Risks Flashcards
What is credit risk?
Default
What types of FIs are more subject to credit risk?
FIs that make loans or that buy bonds with LONG maturities
Financial claims have Limited…. and Large ….
Limited upside return (high probability)
Large downside risk (with a low probability)
How can FIs limit credit risk?
- Borrower diversification
- Screen and monitor borrowers
What is frim specific credit risk?
The risk of default associated with the specific project risk taken by a firm
Conditions that affect a specific borrower/types of borrower
What is systemic credit risk?
The risk of default associated with macroeconomic conditions affecting all borrowers
Why do FIs charge interest rate on loans?
To compensate credit risk
What happens to the balance sheet in case of borrower default?
- Value of loans decrease as well as equity capital
What is liquidity risk?
The risk that FIs may be unable to meet short term financial demands due to the inability to convert assets to cash without a loss of capital/income in the process
The FI would have to liquidate assets in a short period of time and for low prices
What interest rate risk?
The risk related to the mismatch of maturities between assets and liabilities and when interest rates are volatile. Their values change
What risk do FIs face when Assets maturities > liabilities maturity?
Refinance risk –> cost of borrowing > returns from assets –> Passets< P liabilities
What risk do FIs face when Assets maturities < liabilities maturity?
Reinvestment risk.
Returns from assets > cost of borrowings, P assets > p liabilities
What is price risk?
The risk that the price of a security will change, falling interest rates increase the present value of future cash flows of assets and liabilities
What can FIs do to hedge themselves from interest risk and what are its consequences?
- Match the maturities of their assets and liabilities
but - It is inconsistent with their asset transformation function
What is market risk?
When FIs actively trade assets instead of holding them for a longer period for other purposes such as investments and funding. It is related to interest rate and foreign exchange risk.
What are the measures used to asses market risk exposures?
Value at risk (VAR) and Daily earnings at risk (DEAR)
What are off-balance-sheet risks?
Risks due to contingent assets and liability that have the potential of causing cash inflows/outflows.
Why do FIs engage in off-balance-sheet activities?
To earn fixed commissions
Are off-balance-sheet activities recorded on the BS?
No, on notes
Do large banks or small banks usually get involved in OBS activity?
Large banks
Comment on the influence of OBS activity in the 2008 crisis
Banks were highly engaged in OBS activity and didn’t have enough capital to back these commitments. Rating agencies also relied on bankers’ assessment of the riskiness of the securities, rating them higher than they should’ve
What is a letter of credit (LOC)?
A credit guarantee by an FI on which payment is contingent to some future event occurring, most notably default of the agent that purchases the LOC
THE BANK PAYS IN CASE OF DEFAULT
What are some examples of OBS?
- Loan commitments
- Mortgage
- Positions in forwards, futures, swaps and other derivatives
What is foreign exchange risk?
The risk that the value of an asset may change due to changes in the value of currencies
What kind of correlation between economies makes it easier for exchange risk to happen?
In uncorrelated economies because they move in opposite directions.
How can companies reduce exchange risk?
By engaging in domestic-foreign activity/investment diversification
What is a net long position in a foreign country?
Holding more assets than foreign liabilities.
What is a net short position in a foreign country?
Having more liabilities than foreign assets
What is country/sovereign risk?
Repayments from foreign borrowers may be interrupted because of interference of foreign governments, especially to foreign currency shortage and adverse political events
What is fully hedge in foreign country?
Having the same amount of foreign assets and liabilities
What is technology risk?
When technological investments do not produce anticipated cost savings in terms of economies of scale/scope
What is operational risk?
When existing technology malfunctions. It can be affected by in/direct or opportunity cost
What is insolvency risk?
The risk a firm might be unable to satisfy its debts with a sudden decline on the value of its assets wrt its liabilities
Wrt leverage, when is a company more exposed to insolvency risk?
When it has high leverage ( uses debt to finance assets)
