In chapters 17 and 18 we studied how business firms determine their mix of permanent longterm financing and how they finance “internally” by retaining earnings. We now need to find out how firms raise long-term financing “externally.” More specifically, the purpose of this chapter is to observe the ways in which bond and stock issues are initially sold in the capital market. | 8- McGraw-Hill/Irwin Chapter Nineteen Types of Risks Incurred by Financial Institutions 19- McGraw-Hill/Irwin Risks at Financial Institutions One of the major objectives of a financial institution’s (FI’s) managers is to increase the FI’s returns for its owners Increased returns often come at the cost of increased risk, which comes in many forms: credit risk – foreign exchange risk liquidity risk – country or sovereign risk interest rate risk – technology risk market risk – operational risk off-balance-sheet risk – insolvency risk 19- McGraw-Hill/Irwin Risks at Financial Institutions Credit risk is the risk that the promised cash flows from loans and securities held by FIs may not be paid in full FIs that make loans or buy bonds with long maturities are relatively more exposed to credit risk thus, banks, thrifts, and insurance companies are more exposed than MMMFs and property-casualty insurance companies many financial claims issued by individuals or corporations have: limited upside return with a high probability large downside risk with a low probability a key role of FIs involves screening and monitoring loan applicants to ensure only the creditworthy receive loans FIs also charge interest rates commensurate with the riskiness of the borrower 19- McGraw-Hill/Irwin Risks at Financial Institutions Credit risk (cont.) the effects of credit risk are evidenced by charge-offs the Bankruptcy Reform Act of 2005 makes it more difficult for consumers to declare bankruptcy FIs can diversify away some individual firm-specific credit risk, but not systematic credit risk firm-specific credit risk is the risk of default for the borrowing firm associated with the specific types of project risk taken by that firm systematic credit risk is the risk of default associated with general economy-wide or macroeconomic conditions affecting all borrowers 19- McGraw-Hill/Irwin Risks at Financial Institutions Liquidity risk is the risk that a sudden and | 8- McGraw-Hill/Irwin Chapter Nineteen Types of Risks Incurred by Financial Institutions 19- McGraw-Hill/Irwin Risks at Financial Institutions One of the major objectives of a financial institution’s (FI’s) managers is to increase the FI’s returns for its owners Increased returns often come at the cost of increased risk, which comes in many forms: credit risk – foreign exchange risk liquidity risk – country or sovereign risk interest rate risk – technology risk market risk – operational risk off-balance-sheet risk – insolvency risk 19- McGraw-Hill/Irwin Risks at Financial Institutions Credit risk is the risk that the promised cash flows from loans and securities held by FIs may not be paid in full FIs that make loans or buy bonds with long maturities are relatively more exposed to credit risk thus, banks, thrifts, and insurance companies are more exposed than MMMFs and property-casualty insurance companies many financial claims issued by individuals or corporations
