Ch. 7 Risks faced by FIs (Saunders et al, 2006)
Outline
This chapter discusses the risks associated with financial institutions
Uncertainty vs. Risk
Interest rate risk
Market risk
Credit Risk
Off-balance sheet risk
Operating risk
Foreign exchange risk
Liquidity risk
Other risks
The main objective of FIs is the proper management of these risks
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Uncertainty vs. Risk
Uncertainty. A situation where an action has more than one possible result and the probability of each result is unkwnown.
Risk. A situation where an action has more than one possible result and the probability of each result is known.
Alternatively, Risk is the degree of uncertainty associated to the outcome of an event
Usually FIs make decisions under uncertainty in terms of risk, ., they know (estimate) the probability of the results of a course of action.
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Interest rate risk
Interest rate risk is the potential impact on an FI’s earnings and market value of equity of changes in interest rates
This risk is incurred by an FI when the maturities of its assets and liabilities are mismatched.
a) Reinvestment risk. The risk that the returns on funds to be reinvested will fall below the originally anticipated returns
Example: 1-year loans at 10% annual funded with 2-year deposits at 9%
Profit spread 1st year = 10% - 9% = +1%. 2nd year: ?? - 9%
[Other example of reinvestment risk: mortgage refinancing at a lower interest rate]
., FI pays deposits at a fix-rate, investing in floating-rate loans
0
1 year
2 years
Assets (Loans at 10%)
0
1 year
2nd year i = ?
i= 8%
i= 11%
Liabilities (Deposits at 9%)
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b) Refinancing risk
The risk that the cost re-borrowing funds will rise above the originally estimated cost of borrowing
Example: 2-year loans at 10% annual funded with 1-year deposits at 9%
Profit spread 1st year = 10% - 9% = +1%. 2nd year: 10% - ??
1-year
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