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51ChapterSevenRisksofFinancialIntermediationChapterOutlineIntroductionInterestRateRiskMarketRiskCreditRiskOff-Balance-SheetRiskTechnologyandOperationalRiskForeignExchangeRiskCountryorSovereignRiskLiquidityRiskInsolvencyRiskOtherRisksandtheInteractionofRisksSummary52SolutionsforEnd-of-ChapterQuestionsandProblems:ChapterSeven1.Whatistheprocessofassettransformationperformedbyafinancialinstitution?Whydoesthisprocessoftenleadtothecreationofinterestraterisk?Whatisinterestraterisk?AssettransformationbyanFIinvolvespurchasingprimaryassetsandissuingsecondaryassetsasasourceoffunds.TheprimarysecuritiespurchasedbytheFIoftenhavematurityandliquiditycharacteristicsthataredifferentfromthesecondarysecuritiesissuedbytheFI.Forexample,abankbuysmedium-tolong-termbondsandmakesmedium-termloanswithfundsraisedbyissuingshort-termdeposits.Interestrateriskoccursbecausethepricesandreinvestmentincomecharacteristicsoflong-termassetsreactdifferentlytochangesinmarketinterestratesthanthepricesandinterestexpensecharacteristicsofshort-termdeposits.Interestrateriskistheeffectonprices(value)andinterimcashflows(interestcouponpayment)causedbychangesinthelevelofinterestratesduringthelifeofthefinancialasset.2.Whatisrefinancingrisk?Howisrefinancingriskpartofinterestraterisk?IfanFIfundslong-termfixed-rateassetswithshort-termliabilities,whatwillbetheimpactonearningsofanincreaseintherateofinterest?Adecreaseintherateofinterest?Refinancingriskistheuncertaintyofthecostofanewsourceoffundsthatarebeingusedtofinancealong-termfixed-rateasset.ThisriskoccurswhenanFIisholdingassetswithmaturitiesgreaterthanthematuritiesofitsliabilities.Forexample,ifabankhasaten-yearfixed-rateloanfundedbya2-yeartimedeposit,thebankfacesariskofborrowingnewdeposits,orrefinancing,atahigherrateintwoyears.Thus,interestrateincreaseswouldreducenetinterestincome.Thebankwouldbenefitiftheratesfallasthecostofrenewingthedepositswoulddecrease,whiletheearningrateontheassetswouldnotchange.Inthiscase,netinterestincomewouldincrease.3.Whatisreinvestmentrisk?Howisreinvestmentriskpartofinterestraterisk?IfanFIfundsshort-termassetswithlong-termliabilities,whatwillbetheimpactonearningsofadecreaseintherateofinterest?Anincreaseintherateofinterest?Reinvestmentriskistheuncertaintyoftheearningrateontheredeploymentofassetsthathavematured.ThisriskoccurswhenanFIholdsassetswithmaturitiesthatarelessthanthematuritiesofitsliabilities.Forexample,ifabankhasatwo-yearloanfundedbyaten-yearfixed-ratetimedeposit,thebankfacestheriskthatitmightbeforcedtolendorreinvestthemoneyatlowerratesaftertwoyears,perhapsevenbelowthedepositrates.Also,ifthebankreceivesperiodiccashflows,suchascouponpaymentsfromabondormonthlypaymentsonaloan,theseperiodiccashflowswillalsobereinvestedatthenewlower(orhigher)interestrates.Besidestheeffectontheincomestatement,thisreinvestmentriskmaycausetherealizedyieldsontheassetstodifferfromtheaprioriexpectedyields.534.Thesalesliteratureofamutualfundclaimsthatthefundhasnoriskexposuresinceitinvestsexclusivelyinfederalgovernmentsecuritiesthatarefreeofdefaultrisk.Isthisclaimtrue?Explainwhyorwhynot.Althoughthefund'sassetportfolioiscomprisedofsecuritieswithnodefaultrisk,thesecuritiesremainexposedtointerestraterisk.Forexample,ifinterestratesincrease,themarketvalueofthefund'sTreasurysecurityportfoliowilldecrease.Further,ifinterestratesdecrease,therealizedyieldonthesesecuritieswillbelessthantheexpectedrateofreturnbecauseofreinvestmentrisk.Ineithercase,investorswholiquidatetheirpositionsinthefundmaysellataNetAssetValue(NAV)thatislowerthanthepurchaseprice.5.Whatiseconomicormarketvaluerisk?InwhatmanneristhisriskadverselyrealizedintheeconomicperformanceofanFI?Economicvalueriskistheexposuretoachangeintheunderlyingvalueofanasset.Asinterestratesincrease(ordecrease),thevalueoffixed-rateassetsdecreases(orincreases)becauseofthediscountedpresentvalueofthecashflows.Totheextentthatthechangeinmarketvalueoftheassetsdiffersfromthechangeinmarketvalueoftheliabilities,thedifferenceisrealizedinthemarketvalueoftheequityoftheFI.Forexample,formostdepositoryFIs,anincreaseininterestrateswillcauseassetvaluestodecreasemorethanliabilityvalues.Thedifferencewillcausethemarketvalue,orshareprice,ofequitytodecrease.6.Afinancialinstitutionhasthefollowingbalancesheetstructure:AssetsLiabilitiesandEquityCash$1,000CertificateofDeposit$10,000Bond$10,000Equity$1,000TotalAssets$11,000TotalLiabilitiesandEquity$11,000Thebondhasa10-yearmaturityandafixed-ratecouponof10percent.Thecertificateofdeposithasa1-yearmaturityanda6percentfixedrateofinterest.TheFIexpectsnoadditionalassetgrowth.a.Whatwillbethenetinterestincome(NII)attheendofthefirstyear?Note:Netinterestincomeequalsinterestincomeminusinterestexpense.Interestincome$1,000$10,000x0.10Interestexpense600$10,000x0.06Netinterestincome(NII)$400b.Ifattheendofyear1marketinterestrateshaveincreased100basispoints(1percent),whatwillbethenetinterestincomeforthesecondyear?IsthechangeinNIIcausedbyreinvestmentriskorrefinancingrisk?54Interestincome$1,000$10,000x0.10Interestexpense700$10,000x0.07Netinterestincome(NII)$300Thedecrea