Risks

Question 1

What is credit risk?

Answer 1

Default

Question 2

What types of FIs are more subject to credit risk?

Answer 2

FIs that make loans or that buy bonds with LONG maturities

Question 3

Financial claims have Limited…. and Large ….

Answer 3

Limited upside return (high probability)

Large downside risk (with a low probability)

Question 4

How can FIs limit credit risk?

Answer 4

• Borrower diversification

- Screen and monitor borrowers

Question 5

What is frim specific credit risk?

Answer 5

The risk of default associated with the specific project risk taken by a firm
Conditions that affect a specific borrower/types of borrower

Question 6

What is systemic credit risk?

Answer 6

The risk of default associated with macroeconomic conditions affecting all borrowers

Question 7

Why do FIs charge interest rate on loans?

Answer 7

To compensate credit risk

Question 8

What happens to the balance sheet in case of borrower default?

Answer 8

• Value of loans decrease as well as equity capital

Question 9

What is liquidity risk?

Answer 9

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

Question 10

What interest rate risk?

Answer 10

The risk related to the mismatch of maturities between assets and liabilities and when interest rates are volatile. Their values change

Question 11

What risk do FIs face when Assets maturities > liabilities maturity?

Answer 11

Refinance risk –> cost of borrowing > returns from assets –> Passets< P liabilities

Question 12

What risk do FIs face when Assets maturities < liabilities maturity?

Answer 12

Reinvestment risk.

Returns from assets > cost of borrowings, P assets > p liabilities

Question 13

What is price risk?

Answer 13

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

Question 14

What can FIs do to hedge themselves from interest risk and what are its consequences?

Answer 14

• Match the maturities of their assets and liabilities
  but
• It is inconsistent with their asset transformation function

Question 15

What is market risk?

Answer 15

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.

Question 16

What are the measures used to asses market risk exposures?

Answer 16

Value at risk (VAR) and Daily earnings at risk (DEAR)

Question 17

What are off-balance-sheet risks?

Answer 17

Risks due to contingent assets and liability that have the potential of causing cash inflows/outflows.

Question 18

Why do FIs engage in off-balance-sheet activities?

Answer 18

To earn fixed commissions

Question 19

Are off-balance-sheet activities recorded on the BS?

Answer 19

No, on notes

Question 20

Do large banks or small banks usually get involved in OBS activity?

Answer 20

Large banks

Question 21

Comment on the influence of OBS activity in the 2008 crisis

Answer 21

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

Question 22

What is a letter of credit (LOC)?

Answer 22

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

Question 23

What are some examples of OBS?

Answer 23

• Loan commitments
• Mortgage
• Positions in forwards, futures, swaps and other derivatives

Question 24

What is foreign exchange risk?

Answer 24

The risk that the value of an asset may change due to changes in the value of currencies

Question 25

What kind of correlation between economies makes it easier for exchange risk to happen?

Answer 25

In uncorrelated economies because they move in opposite directions.

Question 26

How can companies reduce exchange risk?

Answer 26

By engaging in domestic-foreign activity/investment diversification

Question 27

What is a net long position in a foreign country?

Answer 27

Holding more assets than foreign liabilities.

Question 28

What is a net short position in a foreign country?

Answer 28

Having more liabilities than foreign assets

Question 29

What is country/sovereign risk?

Answer 29

Repayments from foreign borrowers may be interrupted because of interference of foreign governments, especially to foreign currency shortage and adverse political events

Question 30

What is fully hedge in foreign country?

Answer 30

Having the same amount of foreign assets and liabilities

Question 31

What is technology risk?

Answer 31

When technological investments do not produce anticipated cost savings in terms of economies of scale/scope

Question 32

What is operational risk?

Answer 32

When existing technology malfunctions. It can be affected by in/direct or opportunity cost

Question 33

What is insolvency risk?

Answer 33

The risk a firm might be unable to satisfy its debts with a sudden decline on the value of its assets wrt its liabilities

Question 34

Wrt leverage, when is a company more exposed to insolvency risk?

Answer 34

When it has high leverage ( uses debt to finance assets)