Answer the following quesion below:
1 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?
2 What isrefinancing 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 interest?
3 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?
4. How can interest rate risk adversely affect the economic or market value of an FI?
5. A financial institution has the following market value balance sheet structure:
Assets Liabilities and Equity
Cash $1,000 Certificate of deposit $10,000
Bond $10,000 Equity $1,000
Total assets $11,000 Total liabilities and equity $11,000
a. The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth. What will be the net interest income (NII) at the end of the first year? Note: Net interest income equals interest income minus interest expense.
b. If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing risk?
c. Assuming that market interest rates increase 1 percent, the bond will have a value of $9,446 at the end of year 1. What will be the market value of the equity for the FI? Assume that all of the NII in part (a) is used to cover operating expenses or is distributed as dividends.
d. If market interest rates had decreased 100 basis points by the end of year 1, would the market value of equity be higher or lower than $1,000? Why?
e. What factors have caused the changes in operating performance and market value for this firm?
6. Two 10-year bonds are being considered for an investment that may have to be liquidated before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon rate higher than its required rate of return, and the second bond is a zero-coupon bond that pays only a lump-sum payment after 10 years with no interest over its life. Which bond would have more interest rate risk? That is, which bond's price would change by a larger amount for a given change in interest rates? Explain your answer.
7. Consider again the two bonds in problem 9. 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 risk?
8. A bank invested $50 million in a two-year asset paying 10 percent interest per year and simultaneously issued a $50 million, one-year liability paying 8 percent interest per year. The liability will be rolled over after one year at the current market rate. What will be the bank's net interest income if at the end of the first year all interest rates have increased by 1 percent (100 basis points)?
9. What is market risk? How does this risk affect the operating performance of financial institutions? What actions can be taken by FI management to minimize the effects of this risk?
10. What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?
11. What is the difference between firm-specific credit risk and systematic credit risk? How can an FI alleviate firm-specific credit risk?
12. What is foreign exchange risk? What does it mean for an FI to be net long in foreign assets? What does it mean for an FI to be net short in foreign assets? In each case, what must happen to the foreign exchange rate to cause the FI to suffer losses?
13. Suppose you purchase a 10-year, AAA-rated Swiss bond for par that is paying an annual coupon of 6 percent. The bond has a face value of 1,000 Swiss francs (SF). The spot rate at the time of purchase is SF1.50/$. At the end of the year, the bond is downgraded to AA and the yield increases to 8 percent. In addition, the SF appreciates to SF1.35/$.
a. What is the loss or gain to a Swiss investor who holds this bond for a year? What portion of this loss or gain is due to foreign exchange risk? What portion is due to interest rate risk?
b. What is the loss or gain to a U.S. investor who holds this bond for a year? What portion of this loss or gain is due to foreign exchange risk? What portion is due to interest rate risk?
14. What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency?
15. What is technology risk? What is the difference between economies of scale and economies of scope? How can these economies create benefits for an FI? How can these economies prove harmful to an FI?
16. What is the difference between technology risk and operational risk? How does internationalizing the payments system among banks increase operational risk?
17. Characterize the risk exposure(s) of the following FI transactions by choosing one or more of the risk types listed below:
a. Interest rate risk d. Technology risk
b. Credit risk e. Foreign exchange rate risk
c. Off-balance-sheet risk f. Country or sovereign risk
18. 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?
19. Why can insolvency risk be classified as a consequence or outcome of any or all of the other types of risks?
Academic requirements:
• Your work must be submitted as pages 6-7 of pages
• Your work should be submitted in the formats outlined for each questionin the assignment.