Deck 16: Off-Balance-Sheet Risk

Question 1

The current market value of an off-balance-sheet item is determined by finding the current market value of the underlying item.

Answer 1

True

Question 2

Even though an FI has off-balance-sheet activities, the true net worth is equal to on-balance sheet assets minus on-balance sheet liabilities.

Answer 2

False

Question 3

A default option is exercised when the holder requests a draw on the loan commitment.

Answer 3

False

Question 4

The use of an up-front fee by a bank eliminates the contingent risk on a loan commitment.

Question 5

All off-balance-sheet items will eventually move on to the balance sheet at some point in time.

Question 6

An FI can protect itself against insolvency resulting from off-balance sheet activities by purchasing insurance.

Question 7

All call options are eventually exercised and the underlying asset must be delivered.

Question 8

Off-balance-sheet items can generate cash flows that immediately impact the bank's financial performance.

Question 9

OSFI requires each bank to provide a quarterly report that includes the notional amounts, type, maturity, and risk weight equivalent of off-balance-sheet derivatives.

Question 10

Off-balance sheet positions are risky because they may yield negative future cash flows.

Question 11

Off-balance-sheet items often are called contingent assets and liabilities because they may, or may not, affect the balance sheet in the future.

Question 12

Off-balance-sheet activities are an important source of fee income for many FIs.

Question 13

If an FI enters into a loan commitment, it is essentially entering into a forward contract.

Question 14

Off-balance sheet activities can have both positive and negative effects on the risk of the FI.

Question 15

The present value of an off-balance-sheet item is its notional value.

Question 16

The current market value or contingent claim value of OBS items overestimates their notional value.

Question 17

The delta of an option is the sensitivity of an option's value to a unit change in the value of the underlying asset.

Question 18

Off-balance-sheet activities generally have risk-reducing attributes, but seldom have risk-increasing attributes.

Question 19

The extremely high growth of OBS activities since the early 1990s has caused regulators to recognize the potential risk exposure to FIs from their use.

Question 20

Interest rate risk is part of the loan commitment contingent risk because of the uncertainty of changes in interest rates before the borrower exercises his option to borrow.

Question 21

Basis risk occurs on a loan commitment because the spread of a pricing index over the cost of funds may vary.

Question 22

Commercial letters of credit are guarantees that are issued to cover contingencies that are potentially more severe and less predictable than those covered by standby letters of credit.

Question 23

Derivative products used in managing contingent credit risk can only be acquired as over-the-counter arrangements.

Question 24

In many ways, SLCs perform similar functions for a borrower as do loan commitments.

Question 25

The ability to provide loan commitments is a signal to borrowers that the FI has a lower risk portfolio.

Question 26

In Canada, commercial banks are the only issuers of standby letters of credit.

Question 27

Commercial letters of credit are used only in international trade.

Question 28

One way to minimize contingent credit risk is to use derivative products sold on organized exchanges.

Question 29

The use of LCs and SLCs may result in an FI having a higher concentration ratio than desired for a particular industry.

Question 30

One way to completely protect the lender against interest rate risk on a loan commitment is for the lender to price the loan at a variable rate against some index.

Question 31

The aggregate commitment funding risk can increase the cost of funds above normal levels.

Question 32

If an FI is a counterparty to a swap arrangement, it must record the notional value of the swap as the market value.

Question 33

Contingent credit risk occurs with the use of derivative products and involves the potential default by a counterparty.

Question 34

If a commercial bank engages in OBS activities, there are no additional capital requirements imposed by regulators.

Question 35

Standby letters of credit perform an insurance function similar to that of commercial and trade letters of credit.

Question 36

Contingent credit risk on derivative contracts is more serious for futures contracts than for forward contracts.

Question 37

Loan commitment activities increase the insolvency exposure of FIs that engage in such activities.

Question 38

Contingent credit risk is more serious for futures contracts than forward contracts because the over-the-counter arrangements necessary to replicate the guarantees at a later date.

Question 39

An up-front fee on a loan commitment rewards the FI for its willingness to stand ready to lend the commitment amount during some agreed upon time period.

Question 40

As compared to LCs, SLCs typically are used to cover contingencies that potentially are more severe and which may not be trade related.

Question 41

Settlement risk on wire transfers involves intraday credit risk.

Question 42

Loans sold without recourse have contingent liability off-balance-sheet implications for the FI that sells the loan.

Question 43

Rediscounted bankers' acceptances are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital

Question 44

When an FI pre-commits to lending at a fixed rate, it is exposed to

A)credit risk.
B)interest rate risk.
C)takedown risk.
D)funding risk.
E)exchange rate risk.

Question 45

Credit derivatives allow FIs to hedge credit risk on individual assets, but not on portfolios of assets.

Question 46

Standby letters of credit are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital.

Question 47

Funds transferred on CHIPS are settled immediately.

Question 48

The Clearing House Interbank Payments System (CHIPS) is an international wire transfer system owned by the participating banks in the countries in which it is used.

Question 49

When-issued trading involves the commitment to buy and sell securities before they are issued.

Question 50

Back-end fees on loan commitments are charged as a certain percentage of

A)commitment size.
B)loan taken down.
C)utilized portion of commitment size.
D)unused portion of commitment size.
E)interest payable on the loan commitment.

Question 51

Which of the following refers to the fee charged on the unused balance of a loan commitment.

A)Up-front fee.
B)Facility fee.
C)Compensating balance.
D)Commitment fee.
E)Closing costs.

Question 52

Where are the contingent items disclosed in the financial statements?

A)On the assets side of the balance sheet.
B)On the liabilities side of the balance sheet.
C)As footnotes to financial statements.
D)In the income statement.
E)In the director's report.

Question 53

Funds transferred on Fedwire are settled at the end of the day.

Question 54

The ability to form financial holding companies for the purpose of creating full-service financial institutions has caused an increase in affiliate risk.

Question 55

Loan commitments are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital.

Question 56

Fees from derivative products are an increasing component of noninterest income for many FIs.

Question 57

More FIs fail as a result of credit risk exposures than either interest rate or FX risk exposure.

Question 58

Loan loss reserves are classified as

A)on-balance-sheet assets.
B)off-balance-sheet assets.
C)off-balance-sheet liabilities.
D)on-balance-sheet liabilities.
E)equity capital.

Question 59

The amount of regulations that have been proposed because of the increased use of risk-reducing OBS derivatives is increasing.

Question 60

Up-front fees on loan commitments are charged as a certain percentage of

A)commitment size.
B)loan taken down.
C)utilized portion of commitment size.
D)unused portion of commitment size.
E)interest payable on the loan commitment.

Question 61

If a future credit crunch is possible, a loan commitment may expose the FI to

A)credit risk.
B)interest rate risk.
C)sovereign country risk.
D)funding risk.
E)exchange rate risk.

Question 62

In economic terms, the letters of credit (LCs) and stand-by letters of credit SLCs sold by an FI

A)are contractual commitments to make a loan up to a stated amount at a given interest rate in the future.
B)are insurance against the frequency or severity of some particular future occurrence.
C)are nonstandard contracts between two parties to deliver and pay for an asset in the future.
D)are standardized contract guaranteed by organized exchanges to deliver and pay for an asset in the future.
E)are nonstandard contracts between two parties to deliver and pay for an asset in the future, and are standardized contract guaranteed by organized exchanges to deliver and pay for an asset in the future.

Question 63

Which of the following statements best describe a derivative contract?

A)Contractual commitments to make a loan up to a stated amount at a given interest rate in the future.
B)Contingent guarantees sold by an FI to underwrite the performance of the buyer of the guaranty.
C)Agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future.
D)Trading in securities prior to their actual issue.
E)Loans originated by an FI and then sold to other investors with recourse.

Question 64

What is a swap?

A)An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval.
B)An agreement between a buyer and a seller at time 0 to exchange a nonstandardized asset for cash at some future date.
C)A contract that gives the holder the right, but not the obligation to buy or sell the underlying asset at a specified price within a specified period of time.
D)Trading in securities prior to their actual issue.
E)Contractual commitment to make a loan up to a stated amount at a given interest rate in the future.

Question 65

Off-balance-sheet items are

A)items omitted from the short form balance sheet.
B)contingent assets and liabilities.
C)risk-free assets and liabilities.
D)exceptionally risky assets and liabilities.
E)foreign (off shore) assets and liabilities.

Question 66

FIs are competing directly with loan commitments, one of their own OBS products, when they also offer:

A)Futures contracts.
B)Swaps.
C)Standby letters of credit.
D)Forward contracts.
E)When-issued trading.

Question 67

What are commercial letters of credit?

A)They are contractual commitments to make a loan up to a stated amount at a given interest rate in the future.
B)They are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a pre-specified price for a specified time period.
C)They are nonstandard contracts between two parties to deliver and pay for an asset in the future.
D)They are standardized contract guaranteed by organized exchanges to deliver and pay for an asset in the future.
E)They are contingent guarantees sold by an FI to underwrite the trade or commercial performance of the buyer of the guaranty.

Question 68

What is a possible reason behind restricted supply of spot loans to borrowers during a credit crunch?

A)Expansionary monetary policy actions of the Federal Reserve.
B)FI's increased aversion toward lending.
C)Shift to the right in the loan supply function at all interest rates.
D)Low aggregate demand from borrowers to take down loan commitments.
E)Decrease in cost of funds.

Question 69

Which of the following is true of an 'adverse material change in conditions clause' used in a loan commitment?

A)It allows the FI to cancel or reprice a loan commitment.
B)It protects the lender against takedown risk.
C)It protects the lender against basis risk.
D)Exercise of the clause helps defaulted borrowers.
E)It is exercised frequently by most FIs.

Question 70

Which of the following is the newest addition to the derivative securities markets?

A)Options contracts.
B)Futures contracts.
C)Swap agreements.
D)Forward contracts.
E)Credit derivatives.

Question 71

Takedown risk in a loan commitment exposes the FI to

A)immediate liquidity risk.
B)basis risk.
C)spread risk.
D)externality effects.
E)future liquidity risk.

Question 72

As of June 2012, the vast majority of OBS activities of commercial banks was

A)future and forward contracts.
B)credit derivatives.
C)commitments to buy FX.
D)swap contracts.
E)loans sold with recourse.

Question 73

Which of the following is true of the market price of an options contract over time?

A)It is set at time 0.
B)It is fixed over the life of the contract.
C)It changes based on the market value of the underlying asset.
D)It increases with time to expiration.
E)It is based on supply and demand.

Question 74

An exporter demands a letter of credit in order to

A)guarantee safe delivery of goods to the importer.
B)guarantee receipt of payment from the importer upon receipt of the goods.
C)protect against adverse changes in foreign exchange rates.
D)protect against adverse changes in international interest rates.
E)ascertain the creditworthiness of the importer.

Question 75

Which of the following ratios do FIs and regulators often use as a simple measure of solvency?

A)Current ratio.
B)Capital to assets.
C)Earnings before interest and taxes to total assets.
D)Quick ratio.
E)Asset turnover ratio.

Question 76

An "material adverse change in conditions" clause is included in loan commitments to protect the FI against

A)credit risk.
B)interest rate risk.
C)takedown risk.
D)funding risk.
E)exchange rate risk.

Question 77

The effect to an FI of default by the counterparty to a derivative contract is LEAST serious with

A)options contracts.
B)futures contracts.
C)swap agreements.
D)forward contracts.
E)loan commitments.

Question 78

Which of the following is true of the market price of a futures contract over time?

A)It is set at time 0.
B)It is fixed over the life of the contract.
C)It changes based on the market value of the underlying asset.
D)It decreases with time to expiration.
E)It is based on supply and demand.

Question 79

The quantity risk exposure of a loan commitment is

A)credit risk.
B)interest rate risk.
C)takedown risk.
D)funding risk.
E)exchange rate risk.

Question 80

Which of the following situations is similar to the externality effect?

A)Exercising an adverse material change in conditions clause as a last resort, thereby canceling or repricing a loan commitment.
B)Increase in the cost of funds above normal levels while many FIs scramble for funds to meet their commitments to customers during a credit crunch.
C)In a loan commitment, the borrower takes down only part of the funds over the specified time-period.
D)The buyer of a commercial letter of credit fails to perform as promised under a contractual obligation.
E)All of these.