Quiz #1 Flashcards
Suppose you are concerned with the financial market causing unnecessary swings in the economy. In response, the trading desks of the banks propose VAR targets consistent w/ historical levels. Given your knowledge of VAR, what unintended consequences will this proposal create?
VaR = Value at Risk
VaR is influenced by volatility and the correlation of assets. If the market has unnecessary swings, the volatility is higher and the correlation between assets is higher meaning that the confidence interval of the VaR target is lower. If the target is $100m and the volatility of the market is high, there is lower confidence that the bank will not drop below this target of losses.
In an economic downturn and everyone selling the same thing at the same time, this decreases/tanks the value of the asset.
What does the VIX measure and how is it calculated (be detailed in your answer to receive full)? Why is it used as a global sentiment?
VIX = Volatility Index.
It is based on the Black-Scholes Model and is calculated by the weighted average of calls and puts. It is an estimate of the implied volatility of the S&P 500 over the next 30 days.
It is a global sentiment because it is an indicator of the global economy. It shows the correlation across assets.
What are 3 risk transformations done by the balance sheet of banks (assets relative to liabilities)?
- Liquidity
- Duration
- Equity Transformations (AFS –> HTM)
According to the readings for class, what are 3 special protections our society gives banks because they are ‘special’?
- Restrictions on competition
- Access to the Federal Reserve discount window
- FDIC insured deposits
Explain why VaR may be a better risk measure for a portfolio rather than for a traditional commercial bank that originated and holds loans to individuals and businesses.
VaR is not suitable for measuring the risk associated with traditional commercial banks. This is because commercial banks primarily face credit and liquidity risk. VaR does not have the data to accurately measure this kind of risk.
In class, we showed some banks currently have higher book equity than market equity whereas other banks have lower book equity than higher book equity. Give 2 reasons why the book equity of a bank can be higher than the market value of equity.
- Market perception of the bank can be less confident than what the book portrays (the public is less confident about the future of the bank)
- Unexpected event can make the market freak out and makes the market risk-averse across the board, dropping the market value of equity
In 2021, when interest rates were low, many banks said that they would be more profitable when interest rates rose. Give the balance sheet reasons that the bank believes that higher interest rates would generate higher earnings from their operations. What is the primary profitable measure of banks to determine if they have benefited from higher insurance rates?
Net Interest Margin (NIM) = the difference between the interest paid on their assets and the interest paid on their liabilities
When interest rates are low, banks might experience a compression of theirNIM. When interest rates rise, banks may expect to see an increase in their NIM, which could lead to higher earnings from their operation.
On their balance sheet, their asset yield would increase while the cost of the liabilities would remain the same.
What are 3 primary (most significant) ways that the FED funds its balance sheet
- Create money through the Treasury
- Repos with depository institutions
- Open market operations
When Silvergate faced significant withdrawal requests from its crypto customers, what were 2 significant steps Silvergate did to meet these request?
- Firesale assets
- Acquired Federal Home Loans to increase liquidity
In 2022, Silvergate had an ongoing business relationship with FTX. Was their credit risk in this relationship (highlight all of the credit risk in this relationship)?
FTX was exposed to credit risk at Silvergate (their deposits)
Silvergate was not exposed to any credit risk from FTX as they did not hold any of FTX’s crypto assets
Though Silvergate has eliminated its business relationship with FTX, what risks does Silvergate have with FTX currently? What is the basis for this risk?
Lawsuit risk.
Should have “known their customer”
You work at a money market mutual fund and want to lend money to Morgan Stanley. You have 2 distinct opportunities: you can do a repo with Morgan Stanley with the repo rate being overnight LIBOR. The second investment is commercial paper issued by Morgan Stanley with a rate of LIBOR. Since the rates are the same, which would you choose and briefly explain your reasoning.
I would chose repo because it is collateralized. Commercial Paper is not. Therefore, it is safer to invest in a repo transaction since LIBOR transactions are unsecured.
Describe the Fed funds rate transaction (counterparties and terms)? What is the difference between the effective Fed funds rate and the target Fed funds rate?
The Fed funds rate is the interest rate at which the Fed wants two banks to transact overnight.
Target = the interest rate the Fed wants
Effective = the actual interest rate the banks transact
If a bank marks up its assets due to a market boom, what would happen to leverage? What are 2 actions a bank can take to maintain its leverage ratio?
Leverage = debt-to-equity ratio
Leverage would go down
- Decrease equity (repurchase shares)
- Decrease debt
In the financial crisis of 2008, the haircut of repo lenders increased dramatically. What is a haircut in a repo transaction? Given the landscape of the crisis in 2008, state one rational and one irrational reason that haircuts rose in 2008.
Haircut = the percent difference of collateral value and the money loaned
Rational — the value of the collateral decreased (MBS value tanked) which made haircuts increase because there was not as much confidence in the value of the collateral / being paid back [defaulting]
Irrational — Market perceptions got scared that banks could go bankrupt so they wanted to loan less money
