Lesson 4: Risks of Financial Institution Pt1 Flashcards
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?
Asset transformation by an FI involves purchasing primary assets and issuing secondary assets as a source of funds. The primary securities purchased by the FI often have maturity and liquidity characteristics that are different from the secondary securities issued by the FI. For example, a bank buys medium- to long-term bonds and makes medium-term loans with funds raised by issuing short-term deposits.
Interest rate risk occurs because the prices and reinvestment income characteristics of long-term assets react differently to changes in market interest rates than the prices and interest expense characteristics of short-term deposits.
Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched.
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?
Refinancing risk is 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. For example, if a bank has a ten-year fixed-rate loan funded by a 2-year time deposit, the bank faces a risk in that new deposits may only be obtained, and the loans refinanced, at a higher rate in two years. These interest rate increases would reduce net interest income.
The bank would benefit if interest rates decrease as the cost of renewing the deposits would decrease, while the interest rate earned on the loan would not change.
In this case, net interest income would increase.
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?
Reinvestment risk is 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. For example, if a bank has a two-year loan funded by a ten-year fixed-rate time deposit, the bank faces the risk that interest rates might decrease. In this case, it might be forced to lend or reinvest the money at lower rates after two years, perhaps even below the deposit rates.
Also, if the bank receives periodic cash flows, such as coupon payments from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at the new lower interest rates. In this case, net interest income would decrease.
If interest rates increase, the bank would be able to lend or reinvest the money at higher rates after two years. In this case, net interest income would increase. Besides the effect on the income statement, reinvestment risk may cause realised yields on assets to differ from the a priori expected yields.
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.
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 realised 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 (NAV) that is lower than the purchase price.
How can interest rate risk adversely affect the economic or market value of an FI?
When interest rates increase (or decrease), the values of fixed-rate assets decrease (or increase) because of the discounted present value of the cash flows. To the
extent that the change in market value of the assets differs from the change in market value of the liabilities, the difference is realised in the economic or market value of the equity of the FI.
For example, for most depository institutions, an increase in interest rates will cause asset values to decrease more than liability values. The difference will cause the market value, or share price, of equity to decrease.
