What are the different types of risks the banks and other financial institutions are exposed to?

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Assignment Questions [10 Marks]

 

  1. What are the different types of risks the banks and other financial institutions are exposed to? [2 Marks]

 

There are many types of risks that banks and other financial institutions are exposed to. The most common risks are credit risk, interest rate risk, liquidity risk, and market risk.

Credit risk is the risk of loss that may occur if a borrower defaults on a loan. This type of risk is usually managed by diversifying the types of loans that are made and by monitoring the creditworthiness of borrowers.  When it comes to credit risk, this is the type of risk that could potentially happen to any type of borrower. This happens when the borrower is unable to repay the full amount owed to the lender. In some cases, the borrower may only be able to repay a portion of what is owed. This type of risk is often managed by lenders by requiring borrowers to have a good credit score before approving a loan. Additionally, lenders may diversify the types of loans that they offer to borrowers in order to mitigate this type of risk.

Interest rate risk is the risk that changes in interest rates will adversely affect the value of a financial asset. This type of risk is typically managed by hedging using financial instruments such as interest rate swaps. Interest rate risk is the type of risk that is faced by financial institutions when it comes to the possibility of changes in interest rates. When interest rates go up, the value of a financial asset typically goes down. This is because when rates are high, people are less likely to invest their money. As a result, the demand for the asset decreases, and so does the price. On the other hand, when rates are low, people are more likely to invest their money, and so the demand for the asset increases, and the price goes up. Interest rate risk is typically managed by financial institutions through hedging. This is done by entering into contracts that protect against potential changes in interest rates.

Liquidity risk is the risk that a financial institution will not be able to meet its obligations as they come due. This type of risk is typically managed by holding sufficient cash and investments that can be quickly converted to cash. Liquidity risk is the type of risk that financial institutions face when it comes to their ability to meet their obligations as they come due. This type of risk can happen when a financial institution does not have enough cash on hand to meet its short-term obligations. It can also happen when a financial institution has too many long-term assets and not enough short-term liabilities. Liquidity risk is typically managed by financial institutions by holding enough cash and investments that can be quickly converted to cash.

Market risk is the risk that changes in market conditions will adversely affect the value of a financial asset. This type of risk is typically managed by diversifying the types of investments that are made. Market risk is the type of risk that financial institutions face when it comes to changes in market conditions. This type of risk can happen when there is a change in the overall economy, or when there is a change in a particular industry. Market risk is typically managed by financial institutions by diversifying the types of investments that they make.

 

  1. What are the Asset-Liability Management Strategies? Explain. [2 Marks]

The objective of asset-liability management (ALM) is to ensure that a financial institution has sufficient assets to meet its liabilities as they come due. To achieve this objective, ALM involves managing both the mix of a financial institution’s assets and the level of its liabilities. There are four primary strategies that financial institutions use to manage their assets and liabilities:

  • Interest rate risk management
  • Liquidity risk management
  • Credit risk management
  • Market risk management
  1. Interest rate risk management: Interest rate risk is the risk that changes in interest rates will adversely affect a financial institution’s earnings and capital. To manage interest rate risk, financial institutions use a variety of techniques, including managing the mix of their assets and liabilities, hedging with derivatives, and managing their capital levels.
  2. Liquidity risk management: Liquidity risk is the risk that a financial institution will be unable to meet its obligations as they come due. To manage liquidity risk, financial institutions maintain sufficient levels of liquid assets and use techniques such as asset-liability management and securitization.
  3. Credit risk management: Credit risk is the risk that a borrower will default on a loan. To manage credit risk, financial institutions use a variety of techniques, including credit analysis, risk-based pricing, and collateral requirements.

 

  1. Market risk management: Market risk is the risk that changes in market conditions will adversely affect a financial institution’s earnings and capital. To manage market risk, financial institutions use a variety of techniques, including managing the mix of their assets and liabilities, hedging with derivatives, and managing their capital levels.

 

  1. Explain the loanable fund theory of Interest Rate Determination. [2 Marks]

The Loanable Funds Theory is a model used to determine the interest rate at which lenders are willing to loan money. The model is based on the idea that the interest rate is determined by the supply and demand for loanable funds. The theory states that when the demand for loanable funds is high, the interest rate will be high. When the demand for loanable funds is low, the interest rate will be low. The Loanable Funds Theory is based on the interaction between savers and borrowers in the market for loanable funds. Savers are people who have money to lend, while borrowers are people who need to borrow money. The interest rate is the price of loanable funds, and is determined by the supply and demand for loanable funds. Supply and demand for loanable funds is determined by the marginal productivity of capital. The marginal productivity of capital is the amount of output that an additional unit of capital will produce.

When the marginal productivity of capital is high, firms will demand more loanable funds, and the interest rate will be high. When the marginal productivity of capital is low, firms will demand less loanable funds, and the interest rate will be low. The Loanable Funds Theory is a model used to determine the interest rate at which lenders are willing to loan money. The model is based on the idea that the interest rate is determined by the supply and demand for loanable funds. The theory states that when the demand for loanable funds is high, the interest rate will be high. When the demand for loanable funds is low, the interest rate will be low. The Loanable Funds Theory is based on the interaction between savers and borrowers in the market for loanable funds. Savers are people who have money to lend, while borrowers are people who need to borrow money. The interest rate is the price of loanable funds, and is determined by the supply and demand for loanable funds. Supply and demand for loanable funds is determined by the marginal productivity of capital. The marginal productivity of capital is the amount of output that an additional unit of capital will produce. When the marginal productivity of capital is high, firms will demand more loanable funds, and the interest rate will be high. When the marginal productivity of capital is low, firms will demand less loanable funds, and the interest rate will be low.

 

s the LIBOR. If, at the end of the swap, the floating rate is higher than the fixed rate, then Party A will have made a profit. If the floating rate is lower than the fixed rate, then Party A will have made a loss.

 

  1. What are the different types of derivatives? Take an example and explain Interest rate swaps. [2 Marks]

There are four main types of financial derivatives: forwards, futures, options, and swaps.

Forwards and futures are both types of contracts that obligate the buyer to purchase an asset at a set price at a future date. The key difference between forwards and futures is that futures are traded on an exchange, while forwards are not.

 

Options give the holder the right, but not the obligation, to buy or sell an asset at a set price at a future date. There are two types of options: call options and put options.

Call options provides the holder a right to purchase an asset, whereas put options provided the right to sell an underlying asset.

Swaps are contracts between two parties to exchange cash flows in the future. The most common type of swap is an interest rate swap, which is an agreement to exchange future interest payments.

An interest rate swap is a contract between two parties to exchange future interest payments. The most common type of interest rate swap is a fixed-for-floating swap, where one party agrees to pay a fixed rate of interest in exchange for receiving a floating rate of interest. The fixed rate is usually set at a premium to the floating rate, which means that the party receiving the fixed rate will make periodic payments to the party receiving the floating rate. Interest rate swaps can be used to hedge against interest rate risk or to speculate on future interest rates.

An example of an interest rate swap would be if Party A agreed to pay a fixed rate of 5% interest in exchange for receiving a floating rate of interest. Party B would agree to pay a floating rate of interest in exchange for receiving a fixed rate of 5%. The floating rate of interest would be based on an index, such as the LIBOR. If, at the end of the swap, the floating rate is higher than the fixed rate, then Party A will have made a profit. If the floating rate is lower than the fixed rate, then Party A will have made a loss.

 

  1. Calculate the interest-sensitive GAP (IS GAP) and Relative IS GAP ratio for a financial institution if interest-sensitive assets (ISA) are $100 million and interest-sensitive liabilities (ISL) are $125 million. Is that firm an Asset sensitive? Explain. [2 Marks]

 

As per the given data :

 

Interest Sensitive Assets (ISA) = $100 million

 

Interest Sensitive Liabilities (ISL) = $125 million

Firm an Asset sensitive

 

Interest Sensitive GAP = Interest Sensitive Assets (ISA) – Interest Sensitive Liabilities (ISL)

 

= $100 Million – $125 million

 

= – $25 Million

 

Relative Interest Sensitive GAP Ratio = Interest Sensitive

 

Assets (ISA) / Interest Sensitive Liabilities (ISL)

 

= $100 Million / $125 million

 

= 4/5

 

= 0.8

From the past step, we see that the proportion of Relative Premium Touchy Hole is less that 1 which implies that when rates rise, the benefits won’t rise and would fall.

 

 

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