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Financial Risk Management Assignment

2345 words - 10 pages

FRM

1.

(a) The type of mortgage-related default risk (systematic or non-systematic) depends on the reason of default. Reasons of default such as unanticipated increase in interest rates, and falling home prices make the default risk systematic. As these factors affect the financial industry as a whole and are present everywhere, they cannot be diversified away, but can be hedged.

On the other hand, reasons of default that are borrower-focused such as loss of job, occupational disability, and finance mismanagement make default risk non-systematic. This is because stricter underwriting processes and the borrowers’ insurance policies can reduce default risks triggered by these ...view middle of the document...

By issuing MBS to raise funds, the mortgage lender has created a secondary market that is substantially more liquid than one based on individual mortgage loans. This raises more capital and allows the lender to issue more mortgage loans. As the mortgage pool increases in size, it becomes more diversified. Non-systematic default risks will decrease and the MBS becomes more attractive and will sell more. The higher volume will compensate for lower interest profits the lender had to sacrifice initially.

Therefore, by issuing MBS, the lender can achieve the same or even higher profit levels without issuing MBS, but without exposure to default risk (transferred to investors).

(d)

Instead of pooling all mortgages together to form one Mortgage-Backed Security, the lender can classify mortgages according their maturities, risks, and returns and form many Mortgage-Backed Securities. This creates a new bond range from the same mortgage pool that investors can choose from according to characteristics that meet their needs.

For example, three different classes of bonds are created from a 30 year mortgage. Bond A receives prepayments before B and C, while B receives prepayments before C. Since Bond A is expected to mature sooner, it will have a lower interest rate. Investors that require high interest rates can buy Bond C while those looking for short term investments can buy Bond A.

Another variation would be to make Bond A absorb losses before B and C, and B before C. Bond A has the highest risk and would thus be associated with a higher interest rate. Investors who are risk averse would have the choice of lower interest rates for low risk.

As such, the new ‘subsets’ of the Mortgage-Backed Security create a new line of business for the mortgage lender.



2

(a)

The purpose of the Interbank Market is to facilitate trading of currencies, loans, derivative instruments and other financial products between major banks around the world. This market is for banks to trade for themselves and on behalf of investors since they are the only parties that have access to this market.

Unlike stock markets, there is no centralised exchange where trading occurs in the Interbank Market. Instead, it is a network of banks that are interconnected electronically, making trading done over-the-counter. Transactions take place over communication networks such as Bloomberg. Active banks become market makers who create required derivative instruments by demand.

(b)

The London Interbank Offered Rate (LIBOR) is the daily interest rates at which participating banks in London offer to lend unsecured funds to other banks in the London Interbank Market. This dynamic information serves as a reference rate or basis to determine variable future interest rates in financial instruments such as interest rate swaps, forward rates agreements and Eurodollar futures.

For example, ‘A’ pays ‘B’ interest payments pegged to LIBOR...

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