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Managing Risk off the
Balance Sheet with
Derivative Securities
23-2
Managing Risk off the Balance
Sheet
Managers are increasingly turning to off-balance-sheet
their financial institutions
from derivative securities
Managers are increasingly turning to off-balance-sheet
(OBS) instruments such as forwards, futures, options,
and swaps to hedge the risks their financial institutions
(FIs) face
interest rate risk
foreign exchange risk
credit risk
FIs also generate fee income from derivative securities
transactions
23-3
Managing Risk off the Balance
Sheet
A spot contract is an agreement to transact
transact at a point in the future with the terms of the
A spot contract is an agreement to transact
involving the immediate exchange of assets and
funds
A forward contract is a negotiated agreement to
transact at a point in the future with the terms of the
deal set today
Any amount can be negotiated
Not generally liquid, so each party must perform
Counterparty default risk can be significant
23-4
Managing Risk off the Balance
Sheet
A futures contract is an exchange-traded agreement to
Futures are liquid, most traders close their position before
traders’ gains and losses on outstanding futures contracts
A futures contract is an exchange-traded agreement to
transact involving the future exchange of a set amount
of assets for a price that is fixed today
Futures are liquid, most traders close their position before
the delivery date so the underlying transaction may never
take place
Futures contracts are marked to market daily—i.e., the
traders’ gains and losses on outstanding futures contracts
are realized each day as futures prices change
Exchange clearinghouse stands behind all contracts so
there is no counterparty default risk and trading is
anonymous
2
23-5
Hedging with Forwards
A naïve hedge is a hedge of a cash asset on a direct
assets against risk by using hedging to
A naïve hedge is a hedge of a cash asset on a direct
dollar-for-dollar basis with a forward (or futures) contract
Managers can predict capital loss (ΔP) using the duration
formula:
where P = the initial value of an asset
D = the duration of the asset
R = the interest rate (and thus ΔR is the change in interest)
FIs can immunize assets against risk by using hedging to
fully protect against adverse movements in interest rates
)1( R
RPDP
23-6
Hedging with Futures
Microhedging is using futures (or forwards) contracts to
price is not perfectly correlated with the movement in
firms use short positions in futures contracts to hedge
Microhedging is using futures (or forwards) contracts to hedge a specific asset or liability
basis risk is a residual risk that occurs in a hedged position because the movement in an asset’s spot price is not perfectly correlated with the movement in the price of the asset delivered under a futures (or forwards) contract
firms use short positions in futures contracts to hedge an asset that declines in value as interest rates rise
Macrohedging is hedging the entire (leverage-adjusted) duration gap of an FI
23-7
Futures Gain and Loss and Hedging with Futures Futures Gain and Loss and Hedging with Futures
23-8
Hedging Considerations
Microhedging and macrohedging
derivatives used to hedge must be recognized immediately
requirements imposed by bank regulators (forward can be)
Microhedging and macrohedging
Risk-return considerations
FIs hedge based on expectations of future interest rate movements
FIs may microhedge, macrohedge, or even overhedge
Accounting rules can influence hedging strategies
in 1997 FASB required that all gains and losses from derivatives used to hedge must be recognized immediately
U.S. companies must report derivative-related trading activity in annual reports
futures contracts are not subject to risk-based capital requirements imposed by bank regulators (forward can be)
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23-9
Hedging Considerations
Routine hedging: In a full hedge or ‘routine
Most managers engage in partial hedging or
Routine hedging: In a full hedge or ‘routine hedge’ the bank eliminates all or most of its risk exposure such as interest rate risk
Most managers engage in partial hedging or what the text terms ‘selective hedging’ where some risks are reduced and others are borne by the institution
23-10
The Effects of Hedging
23-11
Options
Buying a call option on a bond
Buying a call option on a bond
As interest rates fall, bond prices rise, and the call option buyer has a large profit potential
As interest rates rise, bond prices fall, but the call option losses are no larger than the call option premium
Writing a call option on a bond
As interest rates fall, bond prices rise, and the call option writer has a large potential loss
As interest rates rise, bond prices fall, but the call option gains will be no larger than the call option premium
23-12
Purchased and Written Call Option Positions Purchased and Written Call Option Positions
4
23-13
Options
Buying a put option on a bond
option losses are bounded by the put option premium
Buying a put option on a bond
As interest rates rise, bond prices fall, and the put option buyer has a large profit potential
As interest rates fall, bond prices rise, but the put option losses are bounded by the put option premium
Writing a put option on a bond
As interest rates rise, bond prices fall, and the put option writer has large potential losses
As interest rates fall, bond prices rise, but the put option gains are bounded by the put option premium
23-14
Purchased and Written Put Option Positions Purchased and Written Put Option Positions
23-15
Options
Many types of options are used by FIs to hedge
Buying a put option on a bond can hedge interest rate risk
Similarly, buying a call option on a bond can hedge interest rate risk exposure related to bonds held on the liability side
Many types of options are used by FIs to hedge
exchange-traded options
over-the-counter (OTC) options
options embedded in securities
caps, collars, and floors
Buying a put option on a bond can hedge interest rate risk exposure related to bonds that are held as assets
the put option truncates the downside losses
the put option scales down the upside profits, but still leaves upside profit potential
Similarly, buying a call option on a bond can hedge interest rate risk exposure related to bonds held on the liability side of the balance sheet
23-16
Hedging with Put Options
Payoff
Gain
Payoff
Loss
Payoff
Gain
0 Bond price
X
-P Payoff from
buying a put
Payoff on a bond
Loss
Net payoff function
Payoff for a bond
held as an asset
5
23-17
Caps, Floors, and Collars
Buying a cap means buying a call option, or a succession
like buying insurance against an (excessive) increase in
amounts to a simultaneous position in a cap and a
usually involves buying a cap and selling a floor to offset
Buying a cap means buying a call option, or a succession of call options, on interest rates rather than on bond prices like buying insurance against an (excessive) increase in
interest rates Buying a floor is akin to buying a put option on interest
rates seller compensates the buyer should interest rates fall
below the floor rate like caps, floors can have one or a succession of
exercise dates A collar amounts to a simultaneous position in a cap and a
floor usually involves buying a cap and selling a floor to offset
cost of cap
23-18
Contingent Credit Risk
Contingent credit risk is the risk that the counterparty defaults on payment
forward contracts and all OTC derivatives
Contingent credit risk is the risk that the counterparty defaults on payment obligations
forward contracts and all OTC derivatives are exposed to counterparty default risk as they are nonstandard contracts entered into bilaterally
23-19
Swaps
Swap agreements are contracts where two parties
Swap agreements are contracts where two parties agree to exchange a series of payments over time
There are several types of swaps:
Interest rate swaps
Parties agree to swap interest payments on a stated notional principal amount for a set period of time (some are for more than 5 years) (No principal is usually exchanged)
Currency swaps
Parties agree to swap interest and principal payments in different currencies at a preset exchange rate
23-20
Swaps
Types of swaps (continued)
Types of swaps (continued) Credit default swaps (aka credit swaps)
Total return swap (TRS):
o A TRS buyer agrees to make a fixed rate payment to the seller plus the capital gain or minus the capital loss on the underlying instrument
o In exchange, the TRS seller may pay a variable or a fixed rate of interest to the buyer
o Pure Credit Swap (PCS): o The swap buyer makes fixed payments to the seller
and the seller pays the swap buyer only in the event of default. The payment is usually equal to par – secondary market value of the underlying instrument
6
23-21
Swaps
Credit Swaps and the crisis
markets was more widespread than it would have been
would not otherwise make and earn fee income on other
Credit Swaps and the crisis Lehman Brothers and AIG sold credit default swaps
worth billions of dollars in payments insuring mortgage-backed securities (MBS)
When mortgage security values collapsed, required outflows at these firms far exceeded capital
Other institutions invested more heavily in MBS because they were insured; exposure to mortgage markets was more widespread than it would have been otherwise
Credit swaps may cause lenders to make loans they would not otherwise make and earn fee income on other services offered to borrowers.
23-22
Swaps
There are also some less common types of
The notional value of swap contracts outstanding at U.S. commercial banks was more than $146.9
There are also some less common types of swaps: commodity swaps
equity swaps
The market for swaps has grown enormously in recent years The notional value of swap contracts outstanding
at U.S. commercial banks was more than $146.9 trillion in 2010
23-23
Swaps
Hedging with interest rate swaps: An Example Hedging with interest rate swaps: An Example a money center bank (MCB) may have floating-rate
loans and fixed-rate liabilities the MCB has a negative duration gap
a savings bank (SB) may have fixed-rate mortgages funded by short-term liabilities such as retail deposits the SB has a positive duration gap
accordingly, an interest swap can be entered into between the MCB and the SB either: directly between the two FIs OR indirectly through a broker or agent who charges a fee
to accept the credit risk exposure and guarantee the cash flows
23-24
Swaps
A plain vanilla swap is:
fixed rate of interest and the other party pays a variable
rate inflows are now matched to
A plain vanilla swap is:
A standard agreement where one participant pays a
fixed rate of interest and the other party pays a variable
rate of interest on a stated notional principal; no
principal is exchanged
The SB sends fixed-rate interest payments to the MCB
thus, the MCB’s fixed-rate inflows are now matched to
its fixed-rate payments
the MCB sends variable-rate interest payments to the SB
thus, the SB’s variable-rate inflows are now matched to
its variable-rate payments
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23-25
Swap Hedging Example Illustrated Swap Hedging Example Illustrated
23-26
Swaps
Hedging with currency swaps: An Example
rate $ denominated assets
That is, the FIs agree on a fixed exchange rate at the
Hedging with currency swaps: An Example
Consider a U.S. FI with fixed-rate $ denominated assets and fixed-rate £ denominated liabilities
Also, consider a U.K. FI with fixed-rate £ denominated assets and fixed-rate $ denominated liabilities
The FIs can engage in a currency swap to hedge their foreign exchange exposure
That is, the FIs agree on a fixed exchange rate at the inception of the swap agreement for the exchange of cash flows at some point in the future
Both FIs have effectively hedged their foreign exchange exposure by matching the denominations of their cash flows
23-27
Currency Swap Hedging Example Illustrated Currency Swap Hedging Example Illustrated
23-28
Hedging with Credit Swaps
Pure Credit Swap Pure Credit Swap
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23-29
Credit Risk on Swaps
The growth of the over-the-counter swap market was a
money counterparties would
BIS now requires capital to be held against interest rate,
The growth of the over-the-counter swap market was a major factor underlying the imposition of the BIS risk-based capital requirements
the fear was that out-of-the-money counterparties would have incentives to default
BIS now requires capital to be held against interest rate, currency, and other swaps
Credit risk on swaps differs from that on loans
Netting: only the difference between the fixed and the floating payment is exchanged between swap parties
Payment flows are often interest and not principal
Standby letters of credit are required of poor-quality swap participants
23-30
Comparing Hedging Methods
Writing vs. buying options
Writing vs. buying options
writing options limits upside profits, but not downside losses
buying options limits downside losses, but not upside profits
CBs are prohibited from writing options in some areas
Futures vs. options hedging
futures produce symmetric gains and losses
options protect against losses, but do not fully reduce gains
Swaps vs. forwards, futures, and options
swaps and forwards are OTC contracts, unlike options and futures
futures are marked to market daily
swaps can be written for longer-time horizons
23-31
Regulation
Regulators specify “permissible activities” that FIs may
Institutions engaging in permissible activities are subject to
Regulators specify “permissible activities” that FIs may
engage in
Institutions engaging in permissible activities are subject to
regulatory oversight
Regulators judge the overall integrity of FIs engaging in
derivatives activity based on capital adequacy regulation
The Securities and Exchange Commission (SEC) and
the Commodity Futures Trading Commission (CFTC)
are the functional regulators of derivatives securities
markets
23-32
Regulation
The Federal Reserve, the Federal Deposit Insurance
have implemented uniform guidelines that require
Frank Act, swap markets were governed by relatively
The Federal Reserve, the Federal Deposit Insurance
Corporation (FDIC) and the Office of the Comptroller of the
Currency (OCC) have implemented uniform guidelines that require
banks to:
establish internal guidelines regarding hedging activity
establish trading limits
disclose large contract positions that materially affect the risk to
shareholders and outside investors
As of 2000 the FASB requires all firms to reflect the marked-to-market
value of their derivatives positions in their financial statements
Prior to the Dodd-Frank Act, swap markets were governed by relatively
little regulation—except indirectly at FIs through bank regulatory
agencies
9
23-33
Regulation
The Dodd-Frank Act of 2010 requires most
The Dodd-Frank Act of 2010 requires most
OTC derivatives to be exchange-traded to
ensure performance by all parties
The act also requires OTC derivatives be
regulated by the SEC and/or the CFTC
Managing Liquidity
Risk on the
Balance Sheet
23-35
Liquidity Risk Management
Unlike other risks, liquidity risk is a normal aspect
of the everyday management of financial institutions
Unlike other risks, liquidity risk is a normal aspect
of the everyday management of financial institutions
(FIs)
At the extreme, liquidity risk can lead to insolvency
Some FIs are more exposed to liquidity risk than
others
Depository institutions (DIs) are highly exposed
Mutual funds, pension funds, life insurers and property-
casualty insurers have relatively low liquidity risk
23-36
Liquidity Risk Management
One type of liquidity risk arises when an FI’s liability
Alternately, FIs may have to sell assets to generate cash, which
A second type of liquidity risk arises from the exercise of
One type of liquidity risk arises when an FI’s liability holders seek to withdraw their financial claims FIs must meet the withdrawals with stored or borrowed funds
Alternately, FIs may have to sell assets to generate cash, which can be costly if assets can only be sold at fire-sale prices
A second type of liquidity risk arises from the exercise of off-balance-sheet commitments made by the FI Unexpected loan demand can occur when off-balance-sheet
loan commitments are drawn down suddenly and in large volumes
FIs are contractually obliged to supply funds through loan commitments immediately should they be drawn down
10
23-37
Liquidity Risk and
Depository Institutions (DIs)
DIs’ balance sheets typically have:
DIs’ balance sheets typically have:
Large amounts of short-term liabilities such as deposits and other transaction accounts that must be paid out immediately if demanded by depositors
Large amounts of relatively illiquid long-term assets such as commercial loans and mortgages
DIs know that normally only a small portion of demand deposits will be withdrawn on any given day
Most demand deposits act as core deposits—i.e., they are a stable and long-term funding source
Deposit withdrawals are normally offset by the inflow of new deposits
23-38
Liquidity Risk and Depository
Institutions
DI managers monitor net deposit drains—i.e., the
amount by which cash withdrawals exceed additions; a
DI managers monitor net deposit drains—i.e., the
amount by which cash withdrawals exceed additions; a
net cash outflow
DIs manage liquidity needs by two methods:
1. Stored liquidity
Maintaining liquid assets to meet cash needs
Primary method for community banks
23-39
Liquidity Risk and Depository
Institutions
DIs manage liquidity needs by two methods:
Used primarily by the largest banks with access to
DIs manage liquidity needs by two methods: (continued)
1. Purchased liquidity
Rely on the ability to acquire funds from brokered deposits and borrowings
Used primarily by the largest banks with access to the money market and other nondeposit sources of funds
Most DIs utilize a combination of stored and purchased liquidity management
23-40
Liquidity Risk and Depository
Institutions
Stored liquidity
Banks hold cash reserves in their vaults and at the
Stored liquidity
Liquidating cash stores and selling existing assets
Banks hold cash reserves in their vaults and at the Federal Reserve in excess of minimum requirements
When managers utilize stored liquidity to fund deposit drains, the size of the balance sheet is reduced and its composition changes
11
23-41
Liquidity Risk and Depository
Institutions
Purchased liquidity includes:
Allows FIs to maintain the overall size of their balance
Purchased liquidity includes:
Using interbank markets for short-term loans
fed funds
repurchase agreements
Acquiring fixed-maturity certificates of deposits
Issuing notes and bonds
Allows FIs to maintain the overall size of their balance when faced with liquidity demands
Purchased liquidity may be expensive relative to stored liquidity and adds to volatility of interest expense
23-42
Liquidity Risk and Depository
Institutions
Loan commitments and other credit lines can cause
Loan commitments and other credit lines can cause
liquidity needs
as with liability side liquidity risk, asset side liquidity risk can
be managed with stored or purchased liquidity
If stored liquidity is used to fund commitments, the
composition of the asset side of the balance sheet
changes, but not the size of the balance sheet
If purchased liquidity is used to fund commitments, the
composition of both the asset and liability sides of the
balance sheet changes, and the size of the balance
sheet increases
23-43
Measuring Liquidity Risk
Exposure
The liquidity position of banks is measured by
The liquidity position of banks is measured by managers on a daily basis
A net liquidity statement lists sources and uses of liquidity
I.
Net Liquidity Position (millions $)
Sources
1. Total near cash assets $ 5,000
2. Excess cash reserves $ 2,000
3. Maximum new borrowings $ 9,000
Total $16,000
Uses
1. Funds already borrowed $ 8,000
2. Discount Window loans that
must be repaid quickly
$ 1,000
Total $ 9,000
Total Net Liquidity $ 7,000
23-44
Measuring Liquidity Risk
Exposure
Peer group ratio comparisons are used to compare a
Ratios are often compared to those of banks of a similar size
Ratios for peer groups of similar banks can be constructed at
Peer group ratio comparisons are used to compare a bank’s liquidity position against its competitors
Source: FFIEC; all banks in the nation, Peer Group Data Report, Report
Dates March 2011 and March 2008
Ratios are often compared to those of banks of a similar size and in the same geographic location
Ratios for peer groups of similar banks can be constructed at the FFIEC website
March 2008 March 2011
Loans to deposits 81.33% 71.66%
Loans to core deposits 102.84% 78.64%
Short Term Non Core Funding to Assets 17.08% 5.76%
Core deposits to total liabilities & equity 65.24% 77.75%
Commitments to lend to loans 14.51% 13.44%
12
23-45
Measuring Liquidity Risk
Exposure
A liquidity index measures the potential losses a bank could
the sale of the same assets at fair market value under normal
A liquidity index measures the potential losses a bank could
suffer from a sudden or fire-sale disposal of assets versus
the sale of the same assets at fair market value under normal
market conditions
where wi = the percent of each asset i in the FI’s portfolio
Pi = the price it gets if an FI liquidates asset i today
Pi* = the price it gets if an FI liquidates asset i under
normal market conditions
N
iiiiPPw
1
* )]/)([(I
23-46
Measuring Liquidity Risk
Exposure
For simplicity, assume a bank has only two assets. For simplicity, assume a bank has only two assets.
N
1i
*iii )]/P)(P[(wI
Securities
Value if liquidated
immediately
Fair market value
if liquidated in 1
month
% invested in
each (at FMV)
Treasury Bills $ 9,700,000 $ 9,850,000 38.58%
Bonds $15,000,000 $15,675,000 61.42%
96.76%$15.675m
$15m61.42%
$9.85m
$9.7m38.58%I
23-47
Measuring Liquidity Risk
Exposure
The financing gap is the difference between a The financing gap is the difference between a
bank’s average loans and average (core)
deposits
If the financing gap is positive, the bank must
borrow to fund the gap
Financing gap funding = - Liquid Assets +
Borrowed funds
23-48
Measuring Liquidity Risk
Exposure
The financing requirement is the financing gap The financing requirement is the financing gap
plus a bank’s liquid assets
Financing gap funding = - Liquid Assets +
Borrowed funds
Thus, Financing Requirement (or Borrowed
Funds) = Financing Gap + Liquid Assets
A widening financing gap can be an indicator of
future liquidity problems
13
23-49
Measuring Liquidity Risk
Exposure
The financing requirement is the financing gap plus a
The financing requirement is the financing gap plus a
bank’s liquid assets
Financing Requirement (or Borrowed Funds) =
Financing Gap + Liquid Assets = $5 + $5 = $10
23-50
Measuring Liquidity Risk
Exposure
The BIS Approach: Maturity Ladder/Scenario
day basis and over a series of
The BIS Approach: Maturity Ladder/Scenario
Analysis
Liquidity management involves assessing all cash inflows
against cash outflows
The maturity ladder allows a comparison of cash inflows
versus outflows on a day-to-day basis and over a series of
specified time intervals
Daily, maturity segment, and cumulative net funding
requirements are determined from the maturity ladder
The BIS also suggests that DIs prepare for abnormal
conditions using various “what if” scenarios
23-51
Measuring Liquidity Risk
Exposure
23-52
Liquidity Planning
Liquidity planning allows managers to make important
Lowers the costs of funds by determining an optimal funding mix
List of fund providers most likely to withdraw funds and a pattern
Identification of the size of potential deposit and fund withdrawals
Liquidity planning allows managers to make important borrowing priority decisions before liquidity problems arise
Lowers the costs of funds by determining an optimal funding mix
Minimizes the amount of excess reserves that a bank needs to hold
Liquidity plan components:
Delineation of managerial responsibilities
List of fund providers most likely to withdraw funds and a pattern of fund withdrawals
Identification of the size of potential deposit and fund withdrawals over various time horizons
Internal limits on separate subsidiaries’ and branches’ borrowings as well as acceptable risk premiums to pay in each market
14
23-53
Example: Liquidity Plan Example: Liquidity Plan
Potential Deposit
Withdrawals
From most likely to withdraw to least likely
Mutual Funds $ 70
Pension Funds $ 40
Correspondent banks $ 50
Large corporations $ 45
Small businesses $ 25
Consumers $ 75
Total $305
Expected total withdrawals per period Average Maximum Likely
One week $ 60 $100
One month $ 70 $150
Three months $130 $220
Total $260 $470
Sequence of funding
options as needed
One Week
One month
Three month
New deposits $ 15 $ 35 $ 75
Sale liquid assets $ 15 $ 25 $ 55
Sale investment portfolio $ 30 $ 40 $ 50
Borrowings from other FIs $ 30 $ 40 $ 35
Borrowings from Fed $ 10 $ 10 $ 5
Total $100 $150 $220
23-54
Liquidity Risk
Major liquidity problems arise if deposit drains are
Major liquidity problems arise if deposit drains are abnormally large and unexpected
Abnormal deposit drains can occur because:
Concerns about a bank’s solvency
Failure of another bank (i.e., the contagion effect)
Sudden changes in investors’ preferences regarding holding nonbank financial assets relative to bank deposits
A bank run is a sudden and unexpected increase in deposit withdrawals from a bank
23-55
Liquidity Risk
Demand deposits are first-come, first-served contracts
the first sign of trouble creates a fundamental instability
is a systemic or contagious run on the deposits of
Demand deposits are first-come, first-served contracts
The incentives for depositors to withdraw their funds at
the first sign of trouble creates a fundamental instability
in the banking system
a bank panic is a systemic or contagious run on the deposits of
the banking industry as a whole
Regulatory mechanisms are in place to ease banks’
liquidity problems and to deter bank runs and panics
deposit insurance ($250,000 per account since the
financial crisis of 2008-2009)
the discount window
23-56
Deposit Insurance
Deposit insurance was first introduced in the U.S. in
Deposit insurance was first introduced in the U.S. in 1933 with coverage up to $2,500
Coverage was increased to $100,000 in 1980
Beginning in 2011 the Federal Deposit Insurance Corporation (FDIC) will increase coverage every year based on the Consumer Price Index (CPI)
The Federal Deposit Insurance Reform Act of 2005 increased deposit insurance for retirement accounts from $100,000 to $250,000
15
23-57
Deposit Insurance
Individuals can achieve many times the $250,000
program to evaluate and assign deposit
Individuals can achieve many times the $250,000 coverage cap on deposits by creatively structuring their deposits and by using multiple banks
The FDIC now uses a risk-based deposit insurance program to evaluate and assign deposit insurance premiums
Some states operate state guarantee funds to insure investments made with insurance firms, but they are not federally backed
23-58
The Discount Window
The Federal Reserve also provides a “discount
In response to the liquidity problems caused by
The Federal Reserve also provides a “discount window” lending facility
Historically, the borrowing rate was below market rates and borrowing was restricted
In response to the liquidity problems caused by the credit crunch in 2007 and 2008, the Fed announced in March 2008 that it would lend up to $200 billion to both commercial and investment banks through its new Primary Dealer Credit Facility (PDCF)
23-59
The Discount Window
New federal borrowing programs emerged
New federal borrowing programs emerged over the succeeding months providing funding to money market mutual funds, commercial paper, insurance companies, and others
The Fed also lowered interest rates to near zero and reduced the spread between the discount rate and the Fed funds rate
23-60
Liquidity Risk and Insurance
Companies
Life insurance companies hold cash reserves and other
of a life insurance policy is the amount that
Life insurance companies hold cash reserves and other liquid assets
Meet policy payments
Meet cancellation (surrender) payments
The surrender value of a life insurance policy is the amount that an insurance policyholder receives when cashing in a policy early
Fund working capital needs which can be unpredictable
Property-casualty (P&C) insurance companies
Claims against P&C insurers are hard to predict
Thus, P&C insurance companies have a greater need for liquidity than life insurance companies
16
23-61
Liquidity Risk and Mutual Funds
Mutual funds (MFs) can be subject to dramatic
assets are distributed on a pro rate basis (i.e., rather than
Mutual funds (MFs) can be subject to dramatic liquidity needs if investors become nervous about the true value of the funds’ assets
However, the way MFs are valued reduces the incentive of fund shareholders to engage in bank-like runs on any given day assets are distributed on a pro rate basis (i.e., rather than
a first-come, first-served basis)
losses are incurred to shareholders on a proportional basis
