2. What is the difference between firm-specific credit risk and systematic credit risk?

How can an FI
alleviate firm-specific credit risk?

 Firm-specific credit risk refers to the likelihood that specific individual assets may deteriorate in quality,
while systematic credit risk involves macroeconomic factors that may increase the default risk of all
firms in the economy. Thus, if S&P lowers its rating on IBM stock and if an investor is holding only this
particular stock, she may face significant losses as a result of this downgrading. However, portfolio
theory in finance has shown that firm-specific credit risk can be diversified away if a portfolio of well-
diversified stocks is held. Similarly, if an FI holds well-diversified assets, the FI will face only
systematic credit risk that will be affected by the general condition of the economy. The risks specific to
any one customer will not be a significant portion of the FIs overall credit risk.

5. Which type of cash withdrawal presents very little liquidity risk? Which type of cash withdrawal is a source
of significant liquidity risk for DIs?

 Day-to-day withdrawals by liability holders are generally predictable, and large FIs can normally expect
to borrow additional funds to meet any sudden shortfalls of cash in the money and financial markets.

 Because of a lack of confidence in an FI or some unexpected need for cash, liability holders may be led
to demand larger withdrawals than usual. When all, or many, FIs face abnormally large cash demands,
the cost of purchased or borrowed funds rises and the supply of such funds becomes restricted. As a
consequence, FIs may have to sell some of their less liquid assets to meet the withdrawal demands of
liability holders. This results in a more serious liquidity risk, especially as some assets with “thin”
markets generate lower prices when the sale is immediate than when an FI has more time to negotiate
the sale of an asset. As a result, the liquidation of some assets at low or “fire-sale” prices (the price the
FI receives if the assets must be liquidated immediately at less than their fair market value) could
threaten an FI’s profitability and solvency.

7. What is refinancing risk? How is refinancing risk part of interest rate risk? If an FI funds long-term fixed-
rate assets with short-term liabilities, what will be the impact on earnings of an increase in the rate of interest?
A decrease in the rate of interest?

 Refinancing risk is the uncertainty of the cost of a new source of funds that are being used to finance a
long-term fixed-rate asset. This risk occurs when an FI is holding assets with maturities greater than the
maturities of its liabilities. For example, if a bank has a ten-year fixed-rate loan funded by a 2-year time
deposit, the bank faces a risk of borrowing new deposits, or refinancing, at a higher rate in two years.
Thus, interest rate increases would reduce net interest income. The bank would benefit if the rates fall
as the cost of renewing the deposits would decrease, while the earning rate on the assets would not
change. In this case, net interest income would increase.

8. What is reinvestment risk? How is reinvestment risk part of interest rate risk? If an FI funds short-term
assets with long-term liabilities, what will be the impact on earnings of a decrease in the rate of interest? An
increase in the rate of interest?

 Reinvestment risk is the uncertainty of the earning rate on the redeployment of assets that have matured.
This risk occurs when an FI holds assets with maturities that are less than the maturities of its liabilities.
For example, if a bank has a two-year loan funded by a ten-year fixed-rate time deposit, the bank faces
the risk that it might be forced to lend or reinvest the money at lower rates after two years, perhaps even
 below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments from a
bond or monthly payments on a loan, these periodic cash flows will also be reinvested at the new lower
(or higher) interest rates. Besides the effect on the income statement, this reinvestment risk may cause
the realized yields on the assets to differ from the a priori expected yields.

16. What is the nature of an off-balance-sheet activity? How does an FI benefit from such activities? Identify
the various risks that these activities generate for an FI and explain how these risks can create varying degrees
of financial stress for the FI at a later time.

 Off-balance-sheet activities are contingent commitments to undertake future on-balance-sheet

investments. The usual benefit of committing to a future activity is the generation of immediate fee
income without the normal recognition of the activity on the balance sheet. As such, these contingent
investments may be exposed to credit risk (if there is some default risk probability), interest rate risk (if
there is some price and/or interest rate sensitivity) and foreign exchange rate risk (if there is a cross
currency commitment).

17. What is foreign exchange risk? What does it mean for an FI to be net long in foreign assets? What does it
mean for an FI to be net short in foreign assets? In each case, what must happen to the foreign exchange
rate to cause the FI to suffer losses?

Foreign exchange risk involves the adverse affect on the value of an FI’s assets and liabilities that are located in
another country when the exchange rate changes. An FI is net long in foreign assets when the foreign currency-
denominated assets exceed the foreign currency denominated liabilities. In this case, an FI will suffer potential
losses if the domestic currency strengthens relative to the foreign currency when repayment of the assets will
occur in the foreign currency. An FI is net short in foreign assets when the foreign currency-denominated
liabilities exceed the foreign currency denominated assets. In this case, an FI will suffer potential losses if the
domestic currency weakens relative to the foreign currency when repayment of the liabilities will occur in the
domestic currency.

22. If the Swiss franc is expected to depreciate in the near future, would a U.S.-based FI in Bern City prefer to
be net long or net short in its asset positions? Discuss.

The U.S. FI would prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of
the franc relative to the dollar means that the U.S. FI would pay back the net liability position with fewer
dollars. In other words, the decrease in the foreign assets in dollar value after conversion will be less than the
decrease in the value of the foreign liabilities in dollar value after conversion.
Problems:

1. A financial institution has the following balance sheet structure:

Assets Liabilities and Equity

Cash $1,000 Certificate of Deposit $10,000
Bond $10,000 Equity $1,000
Total Assets $11,000 Total Liabilities and Equity $11,000

The bond has a 10-year maturity and a fixed-rate coupon of 10 percent. The certificate of deposit has a 1-
year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth.

a. What will be the net interest income (NII) at the end of the first year? Note: Net interest income equals
interest income minus interest expense.

Interest income $1,000 $10,000 x 0.10

Interest expense 600 $10,000 x 0.06
Net interest income (NII) $400

b. If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the
net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing
risk?

Interest income $1,000 $10,000 x 0.10

Interest expense 700 $10,000 x 0.07
Net interest income (NII) $300

The decrease in net interest income is caused by the increase in financing cost without a corresponding
increase in the earnings rate. Thus, the change in NII is caused by refinancing risk. The increase in
market interest rates does not affect the interest income because the bond has a fixed-rate coupon for ten
years. Note: this answer makes no assumption about reinvesting the first year’s interest income at the new
higher rate.

c. Assuming that market interest rates increase 1 percent, the bond will have a value of $9,446 at the end of
year 1. What will be the market value of the equity for the FI? Assume that all of the NII in part (a) is
used to cover operating expenses or is distributed as dividends.

Cash $1,000 Certificate of deposit $10,000

Bond $9,446 Equity $ 446
Total assets $10,446 Total liabilities and equity $10,446
 d. If market interest rates had decreased 100 basis points by the end of year 1, would the market value of
equity be higher or lower than $1,000? Why?
The market value of the equity would be higher ($1,600) because the value of the bond would be higher
($10,600) and the value of the CD would remain unchanged.

e. What factors have caused the change in operating performance and market value for this firm?
The operating performance has been affected by the changes in the market interest rates that have caused
the corresponding changes in interest income, interest expense, and net interest income. These specific
changes have occurred because of the unique maturities of the fixed-rate assets and fixed-rate liabilities.
Similarly, the economic market value of the firm has changed because of the effect of the changing rates
on the market value of the bond.

6. Suppose you purchase a 10-year AAA-rated Swiss bond for par that is paying an annual coupon of 8
percent and has a face value of 1,000 Swiss francs (SF). The spot rate is U.S. $0.66667 for SF1. At the end
of the year, the bond is downgraded to AA and the yield increases to 10 percent. In addition, the SF
depreciates to U.S. $0.74074 for SF1. ( LG 19-1 )

a. What is the loss or gain to a Swiss investor who holds this bond for a year? What portion of this loss or
gain is due to foreign exchange risk? What portion is due to interest rate risk?

Beginning of
in Swiss Franc year End of year
Face Value of
Bond 1000 1000
Coupon 0.08 0.08
Yield 0.08 0.1
Period 10 9
Payment 80 80
Price of Bond 1000 884.82

The loss to the Swiss investor (SF884.82 + SF80 - SF1,000)/SF1,000 = -3.52%. The entire amount of the
loss is due to interest rate risk.

b. What is the loss or gain to a U.S. investor who holds this bond for a year? What portion of this loss or
gain is due to foreign exchange risk? What portion is due to interest rate risk?

Price at beginning of year = SF1,000 * 0.66667 = $666.67

Price at end of year = SF884.82 * 0.74074 = $655.42
Interest received at end of year = SF80 * 0.74074 = $59.26
Gain to U.S. investor = ($655.42 + $59.26 - $666.67)/$666.67 = +7.20%.

The U.S. investor had an equivalent loss of 6.49 percent from interest rate risk, but he had a gain of 10.38
percent (3.89 - (-6.49)) from foreign exchange risk. If the Swiss franc had depreciated, the loss to the U.S.
investor would have been larger than 6.49 percent.