Define each of the following four measures of liquidity risk. Explain how each measure would be implemented and utilized by a DI. a. Financing gap and financing requirement. b. Sources and uses of liquidity. c. Peer group ratio comparisons. d. liquidity index.
> Calculate the following: a. What is the amount of the annuity purchase required if you wish to receive a fixed payment of $200,000 for 20 years? Assume that the annuity will earn 10 percent per year. b. Calculate the annual cash flows (annuity payments)
> How does a bank’s report of condition differ from its report of income?
> What are the three levels of regulatory taxes faced by FIs when making loans? How does securitization reduce the levels of taxation?
> In addition to managing credit risk, what are some other reasons for the sale of loans by FIs?
> Who are the buyers and sellers of U.S. loans? Why do they participate in this activity?
> What are highly leveraged transactions? What constitutes the federal regulatory definition of an HLT?
> What is the difference between loan participations and loan assignments?
> Why are yields higher on loan sales than they are for similar maturity and issue size commercial paper issues?
> What are some of the key features of short-term loan sales?
> What is the difference between loans sold with recourse and without recourse from the perspective of both sellers and buyers?
> Can all assets and loans be securitized? Explain your answer.
> What is the capital conservation buffer? How would this buffer affect your answers in Problem 6? Data from Problem 6: National Bank has the following balance sheet (in millions) and has no off-balance-sheet activities. a. What is the CET1 risk-based
> Why do buyers of Class C tranches of collateralized mortgage obligations (CMOs) receive a lower return than purchasers of Class A tranches?
> How do FIs use securitization to manage their interest rate, credit, and liquidity risks?
> What are the differences between CMOs and MBBs?
> What is a collateralized mortgage obligation (CMO)? How is it similar to a pass-through security? How does it differ? In what way does the creation of a CMO use market segmentation to redistribute prepayment risk?
> What is prepayment risk? How does prepayment risk affect the cash flow stream on a fully amortized mortgage loan? What are the two primary factors that cause early payment?
> What specific changes occur on the balance sheet at the completion of the securitization process? What adjustments occur to the risk profile of the FI?
> Why have FIs been very active in loan securitization issuance of pass-through securities while they have reduced their volume of loan sales? Under what circumstances would you expect loan sales to dominate loan securitization?
> Answer the following: a. What are the two ways to use call and put options on T-bonds to generate positive cash flows when interest rates decline? b. When and how can an FI use options on T-bonds to hedge its assets and liabilities against interest rate
> What is basis risk? What are the sources of basis risk?
> What are the differences between a microhedge and a macrohedge for an FI? Why is it generally more efficient for FIs to employ a macrohedge than a series of microhedges?
> The following net transaction accounts have been documented by a bank for the computation of its reserve requirements (in millions). The average daily reserves at the Fed for the 14-day reserve maintenance period have been $22.7 million per day, and th
> An insurance company owns $50 million of floating-rate bonds yielding LIBOR plus 1 percent. These loans are financed with $50 million of fixed-rate guaranteed investment contracts (GICs) costing 10 percent. A finance company has $50 million of auto loans
> Suppose that you purchase a Treasury bond futures contract at $95 per $100 of face value. a. What is your obligation when you purchase this futures contract? b. If an FI purchases this contract, in what kind of hedge is it engaged? c. Assume that the Tre
> What is a naive hedge? How does a naive hedge protect an FI from risk?
> Why is the credit risk on a swap lower than the credit risk on a loan?
> How does a pure credit swap differ from a total return swap?
> What is a total return swap?
> Explain the similarity between a swap and a forward contract.
> How can caps, floors, and collars be used to hedge interest rate risk?
> Suppose that an FI manager writes a call option on a T-bond futures contract with an exercise price of 114 at a quoted price of 0-55. What type of opportunities or obligations does the manager have?
> In each of the following cases, identify what risk the manager of an FI faces and whether the risk should be hedged by buying a put or a call option. a. A commercial bank plans to issue CDs in three months. b. An insurance company plans to buy bonds in t
> How does hedging with options differ from hedging with forward or futures contracts?
> An FI has purchased a $200 million cap of 9 percent at a premium of 0.65 percent of face value. A $200 million floor of 4 percent is also available at a premium of 0.69 percent of face value. a. If interest rates rise to 10 percent, what is the amount re
> What are some of the major differences between futures and forward contracts?
> What are two ways a DI can offset the effects of asset-side liquidity risk, such as the drawing down of a loan commitment?
> What are two ways a DI can offset the liquidity effects of a net deposit drain of funds? How do the two methods differ? What are the operational benefits and costs of each method?
> How is a DI’s distribution pattern of net deposit drains affected by the following? a. The holiday season. b. Summer vacations. c. A severe economic recession. d. Double-digit inflation.
> What are core deposits? What role do core deposits play in predicting the probability distribution of net deposit drains?
> The probability distribution of the net deposit drain of a DI has been estimated to have a mean of 2 percent. a. Is this DI increasing or decreasing in size? Explain. b. If a DI has a net deposit drain, what are the two ways it can offset this drain of
> What are the two reasons liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance sheet? What is meant by fire-sale prices?
> How is the liquidity problem faced by investment funds different from the liquidity problem faced by DIs and insurance companies?
> What is the greatest cause of liquidity exposure that property–casualty insurers face?
> Why does deposit insurance deter bank runs?
> A mutual fund plans to purchase $10 million of 20-year T-bonds in two months. The bonds are yielding 7.68 percent. These bonds have a duration of 11 years. The mutual fund is concerned about interest rates changing over the next two months and is conside
> Describe the unprecedented steps the Federal Reserve took with respect to the discount window operations during the financial crisis.
> What is a bank run? What are some possible withdrawal shocks that could initiate a bank run? What feature of the demand deposit contract provides deposit withdrawal momentum that can result in a bank run?
> What are the several components of a DI’s liquidity plan? How can such a plan help a DI reduce liquidity shortages?
> Why should a credit officer be concerned if a mid-market business borrower’s liquidity ratios differ from the industry norm?
> How does ratio analysis help answer questions about the production, management, and marketing capabilities of a prospective borrower?
> Why must an account officer be well versed in the FI’s credit policy before talking to potential mid-market business borrowers?
> What are some of the special risks and considerations when lending to small businesses rather than large businesses?
> In what ways does the credit analysis of a mid-market borrower differ from that of a small-business borrower?
> How does an FI evaluate its credit risks with respect to consumer and small-business loans?
> An FI has a $200 million asset portfolio that has an average duration of 6.5 years. The average duration of its $160 million in liabilities is 4.5 years. Assets and liabilities are yielding 10 percent. The FI uses put options on T-bonds to hedge against
> What are the purposes of credit-scoring models? How do these models assist an FI manager to better administer credit?
> What are the primary considerations used by FIs to evaluate mortgage loans?
> Explain how modern portfolio theory can be applied to lower the credit risk of an FI’s portfolio.
> Consider the coefficients of Altman’s Z score. Can you tell by the size of the coefficients which ratio appears most important in assessing the creditworthiness of a loan applicant? Explain.
> Why is an FI’s bargaining strength weaker when dealing with large corporate borrowers than mid-market business borrowers?
> What are conditions precedent?
> Why is credit risk analysis an important component of FI risk management?
> The sales literature of a mutual fund claims that the fund has no risk exposure since it invests exclusively in default risk free federal government securities. Is this claim true? Why or why not?
> 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?
> What is refinancing risk? How is refinancing risk part of interest rate risk? If an FI funds long-term fixed-rate 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 in
> Corporate Bank has $840 million of assets with a duration of 12 years and liabilities worth $720 million with a duration of seven years. Assets and liabilities are yielding 7.56 percent. The bank is concerned about preserving the value of its equity in t
> 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?
> Which type of cash withdrawal presents very little liquidity risk? Which type of cash withdrawal is a source of significant liquidity risk for DIs?
> 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?
> In the 1980s, many thrifts that failed had made loans to oil companies located in Louisiana, Texas, and Oklahoma. When oil prices fell, these companies, the regional economy, and the thrifts all experienced financial problems. What types of risk were inh
> 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?
> Characterize the risk exposure(s) of the following FI transactions by choosing one or more of the following: a. Credit risk b. Interest rate risk c. Off-balance-sheet risk d. Foreign exchange rate risk e. Country/sovereign risk f. Technology risk (1) A b
> What is the difference between technology risk and operational risk? How does internationalizing the payments system among banks increase operational risk?
> What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency?
> If you expect the Swiss franc to depreciate in the near future, would a U.S.-based FI in Basel, Switzerland, prefer to be net long or net short in its asset positions? Discuss.
> 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 £1.5612 for US$1, what is the nature of the insurance company’s exchange rate risk
> An FI has a $100 million portfolio of six-year Eurodollar bonds that have an 8 percent coupon. The bonds are trading at par and have a duration of five years. The FI wishes to hedge the portfolio with T-bond options that have a delta of –0.625. The under
> 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.
> What is the difference between firm-specific credit risk and systemic credit risk? How can an FI alleviate firm-specific credit risk?
> If the Swiss franc is expected to depreciate in the near future, would a U.S.-based FI in Bern City, Switzerland, prefer to be net long or net short in its asset positions? Discuss.
> What two factors provide potential benefits to FIs that expand their asset holdings and liability funding sources beyond their domestic borders?
> 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?
> 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
> Consider again the two bonds in Question 13. 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 r
> Consider two bonds, a 10-year premium bond with a coupon rate higher than its required rate of return and a zero coupon bond that pays only a lump sum payment after 10 years with no interest over its life. Which do you think would have more interest rate
> 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 for FIs?
> How can interest rate risk adversely affect the economic or market value of an FI?
> Village Bank has $240 million worth of assets with a duration of 14 years and liabilities worth $210 million with a duration of four years. In the interest of hedging interest rate risk, Village Bank is contemplating a macrohedge with interest rate T-bon
> What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?
> Describe the different pension funds sponsored by the federal government.
> Describe the “pay as you go” funding method that is used by many federal and state or local government pension funds. What is the problem with this method that may damage the long-term viability of such funds?
> What is the difference between an IRA and a Keogh account?
> What have the trends been for assets invested in defined benefit versus defined contribution pension funds in the last three decades?
> What are the three types of formulas used to determine pension benefits for defined benefit pension funds? Describe each.
> Describe the difference between a defined benefit pension fund and a defined contribution pension fund.
> Describe the difference between an insured pension fund and a noninsured pension fund. What type of financial institutions would administer each of these?
> What types of pension reforms have countries tried as their populations age and contributions to pension funds decrease?
> Describe the major features of ERISA.
> Refer to Problem 12. How does consideration of basis risk change your answers? a. Compute the number of T-bond futures contracts required to construct a macrohedge if T-bond futures are priced at 96 and the duration of the T-bond underlying the futures c
