Financial Risk Manager Part 1
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Tohonday, a motor vehicle production company, has historically channeled most of its earnings and spare cash into short-term government bonds maturing in less than a year. The board wishes to change its investment policy substantially and intends to tap the riskier but more profitable long-term bond market. Assuming you're the risk manager for the company, which of the following risks would be of utmost (immediate) concern from an operational point of view?
Other
Community
TTanishq
A
Trading liquidity risk
B
Funding liquidity risk
C
Interest rate risk
D
Market risk
Explanation:
Explanation
Financial institutions do not always fail because of the inability to generate a profit. Rather, it's the inability to meet short-term financial obligations that often leads to bankruptcy. This is known as funding liquidity risk.
When Tohonday decides to invest in long-term assets, it must take into account its day-to-day funding requirements, especially because funds invested in long-term assets cannot be realized quickly enough to meet short-term debts and other unforeseen obligations, such as lawsuits.
Why B is correct:
- Funding liquidity risk refers to the risk that an institution cannot meet its short-term financial obligations
- Long-term bonds are less liquid and cannot be quickly converted to cash
- This creates an immediate operational concern for meeting daily funding needs
Why other options are incorrect:
- A (Trading liquidity risk): This is the risk of not being able to execute transactions at prevailing market prices, not the primary operational concern for funding
- C (Interest rate risk): This relates to fluctuations in market interest rates affecting portfolio values, not immediate operational funding
- D (Market risk): This encompasses broader price movements in markets, not the specific operational funding concern
The Northern Rock example illustrates this perfectly - they had long-term mortgage assets but couldn't meet short-term obligations, leading to a liquidity crisis.
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