Money and Banking I

Fall 2013

(BEE3043 & BEE2028)

Yoske Igarashi
Office: Streatham Court 0.51
Office hours: Tue 14:00-15:00
Wed 11:00-12:00
Thu 11:00-12:00
1

About the textbook

Greenbaum & Thakor, Contemporary Financial Intermediation (2nd Edition)
I looked at 15 textbooks and G&T is by far the most suitable for this module
(microeconomics of money and banking, not macroeconomics). Still, it is far
from perfect.

Topics covered
by the module.

Topics covered
by the textbook

Because of this reason, class attendance is crucial. Reading through the textbook
will not replace missed classes!!
2

Announcement

If you find any errors, typos, grammar or spelling mistakes, etc., please let me know.
The lectures are recorded for your convenience. (We do not take responsibility for any
failure in recording due to system errors, so please try to attend the class as much as
possible.)
There will be an assignment (a collection of small questions) which counts 20% of the final
mark. The questions will be different between BEE2028 students and BEE3043 students.
The details will be posted later.
The final exam will be a closed-book/note exam. Only calculators will be permitted.

Math foundations

Summation notation ()

http://www.youtube.com/watch?v=8i9-9zHbW6g

Matrix addition and transpose

http://www.youtube.com/watch?v=U74zP3BsAbM

Matrix multiplication

http://www.youtube.com/watch?v=kuixY2bCc_0

Expectation and variance of a random variable

http://www.youtube.com/watch?v=OvTEhNL96v0

Covariance and correlation

http://www.youtube.com/watch?v=35NWFr53cgA

Graphing a linear function

http://www.youtube.com/watch?v=52RiUx5B-ms

Graphing a linear inequality

http://www.youtube.com/watch?v=5h6YzRRxzO4

Differentiation (Derivatives)

http://www.youtube.com/watch?v=54KiyZy145Y

Solving a system of linear equations by Excel

http://www.youtube.com/watch?v=-EnecLe_0B4

Topics (plan)

Preliminaries 1: Risk diversification

Major risks faced by banks

The origin of banking (Anecdote)

Money creation
Bank as a liquidity provider
Fixed-income claimant vs. Residual claimant
Reserve requirement and capital requirement (Basel II)

Credit risk
Interest risk
Collateral risk
Liquidity risk
Belief update
Hidden type
Adverse selection
Adverse selection in banking and use of collateral
General lesson: How to separate types?
Hidden action
Moral hazard in banking and use of collateral
Moral hazard in banking and use of capital

Off-balance-sheet banking

Banking and asymmetric Information

Revision: Expectation, Variance, Covariance, etc.

Portfolio choice
Insurance

The Deposit Contract and Bank Regulation

Options
No-arbitrage pricing
Loan commitment

Loan sales and Securitization

5

The plan for 1st week (23/06/13)

Risk management (Portfolio managers)
Risk management (Insurance companies)
Revisions/preliminaries

Return on stocks/shares and portfolios

Short-selling
Expectation, variance, covariance, standard deviation, and correlation
Some matrix algebra

Expectation and variance of w1X1 + .. + wnXn

Short break
Portfolio optimization
Excel demonstration for portfolio optimization
Insurance and law of large number
6

(Rate of) Return

Revision: Return

date-(t+1) price

For a stock (share),

dividend per share

Pt +1 + Dt +1
1
Rt +1 =
Pt

Return on portfolio

net
date-t price

Suppose you have 100.

You invest 50% in Stock A, 25% in Stock B, and 25% in Stock C.
What is the return on your portfolio (RP)?

R P = 0.5 R A + 0.25 R B + 0.25 R C

Suppose the returns on A, B and C turn out 5%, 20%, and -10%, respectively.
Stock A

Stock B

Stock C

Total

Invested amount

50

25

25

100

Realized return

5%

20%

-10%

5%

52.5

30

22.5

105

Final value

R P = 0.5(0.05) + 0.25(0.20) + 0.25(0.10) = 0.05

Revision: Short-selling

Short-selling
A principle of capital gain
Expectation of price increase
Buy it, and sell it after the price increases.
Expectation of price decrease
Borrow it and sell it. After the price decreases, buy and return
it. (= short-selling)
Investors can sell a thing even if they dont have it. (In practice,
there are regulations and limitations for short-selling.)

Variance and covariance

Expectation, Variance, Covariance, Standard deviation,

and correlation
Prob.

State 1:
Hot

0.5

9K

8K

State 2:
Mild

0.3

5K

6K

State 3:
Cold

0.2

3K

4K

Weighted
Average

6.6 6.6
K
K
means

E[Y] = 0.5 x 8 + 0.3 x 6 + 0.2 x 4 = 6.6 K

E[X] = 0.5 x 9 + 0.3 x 5 + 0.2 x 3 = 6.6 K

11

Variance and covariance

Expectation, Variance, Covariance, Standard deviation,

and correlation
deviation

Prob.

X X

(X X)2

State 1:
Hot

0.5

9K

8K

2.4 K

5.76 (K)2

State 2:
Mild

0.3

5K

6K

-1.6 K

2.56 (K)2

State 3:
Cold

0.2

3K

4K

-3.6 K

12.96 (K)2

6.24 (K)2

Weighted
Average

6.6 6.6
K
K
means

Var[X] = 0.5 x 5.76 + 0.3 x 2.56 + 0.2 x 12.96 = 6.24 (K)2

14

Variance and covariance

Expectation, Variance, Covariance, Standard deviation,

and correlation
deviation

Prob.

X X

(X X)2

Y - Y

(Y Y)2

State 1:
Hot

0.5

9K

8K

2.4 K

5.76 (K)2

1.4 K

1.96 (K)2

State 2:
Mild

0.3

5K

6K

-1.6 K

2.56 (K)2

-0.6 K

0.36 (K)2

State 3:
Cold

0.2

3K

4K

-3.6 K

12.96 (K)2

-2.6 K

6.76 (K)2

(K)2

variance
0

2.44 (K)2

Weighted
Average

6.6 6.6
K
K
means

6.24

Var[Y] = 0.5 x 1.96 + 0.3 x 0.36+ 0.2 x 6.76

= 2.44 (K)2
15

Variance and covariance

Expectation, Variance, Covariance, Standard deviation,

and correlation
deviation

Prob.

X X

(X X)2

Y - Y

(Y Y)2

State 1:
Hot

0.5

9K

8K

2.4 K

5.76 (K)2

1.4 K

1.96 (K)2

State 2:
Mild

0.3

5K

6K

-1.6 K

2.56 (K)2

-0.6 K

0.36 (K)2

State 3:
Cold

0.2

3K

4K

-3.6 K

12.96 (K)2

-2.6 K

6.76 (K)2

(K)2

variance
0

2.44 (K)2

Weighted
Average

6.6 6.6
K
K
means

6.24

X = 6.24

= 2.50 K Standard

deviation

Y = 2.44
= 1.56 K

16

Variance and covariance

Expectation, Variance, Covariance, Standard deviation,

and correlation
deviation

Prob.

X X

(X X)2

Y - Y

(Y Y)2

(X - X)(Y - Y)

State 1:
Hot

0.5

9K

8K

2.4 K

5.76 (K)2

1.4 K

1.96 (K)2

3.36 (K)2

State 2:
Mild

0.3

5K

6K

-1.6 K

2.56 (K)2

-0.6 K

0.36 (K)2

0.96 (K)2

State 3:
Cold

0.2

3K

4K

-3.6 K

12.96 (K)2

6.76 (K)2

9.36 (K)2

6.24 (K)2

-2.6 K
variance
0

2.44 (K)2

3.84 (K)2
covariance

Weighted
Average

6.6 6.6
K
K
means

X = 6.24

= 2.50 K Standard

deviation

Correlation Coefficient

X,Y = Cov( X , Y ) =
XY

Y = 2.44
= 1.56 K

Cov[X,Y] = 0.5 x 3.36 + 0.3 x 0.96 + 0.2 x 9.36

= 3.84 (K)2

3.84( K ) 2
= 0.984
2.50 K 1.56 K

18

Variance and covariance

Correlation Coefficient X,Y

More intuitive indicator of co-movement or links than covariance.
Perfect
negative -1
correlation

0
No
correlation

1 Perfect
correlation

Most studies report standard deviations and correlation coefficients, but not
variances or covariances.
If you need variances and covariances, you need to recover them from st.
deviations and correlation coefficients.
Std. deviations equivalent variances
covariance
Correlation coef.

19

Tutorial questions

Variance and covariance

Exercise1. Complete the following table.

Prob.

State 1:
Hot

0.5

8K

2K

State 2:
Mild

0.3

7K

6K

State 3:
Cold

0.2

4K

9K

Weighted
Average

X X

(X X)2

Y - Y

(Y Y)2

(X - X)(Y - Y)

Y =

X,Y =

_
X =

Exercise2.
What is the expectation and standard deviation of the number you get from rolling a die?
20

Means and variances of many random variables

Suppose there are 5 stocks. (Stock A, B, C, D and E.)
The expected (monthly) returns are expressed as a vector.
Aviva

British Gas

Capita

Diageo

Easyjet

1.10%

0.90%

1.05%

1.15%

1.20%

How about the variability or risk? Is it a vector of variances?

Aviva

British Gas

Capita

Diageo

Easyjet

290 %2

131 %2

58 %2

24 %2

113 %2

No. You need a 5 x 5 matrix to express variability. (Variance-covariance

matrix)
Aviva
BG
Capita
Diageo
Easyjet
Aviva

290 %2

96 %2

34 %2

31 %2

53 %2

BG

96 %2

131 %2

46 %2

27 %2

45 %2

Capita

34 %2

46 %2

58 %2

15 %2

24 %2

Diageo

31 %2

27 %2

15 %2

24 %2

22 %2

Easyjet

53 %2

45 %2

24 %2

22 %2

113 %2

21

Means and variances of many random variables

Equivalently, you can have the vector of standard deviations and the
correlation matrix.
Std. deviations

Aviva

British Gas

Capita

Diageo

Easyjet

17%

11%

8%

5%

11%

Correlation matrix

Aviva

BG

Capita

Diageo

Easyjet

Aviva

1.000

0.495

0.263

0.368

0.294

BG

0.495

1.000

0.529

0.482

0.368

Capita

0.263

0.529

1.000

0.392

0.301

Diageo

0.368

0.482

0.392

1.000

0.417

Easyjet

0.294

0.368

0.301

0.417

1.000

22

Variance and covariance

Expectation of linear combination

A linear combination of X1, X2, . , Xn
EX) 3X1+0.5X2-10X3+8X4

E[ w1 X 1 + w2 X 2 + + wn X n ] = w1 E[ X 1 ] + w2 E[ X 2 ] + + wn E[ X n ]
EX) E[3X1+0.5X2-10X3+8X4] = 3 E[X1] + 0.5 E[X2] -10 E[X3] + 8 E[X4]

w1

If we denote the
w2
expectation vector by ( 1 , 2 , , n ), and the coefficients by w
,

w
n
w.
then the expectation of a linear combination is simply

w = 1w1 + 2 w2 + + n wn .
23

Variance and covariance

Expectation of linear combination

E[ w1 X 1 + w2 X 2 + + wn X n ] = w1 E[ X 1 ] + w2 E[ X 2 ] + + wn E[ X n ]
Why is this formula useful?
Suppose you already know the expected returns of stocks A, B, C, D and E.

Aviva

British Gas

Capita

Diageo

Easyjet

1.10%

0.90%

1.05%

1.15%

1.20%

Suppose you construct your own portfolio composed of these stocks.

EX) 3,000 to w = (40%, 20%, 20%, 15%, 5%).
Then, you can compute the expected return on your portfolio, using the formula!!
Portfolio return = w = 0.40(1.10%)+0.20(0.90%)+0.20(1.05%)+0.15(1.15%)+0.05(1.20%)
= 1.0625%

How about the variance of the portfolio return?

Can we calculate it if we know variances of individual stock returns?
24

Variance formulas
Var[ X + Y ] = Var[ X ] + 2Cov( X , Y ) + Var[Y ]
EX) If Var[X]=15, Var[Y]=15 and Cov(X,Y)= 10,
then Var[X+Y]=10.

Variance and covariance

MNEMONICS

( x + y ) 2 = x 2 + 2 xy + y 2

Var[aX + bY ] = a 2Var[ X ] + 2abCov( X , Y ) + b 2Var[Y ]

MNEMONICS

(ax + by ) 2 = a 2 x 2 + 2abxy + b 2 y 2

EX) Assume the same X and Y as above

and let a = b = 0.5. Then,
Var[0.5X+0.5Y] = (0.5)2x15+2x0.5x0.5x(-10)+ (0.5)2x15
= 2.5.

Var[aX ] = a 2Var[ X ]
25

Variance formulas

Variance and covariance

Exercise3. (Ref. G&T p16-18)

X and Y are stock returns of companies A and B so they are random. It is known that
means of X and Y are 10% and 20% respectively, and standard deviations are 20% and
40%, respectively. Moreover, the correlation coefficient between X and Y is 0.4.
If one mixes X and Y by fifty-fifty, what is the standard deviation of his portfolio?

Exercise4. Guess the formula forVar[ w1 X 1 + w2 X 2 + w3 X 3 ] .

(Express it in terms of variances and covariances of X 1 , X 2 , X 3 . )

26

Variance formulas

Variance and covariance

More generally,

Var[ w1 X 1 + + wn X n ] =

2
w
i Var[ X i ] + 2wi w j Cov( X i , X j ).

i =1,..., n

i< j

All combinations of i
and j such that i < j

With this formula, as long as you know all the variances and
covariances of Xs, you can compute the variance of any linear
combination given ws.
With a little knowledge of matrix algebra, this computation
becomes a lot clearer.

Math revision: Summation notation ()

http://www.youtube.com/watch?v=8i9-9zHbW6g

28

Variance and covariance

Variance formula in the matrix form

If the variance-covariance matrix of X 1 , X 2 , X n is given by an n by n
(symmetric) matrix V, then the variance of a linear combination of Xs is
given by:

1xn

nxn nx1

w1

Var[ w1 X 1 + + wn X n ] = ( w1 wn )V
w
n
1x1

where

w1

w2
w

w
n

= wVw
.
Matrix addition and transpose
http://www.youtube.com/watch?v=U74zP3BsAbM

Matrix multiplication
http://www.youtube.com/watch?v=kuixY2bCc_0
29

Variance and covariance

Variance formula in the matrix form

EX) Suppose that the variance-covariance
131 46 27

matrix of X 1 , X 2 , X 3 is given by V = 46 58 15 .
27 15 24

Then Var[0.2 X 1 + 0.5 X 2 + 0.3 X 3 ]

131 46 27 0.2

= (0.2 0.5 0.3) 46 58 15 0.5
27 15 24 0.3

131 0.2 + 46 0.5 + 27 0.3

= (0.2 0.5 0.3) 46 0.2 + 58 0.5 + 15 0.3

27 0.2 + 15 0.5 + 24 0.3

57.3

= (0.2 0.5 0.3) 42.7

20.1

= 0.2 57.3 + 0.5 42.7 + 0.3 20.1 = 38.84

30

Exercise 5. There are three random variables X1, X2, and X3.
Their means are given by = (3.5, 4.5, 7.5).
Their standard deviations are given by = (2, 4, 8)
The correlation matrix is given by 1 0.53 0.48 .

0.53 1 0.39
0.48 0.39 1
(1) Find the variance-covariance matrix.

(2) What is the expectation and variance of 0.2X1 + 0.5X2 + 0.3X3? What is the
standard deviation?

31

Variance and covariance

Portfolio choice problem

Suppose there are n assets available.
P t +1 + D t +1
1 ) of each asset is random.
t
The return ( R
P
t

Suppose that by experience one knows the expectations and variance-covariance

matrix of the returns of the n assets.

( 1 , 2 , , n )

11 1n

nn
n1

One can choose her own portfolio:

w ( w1 , w2 , , wn )

subject to

w
i =1

=1
33

Portfolio choice problem

1.

Set the minimal acceptable expected return on the portfolio and minimise its
variance:

min wVw

s.t.

w 10%
n

i =1

2.

A number you
can choose.

Set the maximal acceptable variance on the portfolio return and maximise its
expected return:
wVw (30%) 2

max w
w

3.

=1

s.t.

w
i =1

=1

Maximise the combination of the portfolio return and variance:

n
1
s.t. wi = 1
max w wVw
w
i =1
2
A number you

can choose.

34

Portfolio optimisation by MS Excel

Matrix algebra in MS Excel
Naming a range of cells
Select a range of cells and directly type in the name bar.
To unname the range, go to Formula Name manager

Matrix operation functions

= TRANSPOSE(range name)
= MMULT(range name 1, range name 2)
= MINVERSE(range name)

To use matrix operation functions, first type a function in a single

cell and press enter. Then select the whole range for the output,
click on the function bar, and press Ctr+Shft+Entr.

Solver with Excel

http://www.youtube.com/watch?v=uQU1KfsE5us
35

Adding Solver to Excel

First, you have to add Solver to Excel.
From the Excel main menu, go to

Excel Options Add-Ins Solver Add-Ins

and click Go.
In the list that appears, check Solver Add-In and click OK.
Now under the Data tab, you can use Solver.
The demonstration is provided in the class.

36

Risk diversification by insurance companies

Proposition

If X 1 ,, X n are independently and identically distributed (IID)

with a common mean and std. , then the average has

X ++ X n
the same mean and, its std. is
.
X 1
n
SMALL!!

Proof) In our variance formula, all the covariance terms are zero due
to independence. Therefore,
2

X 1 + + X n
Var
.
=
n

EX) The average of 100 dice. (For one die, E[X1]=3.5 and =1.71)
37

Insurance
What is risk of an asset or a project?
1. variance or standard deviation of its return
2. how its return is correlated with your own income
3. the probability of very bad events

People are willing to buy an insurance even if the premium is more

expensive than the expected payoff of the insurance plan.
For insurance to work well, outcomes of people should be IID from
one another.
Works well for car accident, illness, fire, etc.
Why is it that for earthquake insurances, the premium is higher and insurance
payment is lower than for normal fire insurances?
Why is it that house insurances typically exclude damages caused by
earthquakes, hurricanes, floods, wars, terrorisms, etc?

38

Two types of risk

Idiosyncratic risk/shock
Risk that people face which is independent of one another.
Examples are non-epidemic disease, regular fire, car accident,
unemployment for personal reasons, etc.
Such risks can be diversified out so insurance works very well.

Aggregate risk/shock
The common risk that affect many people altogether.
Examples are natural disasters, wars, pandemic disease,
economic recessions, financial crises, etc.
Such risks are hard to diversify out and insurance does not work
well.

Firms and hence their stock returns suffer both

idiosyncratic and aggregate risks.
39