Financial Risks and Instruments: Banking, Liquidity, and Market Concepts

Credit Risk

Risk that borrowers fail to repay loans

Liquidity Risk

Risk of being unable to meet cash obligations

Interest Rate Risk

Risk from changes in interest rates affecting income or value

Refinancing Risk

Risk when liabilities reprice before assets

Reinvestment Risk

Risk when assets reprice before liabilities

Market Risk

Risk from adverse movements in market prices

Off-Balance-Sheet Risk

Risk from loan commitments, guarantees, and derivatives

Foreign Exchange Risk

Risk from changes in exchange rates

Country Risk

Risk a country prevents debt repayment

Operational Risk

Risk from internal process or system failures

Insolvency Risk

Assets' market value falls below liabilities

Asset-Side Liquidity Risk

Risk from holding illiquid assets

Liability-Side Liquidity Risk

Risk from sudden withdrawals or funding loss

Purchased Liquidity

Liquidity obtained by borrowing funds

Stored Liquidity

Liquidity held in liquid assets

Fire Sale Prices

Selling assets below fair value due to urgency

Liquidity Index

Measures ease of converting assets to cash

Net Deposit Drains

Deposits withdrawn minus new deposits

Financing Gap

Loans minus deposits

Financing Requirement

Financing gap plus liquid asset needs

Bank Run

Sudden large-scale withdrawals by depositors

Rate Sensitive Assets (RSA)

Assets that reprice within a given time period

Rate Sensitive Liabilities (RSL)

Liabilities that reprice within the same period

Repricing Gap

RSA minus RSL

Positive Repricing Gap

Rising rates increase net interest income

Negative Repricing Gap

Falling rates increase net interest income

Duration

Weighted average time to receive cash flows

Duration Gap

Difference between asset and liability duration

Market Value of Equity

Market value of assets minus liabilities

Book Value of Equity

Accounting value of equity

Immunization

Matching asset and liability durations

Convexity

Curvature of price-yield relationship

Loan Sales

Selling loans to reduce risk

Loan Securitization

Pooling loans and selling securities

Pass-Through Security

Security passing cash flows directly to investors

CMO

Collateralized Mortgage Obligation with tranches

Prepayment Risk

Risk borrowers repay loans early

Sales With Recourse

Seller retains credit risk

Sales Without Recourse

Credit risk fully transferred

FNMA

Fannie Mae, government-sponsored mortgage agency

FHLMC

Freddie Mac, government-sponsored mortgage agency

GNMA

Ginnie Mae, government-backed mortgage agency