Quiz 1 Chapter 7

An off-balance-sheet activity does not appear on the current balance sheet because it does not involve holding a current primary claim or the issuance of a current secondary claim.

True

Contingent claims are assets and liabilities that will come into existence at a future time often at the insistence of a customer or second party.

True

Credit risk stems from non-repayment or delays in repayment of either principal or interest on FI assets.

True

During a liquidity crisis assets normally must be sold at a loss because of the FI's immediate need for cash and the rising interest rates caused by financial institutions attempting to raise funds.

True

Effective use of diversification principles allows an FI to reduce the total default risk in a portfolio.

True

Employee fraud is a type of operational risk to a "nancial institution.

True

Employee fraud is a type of operational risk to a #nancial institution.

True

FIs that make loans or buy bonds with long maturity liabilities are more exposed to interest rate risk than FIs that make loans or buy bonds with short maturity liabilities.

True

Foreign exchange rate risk occurs because foreign exchange rates are volatile and can impact banks with exposed foreign assets and/or liabilities.

True

General macroeconomic conditions may affect all risks of a financial institution.

True

Many of the various risks faced by an FI often are interrelated with each other.

True

Market risk is present whenever an FI takes an open position and prices change in a direction opposite to that expected.

True

Returns from domestic and foreign investments may not be perfectly correlated because of different economic infrastructures and growth rates.

True

Similar to loans, non-government bonds expose a lender to principal payment default risk.

True

Technology risk is the uncertainty that economies of scale or scope will be realized from the investment in new technologies.

True

The objective of technological expansion is to achieve economies of scale and economies of scope.

True

The relationship of a limited or fixed upside return with a high probability and the potential large downside loss with a small probability is an example of an asset's credit risk to an FI.

True

The risk that a computer system may malfunction during the processing of data is an example of operational risk.

True

To be immunized against foreign currency and foreign interest rate risk, an FI should match both the size and maturities of its foreign assets and foreign liabilities.

True

Unanticipated withdrawals by liability holders are a major part of liquidity risk.

True

"Matching the book" or trying to match the maturities of assets and liabilities is intended to protect the FI from

interest rate risk.

The risk that many depositors withdraw their funds from an FI at once is

liquidity risk.

Economies of scale refer to an FI's ability to

lower its average costs of operations by expanding its output of #nancial services.

The risk that a debt security's price will fall, subjecting the investor to a potential capital loss is

market risk

A U.S. bank has €40 million in assets and €50 million in CDs. All other assets and liabilities are in U.S. dollars. This bank is

net short €10 million. Any FI is considered to be "net short" when the value of the assets is less than the value of liabilities.

The major source of risk exposure resulting from issuance of standby letters of credit is

off-balance-sheet risk.

Matching the foreign currency book of assets and liability maturity does not protect the FI from

sovereign country risk.

Politically motivated limitations on payments of foreign currency may expose an FI to

sovereign country risk.

The risk that many borrowers in a particular country fail to repay their loans as a result of a recession in that country relates to

sovereign risk.

Reinvestment risk is

"long funded" when the maturity of liabilities exceeds the maturity of assets

Refinancing risk is

"short funded" when the maturity of assets exceeds the maturity of liabilities

Bank of the Sam Houston has liabilities of $4 million with an average maturity of two years paying interest rates of 4.0 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6.0 percent annually. What is the bank's net interest income for the current year?

$140,000 NII = (average interest earning assets × average rate earned) - (average interest bearing liabilities × average rate paid) NII = ($5,000,000 × 0.06) - ($4,000,000 × 0.04) = $300,000 - $160,000 = $140,000

Bank of the Sam Houston has liabilities of $4 million with an average maturity of two years paying interest rates of 4.0 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6.0 percent annually. What is the bank's net interest income in dollars in year 3, after it refinances all of its liabilities at a rate of 6.0 percent?

+$60,000. If liabilities are re"nanced at 6.0 percent, NII = ($300,000 - (4,000,000 × 0.06) = $300,000 - $240,000 = $60,000

Bank of the Sam Houston has liabilities of $4 million with an average maturity of two years paying interest rates of 4.0 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6.0 percent annually. What is the maximum interest rate that it can re"nance its $4 million liability and still break even on its net interest income in dollars?

7.5 percent. To break even, the total net interest expense must equal the interest income of $300,000. NIE = 300,000 = 4,000,000 × RLRL = $300,000 ÷ 4,000,000 = 0.075 or 7.5 percent

An FI is short-funded when the maturity of its liabilities is less than the maturity of its assets.

True

Which of the following situations pose a re"nancing risk for an FI?

An FI issues $10 million of liabilities of one-year maturity to "nance the purchase of $10 million of assets with a two-year maturity. Refinancing risk occurs when maturing liabilities may have to be replaced at higher rates than those of the maturing liability. Re"nancing risk is present when the FI is "net short".The only selection that represents a net short position exposed to re"nancing risk is:"An FI issues $10 million of liabilities of one-year maturity to "nance the purchase of $10 million of assets with a two-year maturity."

Which of the following situations pose a refinancing risk for an FI?

An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-year maturity. Refinancing risk occurs when maturing liabilities may have to be replaced at higher rates than those of the maturing liability. Re#nancing risk is present when the FI is "net short".The only selection that represents a net short position exposed to re#nancing risk is:"An FI issues $10 million of liabilities of one-year maturity to #nance the purchase of $10 million of assets with a two-year maturity."

Which term refers to the risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset investments?

Refinancing risk.

Bank of the Sam Houston has liabilities of $4 million with an average maturity of two years paying interest rates of 4.0 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6.0 percent annually . To what risk is the bank exposed?

Answers B and C only Refinancing and Interest Rate Risk Since liabilities are of shorter term (maturity) than the assets, this bank is exposed to both refinancing risk (the ability to replace the same amount of funds) and interest rate risk (the risk that they may have to pay higher rates on liabilities in order to replace them at maturity).

Which function of an FI involves buying primary securities and issuing secondary securities?

Asset transformation.

Which term refers to the risk that interest income will decrease as maturing assets are replaced with new, more current assets?

Reinvestment risk.

Which of the following refers to an FI's ability to generate cost synergies by producing more than one output with the same inputs?

Economies of scope.

An FI that is short-funded faces the risk that the return of reinvesting assets could exceed the cost of funding those assets.

False

For an FI to exactly hedge the foreign investment risk, the amount of foreign currency assets must equal the amount of foreign currency liabilities.

False

An FI is exposed to reinvestment risk by holding longer-term assets relative to liabilities.

False The FI would be exposed to refinancing risk if it were holding longer term assets relative to liabilities.

Which of the following may occur when a su!cient number of borrowers are unable to repay interest and principal on loans, thus causing an FI's equity to approach zero?

Insolvency risk.

Which of the following observations is NOT true of a letter of credit?

It appears on the FI's current balance sheet.

What type of risk focuses upon future contingencies?

Off-balance sheet risk.

The BIS definition: "the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events," encompasses which of the following risks?

Operational risk and technology risk

If the loans in the bank's portfolio are all negatively correlated, what will be the impact on the bank's credit risk exposure?

The loans' negative correlations will decrease the bank's credit risk exposure because lower than expected returns on some loans will be o"set by higher than expected returns on other loans.

If the loans in the bank's portfolio are all negatively correlated, what will be the impact on the bank's credit risk exposure?

The loans' negative correlations will decrease the bank's credit risk exposure because lower than expected returns on some loans will be o$set by higher than expected returns on other loans.

If the loans in the bank's portfolio are all negatively correlated, what will be the impact on the bank's credit risk exposure?

The loans' negative correlations will decrease the bank's credit risk exposure because lower than expected returns on some loans will be offset by higher than expected returns on other loans.

A lower level of equity capital increases the risk of insolvency to a financial institution.

True

Active trading of assets and liabilities creates market risk.

True

The risk that borrowers are unable to repay their loans on time is

credit risk.

Holding corporate bonds with "xed interest rates involves

default risk and interest rate risk.

Economically speaking, OBS activities are contractual claims that a. may or may not occur b. if the contingency does occur, the asset or liability is transferred onto the FI's balance sheet. c. impact the economic value of the equity. d. if the contingency never occurs, there is virtually no economic meaning to the OBS activity. e. all of the above

e. all of the above

An FI that "nances a euro (€) loan with U.S. dollar ($) deposits is exposed to

foreign exchange risk.