Professional Documents
Culture Documents
Finance
in
investment
decision-
Introduction
Managing financial institutions has never been
an easy task. But, uncertainty in the
economic environment has increased, making
the job of the financial institution manager
much harder specifically when it comes to
managing credit risk and interest-rate risk. In
this chapter, we explore the tools available to
managers to measure these risks and
strategies to reduce them.
the
principles
financial
Asymmetric Information
Moral
hazard
asymmetric
is
the
information
problem
after
the
created
by
transaction
Specialization
in
Lending
helps
in
Monitoring
and
Enforcement
also helps.
Financial institutions
ensure
that
borrowers
are
4. Compensating Balances:
Reserves that a borrower must maintain in an account that act
as collateral should the borrower default.
5. Questioning the substance of the borrowers
transaction not just the form:
Substance over formis anaccountingprincipleused "to ensure
thatfinancial statementsgive a complete, relevant, and
accurate picture of transactions and events". If an entity
practices the 'substance over form' concept, then the
financial statements will show the overall financial reality of
the entity (economic substance), rather than the legal form
of transactions (form). Substance over form is critical for
reliable financial reporting. It is particularly relevant in cases
ofrevenue recognition, sale and purchase agreements, etc.
The key point of the concept is that a transaction should not
be recorded in such a manner as to hide the true intent of
the transaction, which would mislead the readers of a
company's financial statements.
Adverse
Selection
For
many
assets
and
liabilities,
deciding
In this moment the bank manager can analyze what will happen if interest
rates rise by 5 percentage points, say, on average from 10% to 15%. The
income on the assets rises by $1.6 million ( = 5% x $32 million of ratesensitive assets), while the payments on the liabilities rise by $2.475 million
(= 5% x $49.5 million of rate sensitive liabilities). The First National
Banks current year net income will now decrease by $0.875 million (= $1.6
million - $2.475 million).
Gap
Analysis:
measures
the
Lets see
or
Change in Value = DUR x [i / (1 + io)] x
Original Value
= Assets Liabilities
general,
bereducedby
the
interest
diversifying
rateriskcan
thedurationsof
thefixed-incomeinvestmentsthat areheldat a
given time.
In the example above, shorten duration of bank
assets or lengthen duration of bank liabilities