Question 1

The simplest form of hedging interest rate risk is matched funding of loans..

Accepted Answer

Matched funding involves matching the maturities and interest rates of loans and deposits to mitigate the risk of interest rate fluctuations, making it a simple and effective method for hedging interest rate risk.

Question 2

Swaps are usually the best hedging tool to use to hedge short term risks occurring in a half year or less.

Accepted Answer

Swaps are typically used for medium to long-term hedging because they involve exchanging cash flows over a period of time, making them less suitable for short-term risks.

Question 3

If a bank specializes in mortgage lending it will tend to have a negative $ GAP and a positive duration GAP.

Accepted Answer

A bank specializing in mortgage lending typically has long-term assets (mortgages) with rates that adjust more slowly than the rates on its shorter-term liabilities, leading to a negative $ GAP (liabilities maturing or repricing sooner than assets) and a positive duration GAP (assets have a longer duration than liabilities, making the bank's equity more sensitive to interest rate changes).

Question 4

A rate sensitive asset is one that either matures within the maturity bucket or one that will have a payment change within the maturity bucket if interest rates change.

Accepted Answer

Rate sensitive assets are those whose earnings or value are affected by changes in interest rates, including those that mature or have payment adjustments within a specific time frame (maturity bucket) in response to changing rates.

Question 5

A firm informs the bank they will immediately draw down the maximum amount on their credit line. This is an example of liquidity risk.

Accepted Answer

This situation exemplifies liquidity risk for the bank, as it must ensure it has enough liquid assets available to meet the sudden and potentially large withdrawal represented by the firm drawing down the maximum amount on their credit line.

Question 6

Microhedging is hedging the interest rate risk of a specific transaction.

Accepted Answer

Microhedging involves hedging the risk associated with a specific transaction or position, such as the interest rate risk on a particular loan or investment, rather than the overall market or portfolio risk.

Question 7

For a given time period, assets that mature within the period or reprice within the period are considered rate sensitive.

Accepted Answer

Assets that mature or reprice within a given time period are considered rate sensitive because their values or cash flows are directly affected by changes in interest rates during that period.

Question 8

Basis risk is the risk that the prices or value of the underlying spot and the derivatives instrument used to hedge do not move predictably relative to one another.

Accepted Answer

Basis risk arises when there's a mismatch between the hedge and the underlying asset, leading to the possibility that the hedge will not perfectly offset the risk in the underlying due to differences in their price movements.

Question 9

A U.S. company has a euro denominated liability it must repay in 6 months. A short position in euro futures could help offset the corporation's foreign exchange risk.

Accepted Answer

The answer of A U.S. company has a euro denominated...

Question 10

Banks must balance liquidity risk, interest rate risk, credit risk and currency risk while still generating sufficient profitability to satisfy its owners.

Accepted Answer

Banks face various types of risks such as liquidity risk, interest rate risk, credit risk, and currency risk, and they must manage these risks effectively to ensure they remain profitable and can satisfy their owners or shareholders.

Question 11

To hedge a positive duration gap a bank could sell interest rate futures.

Accepted Answer

Selling interest rate futures is a strategy to hedge against the risk of rising interest rates, which negatively impacts the value of a bank's assets when it has a positive duration gap (assets' duration exceeds liabilities' duration).

Question 12

The VaR is typically used to measure a bank's credit risk.

Accepted Answer

VaR, or Value at Risk, is primarily used to measure market risk, not credit risk. It estimates the maximum loss a portfolio could face over a given time period under normal market conditions, at a certain confidence level.

Question 13

As interest rates increase, a long call option position on a bond decreases in value.

Accepted Answer

Higher interest rates increase the cost of carrying the bond, which can decrease the value of a call option on the bond.

Question 14

If the asset duration is less than the weighted duration of the liabilities, then falling interest rates will cause the market value of equity to rise.

Accepted Answer

If the asset duration is less than the weighted duration of the liabilities, falling interest rates will cause the market value of liabilities to increase more than the market value of assets, potentially decreasing the market value of equity.

Question 15

The sensitivity of the market price of a financial futures contract to interest rates depends upon the duration of the security to be delivered under the futures contract.

Accepted Answer

The sensitivity of the market price of a financial futures contract to interest rates is indeed influenced by the duration of the underlying security. Duration measures the price sensitivity of a bond to changes in interest rates, with longer-duration securities being more sensitive to interest rate changes. Therefore, futures contracts on longer-duration securities will also be more sensitive to interest rate changes.

Question 16

Large banks tend to rely more on assets for liquidity and small banks tend to rely more on purchased liquidity.

Accepted Answer

Large banks typically rely more on purchased liquidity due to their access to wholesale funding markets, while small banks often rely on asset liquidity, such as selling loans or securities, due to limited access to such markets.

Question 17

Insolvency occurs when an institution's duration gap becomes negative.

Accepted Answer

Insolvency occurs when an institution is unable to meet its financial obligations as they come due, not specifically due to a negative duration gap. A negative duration gap pertains to interest rate risk management, indicating a mismatch in the timing of cash inflows and outflows.

Question 18

If a bank has a positive repricing gap, falling interest rates increase profitability.

Accepted Answer

A positive repricing gap means a bank's interest-sensitive assets will reprice or adjust to new interest rates sooner than its liabilities. If interest rates fall, the bank's earnings on assets decrease more quickly than its cost of liabilities, potentially reducing profitability.

Question 19

Value at risk (VaR) is to measure price or market risk of a portfolio of assets and attempt to maximum likely loss at a given probability that they might sustain over a designated determine the period of time.

Accepted Answer

Value at Risk (VaR) is a statistical technique used to measure and quantify the level of financial risk within a firm, portfolio, or position over a specific time frame. This measure is often used to estimate the amount of potential loss that could be experienced on a portfolio over a given period of time under normal market conditions, at a specified confidence level.

Question 20

Writing a call option on a bond pays off if interest rates decrease.

Accepted Answer

Writing a call option on a bond means you give someone else the right to buy the bond from you at a predetermined price. If interest rates decrease, bond prices increase, making it more likely that the call option will be exercised against you, leading to a potential loss if you have to sell the bond for less than its increased market value.

Quiz 20: Risk Management in Financial Institutions