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principles of risk management

Questions and Answers of Principles Of Risk Management

North Bank has been borrowing in the U.S. markets and lending abroad, thus incurring foreign exchange risk. In a recent transaction, it issued a one-year, $2 million CD at 6 percent and funded a loan
What are the two primary methods of hedging FX risk for an FI? What two conditions are necessary to achieve a perfect hedge through on-balance-sheet hedging? What are the advantages and disadvantages
What motivates Fls to hedge foreign currency exposures? What are the limita- tions to hedging foreign currency exposures? LO.1
Bank USA just made a one-year $10 million loan that pays 10 percent inter- est annually. The loan was funded with a Swiss franc-denominated one-year deposit at an annual rate of 8 percent. The
Sun Bank USA has purchased a 16 million one-year euro loan that pays 12 percent interest annually. The spot rate of U.S. dollars per euro is 1.40. Sun Bank has funded this loan by accepting a British
City Bank issued $200 million of one-year CDs in the United States at a rate of 6.50 percent. It invested part of this money, $100 million, in the purchase of a one-year bond issued by a U.S. firm at
What are the four FX trading activities undertaken by FIs? How do Fls profit from these activities? What are the reasons for the growth in FX profits at major U.S. FIs? LO.1
The following are the foreign currency positions of an FI, expressed in the foreign currency:Currency Swiss francs (SF) British pound () Japanese yen (Y) Assets FX Bought Liabilities SF 134,394 SF
What two factors directly affect the profitability of an FI's position in a foreign currency? LO.1
X-IM Bank has 14 million in assets and 23 million in liabilities and has sold 8 million in foreign currency trading. What is the net exposure for X-IM? For what type of exchange rate movement does
On July 15, 2009, you convert $500,000 U.S. dollars to Japanese yen in the spot foreign exchange market and purchase a one-month forward contract to con- vert yen into dollars. How much will you
Refer to Table 14-1.a. On June 15, 2009, you purchased a British pound-denominated CD by con- verting $1 million to pounds at a rate of .6110 pound for U.S. dollars. It is now July 15, 2009. Has the
Refer to Table 14-1.a. What was the spot exchange rate of Canadian dollars for U.S. dollars on July 15, 2009?b. What was the six-month forward exchange rate of Japanese yen for U.S. dollars on July
What is the spot market for FX? What is the forward market for FX? What is the position of being net long in a currency? LO.1
What are four FX risks faced by FIs? LO.1
Are Z-class CMOs exactly the same as T-bond strips? If not, why not? LO.1
Would thrifts or insurance companies prefer Z-class CMOs? Explain your answer. LO.1
In the context of the option model approach, list three ways in which transaction and other contracting costs are likely to interfere with the accuracy of its predictions regarding the fair price or
Should an FI with D A < kD L seek to securitize its assets? Why or why not?In general terms, discuss the three approaches developed by analysts to model prepayment behavior. LO.1
Why have the FASB and the SEC advocated that financial services firms replace book value accounting with market value accounting? LO.1
What are some of the factors that are likely to encourage loan sales growth in the future? LO.1
What are some specific legal concerns that have hampered the growth of the loan sales market? LO.1
What are some of the factors that are likely to deter the growth of the loan sales market in the future? LO.1
What institutions are the major sellers in this market? LO.1
What institutions are the major buyers in the traditional U.S. domestic loan sales market? LO.1
Explain the main reason behind the growth in loan sales in the 1980s and the late 2000s. LO.1
Describe the two basic types of loan sale contracts by which loans can be transferred between seller and buyer. LO.1
Which have higher yields, junk bonds or HLT loans? Explain your answer. LO.1
Which loans should have the highest yields: (a) loans sold with recourse or (b) loans sold without recourse? LO.1
Are swaps as risky as equivalent-sized loans? LO.1
Is there any difference between a digital default option (see Chapter 23) and a pure credit swap? LO.1
What is the link between preserving “customer relationships” and credit derivatives such as total return swaps? LO.1
In Example 24–3, what is the notional size of swap contracts if Dfixed 5 and swap contracts require payment every six months? (Ns $51,111,111) LO.1
What are some nonstandard terms that might be encountered in an off-market swap? LO.1
In Example 24–2, which of the two FIs has its liability costs fully hedged and which is only partially hedged? Explain your answer. LO.1
Why are only the most creditworthy FIs able to write a large cap/floor book without external guarantees? LO.1
An FI buys a $100 million cap at a premium of .75 percent and sells a floor at a .85 percent premium. What size floor should be sold so that the net cost of the cap purchase is zero? ($88,235,294)
Assume two exercise dates at the end of year 2 and the end of year 3. Suppose the FI buys a floor of 4 percent at time 0. The binomial tree suggests that rates at the end of year 2 could be 3 percent
In Example 23–4 suppose that in year 3 the highest and lowest rates were 12 percent and 6 percent instead of 11 percent and 7 percent. Calculate the fair premium on the cap. ($975,515) LO.1
What are some of the practical problems an FI manager may face when using catastrophe futures to hedge losses on insurance lines? LO.1
Why are credit forwards useful for hedging the credit risk of an FI’s portfolio? LO.1
In running a regression of St on ft, the regression equation is St .51 .95 ft and R2 72 percent. What is the hedge ratio? What is the measure of hedging effectiveness? LO.1
Suppose that R2 0 in a regression of St on ft. Would you still use futures contracts to hedge? Explain your answer. LO.1
Circle an observation in Figure 22–6 that shows futures price changes exceeding spot price changes. LO.1
In Example 22–3, how many futures contracts should have been sold using the 20-year bond futures contracts if the basis risk measure br .8? LO.1
In Example 22–2, suppose the FI had the reverse duration gap; that is, the duration of its assets was shorter (DA 3) than the duration of its liabilities (DA 5). (This might be the case of a bank
What is the difference between microhedging and macrohedging and between routine hedging and selective hedging? LO.1
What are the major differences between a spot contract and a forward contract? LO.1
What is the difference between a futures contract and a forward contract? LO.1
Comparing the advantages and disadvantages discussed above, why do you think so few U.S. banks have established branches in the Ukraine? LO.1
What are the major disadvantages of international expansion to an FI? LO.1
What are the major advantages of international expansion to an FI? LO.1
How did the IBA of 1978 and the FBSEA of 1991 affect foreign banks operating in the United States? LO.1
What were the major policy changes pertaining to bank expansion introduced by NAFTA? LO.1
What regulatory and economic factors have encouraged the growth of U.S. offshore banking? What factors have deterred U.S. offshore banking? LO.1
Given the same scenario as in question 1, what three characteristics would most discourage you? LO.1
What three characteristics of the target FI would most attract you? LO.1
Suppose you are a manager of an FI looking at another FI as a target for acquisition. LO.1
What are the three dimensions of revenue synergy gains?Suppose each of five firms in a banking market has a 20 percent share. What is the HHI? LO.1
What recent bank mergers have been motivated by cost synergies? LO.1
What are three potential procompetitive effects cited in support of banks’ expansion into securities activities? What reason is given to support the opposite claim (i.e., that bank expansion would
In addition to the six potential conflicts of interest discussed in this section, can you think of any additional possible conflicts that might arise if commercial banks were allowed to expand their
Describe three ways in which the losses of a securities affiliate in a holding company structure could be transmitted to a bank. LO.1
What are some of the issues that tend to arise in response to bank expansion into securities, insurance, and commercial activities? LO.1
How has the Financial Services Modernization Act of 1999 opened the doors for the establishment of full-service financial institutions in the United States? LO.1
Does a bank that currently specializes in making consumer loans but makes no commercial loans qualify as a nonbank bank? LO.1
What was the rationale for the passage of the Glass-Steagall Act in 1933? What permissible underwriting activities did it identify for commercial banks? LO.1
What sources of competition have had an impact on the asset side of banks’ balance sheets? LO.1
Offer support for the claim that product expansion restrictions have affected commercial banks more than any other type of financial services firm. LO.1
How does the NAIC’s model of risk-based capital requirements for PC insurers differ from the life insurance industry’s RBC? LO.1
What types of risks are included by the NAIC in estimating the RBC of life insurance firms? LO.1
How do the capital requirements for securities firms differ from the book value capital rules employed by DI regulators? LO.1
Identify one asset in each of the five credit risk weight categories. LO.1
What is the difference between Tier I capital and Tier II capital? LO.1
What are three problems with the simple leverage ratio measure of capital adequacy? LO.1
Why isn’t a capital ratio levied on exchange-traded derivative contracts? LO.1
You are a DI manager with a total risk-based capital ratio of 6 percent. Discuss four strategies to meet the required 8 percent ratio in a short period of time without raising new capital. LO.1
What are the major strengths of the risk-based capital ratios? LO.1
What does a market to book ratio that is less than 1 imply about an FI’s performance? LO.1
Is book value accounting for loan losses backward looking or forward looking? LO.1
What are the four major components of an FI’s book value equity? LO.1
Why is an FI economically insolvent when its net worth is negative? LO.1
Make up a simple balance sheet example to show a case where the FDIC can lose even when it uses an IDT to resolve a failed DI. LO.1
Why do uninsured depositors benefit from a too-big-to-fail policy followed by regulators? LO.1
Under current deposit insurance rules, how can DI depositors achieve many times the$250,000 coverage cap on deposits? LO.1
Do we need both risk-based capital requirements and risk-based insurance premiums to discipline shareholders? LO.1
If you are managing a DI that is technically insolvent but has not yet been closed by the regulators, would you invest in Treasury bonds or real estate development loans? Explain your answer. LO.1
Why would property–casualty insurers hold more short-term liquid assets to manage liquidity risk than life insurers hold? LO.1
Discuss two strategies insurance companies can use to reduce liquidity risk. LO.1
What are the major differences between fed funds and repurchase agreements? LO.1
Since transaction accounts are subject to both reserve requirements and deposit insurance premiums, whereas fed funds are not, why should a DI not fund all its assets through fed funds? Explain your
Describe the withdrawal risk and funding cost characteristics of some of the major liabilities available to a modern DI manager. LO.1
Describe the trade-off faced by an FI manager in structuring the liability side of the balance sheet. LO.1
How are liquidity and liability management related? LO.1
What explains the decline in the level of required reserves held by DIs between 1990 and August 2008 and the rise in August of 2009 (see Table 18–3)? LO.1
Since 1998, U.S. DIs have operated under a lagged reserve accounting system in which the reserve computation period ends 17 days before the reserve maintenance period begins. Does the reserve manager
For a DI that undershoots its reserve target, what ways are available to a reserve manager to build up reserves to meet the target? LO.1
In addition to the target reserve ratio, what other pieces of information does the DI reserve manager require to manage the DI’s reserve requirement position? LO.1
Can we view reserve requirements as a tax when the consumer price index (CPI) is falling? LO.1
Why do regulators set minimum liquid asset requirements for FIs? LO.1

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