Chapter Seven 
Risks of Financial Intermediation

True/False Questions

T  F  1.  Because the economies of the U.S. and other overseas countries have become more integrated, the risks of financial intermediation have decreased. 
Answer: False   

T  F  2.  The asset transformation function exposes the FI to foreign exchange risk. 
Answer: False   

T  F  3.  Asset transformation involves buying primary securities and issuing secondary securities. 
Answer: True   

T  F  4.  Interest rate risk stems from the impact of both anticipated and unanticipated changes in interest rates on FI profitability. 
Answer: False   

T  F  5.  An FI is short-funded when the maturity of its liabilities is greater than the maturity of its assets. 
Answer: False   

T  F  6.  An FI is exposed to reinvestment risk by holding longer-term assets relative to liabilities. 
Answer: False   

T  F  7.  Refinancing risk is faced by an FI when loan customers renew residential mortgage loans to take advantage of falling interest rates in the residential mortgage market. 
Answer: False   

T  F  8.  An FI that is short-funded faces the risk that the return of reinvesting assets could exceed the cost of funding those assets. 
Answer: False   

T  F  9.  With regard to market value risk, rising interest rates decrease the value of fixed rate liabilities and assets. 
Answer: True   

T  F  10.  Exactly matching the maturities of assets and liabilities will provide a perfect hedge against interest rate risk for an FI. 
Answer: False   

T  F  11.  Matching the maturities of assets and liabilities supports the asset transformation function of FIs. 
Answer: False   

T  F  12.  Funding a portion of assets with equity capital means that hedging risk does not require perfect matching of the assets and liabilities. 
Answer: True   

T  F  13.  Active trading of assets and liabilities creates market risk. 
Answer: True   

T  F  14.  The trading portfolio of an FI typically contains assets and liabilities that are relatively illiquid. 
Answer: False   

T  F  15.  FIs typically are concerned about the value at risk of their trading portfolios. 
Answer: True   

T  F  16.  Market risk is present whenever an FI takes an open position and prices change in a direction opposite to that expected. 
Answer: True   

T  F  17.  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: False   

T  F  18.  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. 
Answer: True   

T  F  19.  Credit risk stems from non-repayment or delays in repayment of either principal or interest on FI assets. 
Answer: True   

T  F  20.  Credit risk exposes the lender to the uncertainty that only interest payments may not be received. 
Answer: False   

T  F  21.  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. 
Answer: True   

T  F  22.  Historically credit card loans have had very low rates of default or credit risk when compared to other assets that an FI may hold. 
Answer: False   

T  F  23.  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. 
Answer: True   

T  F  24.  Managerial monitoring efficiency and credit risk management strategies affect the shape of the risk of the loan return distribution. 
Answer: True   

T  F  25.  Individuals have an advantage over FIs in that individuals more easily can diversify away some of the credit risk of their asset portfolios. 
Answer: False   

T  F  26.  Similar to loans, non-government bonds expose a lender to principal payment default risk.
Answer: True   

T  F  27.  Effective use of diversification principles allows an FI to reduce the total default risk in a portfolio. 
Answer: True   

T  F  28.  Firm-specific credit risk can be eliminated by diversification. 
Answer: False   

T  F  29.  The risk of default associated with general economy-wide conditions affecting all borrowers is an example of firm-specific credit risk. 
Answer: False   

T  F  30.  Systematic credit risk can be reduced significantly by diversification. 
Answer: False   

T  F  31.  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. 
Answer: True   

T  F  32.  Off-balance-sheet risk occurs because of activities that do not appear on the balance sheet. 
Answer: True   

T  F  33.  Off-balance-sheet activities often affect the shape of an FIs current balance sheet through the creation of contingent claims. 
Answer: True   

T  F  34.  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. 
Answer: True   

T  F  35.  A standby letter of credit in effect is a guarantee that some payment will be made should the original guarantor default on the original agreement. 
Answer: True   

T  F  36.  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. 
Answer: True   

T  F  37.  The objective of technological expansion is to achieve economies of scale at the expense of diseconomies of scope. 
Answer: False   

T  F  38.  Technology risk is the uncertainty that economies of scale or scope will be realized from the investment in new technologies. 
Answer: True   

T  F  39.  Economies of scope result from the ability to generate cost synergies by producing more than one output with the same inputs. 
Answer: True   

T  F  40.  The mergers of Citicorp with Travelers Insurance is an example of an attempt to exploit economies of scope. 
Answer: True   

T  F  41.  Economies of scope involve the ability to lower the average cost of operations by expanding the output of financial services. 
Answer: False   

T  F  42.  Employee fraud is a type of operational risk to a financial institution. 
Answer: True   

T  F  43.  The risk that a computer system may malfunction during the processing of data is an example of operational risk. 
Answer: True   

T  F  44.  Direct foreign investment and foreign portfolio investment both can be beneficial to an FI because of imperfectly correlated returns with domestic investments. 
Answer: True   

T  F  45.  Returns from domestic and foreign investments may not be perfectly correlated because of different economic infrastructures and growth rates. 
Answer: True   

T  F  46.  Foreign exchange risk is that the value of assets and liabilities may change because of changes in the foreign exchange rate between two countries. 
Answer: True   

T  F  47.  Foreign exchange risk is that the value of assets and liabilities may change because of changes in the level of interest rates. 
Answer: False   

T  F  48.  Foreign exchange risk includes interest rate risk and credit risk as well as changes in the foreign exchange rate between two countries. 
Answer: False   

T  F  49.  An FI can hold assets denominated in a foreign country, but it cannot issue foreign liabilities. 
Answer: False   

T  F  50.  An FI is net long in foreign assets if it holds more foreign liabilities than foreign assets. 
Answer: False   

T  F  51.  An FI with ¥100 million in loans and ¥80 million in liabilities would be net short in foreign assets. 
Answer: False   

T  F  52.  For an FI to exactly hedge the foreign investment risk, the foreign currency assets must equal the foreign currency liabilities. 
Answer: False   

T  F  53.  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. 
Answer: True   

T  F  54.  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. 
Answer: True   

T  F  55.  Control of the future supply of funds available to a foreign country is one method to ensure the repayment of an existing debt. 
Answer: True   

T  F  56.  Unanticipated withdrawals by liability holders are a major part of liquidity risk. 
Answer: True   

T  F  57.  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. 
Answer: False   

T  F  58.  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. 
Answer: True   

T  F  59.  Insolvency risk may occur when a sufficient number of borrowers are unable to repay interest and principal on loans, thus causing an FI's equity to approach zero. 
Answer: True   

T  F  60.  A lower level of equity capital increases the risk of insolvency to a financial institution. 
Answer: True   

T  F  61.  Many of the various risks faced by an FI often are interrelated with each other. 
Answer: True   

T  F  62.  Event risks often cause sudden and unanticipated changes in financial market conditions. 
Answer: True   

T  F  63.  General macroeconomic risks may affect all risks of a financial institution. 
Answer: True   

T  F  64.  .  Foreign exchange rate risk occurs because foreign exchange rates are volatile and can impact banks with exposed foreign assets and/or liabilities. 
Answer: True   

Multiple Choice Questions

65.  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. 
Answer: D   

66.  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)  Offbalance sheet risk. 
Answer: C   

67.  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)  Offbalance sheet risk. 
Answer: B   

68.  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)  Offbalance sheet risk. 
Answer: D   

69.  The risk that a transaction fails to clear properly is called 
A)  clearance risk. 
B)  exchange risk. 
C)  credit risk. 
D)  settlement risk. 
E)  interest rate risk. 
Answer: D   

70.  Settlement risk is important because 
A)  of the interconnected nature of money market transactions. 
B)  it can result in bank failures. 
C)  of the political ramifications associated with global market transactions. 
D)  of the complexity of the modern technology in electronic payments systems. 
E)  it deals with cracks in a building's foundation which create the risk of building collapse. 
Answer: A   

71.  What type of risk focuses upon future contingencies? 
A)  Liquidity risk. 
B)  Interest rate risk. 
C)  Credit risk. 
D)  Foreign exchange rate risk. 
E)  Offbalance sheet risk. 
Answer: E   

72.  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 one loan 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 one loan 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. 
Answer: A   

73.  The risk that a German investor who purchases British bonds will lose money in 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)  offbalance sheet risk. 
Answer: D   

74.  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. 
Answer: C   

75.  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)  offbalance sheet risk. 
Answer: B   

76.  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)  offbalance sheet risk. 
Answer: B   

77.  Unanticipated diseconomies of scope are a result of 
A)  technology risk. 
B)  interest rate risk. 
C)  credit risk. 
D)  foreign exchange risk. 
E)  offbalance sheet risk. 
Answer: A   

78.  A 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)  offbalance sheet risk. 
Answer: D   

79.  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)  offbalance sheet risk. 
Answer: A   

80.  The potential exercise of unanticipated contingencies can result in 
A)  technology risk. 
B)  interest rate risk. 
C)  credit risk. 
D)  foreign exchange risk. 
E)  offbalance sheet risk. 
Answer: E   

81.  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)  offbalance sheet risk. 
Answer: C   

82.  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)  offbalance sheet risk. 
Answer: E   

83.  Politically motivated limitations on payments of foreign currency may expose the FI to 
A)  sovereign country risk. 
B)  interest rate risk. 
C)  credit risk. 
D)  foreign exchange risk. 
E)  offbalance sheet risk. 
Answer: A   

84.  The risk that a debt security's price will fall, subjecting the investor to a capital loss is 
A)  credit risk. 
B)  political risk. 
C)  currency risk. 
D)  liquidity risk. 
E)  market risk. 
Answer: E   

85.  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. 
Answer: E   

86.  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. 
Answer: A   

87.  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. 
Answer: B   

88.  The risk that many depositors withdraw their funds at once is 
A)  credit risk. 
B)  sovereign risk. 
C)  currency risk. 
D)  liquidity risk. 
E)  interest rate risk. 
Answer: D   

89.  The risk that foreign governments may devalue their exchange rates is: 
A)  credit risk. 
B)  sovereign risk. 
C)  currency risk. 
D)  liquidity risk. 
E)  interest rate risk. 
Answer: C   

Use the following to answer questions 90-92:

A bank has liabilities of $4 million with an average maturity of two years paying interest rates of 4 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6 percent annually. 

90.  To what risk is it exposed? 
A)  reinvestment risk 
B)  refinancing risk. 
C)  interest rate risk. 
D)  Answers a and c. 
E)  Answers b and c. 
Answer: E   

91.  What is its net interest income in dollars in year 3, if it refinances its liabilities at a rate of percent? 
A)  -$20,000 
B)  -$10,000 
C)  -$15,000 
D)  +$20,000 
E)  +$10,000 
Answer: A   

92.  What is the maximum interest rate that it can refinance its $4 million liability and still break even on its net interest income in dollars? 
A)  6.5 percent 
B)  7.0 percent 
C)  7.5 percent 
D)  8.0 percent 
E)  8.5 percent 
Answer: C   

93.  As commercial banks move from their traditional banking activities of deposit taking and lending and shift more of their activities to trading, they are subject more to 
A)  credit risk. 
B)  market risk. 
C)  political risk. 
D)  sovereign risk. 
E)  liquidity risk. 
Answer: B   

94.  An advantage FIs have over individual household investors is that they are able to diversify away credit risk by holding a large portfolio of loans. This reduces 
A)  firm specific credit risk. 
B)  systematic credit risk. 
C)  interest rate risk. 
D)  market risk. 
E)  political risk. 
Answer: A   

Use the following to answer questions 95-97:

A bank has 10 million British pounds (£) in one-year assets and £8 million in one-year liabilities. In addition, it has one-year liabilities of 4 million euros (€). Assets are earning 8 percent and both liabilities are being paid at a rate of 8 percent.  All interest and principal will be paid at the end of the year. 

95.  What is the net interest income in dollars if the spot prices at the end of the year are $1.50/£ and €1.65/$? 
A)  $46,060.61 
B)  $320,000 
C)  $1,200,000 
D)  $266,666.67 
E)  $720,000 
Answer: A   

96.  What is the net interest income in dollars if the spot prices at the end of the year are $1.35/£ and  €1.35/$ and the liabilities instead cost 7 percent instead of 8 percent? 
A)  $1,080,000 
B)  $116,592.59 
C)  $100,567.45 
D)  $112,677.94 
E)  $120,009.76 
Answer: B   

97.  What is the maximum that the € can appreciate and the bank still maintain a zero profit in problem 95? 
A)  €1.30/$ 
B)  €1.33/$ 
C)  €1.35/$ 
D)  €1.50/$ 
E)  €1.60/$ 
Answer: B   

98.  A U.S. bank has €40 million in assets and €50 million in CDs.  All other assets and liabilities are in U.S. dollars.  This bank is 
A)  net long €10 million. 
B)  net short €10 million. 
C)  neither short nor long in €. 
D)  net long -€10 million. 
E)  net short -€10 million. 
Answer: B   

99.  Risk management for financial intermediaries deals with 
A)  controlling the overall size of the institution. 
B)  controlling the scope of the institution's activities. 
C)  limiting the geographic spread of the institution's offices. 
D)  limiting the mismatches on the institution's balance sheet. 
E)    complying scrupulously with all government regulations. 
Answer: D   

100.  The U.S. dollar's decline against European currencies is 
A)  potentially harmful for European banks only. 
B)  potentially harmful dangerous for U.S. banks only. 
C)  potentially harmful for those banks that have financed U.S. dollar assets with liabilities denominated in European currencies. 
D)  potentially harmful for those banks that have financed European currency assets with U.S. dollar liabilities. 
E)  irrelevant for global banks. 
Answer: C