Managing Capital

Question 1

Whats the link of capital and risk

Answer 1

Capital is ultimately there to bear the whole enterprise risk.
Company can reduce capital needs by better managing risks

Question 2

What is the tension of holding capital.

Answer 2

Companies want to hold the min. of capital (So as to increase expected return on capital employed)
Regulator wants high levels of capital.
Companies have to raise the capital from somewhere, which can be difficult.

Question 3

Ideal world how much capital should firm have

Answer 3

Only what is needed and nothing more

Question 4

Explain idea of recycling capital

Answer 4

Capitalism is the system that recycles capital so it finds itself where it can be most profitably used. Capital in theory gets recycled and gets used wherever it has the highest return.

Question 5

Name four types of capital firms need

Answer 5

Start up capital
Working capital
Contingency capital
Strategic capital

Question 6

Explain working capital and its improtance in consultancy

Answer 6

Finance stock for example ie Financing things you have acquired before you sell them.
Working capital is usually the key capital needed in consultancy and can be hard to get clients to pay up front. To minimize your requirement for working capital you want to get client to pay asap as a consultant

Question 7

Explain contingency capital

Answer 7

Cushion against adverse trade fluctuations

Question 8

Explain strategic capital and why shareholders dont like it.

Answer 8

Needs to be built up for further expansion.
Shareholders are not fond of holding this capital, as if merger/acquisition/expansion doesn’t happen/badly priced they can lose out. Other parties however will always win.

Question 9

What are additional reasons a financial firm needs capital

Answer 9

Contracts are typically longer
so working capital is large
Regulator demands high security
especially at start of contract.
There is information asymmetry in the financial industry
Normal course of business. You have your goods and you’ve paid for them and that’s it. - NOT the case in finance
New contract types require establishment of new administration systems.
Capital requirements often depend on investment strategy

Question 10

Define economic capital

Answer 10

Amount of capital appropriate to hold given the firm’s liabilities, and its business objectives. Ex: For a life office it will be determined based upon the risk profile of the individual assets and liabilities in its portfolio, the correlation of the risk and the tolerable level of overall credit deterioration.

Question 11

Define regulatory capital

Answer 11

Required to protect against the risk of statutory insolvency. That is, having sufficient capital to demonstrate solvency under the regulatory regime.
Solvency 2 for the insurance industry and Basel 3 for banks had aim to make these two concepts economic and regulatory closer to each other.

Question 12

How and why do regulators set capital requirements for insurer

Answer 12

Regulators will try to ensure that financial promises are kept
Monitor the adequacy of the provisions, may prescribe the basis ex: insurance ruin prob for example is 1/200
If you’re only just above regulatory capital requirement - caution
If you’re further away from the capital requirement line - can look more long term
Minimum solvency requirement SCR

Question 13

How does capital empower?

Answer 13

Feasibility of growing through
funding new ventures.
Required to fund new business strain
- transacting a contract usually regulator expects you to put aside some capital
Financial strength can encourage product purchasers to favor one provider.
Affects products that can be offered - levels of guarantees
Affects performance of products
Smooth profit and loss accounts.

Question 14

What are mortgage backed securities

Answer 14

Investment products similar to bonds. Each MBS consists of a bundle of home loans and other real estate debt bought from the banks that issued them. Investors in mortgage-backed securities receive periodic payments similar to bond coupon payments.

Question 15

How can a firm obtain capital

Answer 15

Equity capital
Debt or loan capital – loan so that interest and loan capital repaid
Hybrid capital – mix of the above ex: with profits policies.

Question 16

How can a firm increase capital

Answer 16

Retain profit
Free up capital internally
Reinsurance or transferring risk
Securitisation
Contingent capital
Better management
Raise capital on the markets

Question 17

How might a firm Free up capital internally

Answer 17

Could weaken valuation basis (be less prudent and have lower liability valuation as ROCE will seem to be using less capital if liabilities are lower) or distribution of surplus could be deferred. Get assets to better match liabilities. Hedge some risks with derivatives etc

Question 18

What does securitization mean

Answer 18

Securitisation means wrapping up things that are assets or sources of cash flows and getting others to buy them off you. Ex: Voucher funds idea- buy mortgages from an issuing bank and then hold them as investments. Why would someone do this?

Question 19

List Capital Management Tools for Capital Markets ie. Investment banks

Answer 19

Capital Management Tools- Capital Markets ie. Investment banks
Match liabilities
Use derivatives to hedge
Raise equity capital which increasing capital without increased liabilities
Raise loan capital
Securitise and sell some illiquid asset on balance sheet to achieve a greater value

Question 20

List Capital Management Tools for Banks

Answer 20

Provide short-term financing.
Contingent capital
Derivatives
Ask advisers for raising capital in capital markets

Question 21

Name two types of profit for a firm in ROCE

Answer 21

Trading profit and investment profit

Question 22

Define trading profit

Answer 22

this is the total of premiums and investment income on the provisions for future liabilities, less claims, expenses, tax and the net increase in any provisions for future liabilities.

Question 23

Define investment profit

Answer 23

This is the investment return, less tax and investment expenses, earned of that part of the assets not required for the provisions for future liabilities

Question 24

How are the two types of profit used to meet shareholder return requirements

Answer 24

To meet shareholder required return - can combine these two profits but there is a constraint on the trading profit. You compensate for these lower returns by pricing products: Capital adjustment
Shareholders should earn the same return on the assets.
The premium charged should include an allowance for the loss of return on the capital tied up in the contract.
Company will want as much capital to go into investment as possible.

Question 25

Why do state not need to build up capital

Answer 25

State and government organizations do not need to build up capital because they can raise taxes or borrow money to meet outgo.
Assumption is that income will be steady from workers etc
Trust that the government that comes in next won’t piss it away.

Question 26

Why might state keep some reserves

Answer 26

To support fluctuations in the balance of payments, in the economic cycle