Deck 7: Risks of Financial Institutions

Question 1

7-14 Credit risk stems from non-repayment or delays in repayment of either principal or interest on FI assets.

Answer 1

True

Question 2

7-7 Matching the maturities of assets and liabilities supports the asset transformation function of FIs.

Answer 2

False

Question 3

7-12 FIs that make loans or buy bonds with long maturity liabilities are more exposed to interest rate risk than FIs that make loans or buy bonds with short maturity liabilities.

Answer 3

False

Question 4

7-11 Market risk is present whenever an FI takes an open position and prices change in a direction opposite to that expected.

Question 5

7-3 An FI is short-funded when the maturity of its liabilities is less than the maturity of its assets.

Question 6

7-1 Because the economies of the U.S.and other overseas countries have become more integrated,the risks of financial intermediation have decreased.

Question 7

7-6 Exactly matching the maturities of assets and liabilities will provide a perfect hedge against interest rate risk for an FI.

Question 8

7-2 Interest rate risk stems from the impact of both anticipated and unanticipated changes in interest rates on FI profitability.

Question 9

7-13 The relationship of a limited or fixed upside return with a high probability and the potential large downside loss with a small probability is an example of an asset's credit risk to an FI.

Question 10

7-5 An FI that is short-funded faces the risk that the return of reinvesting assets could exceed the cost of funding those assets.

Question 11

7-20 Individuals have an advantage over FIs in that individuals more easily can diversify away some of the credit risk of their asset portfolios.

Question 12

7-17 Historically credit card loans have had very low rates of default or credit risk when compared to other assets that an FI may hold.

Question 13

7-8 Funding a portion of assets with equity capital means that hedging risk does not require perfect matching of the assets and liabilities.

Question 14

7-4 An FI is exposed to reinvestment risk by holding longer-term assets relative to liabilities.

Question 15

7-15 Credit risk exposes the lender to the uncertainty that only interest payments may not be received.

Question 16

7-19 Managerial monitoring efficiency and credit risk management strategies affect the shape of the risk of the loan return distribution.

Question 17

7-16 In the case where a borrower defaults on a loan,the FI may lose only a portion of the interest payments and a portion of the principal that was loaned.

Question 18

7-18 One method of guarding against credit risk is to assess a risk premium based on the estimate of default risk exposure that a borrower carries.

Question 19

7-9 Active trading of assets and liabilities creates market risk.

Question 20

7-10 FIs typically are concerned about the value at risk of their trading portfolios.

Question 21

7-31 Technology risk is the uncertainty that economies of scale or scope will be realized from the investment in new technologies.

Question 22

7-30 The objective of technological expansion is to achieve economies of scale at the expense of diseconomies of scope.

Question 23

7-32 The mergers of Citicorp with Travelers Insurance is an example of an attempt to exploit economies of scope.

Question 24

7-33 Economies of scope involve the ability to lower the average cost of operations by expanding the output of financial services.

Question 25

7-28 Contingent claims are assets and liabilities that will come into existence at a future time often at the insistence of a customer or second party.

Question 26

7-38 Foreign exchange risk is that the value of assets and liabilities may change because of changes in the foreign exchange rate between two countries.

Question 27

7-26 Off-balance-sheet risk occurs because of activities that do not appear on the balance sheet.

Question 28

7-25 An off-balance-sheet activity does not appear on the current balance sheet because it does not involve holding a current primary claim or the issuance of a current secondary claim.

Question 29

7-37 Returns from domestic and foreign investments may not be perfectly correlated because of different economic infrastructures and growth rates.

Question 30

7-39 Foreign exchange risk is that the value of assets and liabilities may change because of changes in the level of interest rates.

Question 31

7-40 Foreign exchange risk includes interest rate risk and credit risk as well as changes in the foreign exchange rate between two countries.

Question 32

7-29 Off-balance-sheet activities have become an important source of fee income,even though losses on these activities can cause a financial institution to fail.

Question 33

7-36 Direct foreign investment and foreign portfolio investment both can be beneficial to an FI because of imperfectly correlated returns with domestic investments.

Question 34

7-35 The risk that a computer system may malfunction during the processing of data is an example of operational risk.

Question 35

7-23 Firm-specific credit risk can be eliminated by diversification.

Question 36

7-24 Systematic credit risk can be reduced significantly by diversification.

Question 37

7-34 Employee fraud is a type of operational risk to a financial institution.

Question 38

7-21 Similar to loans,non-government bonds expose a lender to principal payment default risk.

Question 39

7-22 Effective use of diversification principles allows an FI to reduce the total default risk in a portfolio.

Question 40

7-27 Off-balance-sheet activities often affect the shape of an FIs current balance sheet through the creation of contingent claims.

Question 41

7-43 For an FI to exactly hedge the foreign investment risk,the foreign currency assets must equal the foreign currency liabilities.

Question 42

7-51 Many of the various risks faced by an FI often are interrelated with each other.

Question 43

7-47 Unanticipated withdrawals by liability holders are a major part of liquidity risk.

Question 44

7-48 A natural consequence of the effects of realized liquidity risk across several institutions is the ability to recognize capital gains on the sale of assets in the attempt to generate cash.

Question 45

7-42 An FI is net long in foreign assets if it holds more foreign liabilities than foreign assets.

Question 46

7-60 What type of risk focuses upon mismatched currency positions?

A)Liquidity risk.
B)Interest rate risk.
C)Credit risk.
D)Foreign exchange rate risk.
E)Off?balance sheet risk.

Question 47

7-56 Regulation limits FI investment in non-investment grade bonds (rated below Baa or non-rated).What kind of risk is this designed to limit?

A)Liquidity risk.
B)Interest rate risk.
C)Credit risk.
D)Foreign exchange rate risk.
E)Off?balance sheet risk.

Question 48

7-44 To be immunized against foreign currency and foreign interest rate risk,an FI should match both the size and maturities of its foreign assets and foreign liabilities.

Question 49

7-54 Foreign exchange rate risk occurs because foreign exchange rates are volatile and can impact banks with exposed foreign assets and/or liabilities.

Question 50

7-46 Control of the future supply of funds available to a foreign country is one method to ensure the repayment of an existing debt.

Question 51

7-53 General macroeconomic risks may affect all risks of a financial institution.

Question 52

7-45 Sovereign risk involves the inability of a foreign corporation to repay the principal or interest on a loan because of stipulations by the foreign government that are out of the control of the foreign corporation.

Question 53

7-57 What type of risk focuses upon mismatched asset and liability maturities and durations?

A)Liquidity risk.
B)Interest rate risk.
C)Credit risk.
D)Foreign exchange rate risk.
E)Off?balance sheet risk.

Question 54

7-41 An FI can hold assets denominated in a foreign country,but it cannot issue foreign liabilities.

Question 55

7-50 A lower level of equity capital increases the risk of insolvency to a financial institution.

Question 56

7-59 Which function of an FI involves buying primary securities and issuing secondary securities?

A)Brokerage.
B)Asset transformation.
C)Investment research.
D)Self-regulator.
E)Trading.

Question 57

7-58 The asset transformation function potentially exposes the FI to

A)foreign exchange risk.
B)technology risk
C)operational risk
D)trading risk
E)interest rate risk.

Question 58

7-52 Event risks often cause sudden and unanticipated changes in financial market conditions.

Question 59

7-49 During a liquidity crisis assets normally must be sold at a loss because of the rising interest rates caused by financial institutions attempting to raise funds.

Question 60

7-55 Holding corporate bonds with fixed interest rates involves

A)default risk only.
B)interest rate risk only.
C)liquidity risk and interest rate risk only.
D)default risk and interest rate risk.
E)default and liquidity risk only.

Question 61

7-80 The risk that many borrowers in a particular country fail to repay their loans is

A)credit risk.
B)sovereign risk.
C)currency risk.
D)liquidity risk.
E)interest rate risk.

Question 62

7-68 Matching the book is intended to protect the FI from

A)liquidity risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 63

7-76 Politically motivated limitations on payments of foreign currency may expose an FI to

A)sovereign country risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 64

7-69 When the assets and liabilities of an FI are not equal in size,efficient hedging of interest rate risk can be achieved by

A)increasing the duration of assets and increasing the duration of equity.
B)issuing more equity and reducing the amount of borrowed funds.
C)not exactly matching the maturities of assets and liabilities.
D)issuing more equity and investing the funds in higher-yielding assets.
E)efficient hedging cannot be achieved without the use of derivative securities.

Question 65

7-73 The potential exercise of unanticipated contingencies can result in

A)technology risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 66

7-77 The risk that a debt security's price will fall,subjecting the investor to a potential capital loss is

A)credit risk.
B)political risk.
C)currency risk.
D)liquidity risk.
E)market risk.

Question 67

7-61 What type of risk focuses upon future contingencies?

A)Liquidity risk.
B)Interest rate risk.
C)Credit risk.
D)Foreign exchange rate risk.
E)Off?balance sheet risk.

Question 68

7-72 Matching the foreign currency book does not protect the FI from

A)sovereign country risk.
B)interest rate risk.
C)liquidity risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 69

7-62 If the loans in the bank's portfolio are all negatively correlated,what will be the impact on the bank's credit risk exposure?

A)The loans' negative correlations will decrease the bank's credit risk exposure because lower than expected returns on some loans will be offset by higher than expected returns on other loans.
B)The loans' negative correlations will increase the bank's credit risk exposure because lower than expected returns on some loans will be offset by higher than expected returns on other loans.
C)The loans' negative correlations will increase the bank's credit risk exposure because higher returns on less risky loans will be offset by lower returns on riskier loans.
D)The loans' negative correlations will decrease the bank's credit risk exposure because higher returns on less risky loans will be offset by lower returns on riskier loans.
E)There is no impact on the bank's credit risk exposure.

Question 70

7-71 An FI that finances a euro loan with U.S.dollar deposits is exposed to

A)technology risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 71

7-74 The asymmetric return distribution on risky debt exposes the FI to

A)technology risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 72

7-64 A small local bank failed because a housing market collapse following the departure of the areas largest employer.What type of risk applies to the failure of the institution?

A)Firm-specific risk.
B)Technological risk.
C)Operational risk.
D)Sovereign risk.
E)Insolvency risk.

Question 73

7-65 The risk that a German investor who purchases British bonds will lose money when trying to convert bond interest payments made in pounds sterling into euros is called

A)liquidity risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange rate risk.
E)off?balance-sheet risk.

Question 74

7-63 A mortgage loan officer is found to have provided false documentation that resulted in a lower interest rate on a loan approved for one of her friends.The loan was subsequently added to a loan pool,securitized and sold.Which of the following risks applies to the false documentation by the employee?

A)Market risk.
B)Credit risk.
C)Operational risk.
D)Technological risk.
E)Sovereign risk.

Question 75

7-67 The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as

A)liquidity risk.
B)reinvestment risk.
C)credit risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 76

7-66 An FI that finances long-term fixed rate mortgages with short-term deposits is exposed to

A)increases in net interest income and decreases in the market value of equity when interest rates fall.
B)decreases in net interest income and decreases in the market value of equity when interest rates fall.
C)decreases in net interest income and decreases in the market value of equity when interest rates rise.
D)increases in net interest income and decreases in the market value of equity when interest rates rise.
E)increases in net interest income and increases in the market value of equity when interest rates rise.

Question 77

7-78 The risk that interest income will increase at a slower rate than interest expense is

A)credit risk.
B)political risk.
C)currency risk.
D)liquidity risk.
E)interest rate risk.

Question 78

7-75 The major source of risk exposure resulting from issuance of standby letters of credit is

A)technology risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 79

7-70 Unanticipated diseconomies of scope are a result of

A)technology risk.
B)interest rate risk.
C)credit risk.
D)foreign exchange risk.
E)off?balance-sheet risk.

Question 80

7-79 The risk that borrowers are unable to repay their loans on time is

A)credit risk.
B)sovereign risk.
C)currency risk.
D)liquidity risk.
E)interest rate risk.