Economics of Money and Banking

Bibliography: Stigum, Money Market.

Economists: Young, Hansen, Shaw, Minsky, Bagehot, Hawtrey, Sayers, Goodhart.

Gold is outside money, is an asset that is no ones liability.

The point is that there is a time where scarcity is the issue and another point where
elasticity is. When you have booms there is confidence so credit and currency are
assumed the same, when there is a crisis people are reluctant to accept credit they
want the currency.

Emision de Bonos por parte del Gobierno

Gobierno
Activo: + Depositos (G)
Pasivo: Bonos (Deuda)
Privados
Activo: -Depositos (P), + Bonos
Sector Bancario
Pasivo: +Depositos (P), - Depositos (G)
Lecture 4 The Money View, Micro and Macro
Every transaction can be captured as a simultaneous 4-part entry (at least) in this
system of accounts. This set of accounts differs from the T-accounts of last lecture
in that all entries are flows, not stocks.
Two rules structure the accounts:
Rule 1: For each agent, every use has a corresponding source, and vice versa.
Rule 2: Each agents use is some other agents source, and vice versa
The pattern of cash inflows and commitments its what determines the interest rate.
Financial Liabilities are the accumulation of the past commitments while financial
assets are the accumulation of the flows. Two economies could have the same
amount of financial assets and liabilities but a different time pattern. An Economy
then could be solvent but illiquid because of the time pattern.
Lecture 5: The Central Bank as a Clearing House
The elasticity in the whole sale money market is what provides the elasticity in the
retail market

Lecture 6: Federal Funds, Final Settlement

Fed Funds are assets and liabilities of the bank. Intra bank credit. The interest rate
is a market price, consequence of the several banks that borrow and lend. How do
the Fed manipulate the rate? By manipulating the reserves by entering other
markets like the repo market for instance trying to anticipate the imbalances in the
intra bank credit system. In this way the Fed tries to change the underlying quantity
of reserves that people are borrowing and selling to manipulate the need for this
credit expansion. How does it do it? By making overnight loans to Security Dealers
that create additional reserves. The Security Dealers give securities as their
collateral.
Lecture 7: Repos, Postponing Settlement
Collateralized over-night loan or for term. What makes it special is that it is
simultaneous purchase and sell of a security. A person that is borrowing money
(loan) is selling a security and is promising on re-buying the security tomorrow. Is a
very heterogeneous market where the Security Dealer makes it homogenous as it is
a reference.
Then you have to negotiate on one side the collateral and on the other what interest
rate is the loan going to pay.
The Fed has been buying bonds from the Security Dealers (Operation Twist) and
selling bills distorting the market and that explains the difference in the price in the
market, where repos now have a higher price. The Security dealers are lending at a
high term (they have term repos in their asset) and borrowing short term (they have
overnight loans in their liability). A problem that could arise is lets say that you are
lending x value of your assets by financing it through repos which you have to pay
2%. If that hair cut rises you would have to sell your securities lowering their price.
Repos add reserves to the system (Fed being the lender) reverse take reserves out
(Fed being the borrower).
Case 1
The Fed makes repo with the dealer. The dealer deposits the reserves in the bank. If
the bank doesnt want reserves maybe it goes to the Fed Funds market and lends
them and in this way influences the Fed funds rate.
Bank
+reserves
+deposits

Dealer
+deposits
+repo loan

+ repo
loan

Fed
+reserves

Repos are the cheapest way of financing so you go and finance the buying of
securities through repos. If you need more money you have to go to Fed funds
market and here it is where the discipline part plays a role. However the Fed wants
to lower the price of FF rate and by making this it favors the arbitrage, the RP rate
keeps high and doesnt follow the FF as people need liquidity.
Lecture 8 Eurodollars, Parallel Settlement

Volcker Rule: It enables a client to hedge with a CDS, it makes the bank to hedge
against this issuance of insurance as well but it doesnt let you to speculate against
it saying that the credit is going to default (this is called proprietary trading). Ringfencing on the other side is that retail loans and retail deposits have to be backed
up by a specific capital, it protects, fences this retail operations.
LIBOR- Overnight Index Swap (term Fed Funds) = 0 (in normal times)
The Euro-Dollar market it is a market outside United Stated and is similar to the Fed
Funds market but it differs that in this case there is a dealer, the Eurodollar system
acting as an intermediate. As the FF market the loans have no collateral. What
happens in this market is not part of the USA base money. The reason for the
Eurodollar market to exist is that foreign banks have customers who wish to hold
dollar balances or take out dollar loans from them. This customer-led demand
causes some of the banks to have a natural surplus position (more dollar deposits
than loans) and other banks to have a natural deficit position (more dollar loans
than deposits). The banks do business with each other, with surplus banks lending
to deficit banks, and the rate charged in this interbank market is the London
Interbank Offer Rate, or LIBOR.
In the Euro Dollar market the reserves that the Banks hold are not held in the Fed,
they are held at a bank in let`s say NY. The EU banks of course cannot borrow at the
FF market or get help from the Fed so they have to be more careful.
To try to match up the timing of the inflows and outflows they do something called
Forward Rate Agreements. When there is a difference in the maturity of my deposits
and my loans to cover yourself you use FRA. The loan from one bank to the other is
made at rate F% which is:
Uncovered Interest Rate Parity

[ 1+ R ( 0,2 ) ][ 1+ F ( 0,5 ) ] =[1+ R ( 0,5 ) ]

Another example might be the one of Forward Parity Exchange Rate where your
loans and your deposits are in a different currency so to match this you take a loan
of one currency and you deposit the other currency.
Lecture 9: The World that Bagehot Knew
A raise in the discount rate (you bring a bill and you take notes, what is the implicit
discount rate in that transaction) discourages this type of transactions, while a
decrease in the discount rate increases the incentives for this transaction.
Then there it exists another market where banks transact the bills at a rediscount
rate.
Usually the rate of the Central Bank is above the market rate of interest. When
banks dont want to give notes (interest rate raises and meets bank rate) people go
to the Central Bank. This is in Bagehots time. This is the origin of monetary policy.
The Bank started to raise and lower the bank rate. Land freely but a high rate you
assure that there is not going to be a problem of liquidity and when banks lower the

market rate they are going to repay you and at the same time you impose some
discipline in the market with the high rates.
Lecture 10: Dealers and Liquid Security Markets
Asymmetric Credit Growth in Europe
The countries in the periphery (Italy, Spain, Portugal, and Ireland) are losing
deposits, as people move their deposits in these countries to Core countries that
seem to be stronger. In this way the banks in the periphery lose financing in their
assets and started selling securities, loans and raising capital to balance their
balance sheet. In this way their deleveraging reduced (liabilities/capital).
Economics of the dealer function: the Treynor Model
Volatility: If the volatility of an asset is high, then the risk of holding it is high. In
this case the spread is a form of insurance when you say, I buy this asset as long as
I can sell it at this other price.
Adverse Selection: If I am already holding securities (someone sold them to me) I
might be afraid that there is an asymmetry of information so I am going to still buy
as long as the price to buy is lower.
The price of the asset doesnt have to be related with their fundamentals but with
the position of the dealer regarding inventories. The fundamental value could be
seen when the dealer is at zero at the inventory line (long=short)
Book: Trading and Exchanges (Larry Harris)
Real Dealers
Competition among dealers forces them to offer a very tight inside spread, realizing
a very small profit on any trade. They compensate for this with leverage, i.e. by
reducing cash inventories to a minimum and relying instead on borrowing (which
are backed by collateral, securities). The difference between this model and the
perfect market model is that liquidity is not a free good and is offered by the dealers
to make a profit.
Lecture 11: Banks and the Market for Liquidity
Nowadays the excess reserves pay interest rate (0.25%), this is the floor. And they
are establishing a ceiling too, the discount rate to banks at 0.75%, the FF rate
cannot go over that.
The Fed as a way of holding the FF rate issued Treasury repos to the banks, the
banks were financing themselves through the FF pressuring the FF rate to increase.
This are called temporary open market operations. The Fed buys the repos at the
same time from a Dealer.
Lecture 12: Lender/Dealer of Last Resort
Book: Ralph Hawtrey: The Art of Central Banking.
Monetary Transmission Mechanism

The Fed controls money, which is its liability to manage elasticity and discipline.
Then the market establishes prices within credit. In the interest rate perspective the
Fed manipulates the overnight funds rate and the market establishes longer term
interest rates. The main policy variable that Fed has been more or less explicitly
targeting since 1987 is the Fed funds rate.
If the Fed moves the FF rate around what it does is it shifts the discount rate up
because that is a spread above, and it shifts the overnight rate up because it is a
spread below. If it raises the FF rate that narrows the gap between the FF rate and
the term rate which the bank dealers are not happy with so they raise the term rate
making funding more expensive so bond dealers dont want to hold too much
inventory putting down pressure on bond prices (assets). And this down pressure on
assets influences loans. Transmission mechanism from the overnight FF rate to the
term interest rate, to asset prices.
What moves the prices is not lending or borrowing is arbitrage in securities
markets.
Anatomy of a normal crisis
There is a change in house holds preference which makes them want to hold
deposits instead of securities. They sell the securities to the dealer which finances
this buying of the securities with a repo from a bank. The bank at the same time is
receiving funding from the households which are depositing money in the bank as
a consequence of their change in preference. The dealer like the bank are
motivated by profit reasons and make a profit in the spread. The price which the
dealer buys the security is lower, the interest rate on the repo from the bank to the
dealer is higher, etc.
Anatomy of a serious crisis
In the previous case we saw a small shock. But what happens if it is a big shock? In
this case the Fed comes into play by providing discount rates to the Banks that are
providing the repos, increasing their reserves holdings. In short, the Fed is taking on
the liquidity risk of the banks as repos are short term while deposits are long-term
by going short on reserves, but it cannot go into trouble because is the ultimate
money (at least domestically). In this way we see an expansion in the balance sheet
of the dealers, of the banks and of the Fed.
Should the Fed intervene or not?
In favor: prices are becoming so distorted that makes people to make wrong
economic decisions. As asset prices are falling people that have those assets are
incapable of using them as collateral, therefore they dump them and the whole
thing becomes a liquid downward spiral.
The value-based investors (those investors who wait for the assets to hit a minimum
level in order to buy them) didnt do it or they did it and lost money or they are
waiting too much, for the price to be too low. Therefore in this way the Fed acted as
a lender of last resort in the money market.

Against: We have to consider the question: What is whats causing the movement in
the interest rates? It is a sort of mismatch between cash inflows and outflows. If you
dont let these rates move (by intervening) what are the incentives for them not to
continue being irresponsible?
The Fed as Dealer of Last Resort: 2007-2009
Before Bear Stearns, the Fed was just moving the FF rate, making it more profitable
for banks to take liquidity risk, supporting asset prices indirectly (through repos).
After it failed it was not enough and starting selling treasury bills to lend the
proceeds to brokers and dealers. After Lehman they expanded their balance sheet
and lent, the inter bankin market broke down and the Fed became the inter bank
market
So the crisis started as a normal crisis where Money Market Mutual Funds started
worrying about the value of the underlying asset of residential mortgage backed
securities. So Citi SIV when ABCP matured they cut them off and replaced them with
a loan of Citi Bank. Citi Bank believed that RMBS were very good securities so will
give you a loan and we will fun this loan with a repo from the MMMF. Still the RMBS
is the collateral for the RP that the MMF delivered Citi Bank. But then Citi Bank
started to worry a little bit more about the underlying asset and instead of financing
with a RP (which collateral is the RMBS) I want Commercial Paper from you, that is a
liability that is not secured . Another way of financing was Euro-dollar system as
MMMF also invest in paper that is issued by European banks.
We have to consider that the banks are backed up by the Fed and the FDIC (Federal
Deposit Insurance Corporation) while the SIVs are not. It was worse for the
European banks as they do not have the back up that the domestic banks have. As
this was the case the MMF didnt want to give any more loans to this European
banks and this is where the Fed stepped in and what they did was liquidity swaps
with foreign central banks and the Treasury got involved so the MMMF could replace
all the funding that it was providing (RP, CP, Euro-dollar) with Treasury bills. The
Treasury had deposits at the Fed and they issued Treasury Bills on the other side. So
the point was to give MMMF what they wanted, Treasury Bills and that the european
banks got the dollars they needed which was channeled through Central Bank
channels as money markets were closed down Therefore the banks that before
were being financed by CP, RP, Euro-dollar were being now financed by loans from
the European Central Bank.
The reason because the Fed can put a floor on the system is that its own liabilities
are the best money in the system.
Lecture 13: Chartallism, Metallism and Key Currencies
Reserves (Currency)- Fed Funds (promises to pay reserves)- Eurodollar (international
dollar, promises to pay accounts in NY)
Chartalism and Mettalism
Chartalism: Fiat currency, has to do with the State stamp. Kings money, taxes

Metallism: the source of value is its metal, gold. Private market oriented theory.
International trade money.
Book: Fernand Braudel The Wheels of Commerce.
From a chartalist view, the government monopolizes the cheapest source of finance
in the nation by monopolizing the issue of currency. Fill in the blanks to illustrate this
effect.
Treasury
Assets

Liabilities
T.bills 5%

Assets

Central Bank
Liabilities
Currency 0%

The Money View emphasizes that the exchange rate is the relationship of money in
terms of money.
Hybridity in FX Market-making
The relationship between the profit making FX dealers and the Public Welfare
seeking Central Bank.
Lecture 14: Money and the State, International
In the case of the IMF the quantity of reserves are fixed. Member countries make a
loan to the IMF and then they can withdraw SDR but these cannot be artificially
increased. In the case that you are out of the SDR you can borrow moneey but you
are going to be charged an interest rate.
Bretton Woods: Gold + SDR- Dollar (pegged to the gold, fix rate)- franc, pound, etc
The USA acted as a bank lending to the other countries and getting an interest for
that loan. IMF was not going to expand the reserves so the USA by expanding the
dollar was creating some elasticity. But while the dollar was expanding the gold and
the SDR were not, what is unsustainable. Therefore in 1967 the USA goes out of the
gold standard.
1972-1999: Flexible Exchange Rate. Period of great inflation and unemployment:
Stagnlation. There is no discipline in any Central Bank. As a consequence they
impose on themselves discipline with inflation targeting and monetary policy. What
happened was a lot of private companies speculating with the changing prices of
the FX where they borrowed at a coin and lended at another one which created a lot
of volatility.
Global Financial Crisis, Limits of Central Bank Cooperation
The Shadow Banks principally in Europe were buying Residential Mortgage Back
Securities (RMBS) and were funding them in the international dollar markets (MM
funding), so they are borrowing short term and lending long term. The source of this
funding was MMMF which at the same time were being financed by shares (kind of
deposits) to non-US citizens usually. Then here we see a lending and borrowing in
dollars but outside the U.S. The crisis in the U.S made that the MMMF demanded

their loans back but the Shadow Bank doesnt have an alternative way of financing
in dollars so it goes to its own Central Bank. The ECB gets the dollars from the Fed.
The Fed makes a SWAP, dollar deposit for euro deposit. The Fed gets funded with
deposits from the Treasury who at the same time lends Treasury Bills to the MMMF
markets. The Treasury acted as an intermediary as the MMMF cannot have deposits
at the Fed as it is not American.
All this is a holding action for preventing the Shadow Banking from selling the RMBS
and collapsing the market. What happends eventually is that the Fed ends buying
them so all of this is a transitory solution until a more permanent one is found (Fed
buying the RMBS). This reversal is worrying as it is not good for growth. Countries
debate if they should do monetary policy or fiscal policy which could end in more
indebtness and more crisis.
Lecture 15: Banks and Global Liquidity
With the Gold Standard
The Dealers aks for better exchange rate once the country that is asking runs a
greater deficit, it buys the dollars cheaper speculating that is going to be able to sell
them at a higher price. The floor is the Central Bank of the Deficit country willing to
exchange dollars for gold at a certain fixed rate, for then exchange the gold into
notes. As the domestic currency is the Central Bank liabilities the Central Bank by
buying domestic currency for gold is shrinking the asset and the liability side of the
balance sheet. (We are in 1873) There is a limit regarding that there is a fix quantity
of reserves. Another option would be to sell Treasury bills for reserves. By selling the
T bills you are pushing the price of it down, thus raising interests. The third
additional possibility would be to borrow them from another Central Bank.
On the surplus side, the country is receiving notes and wanting to change them for
gold, so at their Central Bank they are buying Notes and selling gold. Lets
remember that their currency is the note as it is the highest in the ranking and it is
the promise to lend gold. So in this case we also see a shrinking of its balance sheet
as notes would be in the liability side. An option for he Bank of England to not get
out of gold is to raise the discount rate at which it gives out the gold. The third
option is to suspend payments
Lecture 16: Foreign Exchange
The FX Dealers hedge in the future (term) market the reverse of the operation to be
covered in case of a movement in the exchange rate. Who do they hedge with?
Speculators.
The speculators speculates between the future price today and the spot rate at
maturity.
The FX Dealer cover the price risk by hedging but it is exposed to liquidity risk as it
has dollar spot in his liability side and future dollar in his asset side. The larger his
liquidity risk exposure is the larger he would want the spreads to be. IN this way the
future rate is higher than the one you would expect from the expectations

hypothesis. This contradicts the uncovered interest parity cause if this relationship
would work dealers wouldnt make any profit in the market.
FX Dealers
+ 10$ FX (Local Currency)
+ 10 US$ Future
+10 FX Future

+ 10 US$ Spot
+ 10 FX Future
+10 US$ Future

Yellow = Speculative Dealer.

Central Bank as a FX Dealer of Last Resort
The Deficit Country borrows from the Surplus Country and then sells the dollars to
its citizens. The Surplus country is expanding its balance sheet as the Deficit
Country is making a deposit in the surplus country with the dollars for the payment.
The Surplus Country can then sterilize this with a Treasury Bill lets say. The Deficit
Country what is doing is borrowing term (dollars) and then havin as an asset spot FX
currency (as it is selling the dollars that has borrowed).
What the Central Bank is doing is preventing the future FX rate to be distorted by
the profit maximization that is related with the liquidity risk of the FX dealer. This is
an argument of why sometimes FX intervention might be efficiency improving.
A lot has to do with the hierarchy of money, if you re below as it is a less liquid
market the spreads might be bigger and the intervention might be needed while if it
is a more liquid market then this might not be necessary.
Lecture 17: Direct and Indirect Finance
Shadow Bankin refers to the money market funding of capital market lending.
Indirect finance (bank acting as an intermediary) solves mismatches regarding
people wanting liquid assets (deposits) and business needing long-term loans. In
direct finance this doesnt exist, it passes through. Indirect finance solves
mismatches with quantities, deposits are going to be much bigger in quantity than
the loans while direct finance solves this with prices. This exact same thing that
happened in financial markets happened in money markets with the shadow
banking replacing the traditional banking system.
Lecture 18: Forwards and Futures
What we are locking up here is a 3 month loan 3 months from now. And the rate is
fixed by the forward interest parity. You are fixing the rate of the loan which you are
getting 3 months from now today. This is settled by counter party transactions of a
firm that wants to make a deposit 3 months from now at the bank. All this hedge
transactions make sense if the forward rate is larger than the spot interest rate in 3
months. If the bank doesnt find people, banks, funds from both sides then the
futures come into the scenario.
Forwards (3,6)>Futures >Expected Rate (3,6)

The difference between a forward and a future is cash flow. A forward doesnt
provoke any cash flow rather than at maturity. Futures are marked to market and
generate cash flows every day.
Then to sum up what usually happends is that banks are long in forwards so they
dont face a price risk. They do face liquidity risk as future are paid day by day but
as they are a bank and they have lots sources of finance this advantage is what
enables the bank to face liquidity risk
Cash + Carry Explained as Liquidity Risk
Example: You buy a 6 months Treasury bill and you finance it through a 3 months
repo. We are facing some price risk because after 3 months the bond is going to be
a 3 months Treasury Bill and is going to have some value and it would be higher or
lower than what we have to pay regarding the repo. You could cover by doing a
short futures position so that in the case that the Treasury bill falls in value you win.
This represents a position where you hold long position of forwards (why?) and short
position of futures. Then you probably would have positive cash flows at maturity T
regarding the forward and negative cash flows now regarding the future which
implies liquidity risk.
Cash + Carry Explained as Counterparty risk
There is more credit risk with the forward as there is only one big payment while
with the futures there are multiple payments. Could be
Lecture 19: Interest Rate Swaps
Swap curve usually is above the yield curve.
What is a Swap? Example: You have bank AA and bank BBB. Bank AA is being
financed by a long-term loan while bank BBB is being financed by a shorter loan and
in some way they want to change their finance profile. In this way there is a swap of
IOUs. So an interest rate swap is this matching so you can change your financing
profile

Fixed rate

Bank AA
Fixed rate borrowing bond
3 months Libor

Bank BBB
3 months Libor
3 months Libor
Fixed rate loan

Every time you hear the word swap there is a parallel loan going on. In real life
there is no a parallel loan they net the payments and there is no principal loan there
so it doesnt show in your balance sheet, there is no increase leverage (as liabilities
increased), is like off balance sheet but never the less it has the same structure.
Bank AA is the seller of the swap (it is always regarding the fixed rate loan,
therefore the swap rate is of the fixed rate) or short swap or Payer of Floating
(because its paying Libor which is a float rate). Bank BBB is the buyer of the swap,
long swap and they are paying fix. From Bank AA perspective an Interest Rate Swap
is like owning a bond and financing it in the Repo market, a long-term loan financed
by a short-term financing.

In an another way is like a forward contract with a long term loan a 3 month deposit
on the other side. What Stigum says is this is like a portfolio of forward contracts
cause you have a payments dates every six months, an each one of this payments
it is a forward contract. Lets remember that the fixed rate loan can have maturities
of 1 year, 1.5 years, 5 years, etc while the Libor is a one-time thing.
Why Swap?
Term loan, floating rate
6 month Libor + 1/4
6 month Libor + 1/8

BBB
AA

5 year, fixed Eurobond

5.85
5.375

The difference regarding the term loan is 12.5 basis points while the difference in
the 5 year, fixed Eurobond is 47.5 basis points. You have a difference 35 b.p to
work with.
Bank AA
Fixed rate borrowing
bond (5.375)
Fixed rate
(5.5)

3 months Libor

Bank BBB
Flexible Rate borrowing
(6m. Libor +1/4)
6 months
Libor

Fixed rate (5.5)

Bank BB= pays 5.5 from the fixed rate funding and the Libor doesnt match up (6
months vs 6 months +1/4)= 5.50 + 0.25=5.75 which is 10 b.p less compared to
the 5.85 rate to what they could find fixed long-term financing.
Bank AA= Gets 0.125 from the fixed rate lending and borrowing so it is as if they
got Libor -1/8. (1/8=0.125)= 0.25 b.p from the swap
There is certain exposure of BBB from the flexible rate borrowing. If instead of Libor
+ is Libor + 1 then they are not hedge against this new scenario. The credit risk
involved in a swap is much lower than in a parallel loan cause if they stop paying ou
you stop paying them. There is no principal loan involved.
The interest swaps exist cause there are some market imperfections, for example
some business getting lower funding. It could be that the bond market is very
immature so they could borrow short and then swap to borrow long until their bond
market becomes perfected and liquid.
Market Making in Swaps
As there are 35 b.p to work with in the previous example, a Private Dealer could
enter the scenario and say hey I would be the dealer and just get 2 b.p for the
transaction.
Bank AA
Swap

Dealer
Swap AA
Swap BBB

Bank BBB
Swap

The Dealer charges different bids for the Swaps and there it is the profit. The Swap
yield curve comes from this activity
Money Market Swaps, example
AA
1 yr
deposit

Morgan
1 yr
deposit
3 mo Libor

3 mo Libor

Swap 4.44

Swap 4.44
1 yr

LBO
1 yr

3 mo
Swap 4.47

3 mo
Swap 4.47

3 mo
(floating)
1 yr

Morgan was the dealer and swapped with AA. LBO had a 3 months deposit and
wanted to swap as well 1 year and 3 months. It may seem as if Morgan was losing
money, but the Swap for 4.47 is the loan for 1 yr to LBO, while the Swap for 4.44
is the borrowing of 1 yr from AA, so it is making a profit of 3 b.p. The 3 months Libor
in Morgan cancel out.
Life in Arbitrage Land
The chain of hedging and money market swaps ends up in the future market where
people are hedging price risk and what they are taking is liquidity risk in the futures
market. As we saw before there could be a possibility for arbitrage as the Swap yield
curve is below the Treasury yield curve. So why people not borrow short and buy
Treasury bills and then go to the Swap market? There is no credit risk as you are
buying Treasury Bills but there is liquidity risk.

Lecture 20: Credit Default Swaps

Risk free security= risky security (corporate bond)+ interest hedge (interest rate
swaps) + credit hedge (credit default swaps)
What is a Credit Default Swap?
Buyer of insurance= long swap, short credit risk
Seller of Insurance= short swap, long credit risk
Buyer of Insurance
Corporate Bond
Treasury Bond
Corporate Bond
T Bill
T Bond

Credit Default Swap: The Treasury Bond is the same maturity as the Corporate Bond
so the only thing that you are doing is hedging is the credit risk.
Interest Rate Swap
If you wrote it as a Swap it would go on the asset side as on one hand is long
swapand short credit risk cause the credit risk would be Corporate Bond as
originally you are long in Corporate Bond. Whenever we are talking about a hedge
we think of that of a contingent asset. In the case of a Seller of Insurance it would
be the exact opposite way.
Corporate Bond
Corporate Bond: They have a coupon and promise to pay a fixed payment in a
certain period of time and at maturity they pay the principle.

Price of Bond= t Ct + T F T
1

Where Ct are the coupons and = 1+ R

and Ft is the face value that you pay at

maturity. Different bonds may pay different spreads for a given rating, so interest
rate changes and that might be a reason for the difference in the price. Another
reason may be the change in the rating of a bond which also affects R.
CDS Pricing
Example: Bond that pays a constant coupon for 10 years and supposes that we buy
an IRS in which one side pays fix and the other pays LIBOR.

A
Bond
Libor

L
Libor + u%

It pays Libor + s% (credit spread). Libor is a like a flexible rate bench-mark so we

put a s% over that.
One side of the CDS is going to pay Libor * Face value and the other side s going to
pay Libor + u *Face value. If I am the one buying insurance then I am paying Libor
+ u so I have a negative cash flow and every period the bond doesnt default I have
to pay u*F (Libor*F- (Libor + u)*F). If the bond defaults then I holder of the CDS can
trade the defaulted bond for a Treasury bond and you earn the difference between
the price of the treasury bond and the bond whose price is F P(5) where 5 refers to
period 5 that is when the bond defaulted.

The value of the CDs fluctuates over time and it is going to fluctuate inversely to
that of the price of the bond. So the buying of the CDS is not only for insurance
against Default but also against moving prices of the bond.
Market Making in CDS
A
CDSi

Dealer Market Maker

CDS CDX
CDSi
CDSj
CDSk

Asset Manager
CDS CDX

Where CDX is a Credit Default Swap Index, a portfolio of CDS.

Example: Negative basis trade and Liquidity Risk: UBS Switzerland
UBS
CDO tranches
CDS

Money Market
funding
ABCP, Repo

CDO : A structured financial product that pools together cash flow-generating assets
and repackages this asset pool into discrete tranches that can be sold to investors.
A collateralized debt obligation (CDO) is so-called because the pooled assets such
as mortgages, bonds and loans are essentially debt obligations that serve as
collateral for the CDO.
Against this asset they bought a CDS. Then they used the CDO tranches as
collateral for buying Asset Backed Commercial Paper (ABCP) and Repo. They did
what they called Negative Basis Trading what is to say that with the transactions
they made they had profits every period until the CDO maturated. Then they
brought all the future profits of the future and put it as profits of today and pay
bonuses on these profits. But some doubts started to happen regarding the value of
the CDO where everything was okay as lets remember that CDS fluctuate inversely.
But what happened is that the falling value in the CDO caused problems in rolling
over the financing (Repo). So as they couldnt find finance they had to sell the asset,
but if you sell the asset then the price goes down. As the CDS were very expensive
then they said okay we are going to insure only if the variations is 2% but what
happened is that it was greater.
A good thing to notice is that Money Market Funds have regulations to what they
can accept as collaterals and CDS are not permitted.
Example: Private backstop of market-making in CDS
Goldman Sachs was acting as a dealer, buying CDS from AIG and selling them to
clients. Goldman Sachs however, wrote in the contract that in the case that AIGs
rating fell below AAA then they had to pay the CDS. Is not that you owe me 30
billion, you pay me 30 billion now.

Lecture 21: Shadow Banking, Central Banking and Global Finance

Most Shadow banks have bigger entities back upping them in case that they cannot
find funding or whatever. This is denominated liquidity put. The first institution
that failed Reserve Primary Fund (Money Market Fund) failed because it didnt have
an entity back stopping it. Therefore the Fed is the ultimate back stopping the
shadow banking as the Fed back stops the traditional banks.
The crisis was global cause there existed shadow banking there funded by eurodollar markets
What is Shadow Banking?
Money market lending of capital markets funding.
Regulation of systemic risk
Hawtrey (1919) Currency and Credit
Minsky (1986) Stabilizing an Unstable Economy
Adrian and Shin (2010) Liquidity and Leverage
A disequilibrium where the asset manager flows are pushing against the dealer
faster than what the shadow banking can absorb. The dealers push prices around
(interest rates would be going down, both the one to return to asset managers and
the one that shadow banking pay off because of the loan that they would be
receiving). In the case that the flow from the asset managers would be the other
way the opposite consequences would happen. So when this thing happens there is
a loser. And when the dealers because of necessity have to liquidate the Central
Bank comes to action.
Regulation of Collateral and Payment Flows
Aitken and Singh (2010) The sizable role of rehypothecation in the shadow banking
system
Minsky, survival constraint, settlement in the payment system
Private Backstop, and public
If you are a matched book leader then you need liquidity reserves, if you are a
speculative dealer then what you need is capital reserves. Focus regulations on this.
Survival constraint is not only about payment flows but it is about collateral flows.