the event that certain specified events occur.

The primary function of depository institutions is to provide financial intermediation for individual and corporate savers.

By accepting deposits and making
loans, depository institutions allow savers with predominantly small, short-term financial assets to benefit from investments in larger, longer-term assets

These long-term assets typically yield a higher rate of return than short-term assets.

Question 20

3.2 - Question 2

What is the adverse selection problem? How does adverse selection affect the profitable management of an insurance company?

Answer 20

The adverse selection problem occurs because customers who are most in need of insurance are most likely to acquire insurance. However, the premium structure for various types of insurance typically is based on an average population proportionately
representing all categories of risk.

Thus, the existence of a proportionately larger share of
high-risk customers may cause the premium revenue received by the insurance provider to underestimate the revenue needed to cover the insured liabilities and to provide a reasonable profit for the insurance company.

Insurance companies deal with the adverse selection problem by establishing different pools of the population based on health and related characteristics (such as income).

By altering the pool used to determine the probability of losses to a particular customer’s health characteristics, the insurance company can more accurately determine the probability of having to pay out on a policy and can adjust the insurance premium
accordingly.

Question 21

3.2 - Question 4

Explain how annuity activities represent the reverse of life insurance activities.

Answer 21

Whereas life insurance involves different contractual methods of building up a fund, annuities involve different methods of liquidating a fund, such as paying out a fund’s proceeds.

A typical life insurance contract requires a periodic payment by one party for a promised payment of either a lump sum or an annuity if a particular event occurs,
such as death or an accident.

An annuity represents a reverse contract where the party purchases the right to receive periodic payments depending on the market conditions.

The contract may be initiated by investing a lump sum or by making periodic payments before
the annuity payments begin.

Question 22

4.1 - Question 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?

Answer 22

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.

Question 23

4.1 - Question 2

What is refinancing risk? How is refinancing risk part of interest rate risk? If an FI funds long-term 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?

Answer 23

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 a 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 decrease 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.

Question 24

4.1 - Question 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?

Answer 24

Reinvestment risk is the risk that the return 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 interest rates might decrease.

In this case, 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 interest rates.In this case, net interest income would decrease.

If interest rates increase, the bank would be able to lend or reinvest the money at higher rates after two years. In this case, net interest income would increase. Besides the effect on the income statement,
reinvestment risk may cause realised yields on assets to differ from the a priori expected yields.

Question 25

4.1 - Question 4

The sales literature of a mutual fund claims that the fund has no risk exposure since it invests exclusively in federal government securities which are free of default risk.
Is this claim true? Explain why or why not.

Answer 25

Although the fund’s asset portfolio is comprised of securities with no default risk, the securities are exposed to interest rate risk.

For example, if interest rates increase,
the market value of the fund’s Treasury security portfolio will decrease.
Further, if interest rates decrease, the realised yield on these securities will be less than the expected rate of
return because of reinvestment risk.

In either case, investors who liquidate their positions
in the fund may sell at a Net Asset Value (NAV) that is lower than the purchase price.

Question 26

4.1 - Question 5

How can interest rate risk adversely affect the economic or market value of an FI?

Answer 26

When interest rates increase (or decrease), the values of fixed-rate assets decrease (or increase) because of the discounted present value of the cash flows.

To the extent that the change in market value of the assets differs from the change in market value of the liabilities, the difference is realized in the economic or market value of the equity of the FI.

For example, for most depository institutions, an increase in interest rates will cause asset values to decrease more than liability values. The difference will cause the market value, or share price, of equity to decrease.

Question 27

4.1 - Question 15

What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?

Answer 27

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 those FIs that have short investment horizons.

For example, life insurance companies and depository institutions are more exposed to credit risk than are money market mutual funds and property casualty
insurance companies.

Question 28

4.1 - Question 18

What is liquidity risk? What routine operating factors allow FIs to deal with this risk in times of normal economic activity? What market reality can create severe financial difficulty for an FI in times of extreme liquidity crises?

Answer 28

Liquidity risk is the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at less than fair market
prices.

In times of normal economic activity, depository institutions meet cash withdrawals by accepting new deposits and borrowing funds in the short-term money markets.

However, in times of harsh liquidity crises, the FI may need to sell assets at significant losses in order to generate cash quickly.

Question 29

4.1 - Question 21

What is foreign exchange risk? What does it mean for an FI to be net long in foreign assets?
What does it mean for an FI to be net short in foreign assets?
In each case, what must happen to the foreign exchange rate to cause the FI to suffer losses?

Answer 29

Foreign exchange risk is the risk that exchange rate changes can affect the value of
an FI’s assets and liabilities denominated in foreign currencies.

• An FI is net long in foreign assets when the foreign currency-denominated assets exceed the foreign currency-denominated liabilities.
In this case, an FI will suffer potential losses if the domestic currency strengthens relative to the foreign currency when repayment of the assets will occur in the foreign currency.

• An FI is net short in foreign assets when the foreign currency-denominated liabilities exceed the foreign currency-denominated assets.
In this case, an FI will suffer potential losses if the domestic currency weakens relative to the foreign currency when repayment of the liabilities will occur in the domestic currency.

Question 30

4.1 - Question 29

What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency?

Answer 30

Country or sovereign risk is the risk that repayments to foreign lenders or investorsmay be interrupted because of restrictions, intervention, or interference from foreign governments.

A lender FI has very little recourse in this situation unless the FI is able to restructure the debt or demonstrate influence over the future supply of funds to the country in question.

This influence likely would involve significant working relationships with the IMF and the World Bank.

Question 31

4.1 - Question 32

What is technology risk?
What is the difference between economies of scale and economies of scope?
How can these economies create benefits for an FI? How can these economies prove harmful to an FI?

Answer 31

Technology risk occurs when investment in new technologies does not generate the cost savings expected in the production and expansion of financial services.

ECONOMIES OF SCALE occur when the average cost of production decreases with the
production of or an expansion in the amount of financial services provided.

ECONOMIES OF SCOPE occur when an FI is able to lower overall costs by producing new
products with inputs similar to those used for other products.
In financial service industries, the use of data from existing customer databases to assist in providing new
service products is an example of economies of scope.

Failure to produce the perceived synergies or costs savings can result in major losses in competitive efficiency of an FI and, ultimately, in an FI’s long-term failure.

Question 32

4.1 - Question 34

Why can insolvency risk be classified as a consequence or outcome of any or all of the other types of risks?

Answer 32

Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities.

This risk involves the shortfall of capital in times when the operating performance of the institution generates
accounting losses.

These losses may be the result of one or more of interest rate, credit, liquidity, sovereign, foreign exchange, market, off-balance-sheet, and technological risks.

Question 33

5.1 - Question 19

What are some of the weakness of the repricing model?
How have large banks solved the problem of choosing the optimal time period for repricing?
What is runoff cash flow, and how does this amount affect the repricing model’s analysis?

Answer 33

The repricing model has four general weaknesses:

1) It ignores market value effects.

2) It does not take into account the fact that the dollar value of rate-sensitive assets and liabilities within a bucket are not similar.
Thus, if assets, on average, are repriced earlier in the bucket than liabilities, and if interest rates fall, FIs are subject to reinvestment risks.

3) It ignores the problem of runoffs. That is, that some assets are prepaid and some liabilities are withdrawn before the maturity date.
4) It ignores income generated from off-balance-sheet activities.

Large banks are able to reprice securities every day using their own internal models so reinvestment and repricing risks can be estimated for each day of the year.

Runoff cash flow reflects the assets that are repaid before maturity and the liabilities that are withdrawn unexpectedly. To the extent that either of these amounts is significantly greater than expected, the estimated interest rate sensitivity of the FI will be in error.

REMEMBER: The repricing gap is a measure of the difference between the dollar value of assets that will reprice and the dollar value of liabilities that will reprice within a specific time period GAP = RSA-RSL

Question 34

5.2 - Question 28

Identify and discuss three criticisms of using the duration gap model to immunise the portfolio of a financial institution.

Answer 34

The three criticisms are:

1) Immunisation is a dynamic problem because duration changes over time. Thus, it is necessary to rebalance the portfolio as the duration of the assets and liabilities change over time.
2) Duration matching can be costly because it is not easy to restructure the balance sheet periodically, especially for large FIs.
3) Duration is not an appropriate tool for immunising portfolios when the expected interest rate changes are large because of the existence of convexity.

Convexity exists because the relationship between security price changes and interest rate changes is not linear, which is assumed in the estimation of duration. Using convexity to immunise a portfolio will reduce the problem.

Question 35

6.1 - Question 13

Identify and define the borrower-specific and market-specific factors that enter into the credit decision.

a*) What is the impact of each type of factor on the risk premium?

b) Which of these factors is more likely to adversely affect small businesses rather than large businesses in the credit assessment process by lenders?
c) How does the existence of a high debt ratio typically affect the risk of the borrower?
d) Why is the volatility of the earnings stream of a borrower important to a lender?
* {only a) will possibly be in the first mid-term}

Answer 35

a) What is the impact of each type of factor on the risk premium?

The borrower-specific factors are:

> REPUTATION: Based on the lending history of the borrower; better reputation implies a lower risk premium.

> LEVERAGE: measure of the existing debt of the borrower; the larger the debt, the higher the risk premium.

> VOLATILITY OF EARNINGS: The more stable the earnings, the lower the risk premium.

> COLLATERAL: If collateral is offered, the risk premium is lower.

Market-specific factors include:

> Business cycle: Lenders are less likely to lend if a recession is forecasted.
Level of interest rates: A higher level of interest rates may lead to higher default rates, so lenders are more reluctant to lend under such conditions.
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b) Because reputation involves a history of performance over an extended time period, small businesses that are fairly young in operating time may suffer.
c) Increasing amounts of debt increase the interest charges that must be paid by the borrower, and thus, decrease the amount of cash flows available to repay the debt principal.
d) A highly volatile earnings stream increases the probability that the borrower cannot meet the fixed interest and principal payments for any given capital structure

Question 36

8.2 - Question 1

What is meant by market risk?

Answer 36

Market risk is the risk related to the uncertainty of an FI’s earnings on its trading portfolio.

Market risk is caused by changes in market conditions such as interest rate risk and foreign exchange risk.

Market risk emphasises the risks to FIs that actively trade assets and liabilities rather than hold them for longer term investment, funding, or hedging purposes.

Question 37

8.2 - Question 3

What is meant by daily earnings at risk (DEAR)? What are the three measurable components?
What is the price volatility component?

Answer 37

DEAR, or daily earnings at risk, is a measure of market risk over the next 24 hours.

It is defined as the estimated potential loss of a portfolio’s value over a one-day period as
a result of adverse moves in market conditions, such as changes in interest rates, foreign
exchange rates, and market volatility.

DEAR is comprised of:

1) the dollar value of the position;
2) the price sensitivity of the asset to changes in the risk factor;

3) the adverse move in the yield.
The product of the price sensitivity of the asset and the adverse move in the yield
provides the price volatility component.

DEAR = Market value of the share x volatility
VAR = DEAR x √N (N= time period)
Modified Duration = D / (1 + R) (R= interest rate)
Price volatility = (MD) x (potential adverse move in yield)

Question 38

9.1 - Question 1

How does one distinguish between an off-balance-sheet asset and an off-balancesheet liability?

Answer 38

Off-balance-sheet activities or items are contingent claim contracts.

An item is classified as an off-balance-sheet asset when the occurrence of the contingent event results in the creation of an on-balance-sheet asset.

An example is a loan commitment. If the borrower decides to exercise the right to draw down on the
loan, the FI will incur a new asset on its portfolio.
Similarly, an item is an off-balance-sheet liability when the contingent event creates an on-balance-sheet liability.
Another example is a standby letter of credit (SLC). In the event that the original payer of the SLC defaults, then the FI is liable to pay the amount to the payee, incurring a liability on the right-hand-side of its balance sheet.