FIN 4324 FINAL Flashcards
(114 cards)
1
Q
• Firms demand funds, investors supply funds
A
Supply curve shifts to the right and the return on funds drops.
2
Q
• Firms supply Bonds, investors demand bonds.
A
Demand curve shifts to the right, price of bonds increases.
3
Q
Macaulay’s Duration
A
- Find the current price of the bond. Calculate the PV of the cash flow at each year, multiply each cash flow by the year, add them all together and divide by the current price.
4
Q
Qualities of Macaulay’s Duration:
A
o Measures Economic Payback (recovery of investment)
o Measures Interest Rate Risk
5
Q
Properties of Macaulay’s Duration:
A
Duration of a zero-coupon bond = its maturity
Longer maturity = larger duration
Higher Coupon rate = smaller duration
Higher Yield = Smaller Duration
6
Q
Convexity
A
- For large changes in yield: % price change not the same for increases vs. decreases in yield.
o % price increase > % price decrease
o “convexity adjustment needed for accurate estimate in price changes
7
Q
- Duration GAP used to calculate the sensitivity of profits to changes in interest rates:
A
Chang in profits = -Adjusted DGAP * Assets * %ChangeRates
Change in ROA = Change in Profits / Assets
Change in ROE = Change in Profits / Equity
8
Q
- Benefits of DGAP:
A
o NPV based
o Duration accounts for cash flows before and at maturity
9
Q
- Shortcomings of DGAP:
A
o Doesn’t account for convexity
o Since durations change over time, must be recalculated.
o More costly than repricing GAP.
10
Q
o On balance Sheet hedging (Liability Sensitive Banks)
A
Shorten its assets, use more variable rate loans, lengthen its liabilities, use more fixed-rate liabilities.
Banks might not want shorter term assets, or longer term liabilities because they would affect the banks liabilities.
11
Q
- Liability sensitive banks can:
A
o On balance Sheet hedging (Assets-Liability Management)
o Hold more equity capital
Cushion against potential losses, expensive funding
o Hedge off-balance Sheet
12
Q
- Benefits of derivatives:
A
o Provide price information
o Allow risk to be managed and shifted among market participants
o Reduce transaction costs
13
Q
Forward Contracts
A
- Bilateral Contract: One party buys and other sells a specific quantity if an asset at a set price on a set date in the future. (OTC)
14
Q
Payoff of Forward Contracts
A
o If Exp. Future price of the asset goes up, the right to buy will have positive value, right to sell negative.
o If exp. Future price of the asset falls, right to buy will have negative value, right to sell positive.
15
Q
Purpose of Forward Contracts
A
o Hedge a risk they already have, by eliminating uncertainty about the price of an asset they plan to buy or sell.
o Some parties may enter the contract as a speculation on the future price.
16
Q
- Forward rate Agreements (FRAs) (Eurodollar forward contracts)
A
o Can be viewed as a forward contract to borrow/lend money at a certain rate at a future date
o OTC contract
- Find the PV of the payout or loan savings
17
Q
Future Markets and Contracts:
A
- Similar to forwards:
o Deliverable or cash settlements
o Contract valued at 0 at the time it is created. - Differences:
o Futures trade on organized exchanges, forwards are private and do not trade
o Futures, are marked to market; contract price adjusted each day
o Highly standardized vs customized forward contracts
o A single clearinghouse is the counterparty to all futures contracts; forwards are contracts with the originating counterparty
o The government regulates futures markets; forward contracts are not regulated.
18
Q
- Treasury Bill Futures
A
o Launched in 1976, first interest rate futures contract
o Based on 90-day U.S. T-Bill
o One T-bill Future equals $1,000,000
o Barely active today, too much regulation and influence from U.S. gov’t policies, budget deficits, gov’t funding plans, politics and Fed monetary policy.
o Eurodollar contract is considered more important, reflects the interest rate on a dollar borrowed by a high-quality private borrower.
19
Q
- Eurodollar futures
A
o $1,000,000 notional principal of 90-day Eurodollars.
o Underlying rate is on a 90-day dollar-denominated time deposit issued by a bank in London
o Cash Settlement
o Minimum tick size is $25 (=$1,000,000[0.0001(90/360)])
20
Q
- Treasury Bond Futures
A
o Face value of $100,000
o Traded for treasury bonds with a minimum maturity of 15 years and with any coupon
o Deliverable contract, a conversion factor is used to adjust the long’s payment at delivery so that the more valuable bonds receive a higher payment.
o Minimum tick size is 1/32, which is $31.25
21
Q
- You expect interest rates to rise:
A
o Cost of selling deposits and cost of borrowing in the money market will rise.
o The value of existing bonds and fixed-rate loans will decrease.
o To offset expected losses, you sell bond futures contracts (short hedge)
22
Q
- You expect interest rates to fall.
A
o Fixed-rate, long-term deposits will have to be invested in loans and securities bearing lower yields
o To offset expected losses, you buy bond futures contracts (long hedge).
23
Q
- You are asset-sensitive or with negative Duration GAP.
A
o A decrease in interest rates will incur losses.
o To offset expected losses, you buy bond futures contracts (long hedge).
24
Q
- You are liability-sensitive or with positive Duration GAP.
A
o An increase in interest rates will incur losses.
o To offset expected losses, you sell bond futures contracts (short hedge)
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Suppose a bank has an average asset duration of four years, an average liability duration of two years, total assets of $500 million, and total liabilities of $460 million. The bank plans to trade in Treasury bond futures contracts. The underlying T-bonds have a duration of nine years and the Tbonds’ current price is $99,700 per $100,000 contract. (1) What is the adjusted duration gap? (2) How many futures contract does the bank need to hedge against an interest rate increase? (3) Does it have to long or short futures
Solve problem
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Basis Risk:
- Spot bonds and futures on bonds are traded in different markets.
- The shift in yields, ∆𝑅 (1+𝑅) , affecting the values of the on-balance sheet cash portfolio may differ from the shift in yields, ∆𝑅𝐹 1+𝑅𝐹 , affecting the value of the underlying bond in the futures contract.
- Changes in spot and futures prices or values are not perfectly correlated; this lack of perfect correlation is called basis risk.
- Basis = cash market price – futures market price
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- Basis risk with a short hedge:
Dollar Return = Basis at termination of hedge - Basis at initiation of hedge
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Basis risk with a long hedge:
Dollar Return = Basis at initiation of hedge - Basis at termination of hedge
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- Option Premium:
to acquire these rights, owners of options must buy them by paying a price to the seller of the option.
30
Costs of Swaps
o Search costs:
o Credit (counterparty) Risk: Bank B could default on swap contract. o Example: Rates go up to 4%.
Bank A should receive $2,000,000 from Bank B.
If Bank B defaults, Bank A must replace the swap contract.
Replacement swap will be more expensive (4% fixed payments).
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Swaps Dealer
- The dealer is running a “balanced book.”
o Is fully hedged against movements in interest rates.
o Otherwise, the dealer would be speculating on interest rates.
- Dealer earns fee income from the sales of both swap contracts.
o Dealer does the searching.
o Dealer accepts the counterparty risk.
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- Interest rate collars
o An interest rate collar combines a cap and a floor.
o A borrower with a floating rate loan may buy a cap for protection against rates above the cap and sells a floor in order to defray some of the cost of the cap.
o The collar’s purchaser pays a premium for a rate cap while receiving a premium for accepting a rate floor
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- Securitization:
packaging and selling loans to outside parties rather than holding loans on the balance sheet until maturity.
- In effect, illiquid loans are transformed into publicly traded securities
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Reason for securitization
- As a way (1) to manage interest rate, liquidity, and credit risks and (2) to raise new capital, securitization emerged in the 1970s and 80s
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People involved in securitization
- Originator: lender whose loans are securitized
- Issuer: Loans are passed thru the issuer, usually designated as a special-purpose entity.
- A trustee is appointed to ensure the issuer fulfills all the requirements of the transfer of loans to the pool and provides investors with all the services promised.
- Servicer(often also the originator): collects payments on securitized loans and passes them to the trustee who eventually pays the investors
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Freddie Mae
Fed. Nat’l Mortgage Association
Chartered by U.S. gov’t in 1938
Created liquidity by purchasing mortgages from lenders
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o Freddie Mac
Fed. Home Loan Mortgage Association
Chartered by U.S. gov’t in 1970
Similar to fannie mae but bought mostly from thrift institutions
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Ginnie Mae
Gov’t Nat’l Mortgage Association
Split off from Fannie Mae in 1968
Wholly-owned gov’t corp.
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How Do Government Sponsored Enterprises Invest and Securitize?
1. Fannie and Freddie mainly purchase conforming mortgages from banks and securitize them.
a. Creates “passthrough” MBSs, sold to institutional investors
b. Gurantee the MBS payments and timing of those payments
2. Also hold some mortgages
a. During Clinton admin “affordable lending goals”
i. ~50% of fannie and Freddie’s own portfolios must be mortgages to low and moderate income families
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- Mortgage backed security (MBS
a debt instrument backed by a pool of mortgages.
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- Collateralized mortgage obligation (CMO)
a debt instrument backed by a pool of MBS:
o CMO is a securitization of MBS
o Commercial or investment bank purchases hundreds or thousands of MBSs, then it puts the MBSs into a pool and finances the pool by selling CMOs
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- Reasons for CMOS:
o Redistributing prepayment risk
o Creating securities with various maturity range.
- CMOs are created to satisfy a broader range of investor risk/return preferences.
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- CMOs have different “tranches”
o Each tranche has different fixed coupons and different exposure to prepayments
Ex.
A Tranche (Short term): Recieves no prepayment protection
B tranche (the intermediate-term): Protected from prepayment until the A tranche is paid off.
C tranche (the long-term): Protected from prepayment until the B tranche is paid off.
44
How Investors Use CMOs
- Investors who want longer term, more predictable cash flows will invest in C tranches.
- Investors who want shorter term investments, and can live with some cash flow volatility, will invest in A tranches.
- Higher tranches get lower coupon rates and less credit risk because they are paid off earlier
45
- Tranche x:
These investors get no coupon, and they get paid off last. They are exposed to the most credit risk.
o These investors have a special upside: They receive all remaining principal and interest cash flows after other tranches are paid off.
o This is called the "equity tranche.“ These investors benefit if the MBS pool contains fewer than expected loan defaults
46
Credit default swap (CDS):
the most popular instrument used to mitigate credit risk; the CDS is similar to an insurance contract whereby the protection buyer makes premium payments to the protection seller in exchange for a contingent payoff in default or other credit event.
47
CDS Contract
- Protection seller receives periodic (e.g., quarterly) cash flow if the bond issuer has no credit event.
- Protection seller suffers a loss (cash outflow) in case of credit event (e.g., bankruptcy of the bond issuer)
- Protection seller receives a stream of cash flows that are similar to cash flows of the underlying bond.
48
Synthetic Bond
Selling CDS protection + buying Treasuries (or other risk-free assets).
49
Uses of CDSs
- From buyer’s perspective:
o Hedge against credit risk
o Short (credit risk of) the underlying entities
- From protection seller’ perspective
o Long (credit risk of) the underlying entities
o Create synthetic bonds/CMOs.
50
Short
Sell Position. Sell now, buy later. Lock in a sale at the current rates.
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Long
Buy Position. Buy now, sell later. Lock in a buy at the current rates.
52
CDS vs Insurance
- CDS is considered insurance against non-payment.
- Difference: Protection buyer in CDS does not need to hold the reference entity but can still collect payouts without risking actual loss from investments in the reference entity.
- Light regulation, seller is not required to hold reserves to cover payouts.
53
CDS Market:
- CDS first introduced in early 1990s to help hedge credit risk in connection with their lending activities.
- CDS was gradually extended to cover sovereign debt, corp. debt and MBS.
- In the early 2000s, the credit default swap on a basket of reference entities (multi-name CDS, CDS index) was introduced into the market.
- The CDS market experienced an enormous growth after the ISDA standardized the documentation for credit default swaps in 1999 until the 2008-09 crisis.
54
CDS Market Participants:
- Commercial banks: protection buyer/seller, mostly hedging
- Investment banks: broker/dealer, hedging/speculating
- Hedge funds: hedging/speculating
- Insurance Companies: mostly protection seller
- Mutual Funds: hedging/speculating
55
Benefits of using CDSs:
- Reduced transaction costs:
o Do not include funding
o No covenants, coupons, call provisions, etc.
o Demand for the CDSs is bigger than for underlying bonds, because more participants in the CDS market.
- Expanded investment scope: CDS investors can still get exposure to a bond issuer even if its bonds are not available (or are prohibitively expensive) on the bond market
- Embedded leverage effect: the initial cost of selling CDS protection on a bond is usually a fraction of the cost of buying the bond outright.
- Better utilization of information: CDSs enable investor to “short” bonds more easily
56
Issues created by CDS
- Empty creditor problem:
- Transmit and amplify financial market shocks
o Low transparency in the OTC market, hard to ascertain counterparty risk.
o Concentrated counterparty risk: G14 brokers/dealers.
o “Insurance is only as good as the insurer.”
o “Run” on counterparty can occur in an interwoven and informationally opaque system.
57
Liability Side Liquidity Risks
o Bank suffers temp. shortage of cash due to larger than exp. Deposit withdrawals. Caused by:
Increase in interest rates on competing investments
Sudden lack of trust in the financial condition of the bank, causes a “run” on the bank.
58
Asset Side Liquidity Risks
o Bank suffers temp. shortage of cash due to larger than exp. Draw-downs of credit lines. Could be caused by:
General economic or sector-specific slowdown that increases firms’ need for credit.
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Managing Liability-side Liquidity Risk
```
Options:
Use equity as cash buffer
Fire sale of loans at lower than long term prices
Purchase from the fed funds market
Borrow at the fed's discount window
-Short Term solutions
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60
Managing Asset-side Liquidity Risk
```
Options:
Attract large CD customers by paying them an above market rate
Use equity as a cash buffer
Purchase from the fed funds market
Borrow at the fed's discount window
- Short Term solutions
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61
"Natural Hedge" against liquidity risk
o During recessions, deposits flow into banks due to a flight to quality. (Bank liquidity increases.)
o These deposit inflows occur just as business firms begin to draw down their lines of credit.
o Hence, there is a “natural hedge” against liquidity risk embedded in the structure of banks.
62
Managing Liquidity Risk on Balance Sheet
Stored liquidity
Core Deposit funding
Purchased liquidity
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Stored Liquidity
Hold large amounts of cash and liquid securities as a buffer. High opportunity costs: Banks make fewer loans.
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Core Deposit Funding
o Core deposits are more stable and less likely to be withdrawn, but develop only slowly over time since bank-depositor relationship should be created
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Purchased Liquidity
o Funds from other institutions: buy fed funds, sell repos, or use the discount window
o Short term fixes, which become increasingly expensive until the bank’s resources are exhausted.
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Public Policies that reduce liquidity risk
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- Deposit insurance (FDIC)
o Created a class of deposits that are unlikely to run even if the bank is rumored to be (or actually is) in financial trouble.
- Discount window (Fed)
o Provides a short-run stop-gap for banks that have too few deposits to fund their lending obligations.
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67
Net Liquidity
Sources of Liquidity - Uses of Liquidity
- Should never be negative:
o Actual borrowing should not exist beyond the limit and discount windows must be collateralized with treasury securities
- Tracked daily
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Sources of Liquidity
Cash, excess reserves at the fed, liquid securities, short-run borrowing limit
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Uses of liquidity
Short-run borrowing against the limit (fed funds, repos), Discount window loans (from the Fed)
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Financing Gap
- Average Loans – Core Deposits
o Often expressed as a ratio:
Loans-to-core deposits ratio = average loans/ core deposits
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Average Loans
Loan balances over past month or quarter
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Core Deposits
Stable deposit balances
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Positive Financing Gap
Positive = low liquidity, poor management, strong lending opportunities
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Negative Financing Gap
Negative = high liquidity, careful/conservative management and relatively poor lending opportunities
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If loans grow quickly (Gap >0)
bank must fund them until new core deposits can be raised. Options: Draw down liquid assets or use short-run borrowing capacity. Return on assets increases, but liquidity position deteriorates.
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If Loans grow slowly (Gap<0)
bank must invest new deposits until new lending opportunities arise: Invest in low-yielding cash or liquid securities. Liquidity position improves, but return on assets declines.
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Liquidity Index:
- a measure of the potential losses a bank could suffer as the result of a sudden disposal of assets.
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High Liquidation Value
- Cash has a “liquidation value” (ratio in the formula) of 100%
- Treasuries also have an extremely high liquidation value
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Low Liquidation Value
- Loans have lower values:
o Syndicated loans: only a small fire sale discounts
o Loans to middle-market firms: large fire sale discounts
o Loans to small, local businesses: very large fire sale discounts
o Collateralized loans will have smaller discounts, all else equal
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BASEL III Liquidity Proposal
- Liquidity Coverage Ratio (LCR)
o High Quality Liquid Assets / 30 Day Net Cash Outflows
- Net Stable Funding Ratio (NSFR)
o Available Stable Funding / Relative Stable Funding
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The Role of Bank Capital
o Protects taxpayers (FDIC)
| o Fund’s banks’ investment activities
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- Market Value of Capital
o Economically accurate picture of net worth, difficult and costly to implement, unnecessary variability of net worth
o Banks may avoid longer-term asset exposures
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- Book Value of Capital
o May distort true solvency position, Greater discretion in loan loss recognition and write-downs or the impact of such losses on capital, Most commonly used by regulators.
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Problems with Capital to Asset Ratio
o Do not reflect market value, do not measure the difference in credit, interest rate, and other risks of assets.
o Do not take into account off-balance-sheet activities.
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Interest Rate Cap
- Can be viewed as a series of interest rate call options with a strike equal to the cap rate.
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Interest Rate Floor
- a floor can be viewed as a series of interest rate put options with strike rates equal to the floor rate
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Capital Adequacy Requirements (FDIC Improvement Act of 1991)
- Risk-based capital ratios (BASEL I)
- Systematically account for credit risk differences among assets.
- Incorporate off-balance-sheet risk exposures.
- Apply a similar capital requirement to all the major banks across the world
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o Tier1 risk-based ratio
Core Capital (Tier 1) / Credit Risk Adjusted Assets
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o Total risk -based ratio
Total Capital (Tier 1 + Tier 2) / Credit Risk Adjusted Assets
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- Total Capital
Tier 1 (Core) + Tier 2 (Supplementary) – Deductions
91
o Tier 1:
Common stockholders’ equity + retained earnings + qualifying perpetual preferred stock + minority interest in consolidated subsidiaries
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Tier 2
loan loss reserves + other perpetual preferred stock + subordinated debt
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o Deductions
investments in unconsolidated subsidiaries and reciprocal holdings of banking organizations’ capital securities.
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Risk-Based Capital Ratios – Denominator
- Credit Risk Adjusted Assets (Risk-weighted Assets)
o Credit risk adjusted on-balance sheet assets = 0 x Category 1 Assets + 0.2 × Category 2 Assets + 0.5 × Category 3 Assets + 1.0 × Category 4Assets + 1.5 × Category 5Asset
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Category 1
Weight 0
| Cash and Cash Equivalents, Treasury Securities
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Category 2
Weight 0.2
| Munis (General Obligations), Loans to corporates with AA- or better, Some
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Category 3
Weight 0.5
| Munis (Revenue Bonds), Mortgage Loans, Loans corporates with A+ to A-
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Category 4
Weight 1.0
| Loans to corporate with BBB+ to BB-
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Category 5
Weight 1.5
| Loans to corporate with below BB-.
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- Credit Risk Adjusted Assets (Risk-weighted Assets)
o Credit risk adjusted off-balance sheet assets
o Unused loan commitments (maturity of less than one year): 0.2
o Unused loan commitments (maturity of more than one year): 0.5
o Commercial letter of credit (L/C): 0
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Issues with Risk-Based Capital Ratios
- Unclear about risk weights across 5 categories and why they were chosen, doesn’t consider loan portfolio diversification opportunities, may reduce incentive for banks to make commercial loans, do not account for interest rate or liquidity risk.
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o Tier 1 Leverage Ratio:
Tier 1 Capital/ Assets
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- Prompt Corrective Action:
- In 1991, Federal Deposit Insurance Corporation Improvement Act (FDICIA) directed U.S. supervisors to take Prompt Corrective Action (PCA) if banks’ capital ratios fell below “adequately capitalized”
o The primary regulatory influence over bank capital levels.
o Implement more severe supervision as a bank’s capital declines.
o Resolve banking problems at an early stage and at the least possible cost to the bank insurance fund.
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Basel II Bank Capital Regulation
- 2004, the Basel Committee met again and devised the new BASEL Accord. These new standards included:
o An “internal ratings-based” (IRB) approach for more sophisticated banks.
o A framework for considering risks other than credit risk.
o “Three-pillar” Concept
105
Pillar I
Calculation of regulatory minimum capital requirement (1. Credit Risk 2. Market Risk 3. Operational Risk)
Standardized vs Internal Ratings based approach
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Pillar II
Regulatory supervisory review
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Pillar III
Requirements on rules for disclosure of capital structure, risk exposures, and capital adequacy.
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Basel III Capital Proposals for Reform
- Quality, consistency, and transparency of the capital base is raised:
o Predominant form of Tier 1 Capital must be common share and retained earnings.
o Criteria for Tier2 capital will be tightened
- Risk coverage will be strengthened:
o More integrated management of market and counterparty credit risk.
o Adding capital charges due to deterioration in counterparty’s credit rating.
- Leverage ratio will be introduced:
o Supplementary measure to the risk-based framework, put a floor to the build-up of leverage
- Pro-cyclical capital standards is proposed:
o Measures to address pro-cyclicality.
o Banks would build up capital buffers during good times while holding less during bad times.
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Basel III – Liquidity Proposals
- The liquidity coverage ratio (LCR)
- The Net Stable Funding Ratio (NSFR)
- Banks that rely too heavily on short-term wholesale funding or do not hold sufficient high quality liquid assets will face high cost of adjustments to meet these new minimum ratios.
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- The liquidity coverage ratio (LCR)
o High Quality Liquid Assets / 30-day Net Cash Outflows >/= 100%
o To ensure banks always have a 30-day liquidity buffer for emergency situations.
111
High quality liquid assets
cash, central bank reserves, high-quality marketable securities
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Net cash outflows:
stable deposits – less stable deposits – unsecured wholesale funding
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- The Net Stable Funding Ratio (NSFR)
o Available Stable Funding / Required Stable Funding >/= 100% ~ (Stable Core Deposits/Medium And Long-term Loans >/= 100%)
o To ensure that banks hold sufficient stable funding to match their medium and long-term lending.
114
Shortcomings of R GAP
Interest rates unlikely to change by same amount for assets and
liabilities (a constant “spread” is unlikely).
o Interest rate unlikely to change by same amount for all accounts
within the 1-year maturity bucket.
o A book-value method; but market values of assets and liabilities
change with interest rates.
o Deposits can run-off when rates increase (not measured).
o Loans can pre-pay when rates decrease (not measured).
o Ignores interest rate effects on assets and liabilities with longer
remaining maturities.
o Ignores interest rate effects on off-balance sheet activities (e.g.,
interest rate swaps, unused lines of credit).
