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Financial institutions and markets > risk management > Flashcards

risk management Flashcards

1
Q

the floating exchange rates

A 
increased volatility due to
• fluctuation in commodity prices
• stresses in global financial system
• large & ongoing current account deficits run by some
countries
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2
Q

volatility of interest rates

A

cash S/T interest rates

increase and so L/T volatility

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3
Q

what does ALCO stand for?

A

(large banks) asset and liability
management committee (ALCO) i.e. risk management
committee - to identify operational & financial risk
exposures & analyse the impacts

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4
Q

define risk

A

the chance that actual outcome will differ from
expected outcome.

It equals uncertainty (usually of a loss).
Risk is assumed to arise out of variability

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5
Q

what risks do modern FIs face?

A
  • Credit (default) risk
  • Interest rate risk
  • Liquidity risk
  • Off-balance sheet risks
  • Foreign exchange risk
  • Operational/technology risk
  • Country/sovereign risk
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6
Q

Interest Rate Risk For depository FIs

_______ of future cash flows & _____ of assets or liabilities-(for
borrower their liabilities, or lender their investments) to uncertain
changes in interest rates

A

Sensitivity

Value

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7
Q

(1)What are the two important aspects of interest rate risk?

A
  1. refinancing risk

2. reinvestment risk

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8
Q

(1)refinancing risk

A
  • risk that cost of
    reborrowing funds > than returns earned on asset
    investment. (assets have longer maturity than liabilities)

Example:
• if interest rates stay the same, FI can refinance its liabilities at
9% & lock in profit of 1%.
• if interest rates increase & FI can only borrow new 1 yr liabilities at
11%, then spread is negative (-1%)

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9
Q

(1)reinvestment risk

A
  • the risk that the returns
    on the funds to be reinvested will fall below the cost of the
    funds. (Liabilities have longer maturity than assets)

example:
• FI still locks in one-year profit of 1%.
At the end of first year, asset matures & funds have to be
reinvested. If interest rates decrease so that return on assets is 8%,
then FI faces a loss in second year of 1%.

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10
Q

(2)what is price risk?

A

it is Rising interest rates increase discount rates on future cash flows
& the price (market value) of that asset or liability decreases

-So FIs face price risk on their assets & any securities it holds

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11
Q

(2) FIs with assets that are _____ ______,
mismatching maturities by holding _______ assets than
liabilities means that when interest rates _____, the market value of the FI’s assets fall by a greater amount than its liabilities

A
  1. Debt instruments
  2. Longer-term
  3. increase
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12
Q

relationship between interest rates & business cycle

A 
Expansion phase:
all rates tend to rise BUT short-term rates tend to be more volatile than long-term & rise more quickly than long-term rates
.
peak & early stages of recession:
yield curve has negative
slope

Once economy in recession:

all rates decrease BUT short-term tend to
fall more quickly than long-term
At some point in recession, yield curves have positive slope

trough & through
.process begins again

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13
Q

money supply approach to forecasting interest rates

A

– If projected money supply growth greater than projected GDP
income, then interest rates likely to fall
– If projected money supply growth less than projected GDP
income, then interest rates likely to rise

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14
Q

fisher effect to forecasting interest rates

A
  • argument that observed changes in nominal interest rates will reflect changes in rate of inflation expected
    by lenders
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15
Q

(3) what are the 3 methods to measuring interest rate risk?

A
  1. maturity gap analysis
  2. duration gap analysis
  3. scenario analysis
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16
Q

(3) scenario analysis

A

-simulate how much net income changes when rate increase or decrease & use regression technique.

  • Also can model impact on balance sheet through changes
    in value of assets & liabilities
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17
Q

(3) GAP analysis (for identifying risk for net interest income)

A

-Identification of assets (loans) & liabilities (deposits) that are
sensitive to interest rate movements within defined planning period

18
Q

what are interest rate sensitive assets (RSA)?

A
  • those on which a floating rate

is payable; interest rate sensitive liabilities (RSL) similarly defined.

19
Q

GAP=?

A

RSA - RSL

20
Q

if banks expect rates to increase what should it do in relation to GAP?

A

it should have a positive gap & hold rate-sensitive assets in order
to take advantage of future rate increases & hold fixed-rate
liabilities to lock in current low rates

21
Q

if banks expect rates to decrease what should it do in relation to GAP?

A

it should have a negative gap & hold fixed-rate assets to lock in high rates & rate-sensitive
liabilities

22
Q

duration =

A

average lifetime of an asset or liability found by

calculating weighted average time to receipt of each element of cash flow of security

23
Q

duration analysis

A

Provides single measure of risk by applying to balance sheet & offers way to find effect of interest rate risk.

24
Q

Usefulness of duration

A
  • all securities of same duration will increase
    (or decrease) in value by same % for any given change in interest
    rates.
25
Q

Duration GAP analysis

A

Involves the percentage decline in the value of a security

approximately equals the change in interest rates times the duration

26
Q

Duration of a portfolio =

A

weighted duration of each asset or liability in

portfolio

27
Q

Use of duration

A

Managers try to immunise the portfolio by cancelling out reinvestment rate risk & price risk.

28
Q

the easy way (1st) to cancel out reinvestment rate risk & price risk and decrease interest rate risk

A

invest in zero-coupon bonds.

No price risk if held to maturity & no reinvestment risk for coupons.

29
Q

the 2nd way to decrease interest rate risk

A

Restructure asset & debt portfolio so duration of
portfolio matches investment horizon
= DGAP

increase DGAP if negative
Or decrease DGAP if DGAP is positive.

30
Q

Gap analysis & management

A

Internal procedures for managing interest rate risk involve altering
the maturity spectrum of the assets & liabilities.

31
Q

credit risk

A

the chance borrower will default on the repayment of principal loan or fails to service interest payments when due.

32
Q

how to manage credit risk?

A

–need to make assessment of the credit quality of
potential borrower by criteria e.g.

– borrower’s capital position & capacity to service loan &
management skills

– quality of the security to back loan.

Asymmetric info & moral hazard

33
Q

Liquidity Risk

A

banks need to have ongoing liquidity (cash)

to support expected loans & meet obligations due to its liabilities

34
Q

(4) what are the Two liquidity management strategies?

A
  1. borrow funds either from regulators or financial markets e.g. central banks
  2. Have strategy of diversified funding & use asset management
    & sell securities from securities portfolio e.g. T-bills
35
Q

(4) a short position is good when?

A

if interest rates are falling then terms of loan contracts exceed deposit terms is desirible

36
Q

(4) a long position is good when?

A
  • deposit terms exceed terms of loan contracts

are desirable when interest rates 

37
Q

Off- balance sheet risk

A

• Risk incurred by FI when engaging in contingent assets &
liabilities

• May lead to to volatility of income & market value of bank’s
equity that may arise from unexpected losses

38
Q

Foreign exchange risk

A

-Foreign exchange risk surrounds the foreign currency
transactions of FIs especially banks.

-Unexpected currency movements can create losses if bank
hasn’t allowed for movement.

39
Q

Management of Foreign Exchange (FX) Risk

A

• To avoid FX risk & be approximately hedged the FI must
match its assets & liabilities in each foreign currency (needs
to be of same size & maturity to avoid FX risk).

• Domestic FIs may reduce FX risks by trading forward &
entering a currency swap agreement or by operating a
currency hedge.

40
Q

Operational Risk

A

arises when existing technology &/or backoffice
systems break down. Could get situation where funds
borrowed not recorded but funds lent; huge net payment on
funds lent.

41
Q

Technology Risk

A

occurs when these investments don’t
produce anticipated savings- diseconomies of scale due to
excess capacity, redundant technology & inefficiencies.

42
Q

Country or Sovereign risk

A

where difference in laws may not protect FI

from legal address for defaulting loans & sovereign risk

Financial institutions and markets (12 decks)

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