What is foreign exchange risk? What does it mean for an FI to be net long in for- eign 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 Fl to suffer losses?

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Chapter 7

8. Consider the simple FI balance sheet below (in millions of dollars).

______________________________________________________________________________

Assets Liabilities/Equity

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

Bonds 10,000 Equity 1,000

Total Assets $11,000 Liabilities and Equity $11,000

Suppose that depositors unexpectedly withdraw $50 million in deposits and the FI receives no new deposits to replace them. Assume that the FI cannot borrow any more funds in the short-term money markets, and because it cannot wait to get better prices for its assets in the future (as it needs the cash now to meet immediate depositor withdrawals), the FI has to sell any non-liquid assets at 75 cents on the dollar.

A. The bond has a 10-year maturity, a fixed-rate coupon of 10 percent paid at the end of each year, and a par value of $10,000. The certificate of deposit has a 1-year maturity and a 6 percent fixed rate of interest. The FI expects no additional asset growth. 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.)

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?

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 bd 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.

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?

E. What factors have caused the changes in operating performance and market value for this firm?

19. Consider the simple FI balance sheet below (in millions of dollars).

______________________________________________________________________________

Before the Withdrawal

Assets Liabilities/Equity

Cash assets $ 20 Deposit $150

Nonliquid assets 155 Equity 25

$175 $175

Suppose that depositors unexpectedly withdraw $50 million in deposits and the FI receives no new deposits to replace them. Assume that the FI cannot borrow any more funds in the short-term money markets, and because it cannot wait to get better prices for its assets in the future (as it needs the cash now to meet immediate depositor withdrawals), the FI has to sell any non-liquid assets at 75 cents on the dollar.

21. What is foreign exchange risk? What does it mean for an FI to be net long in for- eign 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 Fl to suffer losses?

26. Assume that a bank has assets located in London that are worth £150 million on which it earns an average of 8 percent per year. The bank has £100 million in liabilities on which it pays an average of 6 percent per year. The current spot exchange rate is £1.50/$.

A. If the exchange rate at the end of the year is £2.00/$, will the dollar have appreciated or depreciated against the pound?

B. Given the change in the exchange rate, what is the effect in dollars on the net interest income from the foreign assets and liabilities? Note: The net interest income is interest income minus interest expense.

C. What is the effect of the exchange rate change on the value of assets and liabilities in dollars?

All the above questions are taken from

Saunders, Anthony, and Marcia Milton Cornet, Financial Institutions Management: A Risk Management Approach, 9thed., New York, McGraw-Hill Education, 2018

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