Describe the risk exposure(s) in the following financial transactions. Identify
ID: 2652769 • Letter: D
Question
Describe the risk exposure(s) in the following financial transactions. Identify which transactions are influenced by interest rates or interest income. (CAUTION: Some can be influenced by both!)
Risk Types: Interest rate risk, Credit risk, Technology risk, Foreign exchange rate risk, Country or sovereign risk
Financial Transactions
Risk Type
Describe and justify risk type
Interest Rate or Interest Income?
A bank finances a $10 million, six-year fixed-rate commercial loan by selling one-year certificate of deposit.
An insurance company invests its policy premiums in a long-term municipal bond portfolio.
A French bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to a British entrepreneur.
A Japanese bank acquires an Austrian bank to facilitate clearing operations.
A bond dealer uses his own equity to buy Mexican debt on the less developed country (LDC) bond market.
A securities firm sells a package of mortgage loans as mortgage-backed securities.
Describe the features of the method you would choose to measure the interest risks identified.
Financial Transactions
Risk Type
Describe and justify risk type
Interest Rate or Interest Income?
A bank finances a $10 million, six-year fixed-rate commercial loan by selling one-year certificate of deposit.
An insurance company invests its policy premiums in a long-term municipal bond portfolio.
A French bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to a British entrepreneur.
A Japanese bank acquires an Austrian bank to facilitate clearing operations.
A bond dealer uses his own equity to buy Mexican debt on the less developed country (LDC) bond market.
A securities firm sells a package of mortgage loans as mortgage-backed securities.
Describe the features of the method you would choose to measure the interest risks identified.
Explanation / Answer
(1)
Risk type - Credit risk
Justification - There is a credit default risk for the bank, that its borrower will fail to repay the loan granted.
Transaction influenced by - Interest income that bank earns from the loan it granted.
(2)
Risk type - Interest rate risk
Justification - There is a risk that the municipal bond will default in its coupon interest payments.
Transaction influenced by - Interest income that insurance company earns from the bond.
(3)
Risk type - Exchange rate risk
Justification - since both obligations are fixed-rate loans, the interest is fixed, but fluctuation in exchange rate can make one loan cheaper/costlier than another.
Transaction influence - Interest payment & Interest income, both.
(4)
Risk type - Technology Risk
Justification - purpose of the acquisition is to faciliate clearning operations & there can be a risk that the Austrian bank will not meet the expected technology standards.
Transaction influence - Possibly interest payment (If the acquisition is funded by taking a loan)
(5)
Risk type - Sovereign risk
Justification - There is a risk that the LDC sovereign debt will default.
Transaction influence - Neither interest income nor payment, since transaction is equity funded.
(6)
Risk type - Interest rate risk
Justification - The interest from the pool of MBS loan may be uncertain.
Transaction influence - interest payment, since firm has to pay the MBS buyers interest.
NOTE: The 1st question with 6 sub-parts has been answered.
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