Off Balance Sheet Risk

Question 1

what are off balance sheet assets and liabilities?

Answer 1

contingent assets and liabilities

Question 2

what is the incentive to have OBS assets and liabilities?

Answer 2

• generate additional income

- avoid regulatory cost (i.e. reserve requirements, deposit insurance premium, capital adequecy requirements)

Question 3

what is an example of a contingent asset?

Answer 3

loan commitment, ie comits to issuing a loan at a future date at a predetermined interest rate.
charge fees for the commitment.

Question 4

what are the risks involved with OBS asset? ie loan commitment

Answer 4

interest rate risk: risk that the borrowing cost increases above agreed upon i rate.
Credit risk: credit rating of borrower many change in the time leading up to the comittment (initial i rate not enough to cover risk)
aggregate funding risk: during bad economic periods bank may find it difficult to meet funding commitments

Question 5

what is an example of a contingent liability?

Answer 5

letters of credit: underwriting commercial preformance, insurance functions (ie default guarantees)
exposed to default risk

Question 6

what are examples of OBS instruments?

Answer 6

loan commitments
letters of credit
derivatives

Question 7

what are derivatives?

Answer 7

Financial instruments which derive their value(payoffs) from underlying assets ie:
stocks
bonds
FX

Question 8

what are examples of derivatives?

Answer 8

Options and Forward contracts

Futures and Swaps

Question 9

what is a spot contract?

Answer 9

simultaneous exchange of money and asset, happens immediately

Question 10

what is a forward contract?

Answer 10

agreement between buyer and seller at time 0, that an asset will be sold at a future point in time at a price agreed within the contract established at time 0

Question 11

what is a futures contract?

Answer 11

agreement between buyer and seller at time 0, that an asset will be sold at a future point in time at a price which has been adjusted daily to reflect market to market values.

Question 12

do forward or future contracts have higher default risks?

Answer 12

forward have higher default risk

Question 13

what are options contracts?

Answer 13

gve buyer right but not obligation to buy or sell asset at a prespecified price at the maturity date of the option.

Question 14

what are swaps?

Answer 14

exchanges of cashflows from the underlying asset/bond

Question 15

which two instruments are over the counter instruments?

what type of risk are they exposed to?

Answer 15

swaps and forward

high default risk.

Question 16

which are the two instruments which are considered safer? why? what is the main type of risk they are exposed to?

Answer 16

options and futures
because their value is based on market prices
exposed to price risk

Question 17

How does selling loans to other FI generate OBS risk?

Answer 17

bank removes loan from their balance sheet, however if there is recourse the bank still has a long term contingent liability if the person with the loan were to default, the bank selling the loan would have to bare the loss.
no recourse means the bank buying the loan bares all the risk.

Question 18

how do OBS activities reduce risk?

Answer 18

• they can be used to hedge, reduce banks exposer to interest rate risk and and FX risk
• can reduce insolvency risk, by increasing profitability and through hedging, and fee income