FINA 465 EXAM 2 QUESTIONS AND CORRECT DETAILED
ANSWERS (VERIFIED ANSWERS) ALREADY GRADED A+
refinancing risk Ans✓✓✓the risk that the cost of rolling over or
reborrowing funds will rise above the returns being earned on asset
investments. This risk occurs when an FI is holding assets with
maturities greater than the maturities of its liabilities (e.g. 10-year fixed
rate loan funded by 2-year deposit faces risk of interest rate increase).
Interest rate increase would reduce net interest income. Bank would
benefit from decrease in interest since the cost of renewing the deposits
would decrease
reinvestment risk Ans✓✓✓the risk that the return on funds to be
reinvested will fall below the cost of funds. This risk occurs when an FI
holds assets with maturities that are shorter than the maturities of its
liabilities (e.g. 2-year loan funded by 10-year fixed rate deposit, interest
rates might decrease, and may be forced to reinvest money at lower rates
after 2 years). Any coupons payments will be reinvested at same new
rate, and net interest income would decrease.
The sales literature of a mutual fund claims that the fund has no risk
exposure since it invests exclusively in federal government securities
which are free of default risk. Is this claim true? Explain why or why
not. Ans✓✓✓Although the fund's asset portfolio is comprised of
securities with no default risk, the securities are exposed to interest rate
risk. For example, if interest rates increase, the market value of the
fund's Treasury security portfolio will decrease. Further, if interest rates
decrease, the realized yield on these securities will be less than the
expected rate of return because of reinvestment risk. In either case,
investors who liquidate their positions in the fund may sell at a Net
Asset Value that is lower than the purchase price.
,How does a policy of matching the maturity of assets and liabilities
work (a) to minimize interest rate risk and (b) against the asset-
transformation function of FIs? Ans✓✓✓A policy of maturity matching
will allow changes in market interest rates to have approximately the
same effect on both interest income and interest expense. An increase in
rates will tend to increase both income and expense, and a decrease in
rates will tend to decrease both income and expense. The changes may
not be equal because of different cash flow characteristics of the assets
and liabilities. The asset-transformation function of an FI involves
investing short-term liabilities in long-term assets. Maturity matching
clearly works against successful implementation of this process.
What is the difference between firm-specific credit risk and systematic
credit risk? How can an FI alleviate firm-specific credit risk?
Ans✓✓✓Firm-specific credit risk refers to the likelihood that a single
asset may deteriorate in quality, while systematic risk involves
macroeconomic factors the may increase default risk of all firms in the
economy. Thus, if S&P lowers its rating on IBM stock and if an investor
is holding only this particular stock, he may face significant losses as a
result of this downgrading. However, portfolio theory shows that firm-
specific risk can be alleviated with a diversified portfolio.
What is foreign exchange risk?
What does it mean for an FI to be net long in foreign assets? What does
it mean for an FI to be net short in foreign assets? In each case, what
must happen to the foreign exchange rate to cause the FI to suffer losses
Ans✓✓✓Foreign exchange risk is the risk that exchange rate changes
, can affect the value of an FI's assets and liabilities dominated in foreign
currencies.
An FI is net long in foreign assets when the foreign currency-
denominated assets exceed the foreign currency-denominated liabilities -
FI will suffer potential losses if domestic currency strengthens relative to
foreign currency when repayment of the assets will occur in the foreign
currency.
FI is net short when liabilities exceed assets - FI will suffer potential
losses if the domestic currency weakens relative to foreign currency
when repayment of the liabilities will occur in domestic currency.
If the Swiss franc is expected to depreciate in the near future, would a
U.S.-based FI in Bern City prefer to be net long or net short in its asset
positions? Discuss. Ans✓✓✓It would prefer to be net short (L greater
than A). The depreciation of the Swiss franc relative to the dollar means
that U.S. FI would pay back net L with fewer dollars. In other words, the
decrease in foreign assets in dollar value after conversion will be less
than decrease in the value of the foreign liabilities in dollar value after
conversion.
What is country or sovereign risk? What remedy does an FI realistically
have in the event of a collapsing country or currency? Ans✓✓✓The risk
that repayments to foreign lenders or investors may be interrupted
because of restrictions, intervention, or interference from foreign
governments. A lender FI has very little recourse in this situation unless
the FI is able to restructure the debt or demonstrate influence over the
future supply of funds to the country in question. This influence likely
ANSWERS (VERIFIED ANSWERS) ALREADY GRADED A+
refinancing risk Ans✓✓✓the risk that the cost of rolling over or
reborrowing funds will rise above the returns being earned on asset
investments. This risk occurs when an FI is holding assets with
maturities greater than the maturities of its liabilities (e.g. 10-year fixed
rate loan funded by 2-year deposit faces risk of interest rate increase).
Interest rate increase would reduce net interest income. Bank would
benefit from decrease in interest since the cost of renewing the deposits
would decrease
reinvestment risk Ans✓✓✓the risk that the return on funds to be
reinvested will fall below the cost of funds. This risk occurs when an FI
holds assets with maturities that are shorter than the maturities of its
liabilities (e.g. 2-year loan funded by 10-year fixed rate deposit, interest
rates might decrease, and may be forced to reinvest money at lower rates
after 2 years). Any coupons payments will be reinvested at same new
rate, and net interest income would decrease.
The sales literature of a mutual fund claims that the fund has no risk
exposure since it invests exclusively in federal government securities
which are free of default risk. Is this claim true? Explain why or why
not. Ans✓✓✓Although the fund's asset portfolio is comprised of
securities with no default risk, the securities are exposed to interest rate
risk. For example, if interest rates increase, the market value of the
fund's Treasury security portfolio will decrease. Further, if interest rates
decrease, the realized yield on these securities will be less than the
expected rate of return because of reinvestment risk. In either case,
investors who liquidate their positions in the fund may sell at a Net
Asset Value that is lower than the purchase price.
,How does a policy of matching the maturity of assets and liabilities
work (a) to minimize interest rate risk and (b) against the asset-
transformation function of FIs? Ans✓✓✓A policy of maturity matching
will allow changes in market interest rates to have approximately the
same effect on both interest income and interest expense. An increase in
rates will tend to increase both income and expense, and a decrease in
rates will tend to decrease both income and expense. The changes may
not be equal because of different cash flow characteristics of the assets
and liabilities. The asset-transformation function of an FI involves
investing short-term liabilities in long-term assets. Maturity matching
clearly works against successful implementation of this process.
What is the difference between firm-specific credit risk and systematic
credit risk? How can an FI alleviate firm-specific credit risk?
Ans✓✓✓Firm-specific credit risk refers to the likelihood that a single
asset may deteriorate in quality, while systematic risk involves
macroeconomic factors the may increase default risk of all firms in the
economy. Thus, if S&P lowers its rating on IBM stock and if an investor
is holding only this particular stock, he may face significant losses as a
result of this downgrading. However, portfolio theory shows that firm-
specific risk can be alleviated with a diversified portfolio.
What is foreign exchange risk?
What does it mean for an FI to be net long in foreign assets? What does
it mean for an FI to be net short in foreign assets? In each case, what
must happen to the foreign exchange rate to cause the FI to suffer losses
Ans✓✓✓Foreign exchange risk is the risk that exchange rate changes
, can affect the value of an FI's assets and liabilities dominated in foreign
currencies.
An FI is net long in foreign assets when the foreign currency-
denominated assets exceed the foreign currency-denominated liabilities -
FI will suffer potential losses if domestic currency strengthens relative to
foreign currency when repayment of the assets will occur in the foreign
currency.
FI is net short when liabilities exceed assets - FI will suffer potential
losses if the domestic currency weakens relative to foreign currency
when repayment of the liabilities will occur in domestic currency.
If the Swiss franc is expected to depreciate in the near future, would a
U.S.-based FI in Bern City prefer to be net long or net short in its asset
positions? Discuss. Ans✓✓✓It would prefer to be net short (L greater
than A). The depreciation of the Swiss franc relative to the dollar means
that U.S. FI would pay back net L with fewer dollars. In other words, the
decrease in foreign assets in dollar value after conversion will be less
than decrease in the value of the foreign liabilities in dollar value after
conversion.
What is country or sovereign risk? What remedy does an FI realistically
have in the event of a collapsing country or currency? Ans✓✓✓The risk
that repayments to foreign lenders or investors may be interrupted
because of restrictions, intervention, or interference from foreign
governments. A lender FI has very little recourse in this situation unless
the FI is able to restructure the debt or demonstrate influence over the
future supply of funds to the country in question. This influence likely
