risk management Flashcards
the floating exchange rates
increased volatility due to • fluctuation in commodity prices • stresses in global financial system • large & ongoing current account deficits run by some countries
volatility of interest rates
cash S/T interest rates
increase and so L/T volatility
what does ALCO stand for?
(large banks) asset and liability
management committee (ALCO) i.e. risk management
committee - to identify operational & financial risk
exposures & analyse the impacts
define risk
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
what risks do modern FIs face?
- Credit (default) risk
- Interest rate risk
- Liquidity risk
- Off-balance sheet risks
- Foreign exchange risk
- Operational/technology risk
- Country/sovereign risk
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
Sensitivity
Value
(1)What are the two important aspects of interest rate risk?
- refinancing risk
2. reinvestment risk
(1)refinancing risk
- 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%)
(1)reinvestment risk
- 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%.
(2)what is price risk?
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
(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
- Debt instruments
- Longer-term
- increase
relationship between interest rates & business cycle
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
money supply approach to forecasting interest rates
– 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
fisher effect to forecasting interest rates
- argument that observed changes in nominal interest rates will reflect changes in rate of inflation expected
by lenders
(3) what are the 3 methods to measuring interest rate risk?
- maturity gap analysis
- duration gap analysis
- scenario analysis
(3) scenario analysis
-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
(3) GAP analysis (for identifying risk for net interest income)
-Identification of assets (loans) & liabilities (deposits) that are
sensitive to interest rate movements within defined planning period
what are interest rate sensitive assets (RSA)?
- those on which a floating rate
is payable; interest rate sensitive liabilities (RSL) similarly defined.
GAP=?
RSA - RSL
if banks expect rates to increase what should it do in relation to GAP?
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
if banks expect rates to decrease what should it do in relation to GAP?
it should have a negative gap & hold fixed-rate assets to lock in high rates & rate-sensitive
liabilities
duration =
average lifetime of an asset or liability found by
calculating weighted average time to receipt of each element of cash flow of security
duration analysis
Provides single measure of risk by applying to balance sheet & offers way to find effect of interest rate risk.
Usefulness of duration
- all securities of same duration will increase
(or decrease) in value by same % for any given change in interest
rates.
Duration GAP analysis
Involves the percentage decline in the value of a security
approximately equals the change in interest rates times the duration
Duration of a portfolio =
weighted duration of each asset or liability in
portfolio
Use of duration
Managers try to immunise the portfolio by cancelling out reinvestment rate risk & price risk.
the easy way (1st) to cancel out reinvestment rate risk & price risk and decrease interest rate risk
invest in zero-coupon bonds.
No price risk if held to maturity & no reinvestment risk for coupons.
the 2nd way to decrease interest rate risk
Restructure asset & debt portfolio so duration of
portfolio matches investment horizon
= DGAP
increase DGAP if negative
Or decrease DGAP if DGAP is positive.
Gap analysis & management
Internal procedures for managing interest rate risk involve altering
the maturity spectrum of the assets & liabilities.
credit risk
the chance borrower will default on the repayment of principal loan or fails to service interest payments when due.
how to manage credit risk?
–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
Liquidity Risk
banks need to have ongoing liquidity (cash)
to support expected loans & meet obligations due to its liabilities
(4) what are the Two liquidity management strategies?
- borrow funds either from regulators or financial markets e.g. central banks
- Have strategy of diversified funding & use asset management
& sell securities from securities portfolio e.g. T-bills
(4) a short position is good when?
if interest rates are falling then terms of loan contracts exceed deposit terms is desirible
(4) a long position is good when?
- deposit terms exceed terms of loan contracts
are desirable when interest rates
Off- balance sheet risk
• 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
Foreign exchange risk
-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.
Management of Foreign Exchange (FX) Risk
• 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.
Operational Risk
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.
Technology Risk
occurs when these investments don’t
produce anticipated savings- diseconomies of scale due to
excess capacity, redundant technology & inefficiencies.
Country or Sovereign risk
where difference in laws may not protect FI
from legal address for defaulting loans & sovereign risk
