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ISE Financial Institutions Management A Risk Management Approach 10th International Edition Anthony Saunders Professor, Marcia Millon Cornett, Otgo Erhemjamts - Solutions
19. The balance sheet of A. G. Fredwards, a government security dealer, is listed below. Market yields are in parentheses and amounts are in millions.a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years?b. What is the impact over the next three months on net interest
18. A bank has the following balance sheet:Suppose interest rates fall such that the average yield on ratesensitive assets decreases by 15 basis points and the average yield on rate-sensitive liabilities decreases by 5 basis points.a. Calculate the bank’s CGAP and gap ratio (as defined by
17. A bank has the following balance sheet:Suppose interest rates rise such that the average yield on ratesensitive assets increases by 45 basis points and the average yield on rate-sensitive liabilities increases by 35 basis points.a. Calculate the bank’s CGAP and gap ratio (as defined by
16. Use the following information about a hypothetical government security dealer named M. P. Jorgan. Market yields are in parentheses and amounts are in millions.a. What is the repricing gap if the planning period is 30 days? 3 months? 2 years? Recall that cash is a non interest-earning asset.b.
15. Consider the following balance sheet for WatchoverU Savings Inc.(in millions):a. What is WatchoverU’s expected net interest income for the year?b. What will expected net interest income be at year-end if interest rates rise today by 2 percent?c. Using the cumulative repricing gap model, what
14. A bank manager is quite certain that interest rates are going to fall within the next six months. How should the bank manager adjust the bank’s six-month repricing gap and spread to take advantage of this anticipated rise? What if the manager believes rates will rise in the next six months?
13. What is the spread effect?
12. Which of the following assets or liabilities fit the one-year rate or repricing sensitivity test?3-month U.S. Treasury bills 1-year U.S. Treasury notes 20-year U.S. Treasury bonds 20-year floating-rate corporate bonds with annual repricing 30-year floating-rate mortgages with repricing every
11. What is the gap to total assets ratio? What is the value of this ratio to interest rate risk managers and regulators?
10. What are the reasons for not including demand deposits as ratesensitive liabilities in the repricing analysis for a commercial bank?What is the subtle but potentially strong reason for including demand deposits in the total of rate-sensitive liabilities? Can the same argument be made for
9. Consider the following balance sheet for MMC Bancorp (in millions of dollars):a. Calculate the value of MMC’s rate-sensitive assets, rate-sensitive liabilities, and repricing gap over the next year.b. Calculate the expected change in the net interest income for the bank if interest rates rise
8. Consider the following balance sheet positions for a financial institution:Rate-sensitive assets = $200 million Rate-sensitive liabilities = $100 million Rate-sensitive assets = $100 million Rate-sensitive liabilities = $150 million Rate-sensitive assets = $150 million Rate-sensitive liabilities
7. If a bank manager was quite certain that interest rates were going to rise within the next six months, how should the bank manager adjust the bank’s six-month repricing gap to take advantage of this anticipated rise? What if the manager believed rates would fall in the next six months?
6. Which of the following is an appropriate change to make on a bank’s balance sheet when GAP is negative, spread is expected to remain unchanged, and interest rates are expected to rise?a. Replace fixed-rate loans with rate-sensitive loans.b. Replace marketable securities with fixed-rate
5. What is the CGAP effect? According to the CGAP effect, what is the relation between changes in interest rates and changes in net interest income when CGAP is positive? When CGAP is negative?
4. What is a maturity bucket in the repricing model? Why is the length of time selected for repricing assets and liabilities important in using the repricing model?
3. What is the repricing gap? In using this model to evaluate interest rate risk, what is meant by rate sensitivity? On what financial performance variable does the repricing model focus? Explain.
2. How has the increased level of financial market integration affected interest rates?
1. How do monetary policy actions made by the Federal Reserve impact interest rates?
2. What does runoff mean?
1. What are four major weaknesses of the repricing model?
3. Why is it useful to express the repricing gap in terms of a percentage of assets? What specific information does this provide?
2. How can FIs change the size and the direction of their repricing gap?
1. Summarize the case for and against the inclusion of demand deposits as a rate-sensitive liability.
2. How has financial market integration affected interest rate movements?
1. How is the Federal Reserve’s monetary policy linked to the degree of interest rate uncertainty faced by FIs?
40. Consider these four types of risks: credit, foreign exchange, market, and sovereign. These risks can be separated into two pairs of risk types in which each pair consists of two related risk types with one being a subset of the other. How would you pair off the risk types, and which risk type
39. Characterize the risk exposure(s) of the following FI transactions by choosing one or more of the risk types listed below:a. Interest rate riskb. Credit riskc. Off-balance-sheet riskd. Technology riske. Foreign exchange riskf. Country or sovereign risk A bank finances a $10 million, six-year
38. Discuss the interrelationships among the different sources of FI risk exposure. Why would the construction of an FI risk management model to measure and manage only one type of risk be incomplete?
37. Why can insolvency risk be classified as a consequence or outcome of any or all of the other types of risks?
36. How does risk in FinTech companies differ from that in traditional FIs?
35. How does FinTech risk differ from technology risk?
34. What is FinTech?
33. What is the difference between technology risk and operational risk? How can produce reputational risk increase operational risk?
32. What is technology risk? What is the difference between economies of scale and economies of scope? How can these economies create benefits for an FI? How can these economies prove harmful to an FI?
31. What is the nature of an off-balance-sheet activity? How does an FI benefit from such activities? Identify the various risks that these activities generate for an FI, and explain how these risks can create varying degrees of financial stress for the FI at a later time.
30. What is market risk? How does this risk affect the operating performance of financial institutions? What actions can be taken by an FI’s management to minimize the effects of this risk?
29. What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency?
28. Suppose you purchase a 10-year, AAA-rated Swiss bond for par that is paying an annual coupon of 6 percent. The bond has a face value of 1,000 Swiss francs (SF). The spot rate at the time of purchase is SF1.15/$. At the end of the year, the bond is downgraded to AA and the yield increases to 8
27. Six months ago, Qualitybank issued a $100 million, oneyear maturity CD denominated in euros. On the same date, $60 million was invested in a €-denominated loan and $40 million was invested in a U.S. Treasury bill. The exchange rate on this date was €1.495/$. Assume no repayment of principal
26. Assume that a bank has assets located in London that are worth£150 million on which it earns an average of 8 percent per year.The bank has £100 million in liabilities on which it pays an average of 6 percent per year. The current spot exchange rate is £1.25/$.a. If the exchange rate at the
25. A U.S. insurance company invests $1,000,000 in a private placement of British bonds. Each bond pays £300 in interest per year for 20 years. If the current exchange rate is £1.25/$, what is the nature of the insurance company’s exchange rate risk?Specifically, what type of exchange rate
24. If an FI has the same amount of foreign assets and foreign liabilities in the same currency, has that FI necessarily reduced the risk involved in these international transactions to zero? Explain.
23. If the British pound is expected to appreciate in the near future, would a U.S.-based FI in London prefer to be net long or net short in its asset positions? Discuss.
22. 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.
21. 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?
20. What two factors provide potential benefits to FIs that expand their asset holdings and liability funding sources beyond their domestic borders?
19. Consider the simple FI balance sheet below (in millions of dollars).Suppose that depositors unexpectedly withdraw $50 million in deposits and the FI receives no new deposits to replace them.Assume that the FI cannot borrow any more funds in the short-term money markets, and because it cannot
18. What is liquidity risk? What routine operating factors allow FIs to deal with this risk in times of normal economic activity? What market reality can create severe financial difficulty for an FI in times of extreme liquidity crises?
17. Many banks and savings institutions that failed in the 1980s had made loans to oil companies in Louisiana, Texas, and Oklahoma.When oil prices fell, these companies, the regional economy, and the banks and savings institutions all experienced financial problems. What types of risk were inherent
16. What is the difference between firm-specific credit risk and systematic credit risk? How can an FI alleviate firm-specific credit risk?
15. What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?
14. A bank invested $50 million in a two-year asset paying 10 percent interest per year and simultaneously issued a $50 million, one-year liability paying 8 percent interest per year. The liability will be rolled over after one year at the current market rate. What will be the impact on the
13. A money market mutual fund bought $1 million of two-year Treasury notes six months ago. During this time, the value of the securities has increased, but for tax reasons, the mutual fund wants to postpone any sale for two more months. What type of risk does the mutual fund face for the next two
12. Consider again the two bonds in problem 11. If the investment goal is to leave the assets untouched until maturity, such as for a child’s education or for one’s retirement, which of the two bonds has more interest rate risk? What is the source of this risk?
11. Two 10-year bonds are being considered for an investment that may have to be liquidated before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon rate higher than its required rate of return, and the second bond is a zerocoupon bond that pays only a lump-sum
10. Corporate bonds usually pay interest semiannually. If an FI decided to change from semiannual to annual interest payments, how would this affect the bond’s interest rate risk?
9. How does a policy of matching the maturities of assets and liabilities work (a) to minimize interest rate risk and (b) against the asset-transformation function of FIs?
8. A financial institution has the following market value balance sheet structure:a. The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a one-year maturity and a 6 percent rate of interest. The
7. Consider an FI that issues $200 million of liabilities with two years to maturity to finance the purchase of $200 million of assets with a one-year maturity. Suppose that the cost of funds (liabilities) for the FI is 5 percent per year and the return on the assets is 9 percent per year.a.
6. Consider an FI that issues $100 million of liabilities with one year to maturity to finance the purchase of $100 million of assets with a two-year maturity. Suppose that the cost of funds (liabilities) for the FI is 5 percent per year and the return on the assets is 8 percent per year.a.
5. How can interest rate risk adversely affect the economic or market value of an FI?
4. 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.
3. What is reinvestment risk? How is reinvestment risk part of interest rate risk? If an FI funds short-term assets with long-term liabilities, what will be the impact on earnings of a decrease in the rate of interest? An increase in the rate of interest?
2. What is refinancing risk? How is refinancing risk part of interest rate risk? If an FI funds long-term assets with short-term liabilities, what will be the impact on earnings of an increase in the rate of interest? A decrease in the rate of interest?
1. What is the process of asset transformation performed by a financial institution? Why does this process often lead to the creation of interest rate risk? What is interest rate risk?
2. What are some examples of event and general macroeconomic risks that impact FIs?
1. What is meant by the term event risk?
2. How is insolvency risk related to the other risks discussed in this chapter?
1. When does insolvency risk occur?
2. How does risk in FinTech companies differ from that in traditional FIs?
1. What is FinTech?
3. How does technological expansion help an FI better exploit economies of scale and economies of scope? When might technology risk interfere with these goals?
2. How is operational risk related to technology risk?
1. What is the difference between economies of scale and economies of scope?
2. Why are FIs motivated to pursue off-balance-sheet business? What are the risks?
1. Why are letter of credit guarantees an off-balance-sheet item?
2. What modern conditions have led to an increase in this particular type of risk for FIs?
1. What is market, or trading, risk?
2. What is one major way an FI can discipline a country that threatens not to repay its loans?
1. Can an FI be subject to sovereign risk if it lends only to the highest-quality foreign corporations?
2. A U.S. bank is net long in European assets. If the euro appreciates against the dollar, will the bank gain or lose?
1. Explain why the returns on domestic and foreign portfolio investments are not, in general, perfectly correlated.
2. What circumstances might lead an FI to liquidate assets at fire-sale prices?
1. Why might an FI face a sudden liquidity crisis?
2. How does diversification affect an FI’s credit risk exposure?
1. Why does credit risk exist for FIs?
3. Explain the concept of maturity matching.
2. Why does a rise in the level of interest rates adversely affect the market value of both assets and liabilities?
1. What is refinancing risk?
33. Go to the Insurance Information Institute’s website at www.iii.org and use the following steps to find the most recent data on the largest life insurance companies by total revenue. From the dropdown menu, click on “Research + Data.” Click on “Life + Health.”Click on “Facts +
32. Go to the Federal Reserve Board’s website at www.federalreserve.gov and find the most recent distribution of life insurance industry assets for Table 6–2. Click on “Data.” Click on “Financial Accounts of the United States -Z.1.” Click on“Levels.” This will bring the file (Table
31. A property–casualty insurer brings in $6.25 million in premiums on its homeowners multiple peril line of insurance. The line’s losses amount to $4,343,750, expenses are $1,593,750, and dividends are$156,250. The insurer earns $218,750 on the investment of its premiums. Calculate the
30. An insurance company collected $3.6 million in premiums and disbursed $1.96 million in losses. Expenses amounted to 6.6 percent and dividends paid to policyholders totaled 1.2 percent.The total income generated from the company’s investments was$170,000 after all expenses were paid. What is
29. An insurance company’s projected loss ratio is 77.5 percent and its expense ratio is 23 percent. The company estimates that dividends to policyholders will be 5 percent. What must be the minimum yield on investments to achieve a positive operating ratio?
28.a. What is the combined ratio for a property insurer that has a loss ratio of 73 percent, a loss adjustment expense of 12.5 percent, and a ratio of commissions and other acquisition expenses of 18 percent?b. What is the combined ratio adjusted for investment yield if the company earns an
27. Consider the data in Table 6–6. Since 1980, what has been the necessary investment yield for the industry to enable the operating ratio to be less than 100 in each year? How is this requirement related to the interest rate risk and credit risk faced by a property–casualty insurer?
26. What is the investment yield on premiums earned? Why has this ratio become so important to property–casualty insurers?
25. How is the combined ratio defined? What does it measure?
24. What does the expense ratio measure? Identify and explain the two major sources of expense risk to a property–casualty insurer. Why has the long-term trend in this ratio been decreasing?
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