Finance
Chapter 18 - Liability and Liquidity Management
Fin 698
Fall 2012
Prof. Anderson
HW #7b: chapter 18: 3, 10, 11, 16 and 17. (These appear in the book on pages 568-572.) Solutions for End-of-Chapter Questions and Problems 1. What are the benefits and costs to an FI of holding large amounts of liquid assets? Why are Treasury securities considered good examples of liquid assets?
A major benefit to an FI of holding a large amount of liquid assets is that it can offset any unexpected and large withdrawals without reverting to asset sales or emergency funding. If assets have to be sold at short notice, FIs may not be able to obtain a fair market value. It is more prudent to anticipate withdrawals and keep liquid assets to meet the demand. On the other hand, liquid assets provide lower yields, so the opportunity cost for holding a large amount of liquid assets is high. FIs taking conservative positions by holding large amounts of liquid assets will therefore have lower profits. Treasury securities are considered good examples of liquid assets because they can be converted into cash quickly with very little loss of value from current market levels. 2. How is an FI’s liability and liquidity risk management problem related to the maturity of its assets relative to its liabilities?
For most FIs, the maturity of assets is greater than the maturity of liabilities. As the difference in the average maturity between the assets and liabilities increases, liquidity risk increases. In the event that liabilities begin to leave the FI or are not reinvested by investors at maturity, the FI may need to liquidate some of its assets at fire-sale prices. These prices would tend to deviate further from their market value as the maturity of the assets increase. Thus, the FI may sustain larger losses. 3. Consider the assets (in millions) of two banks, A and B. Both banks are funded by $120 million in deposits and $20 million in equity. Which bank has the stronger liquidity
Fin 698
Fall 2012
Prof. Anderson
HW #7b: chapter 18: 3, 10, 11, 16 and 17. (These appear in the book on pages 568-572.) Solutions for End-of-Chapter Questions and Problems 1. What are the benefits and costs to an FI of holding large amounts of liquid assets? Why are Treasury securities considered good examples of liquid assets?
A major benefit to an FI of holding a large amount of liquid assets is that it can offset any unexpected and large withdrawals without reverting to asset sales or emergency funding. If assets have to be sold at short notice, FIs may not be able to obtain a fair market value. It is more prudent to anticipate withdrawals and keep liquid assets to meet the demand. On the other hand, liquid assets provide lower yields, so the opportunity cost for holding a large amount of liquid assets is high. FIs taking conservative positions by holding large amounts of liquid assets will therefore have lower profits. Treasury securities are considered good examples of liquid assets because they can be converted into cash quickly with very little loss of value from current market levels. 2. How is an FI’s liability and liquidity risk management problem related to the maturity of its assets relative to its liabilities?
For most FIs, the maturity of assets is greater than the maturity of liabilities. As the difference in the average maturity between the assets and liabilities increases, liquidity risk increases. In the event that liabilities begin to leave the FI or are not reinvested by investors at maturity, the FI may need to liquidate some of its assets at fire-sale prices. These prices would tend to deviate further from their market value as the maturity of the assets increase. Thus, the FI may sustain larger losses. 3. Consider the assets (in millions) of two banks, A and B. Both banks are funded by $120 million in deposits and $20 million in equity. Which bank has the stronger liquidity