Risks of Financial Intermediation

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Risks of Financial Intermediation

• Scan
• Interest rate risk
• Market risk
• Credit risk
• Off-balance sheet risk
• Technology and operational risk
• Foreign Exchange Risk
• Country Risk
• Insolvency risk

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Interest Rate Risk

• Refinancing risk
• Reinvestment risk

Risk incurred by an FI when maturities of its
assets and liabilities are mismatched
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Market Risk
The risk incurred in the trading of assets and
liabilities due to changesin interest rates,
exchanged rates, and other asset prices.
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Credit Risk
The risk that the promised cash flows from loans
and investments held by FIs may not be paid in
full.
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Off balance sheet risk
The risk incurred by an FI due to activities
related to contingentassets and liabilities.
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Technology risk
Technology RiskThe risks incurred by an FI when
technological investments do not produce the
cost savings anticipated or technology becomes
obsolete.
Operational RiskThe risks that existing
technologyor support systems may malfunction or
break down
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Foreign exchange risk
Risks that foreign exchange rate changes can
affect the value of assets and liabilitieslocated
abroad.
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Country risk
Risks that repayments from foreign borrowers may
be interrupted because of interferences from
foreign governments.
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Liquidity risk
Risks that an FI will not have enough liquid
assets to operate.
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Insolvency risk
Risks that an FI will not have enough capital to
offset a decline in the valueof its assets
relative to liabilities.
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Interest Rate Fundamentals
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Yield measurements
Difficulty with using this as a measure of
yield?
Discount vs. premium instruments
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Corporate BondsWSJ Reporting

• Bonds Cur Vol Close Yld ATT 6s00 6.1 113
  98ATT 8s10 9.0 115 ?ATT ?s06
  9.4 120 74.5
• ATT name6 annual coupon00 maturity years
  series (not important for us)6.1 coupon
  payment divided by closing price98
  closing pricecomplete table above

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Yield to Maturity

• Simple terms rate of discount that makes the
  present value of all cash flows equal to current
  market price.
• IRR

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Bank Discount Yield

• Used with discount instrumentsUS T-bills,
  commercial paper, bankers acceptances

• 2 Important Issues
• return is based on par
• 360 year

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Interest rate fundamentals

• Why do yields differ across instruments at a
  point in time?
• time to maturity
• default risk
• marketability/liquidity
• callability/convertability
• taxability
• Why do yields on same instrument differ over
  time?
• Inflation
• Real interest rates

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Real vs. Nominal Rates

• Fisher effect
• nominal rate real rate
• expected inflation
• (real rate x expected
  inflation)

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Term Structure of Yields

• Shape?
• Axis?

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Term Structure of Yields(Theories)

• Market segmentation
• Liquidity preference or Premium Approach
• Unbiased ExpectationsObservable long term
  yields are average of unobservable S.T.
  yieldsGeometric average

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Spot vs. Forward Rates
Number of periods
1 year forward rates
3r1
2r1
1r1





0r1
4r1
Initial timePeriod
Time 0
Time 1
Time 2
Time 3
Time 4
0R1
0R2
0R3
SpotRates
0R4
0R5
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Pure Expectations
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Pure Expectations Yield Curve


?
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Forward Rates
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Calculate

• Suppose the following are taken from yield curve.
  What are the implied 1 year rates?
• 1 yr -6.00
• 2 yr- 6.25
• 3 yr- 6.50
• 4 yr- 6.75
• 5 yr- 7.00

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• Suppose that on Aug 31, a SL wished to purchase
  a T-bill maturing Oct 1 (31 days). If the dealer
  quotes a bank discount yield of 2.97 what must
  the SL pay for the T-Bill?
• Assume 100 par value

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Sample

• Suppose we observe the 3 year Treasury security
  rate to be 12, the expected one year rate next
  year to be 8 and the expected one year rate the
  following year to be 10.
• What is the one-year Treasury Rate?
• R1 .1825
• 1.12 (1.1825)(1.08)(11.1)

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