CHAPTER1:WhyareFIssoSpecial?

FLOW OF CAPITAL WITHOUT FINANCIAL INSTITUTIONS Households might find direct investments in corporate securities unattractive because of: o Information/Monitoring Costs need to check the actions of the firm so that the firm does not waste the funs. o Liquidity Costs only two options (Cash/LT investment). Many households may want to keep assets to finance consumption expenditure in near future. o Price Risk risk that sale price of an asset will be lower than the purchase price of the asset. No knowing how securities will sell on the secondary market. As a result: o Flow of funds likely to be low. o Little or no monitoring will occur. o Risk of investments will increase.

Finance 3630 o Less information asymmetry and monitoring costs. o More liquid and less risky.
SPECIALNESS OF FINANCIAL INSTITUTIONS General Areas of FIs Specialness Information services lower cost, economies of scale.

Liquidity services secondary securities have superior liquidity. Price-risk reduction services secondary securities have lower price risk. Transaction cost services lower cost, economies of scale. Maturity intermediation services FIs have the ability to bear the risk of mismatched maturities of assets and liabilities. o Through maturity mismatching, FIs can produce new types of contracts (LT mortgage loans, ST liability contracts). o Although these mismatches can subject FI to interest rate risk, FIs can manage this risk through its superior access to markets and instruments for hedging.

Hence, financial intermediaries are necessary for the flow of funds to occur between households and corporations. cash equity + debt

Households cash Financial Inst. Corporations deposits + insurance FINANCIAL INTERMEDIARIES FUNCTION

Brokerage Function When acting as a broker, a FI acts as an agent for the saver by providing information and transaction services. Reduced costs through economies of scale greater efficiency when one FI performs these services than when household savers trade on their own. E.g. Merrill Lynch carries out investment research and conducts purchase/sale of securities. Asset Transformers FIs purchase primary securities (equities, bonds) from corporations and finance these purchases by selling secondary securities (financial claims/products) to households. These secondary securities are more attractive since:

Information Costs Information collection is costly since household savers must monitor the firms actions after purchasing securities. Failure to monitor exposes the investor to agency costs risk that the owners and managers of the firm will make decisions about the funds that are not in the best interest of the investors. FIs act as delegated monitors by agglomerating funds of individual households: o To avoid free rider problem aggregation of funds provides a greater incentive to collect info and to monitor activities. o To reduce costs of information collection and monitoring. Liquidity and Price risk Many investments are illiquid and involve high price risk (e.g. real estate and long-term loans). However, FIs provide highly liquid and low price-risk contracts to savers even though they invest in these risky sectors. How? o Diversification FIs can diversify away portfolio risks. o Monitoring FIs have developed better risk management techniques.

Finance 3630
Note: Downside of Delegated Investment Intermediary services are not costless

Agency Issues Risk management in FIs Monitoring FIs

INSTITUTION SPECIFIC SPECIALNESS Transmission of Monetary Policy o Liabilities of depository institutions (deposit contracts) are a significant component of the money supply. o Thus, FIs play a key role in the transmission of monetary policy from the central bank to the rest of the economy. Credit allocation o FIs are the major and sometimes only source of financing for special sectors of the economy that are in need of financing. o E.g. policymakers in US have identified residential real estate as needing special subsidies. Intergenerational transfers o Savers are able to transfer wealth across generations. o Allows for life insurance and pensions.

Finance 3630 o Depository institutions are the most heavily regulated of the o Regulation can be imposed on an intl/federal/state level. o Regulation may be institution-specific.
Safety and Soundness regulation Ensures the credibility of the FI in the eyes of its borrowers and lenders. 1. First Layer of Protection: Encourages diversification. 2. Second Layer of Protection: Minimum level of capital/equity funds. 3. Third Layer of Protection: Provision of Guaranty funds. 4. Forth Layer of Protection: Monitoring and surveillance. Monetary Policy regulation Regulators impose a minimum level of required cash reserves to be held against deposits. Imposing reserve requirements makes the control of the money supply and its transmission more predictable. Credit Allocation regulation Regulation may require a FI to hold a minimum amount of assets in one particular sector or to set maximum interest rates, prices or fees to subsidize certain sectors. E.g. usury laws maximum rates that can be charged on mortgages. Consumer Protection regulation This prevents discrimination in lending. Investor Protection regulation Various laws protect investors against abuses such as insider trading, lack of disclosure, outright malfeasance and breach of fiduciary responsibilities. Entry and Chartering regulation Increasing or decreasing the cost of entry into a financial sector affects the profitability of firms already competing in that industry. FIs.

Payment services o Efficient payment services through check clearing and wire transfer services. Denomination intermediation o Many assets have minimum denomination sizes, which makes it difficult for savers to diversify their portfolio. o However, by buying shares in a money market mutual fund, household savers are able to overcome these constraints.

MAJOR TYPES OF REGULATION Regulation FIs are regulated to prevent a disruption in the special services they provide and the costs this would impose on the economy and society. o Negative externalities There are flow on effects when a FI cannot provide its services. It damages the economy and society. o Mortgage Redlining FIs may refuse to loan to residents in a particular socio-economic/geographic cohort. Net regulatory burden difference between private cost of regulation and social welfare benefits of regulation. o Regulatory burden e.g. regulation may prohibit a bank from making a loan even though NPV>0. Regulation is imposed differently on the various FIs.

Finance 3630
Industries heavily protected against new entrants by high direct + indirect costs produce bigger profits for firms than those in which entry is relatively easy. Buckets Assets Liabilities Gaps Cum. Gap 1 day 20 30 -10 -10 <3 30 45 -15 -25 months <6 65 45 +20 -5 months >6 15 10 +5 0 months A negative gap (RSA RSL < 0): o Exposes the FI to refinancing risk: risk that the cost of rolling over or borrowing funds will rise above the returns being earned on asset investments. o A rise in these ST rates would lower the FIs net interest income. A positive gap (RSA RSL > 0): o Exposes the FI to reinvestment risk: risk that the returns on funds to be reinvested will fall below the cost of funds. o A drop in short term rates would lower the FIs net interest income. Change in Net Interest Income (ith bucket):

Future of Regulation Implications of GFC more efficient regulation?

Regulation overhaul in the U.S Dodd-Frank Bill. o Expanded and centralized powers for Federal agencies. o More restrictions and disclosures about risk taking activities by big financial institutions. o Enhances protection of Investors and Consumers.

CHAPTER8:InterestRateRiskI
LEVEL AND MOVEMENT OF INTEREST RATES Central banks monetary policy strategy directly impacts the level and movement of interest rates in turn affects a FIs cost of funds and ROA. Through daily market operations, Fed impacts money supply, inflation and level of interest rates. REPRICING MODEL FIs often mismatch maturities of assets and liabilities exposes them to IRR. The Repricing Model concentrates on interest rate changes on a FIs net interest income (Interest Income Interest Expense). Repricing Gap = RSA - RSL. o Rate sensitive asset/liability an asset or liability that is repriced at or near current market interest rates within a certain time horizon. The federal reserve (regulator) requires commercial banks to report quarterly on the repricing gaps for asset and liabilities with these maturities: o 1 day o < 3 months o < 6 months o < 12 months o < 5 years o > 5 years

I i= ( GA P i ) Ri = ( RS Ai RS L i ) R i o E.g. If gap is negative 10 million and ST rates rise 1%,

change in net interest income is 100,000 (Loss of 100,000). Cumulative Effect on Net Interest Income:

I i= ( CGAP ) Ri o E.g. Cumulative 6 month repricing gap is negative 5 million. Thus, if R is the average interest rate change affecting
assets and liabilities that can be repriced in 6 months, I i= (5 )( 0.1 )=50 , 000 .

Rate Sensitive Assets Short Term Loans repriced at the end of every year.

Three Month T-bills repriced on maturity (rollover) ever three months. 30 year floating rate mortgages repriced every nine months. They are rate sensitive assets in the context of the repricing model with a one year repricing horizon.

Summing up the above gives the total one-year rate sensitive assets (RSA).

Finance 3630 o Larger the abs value of the gap, larger the expected change
in NII. CGAP effects: r/ship between changes in interest rates and changes in NII. o When CGAP > 0, change in NII is positive related to change in IR. o When CGAP < 0, change in NII is negatively related to change in IR. If interest rates are expected to rise, a FI would want its CGAP > 0. If interest rates are expected to fall, a FI would want its CGAP < 0. Change in Interest Rates Increase Decrease Increase Decrease Change in Interest Income Increase Decrease Increase Decrease Change in Interest Expense Increase Decrease Increase Decrease Change in NII Increase Decrease Decrease Increase

Rate Sensitive Liabilities Three-month CDs/bankers acceptances Mature in 3 months and are repriced on rollover. Six-month commercial papers Mature and are repriced every 6 months. One year time deposits Repriced at the end of the one year gap horizon. Summing up the above gives the total one-year rate sensitive liabilities (RSL). Demand deposits are not included as RSLs. Against inclusion: Explicit interest rate on demand deposits is zero by regulation. Many demand deposits act as core deposits: deposits that act as a FIs long-term source of funds. For Inclusion: Demand deposits pay implicit interest because FIs do not charge fees that cover their costs for checking services. If interest rates rise, individuals may withdraw from their deposits (and invest), forcing the bank into more expensive fund substitution. o Higher yielding, interest bearing rate sensitive funds. The Gap Ratio: The interest rate sensitivity as a percentage of assets.

CGA P > 0 > 0 < 0 < 0

> > < <

Gap Ratio=

CGAP RSA RSL = A A

E.g When CGAP = 15 million and A = 270 million, the gap ratio is 5.6%. o The FI has 5.6% more RSAs than RSLs in one year and less buckets as a percentage of total assets. Equal Changes in Rates on RSAs and RSLs The CGAP provides a measure of a FIs interest rate sensitivity.

Expressing the repricing gap in this way is useful since it tells us: o The direction of the interest rate risk exposure (positive or neg). o The scale of the exposure.

Unequal Changes in Rates on RSA and RSLs In reality, rate changes on RSAs generally differ from those on RSLs. o Although rates generally move in the same direction, they are not perfectly correlated. Thus, when considering the impact of interest rate changes on NII, there is both a spread effect and a CGAP effect. Spread Effect: the effect that a change in the spread between rates on RSA and RSLs has on net interest income and interest rates change. Change in Net Interest Income:

I i

Interest Revenue Interest Expense ( RSA R RSA )( RSL R RSL )

WEAKNESSES OF THE REPRICING MODEL

Finance 3630
Although the vast majority of depository institutions in the US use this model of interest rate risk, the repricing model has four major shortcomings.

Market Value Effects Interest rate changes have a market value effect in addition to an income effect on asset and liability values. That is, when the interest rate changes: o PV of cash flows on assets and liabilities change. o Immediate interest received/paid on the assets/liabilities change. The repricing model ignores the market value effect implicitly assuming a book value accounting approach. As such, the repricing gap is only a partial measure of the true interest rate risk exposure of the FI. Over-Aggregation Problem of defining buckets over a range of maturities ignores information regarding the distribution of assets and liabilities within those buckets. E.g. Dollar values of RSAs and RSLs in a 3mth to 6mth bucket are equal but liabilities are repriced at 5months whereas assets are repriced at 3months. o The repricing gap would thus be zero but the assets and liabilities are mismatched within the bucket. One-day bucket gaps would be ideal to minimise this problem and give the FI a more accurate picture of the NII exposure to IR changes. o FI can do this internally regulators only require reporting of repricing gaps over wide maturity bucket ranges. The Problem of Runoffs It was assumed that all consumer loans mature in 1 year or mortgages mature in 30 years. In reality, the FI creates/retires consumer and mortgage loans daily. E.g. A 30 yr mortgage may only have 1 year before it matures. o These loans are listed as 30-year mortgages (not included in RSLs), but sometimes are prepaid earlier when people sell their house. o Thus, the resulting proceeds will be reinvested at current market rates within the year.

In addition, even if an asset or liability is rate insensitive, virtually all assets and liabilities pay some principal/interest back to the FI in any given year. As a result, the FI receives a runoff cash flow from its rate insensitive portfolio that can be reinvested at current market rates. o This runoff CF component in itself is rate sensitive. o Runoff: periodic CF of interest and principal payments on long term assets that can be reinvested at market rates. Solution: FI can estimate the runoff for each asset and liability and add these amounts to the RSAs and RSLs.

Cash Flows from Off-Balance Sheet Activities RSAs and RSLs used in the repricing model only include the assets and liabilities listed on the balance sheet. Changes in interest rates also affect off-balance sheet activities. E.g. FI may have hedged its interest rate risk with an interest rate futures contract. o As interest rates change, these futures contract (as a part of the marking-to-market process) produce a daily cash flow (neg/pos) for the FI that may offset any balance sheet gap exposure. o These offsetting cash flows from futures contracts are ignored by the repricing model but should be used.

CHAPTER9:InterestRateRiskII

INTRODUCTION The weakness of the repricing model is its reliance on book values than market values of assets and liabilities. o Book value accounting this method records the historic values of asset and liabilities. o Market value accounting this method revalues assets and liabilities according to the current level of interest rates. The market value accounting approach reflects the economic reality of assets and liabilities if the FIs portfolio were to be liquidated at todays prices. The duration model is a MV-based model of managing interest rate risk.

Interest Rate Risk Risk that a change in the interest rate will cause a change in the market value. For a fixed-income security: o The market value rises if interest rates fall. o The market value falls if interest rates rise.

Finance 3630 o The larger the numerical value of D, the more sensitive that o Duration is measure of the percentage change in the price
of a security for a 1 percent change in the return on the security. asset or liability is to changes or shocks in interest rates.

However there are some exceptions CFs that change with the interest rate. Central Bank and Interest Rates The central bank targets a specific level (or range) for the interest rate. The target is primarily short term rates: o Federal funds rate in the U.S. o Cash rate in Australia

P / R P D= 1+ R In general, the duration equation is written as: D = t =1N

PV (CF t ) t
PV (CF t ) t= 1

Tools the central bank employs to manage interest rates: o Open market operations (buying or selling government securities). o Cash reserve ratio requirement. These tools influence money supply affects inflation and interest rates.

CALCULATING DURATION Typical Bonds Consider a bond with P=$1000, t=3, r=0.10, YTM=0.08
t 1 2 3 CF 100 100 1100 PV 100(1.08)^(1) 100(1.08)^(2) 1100(1.08)^( -3) 1051.50 Duration PV*t 92.59 171.46 2619.54 2883.59 2.74 years

DURATION DEFINITION Duration is a more complete measure of an assets interest rate sensitivity than maturity because duration takes into account the amount of all cash flows, the timing of all cash flows and the assets maturity. The structure of a fixed income security principle (face) value, time to maturity, coupon rate, interest rate (yield):

P =
t =1

CF ( 1+ R)

Annuity Consider a security with annual CFs=$1000, t=3, r=0.08

t 1 2 3 CF 1000 1000 1000 PV 1000(1.08)^( -1) 1000(1.08)^( -2) 1000(1.08)^( -3) 2577 Duration PV PV*t 925.9

Definition 1: Duration is the weighted average time to maturity on the security using the PV of cash flows as weights. To measure/hedge interest rate risk, the FI needs to manage its duration gap. Definition 2: Duration is a measure of interest rate sensitivity of an asset.

1714.66 2381.4 5021.9 1.95 PV*t

Security now has semi annual CFs=$500, r=0.04 (half year)

t CF

Finance 3630
1 2 3 4 5 6 500 500 500 500 500 500 1000(1.04)^( -1) 1000(1.04)^( -2) 1000(1.04)^( -3) 1000(1.04)^( -4) 1000(1.04)^( -5) 1000(1.04)^( -6) 2621.2 Total Duration 480.4 924.6 1333.6 1709.6 2055 2371.2 8874.4 3.38 1.69

Duration and Maturity Duration increases with the maturity of a fixed income asset or liability. However, it increases at a decreasing rate. Duration and Yield Duration increases as yield decreases.

For semi-annual securities, divide duration by 2.

Since the PVs of the cash flows are used as weights if the yield decreases, the PV of all cash flows will increase but the value of cash flows in later periods will increase more. Example (consol bond): Consider a consol bond with R = 10% p.a. and hence a duration of 11 years. If the yield decreases to 8% p.a., the duration would increase to 13.5 years.

Zero Coupon Bonds Zero Coupon Bonds, also called pure discount bonds: o Do not pay coupons and only the repay the face value at maturity. o Sell at a discount.

Consider a zero-coupon bond with P=$1000, t=3, YTM=0.12

t 2 CF 1000 PV 1000(1.12)^( -2) Duration PV*t 1594.4 2.00 years

Duration and the Coupon Rate Duration decreases as coupon rate increases. o The larger the coupon rate, the higher the weights put on those t before maturity relative to that on the last period. Duration decreases as coupon frequency increases. o The more frequent coupon payments are, the lower the value of t entering into duration calculation. DURATION AND INTEREST RATE RISK Change in the market value of a security due to a change in R:

Consol (Perpetuity) Bonds Consol bonds have no maturity, they are a perpetuity:

P i= D i
M c=

( 1+RR )P

The duration formula of a consol bond:

Change in the market value of a portfolio due to change in R:

1 D c= 1+ R Consider a consol bond with P=$1000, r=0.10 duration = 11 o While the consol bonds maturity is infinite, its duration is o o
finite. The duration of a consol bond is independent of CFs and face values. As interest rates rise (fall), the duration of consol bonds falls (rises).

P = D

( 1+RR )P
D = W i D1 + W 2 D2 + + W N D N
and

Where

W i=

Pi P

Proof:

FEATURES OF DURATION

P = P 1 + P 2 + + P N R P = D iP i 1+ R i D P R P = i i P P 1 +R i

)(

) )( )

Finance 3630
The Duration Gap for a Financial Institution To estimate the overall duration gap of a FI, the duration of the firms asset portfolio and duration of the firms liability portfolio need to be determined. Interest rate risk faced by a firm the change in the firms net worth (E) due to change in interest rate.

The current interest rate is 10% but is expected to increase to 11%. We can calculate the expected change in FIs net worth as follows:

E=

E = A L From the duration model: RA A= D A A 1+ R A L = D L L

( 7 0.84 )1000.01 =$ 3.45 1.1

D A A R A D L L R L E= 1+ R A 1+ R L

( ) ( ) )(
RL 1+ RL

This means the FI could lose $3.45 in net worth if interest rates increase by 1%. Potential strategies for the FI to reduce risk exposure: 1) Reduce DA 2) Increase DL 3) Increase k or leverage

IMMUNISATION AND REGULATORY CONCERNS The typical risk management objective is to immunise the firm from interest rate changes: set D A= k D L E =0 .

Assuming the level of interest rates and expected shock to interest rates are the same for both assets and liabilities, then:

E=

( D A k D L ) A R 1+ R o Where k = L/A (a firms leverage measured in market

Regulators normally set a target for a FIs capital (net worth) ratio = E/A. To immunise capital ratio: D A= D L . The manager can satisfy either the shareholders or regulators but not both simultaneously.

values). o Leverage Adjusted Duration Gap [DA kDL] measured in years and reflects the degree of duration mismatch in a FIs balance sheet. The larger this gap, the more exposed the FI is to interest rate shocks. o The size of the FI [A] measures the size of the FIs assets. The larger the FI, the larger the potential exposure to any interest rate shocks. o Size of interest rate shock the greater the size, the greater the exposure. Important: every variable is a market value rather than an accounting one. Generally the objective of risk management is to minimise the effect of interest rate changes on firm value. Example: Consider a firm with has Assets=$100, Liabilities=$80 and Owners Equity=$20. Assume that the average duration of assets is 7yrs, while the average duration of liabilities is 4yrs.

DIFFICULTIES IN APPLYING DURATION MODEL Duration matching can be costly restructuring the balance sheet of a large and complex FI is costly and time-consuming. Immunisation is a dynamic problem duration depends on instantaneous R. The strategy requires the portfolio manager to rebalance the portfolio continuously to ensure the duration of the investment matches the investment horizon. Large interest rate changes duration accurately measures price sensitivity of small changes in interest rates. If interest rates are much larger, duration becomes a less accurate predictor of interest rate sensitivity. Other complexities of using duration: o OBS assets and liabilities (contingent assets and liabilities), difficult to estimate duration. o Non-parallel interest rate changes. o Large changes in interest rates for which duration is not a correct estimate of risk exposure convexity.

Finance 3630

Limitations of Duration Price changes given large interest rate changes are calculated imprecisely using duration:

P R = D P 1+ R Duration is higher than current D if interest rate decreases and

( )

lower than current D if interest rate increases. Duration only captures a linear relationship between price and yield changes in bonds. In reality, because duration itself changes with the yield, the relationship between changes in price and yield is convex.

CHAPTER10:MarketRisk
INTRODUCTION Market Risk is the uncertainty resulting from changes in market prices. It can be measured over periods as short as one day. Usually measured in terms of dollar exposure amount or as a relative amount against some benchmark. Why is Market Risk Measurement important? o Management information MRM provides management with information on the risk exposure taken by FI traders. o Setting risk limits o Resource allocation MRM can identify the optimal riskreturn. o Performance evaluation MRM can identify the risk-return ratio of traders, allowing a compensation (bonus) system to be put in place. o Regulation MRM can be used to identify misallocation of resources. Calculating Market Risk Exposure: o RiskMetrics o Historic or back simulation o Monte Carlo simulation THE RISK METRICS MODEL Developed by JP Morgan in 1994. It was used to estimate the potential loss under adverse market circumstances in order to gauge market risk exposure. Daily earnings at risk = potential loss under adverse circumstances:

CONVEXITY Over looking the curvature of the price-yield curve would cause errors in predicting the interest rate sensitivity of asset and liability portfolios. This can be captured by measuring the change in the slope of the price-yield curve around the current interest rate.

P D R 1 2 = + CX ( R ) P 1+ R 2 CX = convexity measure, measuring degree of curvature of price

yield relationship. Basically, it measures the change in duration as interest rates change. Mathematically, it is the second derivative of price with respect to interest rate. How to calculate CX is not required.

Finance 3630
DEAR= Market Value of Position Price Volatility Price Volatility = Price Sensitivity*Potential adverse yield move o Price volatility is the daily return under adverse

If the portfolio is well diversified then unsystematic risk is diversified away and only systematic risk is left. Hence, beta will be 1.

o If daily return follows a normal distribution, daily return

circumstances.

under 5% worst case = - 1.65 (generally assumed = 0).

Fixed Income Securities Daily return under 5% worst case (do not want yield to increase):

Example: A FI holds a $1 million trading position in stocks that reflects a US stock market index. Beta = 1 and over the last year, the standard deviation of daily returns on the stock market index was 200bp. Dollar value of position = $1 million

DEAR = MV positionBeta 1.65

MDadverse yield move = MD( +1.65 ) DEAR: DEAR= MV positionMD( +1.65 )

Example: A FI has a $1 million market value position in 7 year zero coupon bonds with a face value of $1,631,483. Todays yield is 7.243% and standard deviation is 100bp. Dollar market value of position = $1 million.

FX Volatility = 1*1.65*200bp = 0.033 DEAR = $1 million*0.033 = $33,000

Value at Risk To calculate the potential loss for N days:

Market Value at Risk ( VAR )= DEAR N Assumes: A normal dist of daily returns and zero correlation
b/w daily returns. Portfolio Aggregation Similarly, assuming mean return is zero, DEAR of a portfolio can be calculated based on the distribution of portfolio returns. Example: A FI has three individual positions in coupon bonds(1), FX(2) and equities(3). Correlation between (1) and (2) = -0.2, (1) and (3) = 0.4, (2) and (3) = 0.1 Two assets:
2 DEA R p= [ DEA R2 a + DEA R b + 2 ab DEA R a DEA Rb ] Three assets: 1/2

DEAR = $1,000,000*6.527*0.00165 = $10,770 Foreign Exchange Dollar market value of position (exchange into $):

Daily price volatility = MD(price sensitivity)*Adverse yield move o MD = 7/(1.07243) = 6.527

Example: A FI had 1.4 million euro trading at an exchange rate at 1.4euro/ $. The volatility of daily changes in the spot exchange rate was 56.5bp. Dollar value of position = $1 million

Dollar MV of position= FX position $ per unit of foreign currency DEAR: DEAR= FX position Exchange Rate1.65

2 2 DEA R p= [ DEA R2 a + DEA R b + DEA R c + 2 ab DEA R a DEA R b + 2 bc DEA R b DEA

FX Volatility = 1.65*56.5bp = 93.2bp DEAR = $1 million*93.2bp = $9,320

Equities From CAPM, there are two types of risk to an equity position in individual stock:

Total Risk = Systematic Risk + Unsystematic Risk 2 2 2 2 it = i mt + eit

HISTORIC OR BACK SIMULATION APPROACH A major criticism of RiskMetrics is that it assumes a symmetric or normal distribution of asset returns. o This is quite questionable for some assets such as shortterm securities (bonds) and options. Historic or back simulation approach get the adverse return from the past actual returns. o The FI will calculate the market or value risk of its current portfolio on the basis of returns that existed for those assets on each of the last 500 days.

Finance 3630 o It will then calculate the 5% worst case portfolio value that
has the 25th lowest value out of 500. Advantages Simple to understand.

Do not need a distribution assumption. Do not need to calculate standard deviations or correlations.

Weaknesses Degree of confidence in the 5% VAR number based on 500 obs 500 observations is not very many from a statistical standpoint. Increasing the number of observations by going back further in time is not desirable since returns in the past may be irrelevant. Could possibly put a higher weighting to the more recent observations and then use more observations.

Finance 3630

CHAPTER11:CreditRiskIndividualLoanRisk
CREDITQUALITYPROBLEMS History: 1980stremendousproblemswithbankloanstolessdeveloped countries. 1990sproblemswithcommercialrealestateloans,junkbonds(ratedas speculativebybondratingagencysuchasMoodys). Late1990sconcernswithrapidgrowthlowqualityautoloansandcredit cards,badloansstartingtoincrease. GFCof2008mortgagedelinquenciessurged,particularlyonsubprime mortgages. CreditRisk

ASyndicatedLoanisaloanprovidedbyagroupofFIsasopposedtoa singlelender. o StructuredbyleadFI(oragent)andborrower.Onceterms(rates, fees,covenants)areset,piecesoftheloanaresoldtootherFIs. ASecuredLoanisaloanthatisbackedbyafirstclaimoncertainassetsof theborrowerifdefaultoccurs. Secureddebtisseniortoanunsecuredloanaloanthathasonlyageneral claimttheassetsoftheborrowerifdefaultoccurs.

Spotvs.Commitment

CreditqualityproblemscancauseaFItobecomeinsolventorcan resultinsuchasignificantdrainoncapital/networththatitcanadversely affect: o Growthprospects o AbilitytocompetewithotherdomesticandinternationalFIs. Creditriskdoesnotapplytojustlendingandbondinvesting.AsFIshave expandedintocreditguaranteesandotheroffbalancesheetactivities,new typesofcreditriskexposurehasarisen.

SpotLoanismadebytheFI,andtheborrowerusesortakestheentireloan amountimmediately. WithaLoanCommitment,lendermakesanamountofcreditavailable. Borrowerhastheoptiontowithdrawfundsuptotheloanamountatany timeoverthecommitmentperiod. o FixedRateinterestratetobepaidisestablishedwhentheloan commitmentcontractbegins. o Floatingrateborrowerpaystheloanrateinforcewhenanypartof theloanamountiswithdrawn.

CommercialPaper

TYPESOFLOANS CommercialandIndustrialLoans

Periodcanbeafewweeksto8yrs,amountfrom100,000to10million, fixed/floatingrateofinterestlongtermaregenerallyunderfloating.

CommercialPaperisanunsecuredshorttermdebtinstrumentissuedby corporations. o Issuedeitherdirectlyorviaanunderwritertopurchasesinthe financialmarkets. Byusingacommercialpaper,acorporationcansidestepbanksandtheloan markettoraisefundsoftenatratesbelowthosebankscharge.

ShortTermvs.LongTerm

RealEstateLoans

ShortTermCommercialLoansareusedtofinancefirmsworkingcapital needsandothershorttermfundingneeds. LongTermCommercialLoansareusedtofinancecreditneedsthatextend beyondoneneed. o E.g.Purchaseofmachinery,newventurestartupcosts,permanent increasesinworkingcapital.

RealEstateLoansareprimarilymortgageloansandsomerevolvinghome equityloans. Characteristicsdifferwidelysize,ratioofloan/propertyprice, maturity. Othercharacteristicsaremortgagerate,feesandchargeontheloan.

Adjustableratemortgage(ARM)isamortgagewhoseinterestrate adjustswithmovementsinanunderlyingmarketindexinterestrate.

OthertypesofLoans

Residentialmortgagesareverylongtermloanswithanaverage maturityof29years.Theresidentialmortgageportfoliocanalsobe susceptibletodefaultrisk. Individual(Consumer)Loans

Finance 3630 o Compensatingbalancerequirement(b):compensatingbalancesarea

percentageofaloanthataborrowerisrequiredtoholdondepositat thelendinginstitution.Thisraisestheeffectivecostofloansless thanthefullamountcanonlybeutilized. o Reserverequirement(RR)imposedbytheFederalReserveontheFIs demanddeposits,includinganycompensatingbalances. Contractuallypromisedgrossreturnontheloan:

Commercialbanks,financecompanies,retailers,savingsinstitutions,credit unionsandoilcompaniesprovideconsumerloanfinancingthroughcredit cardsandproprietycreditcards(Sears,AT&T). Revolvingloanacreditlineonwhichaborrowercanbothdrawandrepay manytimesoverthelifeoftheloancontract. Interestratesoncar,personalandcreditloansdifferwidelydependingon featuressuchascollateralbacking,maturity,defaultrateexperienceand noninterestratefees. o Alsocompetitiveconditionsinmarketandregulationssuchas national/state/cityimposeusuryceilings(maximumrates).

1 + k =1 +

Originating Fee +( BR + m ) 1 b ( 1 RR )

TheExpectedReturnontheLoan

OtherLoans Includeawidevarietyofborrowersandtypes:farmers,nonbankFIs, investmentbanks,stateandlocalgovernments,foreignbanksetc. CALCULATINGTHERETURNONALOAN ContractuallyPromisedReturnonaLoan

FactorsthatimpactthepromisedreturnanFIachievesonanyasset: 1. Theinterestrateoftheloan. 2. Anyfeesrelatingtotheloan. 3. Thecreditriskpremiumontheloan. 4. Collateralbackingofaloan 5. Othernonpriceterms(compensatingbalances,reserve requirements) LoanRate=BaseLendingRate(BR)+CreditRiskPremium(m) o BaseLendingRatecouldreflecttheFIsWACCormarginalcostof funds(federalfundsrate,LIBOR).GenerallyforpricingSTloans. o Alternativelyitcouldreflectprimelendingratebaselendingrate periodicallysetbybanks.GenerallyforpricingLTloans. o Generallybestandlargestborrowerscommonlypaybelowprime ratetobecompetitivewiththecommercialpapermarket. DirectandIndirectfeesrelatingtoloans: o Loanoriginationfee:feeforprocessingtheapplication.

1 + E [ r ] = p ( 1 + k )+ ( 1 p )0 E [ r ] = p ( 1 + k ) 1 o pistheprobabilityofcompleterepaymentoftheloan. FIsmanagermust: o Setriskpremium(m)sufficienthightocompensateforthisrisk. o Recognizethathighriskpremiumsandhighfeesmayreducethe

probabilityofrepayment(p)kandparenotindependent.

Thepromisedreturnontheloan(1+k)maydifferfromtheexpected/actual returnontheloanduetodefautrisk. Defaultriskistheriskthattheborrowerisunabletofulfilltheterms promisedundertheloancontract. Thus,thetimetheloanismade,theexpectedreturnis:

FIsusuallyhavetocontrolforcreditriskwiththepriceorpromisedreturn andthequantityorcreditavailable. RETAILVS.WHOLESALECREDITDECISIONS Retail

Mostloandecisionsmadeattheretaillevelareaccept/rejectdecisions. o SmalldollarsizeoftheloancomparedtoFIsinvestmentportfolio. o Highercostofcollectinginformationonhouseholdborrowers. Retailcustomersaremorelikelytobesorted/rationedbyloanquantity restrictionsthanbypriceorinterestratedifferences. o AFIcontrolsitscreditriskbycreditrationingrestrictingthe quantityofloanmadeavailable.

Finance 3630
canborrowupto10,000bothborrowatthesameinterestrate. E.g.ResidentialmortgagesFIdiscriminatesb/wtwoborrowersaccording totheloantovalueratio.AmountFIiswillingtolendisrelativetothe marketvalueofthehouse.

o E.g.morewealthycanborrowupto100,000whereaslesswealthy

BorrowerSpecificFactors

Reputationborrowing/lendinghistoryofacreditcardapplicant. Leveragecapitalstructure(debttoequity).Largeamountsofdebtcan significantlyimpacttheprobabilityofdefault. Volatilityofearningshighlyvolatileearningsincreasestheprobability thattheborrowercannotmeetfixedinterestandprincipalcharges. Collateralassetsthatbacktheloan.

Wholesale

Atthewholesalelevel,FIsusebothinterestrateandcreditquantityto controlcreditrisk. o LowriskborrowersarechargedalendingratebelowPLR. o HighriskborrowersarechargedPLRandadefaultriskmargin. AslongasFIsarecompensatedwithhighinterestrates,theywillbewilling tolendfundstohighriskwholesaleborrowers.

MarketSpecificFactors BusinessCyclepositionoftheeconomyisenormouslyimportanttoaFI assessingtheprobabilityofborrowerdefault. o Firmsinconsumerdurablegoodssector(autos,refrigerators, houses)dobadlycomparedtothoseinnondurablegoodssector (clothing,foods). Levelofinterestrateshigherinterestratesindicaterestrictivemonetary policyactionsbytheFederalReserve.Highinterestratesarealsocorrelated withhighercreditrisk.

However,increasingloaninterestrates(k)maydecreasetheprobability(p) thataborrowerwillpaythepromisedreturn.Hence,aFIcharging borrowersin14%mayearnalowerreturnthanFIscharging8%. Thissuggeststhatbeyondsomeinterestratelevel,itisbestfortheFIto creditrationitswholesaleloans. o Ratherthanrationingbyprice,FIcanrationbytheamountitis willingtolendtomaximiseitsexpectedreturnsonlending.

CreditScoringModels

Creditscoringmodelsarequantitativemodelsthatuseobservedborrower characteristicsto: o Calculateascoreasaproxyfortheborrowersdefaultprobabilityor o Sortborrowersintodifferentdefaultclasses. Acreditscoringmodelneedsto: o Establishafactorthathelptoexplaindefaultrisk. o Evaluatetherelativeimportanceofthesefactors.

MEASURINGCREDITRISK Qualitativecreditriskmodels.

LinearProbabilityModel

RAROCmodels QualitativeCreditRiskModels

Creditscoringmodels. Termstructurebasedmethods. Mortalityratemodels.

Probability of Default ( Z i )= j X ij + error

j =1

StatisticallyunsoundsincetheZsobtainedarenotprobabilitiesatall. Sincesuperiorstatisticaltechniquesarereadilyavailable,littlejustification foremployinglinearprobabilitymodel.

Inabsenceonpubliclyavailableinformationonthequalityofborrowers,aFI hastoassembleinformationfromprivatesourcestomakeaninformed judgementontheprobabilityofdefaultinordertopricetheloan.

LogitModel

P i = exp ( Z i ) /( exp ( Z i )+1 )

Finance 3630
Overcomesweaknessofthelinearmodelusingatransformation(logistic function)thatrestrictstheprobabilitiestothe(0,1)interval.

1 + i = p (1 + k )
Riskpremium=ki Adjustingforavaryingdefaultrecoveryrate:

LinearDiscriminantModelsAltmansZScoreModel

1 + i =( 1 p ) ( 1 + k ) + p ( 1 + k ) o andpareperfectsubstitutesforeachotherthatis,abondora o
loanwithcollateralbackingof=0.8andp=0.9hasthesame requiredriskpremiumasonewith=0.9andp=0.8. Anincreaseincollateralisadirectsubstituteforanincreasein defaultrisk(adeclineinp).

Formanufacturingfirms:

Z = 1.2 X 1 + 1.4 X 2 + 3.3 X 3 + 0.6 X 4 + 1.0 X 5

TheXterms: o X1=WorkingCapital/TotalAssets o X2=RetainedEarnings/TotalAssets o X3=EBIT/TotalAssets o X4=MVEquity/BVlongtermDebt o X5=Sales/TotalAssets CriticalvaluessuggestedbyAltman: o Z>=2.99highqualityloans,lowdefaultrisk. o Z<=1.81verylowqualityloans,highdefaultrisk. o Ifinbetween,indeterminantdefaultriskfirm. Weaknesses: 1. Broaddistinctionbetweenborrowercategories(default/nodefault). 2. Variablesorweightsinanycreditscoringmodelunlikelytobe constantoverlongperiodsoftime.AlsoassumesXsare independentofoneanother. 3. Themodelignoresqualitativefactorssuchasborrowersreputation orthebusinesscycle. 4. Thereisnocentraliseddatabaseondefaultedbusinessloans constrainstheabilityforFItousecreditscoringmodels.

ProbabilityofDefaultonamultiperiodDebtInstrument

Theoneperiodmodelcanbeextendedfortheanalysisofcreditriskfor longertermloansorbonds. Marginaldefaultprobabilitytheprobabilitythataborrowerwilldefault inanygivenyear. Cumulativedefaultprobabilitytheprobabilitythataborrowerwill defaultoveraspecifiedmultiyearperiod. Example:AFIwantstofindouttheprobabilityofdefaultona2yrbond. o Marginalprobabilityofdefaultinyear1: 1 p 1= 0.05

TermStructureModels

Onemarketbasedmethodofassessingcreditriskexposureanddefault probabilitiesistoanalysetheriskpremiumsinherentinthecurrent structureofyieldsoncorporatedebtorloans. o Ifweknowtheriskpremium,wecaninferprobabilityofdefault. Underthemarketequilibrium,expectedreturnofariskyloanshouldequal toriskfreerateafteraccountingforprobabilityofdefault.

o Marginalprobabilityofdefaultinyear2: 1 p 2= 0.07 o Cumulativeprobabilityofdefault: p p ( 2 )= 0.1165 ( 1 ) 1

Example: o Therequiredyieldononeandtwoyeartreasuriesare10%and11% respectively.Theforwardrate:

1 + f 1=
2

(1+ i 2 )
1 + i1

1 + f 1=

ProbabilityofDefaultonaoneperiodDebtInstrument

( 1.11 ) = 1.1201 f 1= 12.01 1.10

Assumingazerodefaultrecoveryrate:

o Thecurrentyieldononyearandtwoyeardiscountbondsare15.8%
and18%respectively.Theoneyearrateexpectedoncorporate securities:

1 + c 1= 1 + c 1=
oneyearstimeis:

(1+ k 2 )
1+ k 1
2

o Expectedprobabilityofrepaymentononeyearcorporatebondsin p 2= 1+ f 1 1+ c1
OptionModelsofDefaultRisk(NotExaminable)

( 1.18 ) c 1 = 20.24 1.158

Finance 3630 NetIncome: One year net income = ( Spread + Fees ) Dollar Value of Loan Outstanding LoanRisk(transformationofthedurationequation): D lnln R ln = 1+ R Loan Risk = Duration LoanChange Loan Rate Risthebaserate(BR)plusthecreditriskpremium(m).

o Then,theexpectedprobabilityofdefaultis: 1 p 2= 0.065
MortalityRateModels

KMVMertonmodeluseoptionpricingmethodstoevaluatetheoptionto default.

Insteadofextractingexpecteddefaultratesfromthecurrenttermstructure ofinterestrates,theFImayestimatedefaultratesfrompastloandata. MarginalMortalityRate:

MM R t =

Total value of bonds loans defaults any yr t Total value of bonds loans outstanding at the beginning of yr t
C M R2 =1 ( 1 MM R1 )(1 MM R2 )

CumulativeMortalityRate:

RAROCModels

RAROCRiskadjustedriskoncapital.

RAROC =

One year net income on a loan Loan ( asset ) risk capital at risk

Itisamodifiedreturnonassetconceptwhichbalancesexpectedinterest incomeagainstexpectedloanrisk. AloanisonlyapprovedifRAROCissufficientlyhighrelativetoa benchmarkreturnoncapital(ROE)fortheFI. o ROEmeasuresthereturnstockholdersrequireontheirequity investmentwithFI.