week 7

Question 1

what is the interaction between debt and equity markets?

Answer 1

• equity markets look at credit ratings, bond spreads and credit default prices
• debt markets use equity prices

Question 1

what is a stock?

Answer 1

• also known as equity, a stock is a security that represents the ownership of a fraction of the issuing coorporation
• the unit of stocks is called shares which entitles the owner to a proportion of the corporation’s / bank’s assets and profits equal to how much tock they own
• stocks are bought and sold predominantly on the stock exchnage and are foundation of many individual inevestors’ portfolios

Question 2

what is the relationship between the risk and expected return of an investment?

Answer 2

• capital asset pricing model (CAPM) provides an inital framework to the answer of that question
• capm marks the birth of asset pricing theory
• the model provides insight into the kind of risk that is related to return
• it is still widely used in applications
• provides methodoloy for translating risk into estimates of expected return on equity (ROE)
• many scholars argue that it is based on unrealistic assumptions

Question 3

what are the main assumptions of the CAPM model:

Answer 3

• Investors are risk averse as in the Markowitz model.
• Capital markets are perfect => that all assets are infinitely divisible, no transaction costs, short selling
  restrictions or taxes occur, all investors can lend and borrow at the risk-free rate and all information is costless and available for everyone.
• All investors have the same investment opportunity.
• All investors estimate the same individual asset return, correlation among assets and standard deviations of return.

Question 3

what are the main assumptions of the Markowimodel:

Answer 3

• investors are risk averse
• when choosing among portfolios, investors care only about the mean (return) and variance (risk) of their one-period investment return

Question 4

what is the CAPM formula?

Answer 4

Question 5

what are the CAPM applications?

Answer 5

• used to obtain expected returns on any asset or portfolio as long as we are able to obtain the 3 factors:
• risk free rate
• expected return on market portoflio
• beta of asset on the portfolio

Question 6

what is the slope of the SML: (security market line)

Answer 6

• the difference between the expected return on market portfolio and the risk free rate

Question 7

what does the CAPM beta tell us?

Answer 7

• singe measure that tell us which stock is riskier
• calculated in the CAPM model for calculating the rate of return of a stock or portfolio
• measure the stock risks in relation to the overall market
• covariance of market return with stock return / variance of market return

Question 8

what are the two type of risks each stock is exposed to?

Answer 8

• non-systemic risk
  -systemic risk

Question 9

what is non-systemic risk?

Answer 9

• include risks that are specific to a company / bank or industry
• this kind of risk can be eliminated through diversification across sectors and companies

Question 10

what are systemic risks?

Answer 10

• those risks affecting the whole overall stock market
• systemic risks can’t be mitigated through diversification but can be well understood via an important measure - capm beta
• the banking sector is one sector that is directly related to systemic risk

Question 11

what is the formula for the beta?

Answer 11

Question 12

how to interpret beta?

Answer 12

• represents the sensitivity of the stock to the movement of the market
• high beta stock exhibits mroe volatility than the benchmark index
• low beta stock exhibits less volatility than the benchmark index
• the beta of the benchmark index - a market portfolio - is always set at 1
• a beta greater than 1 indicated the stock is more volatile
• a beta less than 1 indicates that the stock is less volatile than the benchmark index

Question 13

what is volatility in finance?

Answer 13

it is the degree of variation of trading price series over time

Question 14

what is an example of risk free investment?

Answer 14

• Tbills - they have a beta of zero

Question 15

summary of reading the beta?

Answer 15

• If beta =1 it indicates that the stock /security price is moving in line with the market.
• If beta <1; the return of the security/stock price is less likely to respond to the market movements.
• These shares will generally experience smaller than average gains in a rising market and smaller than average falls in a declining market.
• If beta > 1, the returns from the security are more likely to respond to market movements, => making it volatile
• These shares tend to go up faster than the market in a rising(bull) market and fall more than the market in a declining (bear) market.

Question 16

what are some of the extreme values that beta has given?

Answer 16

2.5

Question 17

what is the differences between a systemic and systematic risk?

Answer 17

systematics risk - relates to non-diversifiable risk factors that affect everybody, perhaps the stock market. It is an important predictor of banks’ systemic risk

systemic risk - relates to the danger of the entire financial system collapsing

Question 18

what are the worries abotu systemic risk?

Answer 18

• a systemic event can be global in reach or just affect a single country
• some countries are more vulnarable to systemic risk than others, especially those that have based theor economies on finance and are exporters of financial services

Question 19

what is the bank’s perspective on systemic risk?

Answer 19

• one way to identify who is susceptible is to consider the size of the banking system
• it matter how much of the banking system is domestic and how much it is foreing owned
• and how well a country is insulated

Question 20

what are the different types of systemic risk?

Answer 20

1) common exposure to asset price bubbles, particlarly real estate bubbles
2) liquidity provision and mispricing of assets
3) multiple equilibria and panics
4) contagion - spread of economic problems or market disturbances from one country or region to another, often through financial markets.
5) sovereign default
6) currency mismatch in the banking system

Question 21

can systemic risk be exogenous or endogenous?

Answer 21

• can be both
• endogenous: resulting from the collective behaviour of financial institutions
• exogenous: when its source is outside the financial system - imbalances in the real economy

Question 22

when was the closest we have ever got to a systemic crisis?

Answer 22

• globalism was at peak ini 1914
• the world’s financial system was highly integrated
• the importance of observation is that the financial crisis did not happen because of world war 1, but in anticipation of it
• confidence, and hence liquidity disappeared

Question 23

why does systemic risk arises?

Answer 23

- because of inherent structural weaknesses in the financial system ex: pro-cyclicality, information asymmetries, interdependence, and perverse incentives. - they enable the systemic risk to be created wthout much scrutiny , only to be realised when it is too late - it is neccessary to address the underlying causal factors to develop policies to mitigate risk - macro-prudential policies

Question 24

what are macroprudential policies?

Answer 24

- a broad regulatory approach that aims to safeguard the entire financial system from systemic risks, rather than focusing solely on the stability of individual financial institutions - aim to reduce the financial system's sensitivity to shocks by limiting the buildup of financial vulnerabilities

Question 25

what is pro-cyclicality?

Answer 25

- Fire-sale externalities arise when financial institutions need liquidity and aim to convert risky assets into cash - there are many sellers and few buyers of risky assets. That means prices collapse, making it even harder to raise cash and forcing institutions to sell even more risky assets, in what has become a vicious cycle - ex: The Fed reduced credit between December 1930 and April 1931. This led to more and more banks being forced to sell assets at fire-sale prices, and to deteriorating liquidity conditions

Question 26

what is information assymetry?

Answer 26

-  A loss of confidence can lead to bank failure. It does not matter much whether the loss in confidence arises from unfounded rumours or from real negative information => agency problem between counterparties and the bank, caused by information asymmetry - Counterparties may refuse to enter into new transactions or renew existing ones if they suspect a bank is in trouble

Question 27

what is interdependence ?

Answer 27

- A financial institution can have an indirect exposure to another financial institution without any direct dealings with it - quite dangerous during crises - At any given time, a financial institution simultaneously owes money to other institutions and is owed money often from the very same institutions => These linkages make the financial system fragile

Question 28

what are perverse incentives?

Answer 28

- Banks have incentives to become as big, interconnected and dangerous as possible to maximise the chance of a bailout - Because of the interconnectedness of the financial system and the very high cost of systemic crises, the government will have no choice but to do anything it can to prevent such an outcome. This often takes the form of bailouts of various types, creating moral hazard - A small, prudently run and non-systematically important institution is less likely to get support from the government than a very large, badly run, interconnected bank.

Question 29

why are perverse incentives a systemic risk - what happens?

Answer 29

 Interconnectedness of the financial system + high cost of systemic crisis Bailout+Moral Hazard

Question 30

how can systemic risk be analyzed?

Answer 30

through two principal components: 1) a shock that affects one or more of institutions 2) transmission mechanism that multiplies the shock HOWEVER, the impact of the shock can be non-linear and can change rapidly => important to attempt to measure the scale of the shock

Question 31

what is the blueprint for systemic risk?

Answer 31

Question 32

what is systemic risk in general - summary?

Answer 32

There are many definitions of systemic risk, but most emphasise the risk of widespread failures in the financial system, caused by the interlinkages between financial institutions, eventually resulting in a severe economic downturn. The authorities have to find the appropriate risk–return combination, similar to what investors do for their own portfolios. The failure of a single institution quickly spreads to other banks, even if they have been prudently run.