FINA 465 EXAM 2 QUESTIONS AND
ANSWERS 100% PASS 2026/2027
Refinancing Risk - ANS Refinancing risk is the risk that the cost of rolling over or reborrowing
funds will rise above the returns being earned on asset investments. This risk occurs when an FI
is holding assets with maturities greater than the maturities of its liabilities. For example, if a
bank has a ten-year fixed-rate loan funded by a 2-year time deposit, the bank faces a risk in that
new deposits may only be obtained, and the loans refinanced, at a higher rate in two years.
These interest rate increases would reduce net interest income. The bank would benefit if
interest rates decrease as the cost of renewing the deposits would decrease, while the interest
rate earned on the loan would not change. In this case, net interest income would increase.
Reinvestment Risk - ANS Reinvestment risk is the risk that the return on funds to be
reinvested will fall below the cost of funds. This risk occurs when an FI holds assets with
maturities that are shorter than the
maturities of its liabilities. For example, if a bank has a two-year loan funded by a ten-year fixed-
rate time deposit, the bank faces the risk that interest rates might decrease. In this case, it
might be forced to lend or reinvest the money at lower rates after two years, perhaps even
below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments
from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at
the new lower interest rates. In this case, net interest income would decrease. If interest rates
increase, the bank would be able to lend or reinvest the money at higher rates after two years.
In this case, net interest income would increase. Besides the effect on the income statement,
reinvestment risk may cause realized yields on assets to differ from the a priori expected yields.
@2026 ALLRIGHTS RESERVED 1
,The sales literature of a mutual fund claims that the fund has no risk exposure since it invests
exclusively in federal government securities which are free of default risk. Is this claim true?
Explain why or why not. - ANS Although the fund's asset portfolio is comprised of securities
with no default risk, the securities are exposed to interest rate risk. For example, if interest rates
increase, the market value of the fund's Treasury security portfolio will decrease. Further, if
interest rates decrease, the realized yield on these securities will be less than the expected rate
of return because of reinvestment risk. In either case, investors who liquidate their positions in
the fund may sell at a Net Asset Value (NAV) that is lower than the purchase price.
Calculate the FI's profit spread and dollar value of profit in year 1. - ANS 1. ROA Percent -
Liabilities Percent
2. % x $ of Liabilities
Its profit for the second year, however, is uncertain. The risk always exists that interest rates will
change between years 1 and 2.
How does a policy of matching the maturities of assets and liabilities work (a) to minimize
interest rate risk and (b) against the asset-transformation function of FIs? - ANS A policy of
maturity matching will allow changes in market interest rates to have approximately the same
effect on both interest income and interest expense. An increase in rates will tend to increase
both income and expense, and a decrease in rates will tend to decrease both income and
expense. The changes in income and expense may not be equal because of different cash flow
characteristics of the assets and liabilities. The asset-transformation function of an FI involves
investing short-term liabilities in long-term assets. Maturity matching clearly works against
successful implementation of this process.
What is the difference between firm-specific credit risk and systematic credit risk? How can an
FI alleviate firm-specific credit risk? - ANS Firm-specific credit risk refers to the likelihood that
a single asset may deteriorate in quality, while systematic credit risk involves macroeconomic
factors that may increase the default risk of all firms in the economy. Thus, if S&P lowers its
rating on IBM stock and if an investor is holding only this particular stock, he may face
significant losses as a result of this downgrading. However, portfolio theory in finance has
shown that firm-specific credit risk can be diversified away if a portfolio of well-diversified
stocks is held. Similarly, if an FI holds a well-diversified portfolio of assets, the FI will face only
@2026 ALLRIGHTS RESERVED 2
, systematic credit risk that will be affected by the general condition of the economy. The risks
specific to any one customer will not be a significant portion of the FIs overall credit risk
Liquidity Risk - ANS Liquidity risk is the risk that a sudden surge in liability withdrawals may
require an FI to liquidate assets in a very short period of time and at less than fair market prices.
In times of normal economic activity, depository institutions meet cash withdrawals by
accepting new deposits and borrowing funds in the short-term money markets. However, in
times of harsh liquidity crises, the FI may need to sell assets at significant losses in order to
generate cash quickly.
Foreign Exchange Risk - ANS Foreign exchange risk is the risk that exchange rate changes can
affect the value of an FI's assets and liabilities denominated in foreign currencies. An FI is net
long in foreign assets when the foreign currency-denominated assets exceed the foreign
currency-denominated liabilities. In this case, an FI will suffer potential losses if the domestic
currency strengthens relative to the foreign currency when repayment of the assets will occur in
the foreign currency. An FI is net short in foreign assets when the foreign currency-denominated
liabilities exceed the foreign currency-denominated assets. In this case, an FI will suffer potential
losses if the domestic currency weakens relative to the foreign currency when repayment of the
liabilities will occur in the domestic currency.
If the Swiss franc is expected to depreciate in the near future, would a U.S.-based FI in Bern City
prefer to be net long or net short in its asset positions? Discuss. - ANS The U.S. FI would
prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of
the Swiss franc relative to the dollar means that the U.S. FI would pay back the net liability
position with fewer dollars. In other words, the decrease in the foreign assets in dollar value
after conversion will be less than the decrease in the value of the foreign liabilities in dollar
value after conversion.
Country or Sovereign Risk - ANS Country or sovereign risk is the risk that repayments to
foreign lenders or investors may be interrupted because of restrictions, intervention, or
interference from foreign governments. A lender FI has very little recourse in this situation
unless the FI is able to restructure the debt or demonstrate influence over the future supply of
funds to the country in question. This influence likely would involve significant working
relationships with the IMF and the World Bank.
@2026 ALLRIGHTS RESERVED 3
ANSWERS 100% PASS 2026/2027
Refinancing Risk - ANS Refinancing risk is the risk that the cost of rolling over or reborrowing
funds will rise above the returns being earned on asset investments. This risk occurs when an FI
is holding assets with maturities greater than the maturities of its liabilities. For example, if a
bank has a ten-year fixed-rate loan funded by a 2-year time deposit, the bank faces a risk in that
new deposits may only be obtained, and the loans refinanced, at a higher rate in two years.
These interest rate increases would reduce net interest income. The bank would benefit if
interest rates decrease as the cost of renewing the deposits would decrease, while the interest
rate earned on the loan would not change. In this case, net interest income would increase.
Reinvestment Risk - ANS Reinvestment risk is the risk that the return on funds to be
reinvested will fall below the cost of funds. This risk occurs when an FI holds assets with
maturities that are shorter than the
maturities of its liabilities. For example, if a bank has a two-year loan funded by a ten-year fixed-
rate time deposit, the bank faces the risk that interest rates might decrease. In this case, it
might be forced to lend or reinvest the money at lower rates after two years, perhaps even
below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments
from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at
the new lower interest rates. In this case, net interest income would decrease. If interest rates
increase, the bank would be able to lend or reinvest the money at higher rates after two years.
In this case, net interest income would increase. Besides the effect on the income statement,
reinvestment risk may cause realized yields on assets to differ from the a priori expected yields.
@2026 ALLRIGHTS RESERVED 1
,The sales literature of a mutual fund claims that the fund has no risk exposure since it invests
exclusively in federal government securities which are free of default risk. Is this claim true?
Explain why or why not. - ANS Although the fund's asset portfolio is comprised of securities
with no default risk, the securities are exposed to interest rate risk. For example, if interest rates
increase, the market value of the fund's Treasury security portfolio will decrease. Further, if
interest rates decrease, the realized yield on these securities will be less than the expected rate
of return because of reinvestment risk. In either case, investors who liquidate their positions in
the fund may sell at a Net Asset Value (NAV) that is lower than the purchase price.
Calculate the FI's profit spread and dollar value of profit in year 1. - ANS 1. ROA Percent -
Liabilities Percent
2. % x $ of Liabilities
Its profit for the second year, however, is uncertain. The risk always exists that interest rates will
change between years 1 and 2.
How does a policy of matching the maturities of assets and liabilities work (a) to minimize
interest rate risk and (b) against the asset-transformation function of FIs? - ANS A policy of
maturity matching will allow changes in market interest rates to have approximately the same
effect on both interest income and interest expense. An increase in rates will tend to increase
both income and expense, and a decrease in rates will tend to decrease both income and
expense. The changes in income and expense may not be equal because of different cash flow
characteristics of the assets and liabilities. The asset-transformation function of an FI involves
investing short-term liabilities in long-term assets. Maturity matching clearly works against
successful implementation of this process.
What is the difference between firm-specific credit risk and systematic credit risk? How can an
FI alleviate firm-specific credit risk? - ANS Firm-specific credit risk refers to the likelihood that
a single asset may deteriorate in quality, while systematic credit risk involves macroeconomic
factors that may increase the default risk of all firms in the economy. Thus, if S&P lowers its
rating on IBM stock and if an investor is holding only this particular stock, he may face
significant losses as a result of this downgrading. However, portfolio theory in finance has
shown that firm-specific credit risk can be diversified away if a portfolio of well-diversified
stocks is held. Similarly, if an FI holds a well-diversified portfolio of assets, the FI will face only
@2026 ALLRIGHTS RESERVED 2
, systematic credit risk that will be affected by the general condition of the economy. The risks
specific to any one customer will not be a significant portion of the FIs overall credit risk
Liquidity Risk - ANS Liquidity risk is the risk that a sudden surge in liability withdrawals may
require an FI to liquidate assets in a very short period of time and at less than fair market prices.
In times of normal economic activity, depository institutions meet cash withdrawals by
accepting new deposits and borrowing funds in the short-term money markets. However, in
times of harsh liquidity crises, the FI may need to sell assets at significant losses in order to
generate cash quickly.
Foreign Exchange Risk - ANS Foreign exchange risk is the risk that exchange rate changes can
affect the value of an FI's assets and liabilities denominated in foreign currencies. An FI is net
long in foreign assets when the foreign currency-denominated assets exceed the foreign
currency-denominated liabilities. In this case, an FI will suffer potential losses if the domestic
currency strengthens relative to the foreign currency when repayment of the assets will occur in
the foreign currency. An FI is net short in foreign assets when the foreign currency-denominated
liabilities exceed the foreign currency-denominated assets. In this case, an FI will suffer potential
losses if the domestic currency weakens relative to the foreign currency when repayment of the
liabilities will occur in the domestic currency.
If the Swiss franc is expected to depreciate in the near future, would a U.S.-based FI in Bern City
prefer to be net long or net short in its asset positions? Discuss. - ANS The U.S. FI would
prefer to be net short (liabilities greater than assets) in its asset position. The depreciation of
the Swiss franc relative to the dollar means that the U.S. FI would pay back the net liability
position with fewer dollars. In other words, the decrease in the foreign assets in dollar value
after conversion will be less than the decrease in the value of the foreign liabilities in dollar
value after conversion.
Country or Sovereign Risk - ANS Country or sovereign risk is the risk that repayments to
foreign lenders or investors may be interrupted because of restrictions, intervention, or
interference from foreign governments. A lender FI has very little recourse in this situation
unless the FI is able to restructure the debt or demonstrate influence over the future supply of
funds to the country in question. This influence likely would involve significant working
relationships with the IMF and the World Bank.
@2026 ALLRIGHTS RESERVED 3
