Exam 3 - Commercial Bank
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100 Terms
What is the repricing or funding gap?
Difference between assets and liabilities each of whose interest rates will be repriced or changed over some future period.
What does the repricing gap model measure?
Impact on profitability.
What does the duration gap model measure?
Impact on equity.
What has the Federal Reserve's monetary policy had a major influence on?
Interest rates.
What are rate-sensitive assets and rate-sensitive liabilities bucketed by?
Maturity.
What is a refinancing risk?
Negative gap, or rate-sensitive assets less than rate-sensitive liabilities.
What is a reinvestment risk?
Positive gap, or rate-sensitive assets greater than rate-sensitive liabilities.
How is the change in net interest income in a specific maturity bucket calculated?
Change in net interest income equals the gap in a specific maturity bucket multiplied by the change in interest rates in a specific maturity bucket.
What happens to net interest income when there is a positive gap and interest rates increase?
Net interest income increases.
What happens to net interest income when there is a positive gap and interest rates decrease?
Net interest income decreases.
What happens to net interest income when there is a negative gap and interest rates increase?
Net interest income decreases.
What happens to net interest income when there is a negative gap and interest rates decrease?
Net interest income increases.
What is spread effect?
The effect that a change in the spread between rates on rate-sensitive assets and rate-sensitive liabilities has on net interest income as interest rates change.
What happens to net interest income when the spread increases?
Net interest income increases.
What happens to net interest income when the spread decreases?
Net interest income decreases.
What are the four major weaknesses of the repricing model?
Ignores market value effects of interest rate changes; ignores cash flow patterns within a maturity bucket; fails to deal with the problem of rate-insensitive asset and liability cash flow runoffs and prepayments; ignores cash flows from off-balance-sheet activities.
What does duration measure?
The interest rate sensitivity of an asset or liability's value to small changes in interest rates.
What is duration gap?
A measure of overall interest rate risk exposure for a financial institution.
What are managers increasingly turning to off-balance-sheet instruments such as forwards, futures, options, and swaps to do?
Hedge the risks their financial institutions face.
What risk exposures do derivatives play a role in managing?
Interest rate, foreign exchange, and credit risk exposures.
What is a hedger?
A trader who takes a position in a derivative contract as protection against an increase or decrease in the price of a security.
What is a speculator?
A trader who buys derivative contracts to profit from a price increase or sells to profit from a price decrease.
What are spot contracts?
Agreements to buy or sell an asset quickly, usually within two or three days.
What are forward contracts?
Agreements to buy or sell an asset at some future point in time.
Why are forward contracts not always liquid?
They are not traded on an exchange and are not standardized.
How are futures contracts different from forward contracts?
Futures contracts are exchange traded.
Why are futures contracts generally more liquid than forward contracts?
They are more standardized and the exchange guarantees that the buyer or seller pays what is owed.
What is a naive hedge?
A hedge of a cash asset on a direct dollar-for-dollar basis with a forward or futures contract.
What does hedging allow financial institutions to do?
Immunize assets against interest rate risk.
What are the steps to determine a potential hedge?
Identify the rate or price change that hurts the position; choose a derivatives position that makes money if the bad event happens; calculate the number of contracts required; secure sources of interim funding if needed.
What is microhedging?
Using a derivative securities contract to hedge a specific asset or liability.
What is basis risk?
A residual risk that occurs because the movement in a spot asset's price is not perfectly correlated with the movement in the price of the asset delivered under a futures or forward contract.
What is macrohedging?
Hedging the entire duration gap of a financial institution.
What is the efficiency of a macrohedge?
It focuses only on those mismatch positions that are candidates for off-balance-sheet hedging activities.
When is a long position the appropriate hedge?
When the financial institution stands to lose on the balance sheet if interest rates are expected to fall.
When is a short position the appropriate hedge?
When the financial institution stands to lose on the balance sheet if interest rates are expected to rise.
What option products do financial institutions use in hedging?
Exchange-traded options, over-the-counter options, options embedded in securities, caps, collars, and floors.
Why are options called options?
Because the buyer is purchasing the option to buy or sell an underlying asset at an agreed upon price in the future.
What does the buyer of an option pay to the seller?
A premium.
What is loan securitization?
The packaging and selling of loans and other assets backed by loans issued by the financial institution.
What risks have loan sales and securitization been used to hedge?
Credit risk, interest rate risk, and liquidity risk exposures.
How have loan sales and securitization affected financial institution asset portfolios?
Allowed asset portfolios to become more liquid.
How have loan sales and securitization affected fee income?
Provided an important source of fee income.
How have loan sales and securitization affected regulatory taxes?
Helped reduce the effects of regulatory taxes on financial institution profitability.
How do loan sales differ from loan securitization?
Loan sales involve splitting up larger loans and loan portfolios, whereas loan securitization involves the grouping of smaller loans into larger pools.
What is a loan sale?
A financial institution originates a loan and sells it with or without recourse to an outside buyer.
What is recourse?
Whether the loan seller has responsibility in case the borrower does not pay.
What is the syndicated loan market?
Market for buying and selling loans once a bank has originated them.
Who are the three types of participants in the syndicated loan market?
Market makers, active traders, and occasional participants.
What is a participation?
The act of buying a share in a loan syndication with limited contractual control and rights over the borrower.
What is an assignment?
The purchase of a share in a loan syndication with some contractual control and rights over the borrower.
What are the three segments of the United States loan sales market?
Traditional short-term loans, highly leveraged transactions loans, and less developed country loans.
What are pass-through securities?
Securities that offer investors an interest in a pool created by financial institutions pooling mortgages and other loans they originate.
What do pass-through mortgage securities do?
Pass through promised payments by households of principal and interest on pools of mortgages created by financial institutions to secondary market investors holding an interest in these pools.
Which three government agencies or government-sponsored enterprises are directly involved in the creation of mortgage-backed pass-through securities?
Ginnie Mae, Fannie Mae, and Freddie Mac.
Which model is a simple model used by small financial institutions in the United States with results reported quarterly?
Repricing or funding gap model.
What is the common cumulative gap of interest?
The one-year repricing gap.
What is the cumulative gap effect?
The relationship between changes in interest rates and changes in net interest income.
What does the duration gap model estimate?
The effect of interest rate changes on the market value of a financial institution's equity or net worth.
What is the leverage-adjusted duration gap?
Asset duration minus the leverage ratio multiplied by liability duration.
What does a larger duration gap in absolute terms indicate?
The financial institution is more exposed to interest rate risk.
What are forwards used to hedge?
Interest rate, foreign exchange, and credit risk exposures.
What are the two types of traders of derivatives?
Hedgers and speculators.
What is the key to microhedging with futures?
Take a position in the futures market to offset a loss on the balance sheet due to a move in interest rates with a gain in the futures market.
What happens in a long hedge when interest rates decrease?
Cash market loss and futures market gain.
What happens in a short hedge when interest rates increase?
Cash market loss and futures market gain.
What are the four basic option strategies that financial institutions might employ?
Long call, short call, long put, and short put.
What is the exercise price?
The agreed upon price at which the underlying asset may be bought or sold.
What is the call premium?
The premium paid for a call option.
What is the put premium?
The premium paid for a put option.
What does a call option give the buyer?
The right to buy the underlying asset.
What does a put option give the buyer?
The right to sell the underlying asset.
What is the original use of pass-through securitization?
Government-sponsored programs to enhance the liquidity of the residential mortgage market.
What factors encourage future loan sales growth?
Fee income, liquidity risk, capital costs, and reserve requirements.
How can loan sales boost reported income?
By originating and quickly selling loans.
How can loan sales mitigate a liquidity problem?
By selling some loans to outside investors.
How can loan sales improve the capital-to-assets ratio?
By reducing assets through loan sales rather than boosting capital.
Why do reserve requirements encourage loan sales?
They represent a form of tax that adds to the cost of funding the loan portfolio.
What factors deter future loan sales growth?
Access to the commercial paper market, customer relationship effects, and legal concerns.
How can access to the commercial paper market reduce loan sales growth?
Firms rely less on bank loans to finance short-term expenditures.
How can customer relationship effects deter loan sales growth?
Loan sales can harm revenues generated by the financial institution as current and future customers take their business elsewhere.
What is an example of a legal concern hampering loan sales growth?
Fraudulent conveyance.
Who are the major buyers in the nondistressed market and traditional United States domestic loan sales market?
Investment banks, vulture funds, other domestic banks, foreign banks, insurance companies and pension funds, closed-end bank loan mutual funds, and nonfinancial corporations.
Who are the sellers of domestic loans and highly leveraged transaction loans?
Major money center banks, small regional or community banks, foreign banks, investment banks, and the United States government and its agencies.
What did the Debt Collection Improvement Act of 1996 authorize?
Federal agencies to sell delinquent and defaulted loans.