Chapter 4: Market Risk (Sections 4.1 & 4.5) Flashcards
(5 cards)
In the CAPM two-fund separation, what two “funds” does every investor hold?
A risk-free asset (e.g. government bonds) and the market portfolio of all risky assets in fixed proportions.
What practical use does two-fund separation give a bank managing an investment portfolio?
It reduces portfolio choice to a single decision—how much to put into the safe asset versus the market fund—simplifying risk management and capital allocation.
What is a bank’s capital ratio, and why is it important?
The capital ratio is the share of a bank’s equity relative to its total risk-weighted assets. It serves as a buffer against losses, ensures depositors’ confidence, and makes banks internalize the cost of risk they take on.
How do higher capital‐ratio requirements influence a bank’s portfolio choices?
They force the bank either to reduce portfolio risk (hold safer assets) or to seek higher expected returns on its assets to cover its funding costs while meeting the ratio.
Why do regulators and investors use capital ratios as a risk‐management tool?
Because capital ratios provide a simple, comparable metric across banks that correlates with the probability of default and the size of potential losses.
