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Bernd Scherer

Capital Markets

May 2010

Dr. Bernd Scherer

Professor of Finance, EDHEC Business School

Member of EDHEC Risk

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Prof. Dr. Bernd Scherer

Sessions

• Session 2: Bank Management and Bank Regulation

• Session 3: Capital Markets and Their Returns

• Session 4: Equity Markets

• Session 5: Futures, Options and Principal Protection

• Session 6: Fixed Income Markets and Products

• Session 7: Currency Markets and Products

• Session 8: Credit Markets and Credit Products

• Session 9: Volatility Products

• Session 10: Risk Management

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Prof. Dr. Bernd Scherer

Teaching Format

• The course will comprise a total of 30 hours split roughly into 10 sessions of

3 hours.

• The lecture notes are thought as a guidance to the literature. Lecture notes

can not replace studying the suggested literature, neither is reading the

literature a substitute for the course.

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Prof. Dr. Bernd Scherer

Course Assessment

• The exam will be a take home exam, where students have to answer a set

of questions and hand in their solutions two weeks after they received the

questions.

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Prof. Dr. Bernd Scherer

1. Financial System

– How does the financial system promote efficiency?

– Why is market valuation important in financial economics?

3. Financial Structure

– What are the basic facts of financial structure around the world?

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Prof. Dr. Bernd Scherer

Literature

Markets, Pearson

Corporate Policy, 4th edition

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Prof. Dr. Bernd Scherer

• Functions of financial markets (direct finance)

• Functions of financial intermediaries (indirect finance)

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Prof. Dr. Bernd Scherer

Financial

Intermediaries

Indirect

finance

Lenders/Savers Borrower/Spender

Financial

Households Corporates

Corporates Markets Governments

Governments Households

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Prof. Dr. Bernd Scherer

• Ultimate investors sell financial assets to savers; they use the proceeds to

buy real assets (buying real assets is the same thing as investment).

time. Examples include land, people, factories, inventions, business plans,

goodwill with consumers, reputation. Anything that generates a flow of

goods or services counts. Key point: real assets need not be tangible.

• A financial asset is a legal contract that gives its owner a claim to payments,

usually generated by a real asset. Examples include currency ($), stocks,

bonds, bank deposit, bank loans, options, futures, etc.

• The FS is the place where savers (or, more generally, economic agents with

a surplus of funds relative to their immediate need for those funds) meet

investors (or, more generally, economic agents with a deficit of funds

relative to their immediate need for those funds).

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Prof. Dr. Bernd Scherer

Transfer Economic Resources Across Time And Space

• The first goal of the financial system (FS) is to facilitate the flow of funds

from savers (entities with a surplus of funds) to investors (entities with a

deficit of funds).

• Across Time

– By a house today rather than have to wait until to the rest of your life when you

will have save all the money.

– Go to university and pay back your fees after graduation allows you to develop

skills early in life.

• Across Space

– Channel investments to places with higher marginal returns

– Example: Provide capital to Russian oil firms either via stocks and bonds (direct

finance) or bank loans (indirect finance)

key in a market economy for allowing growth!

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Prof. Dr. Bernd Scherer

Risk Sharing

– Lufthansa hedges out oil risk or Porsche its Dollar risk

– Usually people with specific skills don’t have the money and people with money

don’t have the specific skills

– Even, if they had the skills and the money would it be wise to invest all your

wealth in your own business?

– Options, CDS, CDOs

– Create complete markets where all claims could be traded at minimal costs

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Prof. Dr. Bernd Scherer

Banking, Clearing and Settlement

facilitate exchange of goods and services. Example: money, credit

cards, SWIFT transfers, etc.

– Economies of scale (standardized loan contracts, instead of everybody writnig his

own contract)

– Provide liquidity (bank accounts, checks)

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Prof. Dr. Bernd Scherer

Reducing Asymmetric Information

Often one party of a deal lacks the information to make a good decision

– How does the borrower know which are the bad risks (they will be the most keen

to get a loan)?

– How does the investor know which firms are not overvalued (those will be the

most keen to issue new equity)?

– How do creditors protect themselfes against risk shifting (asset substitution), i.e.

increasing the risks after the bond has been issued?

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Prof. Dr. Bernd Scherer

• Understand how information gets reflected in security prices

• Fair Value or Accounting Value

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Prof. Dr. Bernd Scherer

Value Maximization

their life. How can they do this?

irrespective of preferences. Example: You like oranges and hate

apples. You are offered for free a box of apples (market value of 100)

and a box of oranges (market value of 90). Which should you choose?

How do you compare apples and oranges. Answer: By price! Your

taste does not matter

information is allowed to move into prices: no short sales restrictions,

no ban on CDS , etc. What do you do if assets are not traded? Use

comparables!

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Prof. Dr. Bernd Scherer

Fisher Separation –

Production and Consumption

• Endowment: y1 y0

U2 transformation curve raises

U1 utility to higher level

depends on utility –

Impossible for manager to

make the right choice on

behalf of shareholders

y1

y0

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Prof. Dr. Bernd Scherer

Fisher Separation –

Production and Consumption with Capital Markets

increases welfare

transformed across time

U2 U 3 y

Wo = yo + ( 1+1r )

U1

• We can separate the choice of

optimal investment from

consumption preferences –

Slope:

-(1+r) • Managers don’t need to know

shareholders preferences –

they just pick projects with

highest NPV

y1

y0

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Prof. Dr. Bernd Scherer

relative pricing, not absolute pricing!

• Examples:

– Bonds: Coupon bond must equal the sum of implicit zero bonds

– Currency: If we know USD/EUR and EUR/YEN exchange rate we also know the

right value

– Capital structure arbitrage: When credit spreads move so should stock prices

– Derivatives: Option price equals value from replicating strategy

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Prof. Dr. Bernd Scherer

Rational Expectations in Financial Markets

• Explains how all relevant information gets into prices (almost

instantaneously).

• Prices in financial markets will be set such that the optimal forecast - using

all available information - equals the securities equilibrium return (investors

get a fair compensation for risk, no more).

oldest prediction markets).

Crisis is unpredictable (credit crisis!), … Does not mean markets make no

errors!

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Prof. Dr. Bernd Scherer

Rational Expectations in Financial Markets

contains no information about future changes

investors to achieve consistently superior rates of return

• Read the entrails: prices (stock / bond) impound all available information –

example: if the firm’s bonds are offering a much higher than average yield,

one can deduce that the firm is most probably in trouble

with the firm’s cash flows

• The do-it-yourself alternative: investors will not pay others for what they

can do equally well themselves (e.g. diversify, create leverage)

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Prof. Dr. Bernd Scherer

Rational Expectations in Financial Markets

What Makes Markets Efficient?

• There are many investors out there doing research. As new information

comes to market, this information is analyzed and trades are made based

on this information.

• Therefore, prices should reflect all available public information If investors

stop researching stocks, then the market will not be efficient

(GROSSMAN/STIGLITZ argument)

• Efficient markets do not mean that you can’t make money

• They do mean that, on average, you will earn a return that is appropriate

for the risk undertaken and there is not a bias in prices that can be

exploited to earn excess returns

• Market efficiency will not protect you from wrong choices if you do not

diversify – you still don’t want to put all your eggs in one basket

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Prof. Dr. Bernd Scherer

Rational Expectations in Financial Markets

• Strong Form Efficiency: Prices reflect all information, including public and

private

– If the market is strong form efficient, then investors could not earn abnormal returns

regardless of the information they possessed

– Empirical evidence indicates that markets are NOT strong form efficient and that insiders could

earn abnormal returns

– Prices reflect all publicly available information including trading information, annual reports,

press releases, etc.

– If the market is semi-strong form efficient, then investors cannot earn abnormal returns by

trading on public information

– Implies that fundamental analysis will not lead to abnormal returns

– Prices reflect all past market information such as price and volume

– If the market is weak form efficient, then investors cannot earn abnormal returns by trading on

market information

– Implies that technical analysis will not lead to abnormal returns

– Empirical evidence indicates that markets are generally weak form efficient

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Prof. Dr. Bernd Scherer

• Book value is a fantasy price that does not resemble market value nor can it

be transacted on. If all prices in an economy where accounting values

capital could not be allocated efficiently.

must be reflected, while losses on passive side must not) incorrectly

portrays hedges.

Bond of owed to Bond of owed to

company C company C company C company C

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Prof. Dr. Bernd Scherer

3. Financial Structure

• The role of asymmetric information

• Financial crisis and economic activity

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Prof. Dr. Bernd Scherer

– The US stock market only accounts for 11% of external financing between 1970

and 2000; The same applies to other countries around the world.

– Why do companies rely more on other sources?

finance their operations

– Why do companies not rely more on marketable securities

– Why are financial intermediaries so important?

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Prof. Dr. Bernd Scherer

– Bank loans are the most important source of external finance

– What are the reasons for this and why is this share declining?

5. The Financial System is the most heavily regulated part of the economy

– Why are financial markets so regulated?

markets (direct finance)

– Why do smaller firms have to recur to banks?

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Prof. Dr. Bernd Scherer

debt markets

– Why is collateral such an important feature of debt markets?

restrictions (covenants) on the borrower.

– Why are debt contract so complicated and restrictive?

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Prof. Dr. Bernd Scherer

• The Problem: Fixed transaction costs crowd out low volume business. If you

have only 1000 Euros invest you can not get diversify across international

assets, commodities, hedge funds in your portfolios. Lower income

population gets cut out! How can financial intermediaries help to reduce

TC?

– Bundling of transactions (mutual funds)

– One legal master document from the best lawyers available can be used for all

personal loans

– IT services (call centre / online banking, etc.)

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Prof. Dr. Bernd Scherer

• The original lemon paper (AKERLOF, 1970): Potential buyers of used cars can

not evaluate the true value of a car. There is asymmetric information (seller

knows the true quality of his car) .

– Buyer suspects car is bad (lemon) and offers a low price

– Lower prices crowd out the seller of good cars

– Only bad cars are on offer – market does not function

• Adverse selection costs in finance (MYERS & MAJLUF, 1984) arise because two

types of firms might raise capital

• Firms that need to finance positive-NPV projects (starting the project is good for

existing investors, new investors get required rate of return)

• Firms whose claims are overvalued (raising capital transfers wealth from new investors

to existing investors!)

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Prof. Dr. Bernd Scherer

compensation contracts) and issue claims whenever they are overvalued or a

positive-NPV project emerges

• Outside investors cannot distinguish between overvalued firms and those with

positive-NPV projects

– New investors would have, on average, a lower than required return

– Potential investors understand this, and offer to pay LESS so that the earn

their required rate of return on average

– underinvestment (positive-NPV projects are not realized because

necessary capital can only be raised at additional cost)

• The lemon problem explains why marketable securities are not the

primary source of funding (Fact #2)

• It also explains why there is a pecking order (prefer internal funds over

bonds over equity as the degree of information release is different)

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Prof. Dr. Bernd Scherer

Numerical Example

• Suppose the management knows the intrinsic value of its assets (a) as well

as the NPV of a new project (b). These values are not known to capital

markets. In order to fund the project the company needs an amount of I.

• Let P and P* be the market value of the old stockholders’ shares before and

after issuance. Note that P does not need to equal a. In fact we have argued

that companies are reluctant to finance new projects if their stocks are

undervalued P < a.

• The total value of the firm after issuance is the sum of the money raised

from new shareholders and the market value of old stockholders’ shares (I

+ P*). Note that any price drop due to adverse selection is already included

in P*.

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Prof. Dr. Bernd Scherer

Numerical Example

• Old shareholders now own only a fraction of company assets. The company

will issue new stock if the old shareholders’ participation on assets after

issuance, namely I + a + b, is larger that the 100% participation in a. The

condition for issuance becomes

equilibrium, we simply assume that a >P = P*. The company can issue

shares at P = P*. Suppose a company trades at P = 50 and can issues shares

at p* = 50. However, it knows the intrinsic value of its assets is a = 90 and it

has a positive NPV project of b = 10, which needs funding of I = 20.

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Prof. Dr. Bernd Scherer

Numerical Example

• In this setting, issuing equities is not good idea for old stockholders. While

the value of the company would eventually increase to 120 (90 + 10 + 20),

they get only a share of 71.4% (50/70), which totals 85.71.

• Not issuing equities and giving up the positive NPV project gives them 100%

in the intrinsic value of 90. The result of this form of adverse selection is

underinvestment.

raised only at additional cost.

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Prof. Dr. Bernd Scherer

etc.) sell information that identifies good and bad companies.

– Limited success due to free rider problem (copy other peoples action without

paying for the information)

– Does not always work well (see ENRON)

– (Allow insider trading)

• C. Financial intermediation

• Banks build expertise in evaluating good and bad firms, acquire funds from

depositors and start lending to good firms.

• Similar model for cars (used car dealership, guarantees on used cars, BMW sells

used BMWs)

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Prof. Dr. Bernd Scherer

– Financial intermediaries produce private information that they can directly profit from

– Banking market needs competition!

– Large established firms go to markets (as there is already a lot of information on

them) while small firms go to banks

• D. Collateral

– Collateral (positive equity) protects the lender in times of default.

– Example: Mortgage market

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Prof. Dr. Bernd Scherer

• Definition: Engage in activities that are undesirable for the purchaser of the

issued security

– Bondholders are hurt if management increases business risks.

– This helps shareholders and hurts bondholders. Why?

monitoring costs)

• Venture capital: manager and owner are the same person, solves

defrauding equity investors, but what about bondholders?

• Debt Contracts

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Prof. Dr. Bernd Scherer

• Collateralization

• Covenants

– Discourage undesirable behaviour (loan money must only be used for particular

project, business risk must remain the same)

– Encourage desirable behaviour (no further leverage allowed, no external funding

of pension plans)

– Keep collateral value (required maintenance until loan is paid off)

– Information provision

management) that can only be mitigated.

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Prof. Dr. Bernd Scherer

Liquidity

• Liquid assets are more valuable than illiquid assets. If you buy an illiquid asset and

transform into a liquid assets you made a profit!

• Information is the key to liquidity. If the owner knows more than the buyer he will

have difficulties to sell at a fair price. Result: adverse selection.

– Provide information to increase liquidity: detailed prospectus, rating

– Share losses: own stake, reputation loss

– Split asset into two assets: one safe and therefore liquid and one illiquid and

highly risky assets.

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Prof. Dr. Bernd Scherer

Conflicts of Interest

cost of information production for each service by applying on resource to

all services)

– However, this comes at a cost: conflicts of interest: which product to sell? Best

advice or highest profit?

– Reduction in the quality of information in financial markets increases asymmetric

information problems and hence stops financial markets to work!

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Prof. Dr. Bernd Scherer

– Investment banks sell research (evaluate prospects of a company) on companies

as well as underwriting (buy stocks from company to sell it to the market) equity

issuance

– Where do you make more money from? How independent is research? How

much arm twisting is going on?

– Do auditors skew their opinions to win consulting business?

– Do auditors pass inside information to consulting unit?

– Do auditors criticize the systems created by their own consulting unit?

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Prof. Dr. Bernd Scherer

selection and moral hazard.

– Developing / ex-communist countries lack the legal system and efficient bankruptcy

procedures

– This increases TC (information costs) to solve adverse selection

– Collateral can not easily be seized: moral hazard prevails

– Politically important projects get preferred conditions

– Loans for the boys,…

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Prof. Dr. Bernd Scherer

Factors Causing Crisis

– With higher rates the good risks are crowded out while the bad risks will still want to borrow.

The resulting adverse selection will make it unattractive to provide loans. Aggregate activity

falls.

• Increase in Uncertainty

– Stock market crash, bank failure makes it more difficult to identify the good borroers. Credit

market freezes

• Deterioration of Balance Sheets

– Deterioration in collateral

• Banking Sector Deterioration of Balance Sheets

– Increases adverse selection and moral hazard

• Government Imbalances

– Capital flight, black economy …

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Prof. Dr. Bernd Scherer

Depository Institutions

• Key function: asset transformation: transform low liquidity left side of balance sheet

(assets) into high liquidity right side (deposits)

– Deposit insurance

– State guarantees

– Reputation, risk management, financial capital

– Create financial assets

– Enhance liquidity

– Risk management, sharing

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Prof. Dr. Bernd Scherer

Investment Banks

primary and secondary securities markets.

• The key functions of securities firms are:

– Securities Underwriting: Marketing and distributing new issues of debt and

equity for corporations.

– Brokerage and Market Making: In market making, a securities dealer holds an

inventory of a security and stands ready to buy the security from anyone at the

bid price, and sell the security at the ask price. Other firms act strictly as brokers,

that is, agents that conduct trades on behalf of customers.

– Trading: This activity is similar to market making, although the firm may ben

engaged in speculating about the direction of price change.

– Mergers & Acquisitions (M&A): Assisting firms wanting to expand by buying

another company, or wanting to sell out to another company. This entails finding

merger partners, provide advice about deal pricing and structure, underwriting

securities to facilitate a deal, and so on.

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Prof. Dr. Bernd Scherer

Fund Management

• Mutual funds are FSF that pool the resources of individuals and firms and invest those

funds in a large, diversified portfolio of financial assets.

• Money market mutual funds, Bond funds, Stock funds, Pension funds

prospectus, to disclose their holdings at regular intervals, and are limited in the

degree of short selling that they can do.

• Hedge funds: These are pooled investment vehicles like mutual funds but they are

very lightly regulated. Hedge funds usually raise funds from wealthy investors and also

from pension funds, University endowments and state funds. They avoid most

regulations on disclosure requirements and are unrestricted in the kinds of assets that

they can hold. Also, hedge funds face no restrictions on short positions.

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Prof. Dr. Bernd Scherer

1. Bank Management

– Understand the general principles of bank management

2. Banking Regulation

– Understand the credit crisis and the current debate on bank regulation

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Prof. Dr. Bernd Scherer

Literature

Markets, Pearson

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Prof. Dr. Bernd Scherer

1. Bank Management

Assets Liabilities

Excess Reserves 90

Assets Liabilities

Loans 90

• Transform deposits into longer term loans, hold 10% cash buffer reserve

requirement. Money is created in the banking system!

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Prof. Dr. Bernd Scherer

Liquidity Management

• Hold excess liquidity reserves

Assets Liabilities

Loans 80 Bank Capital 10

Buffer Securities 10

against sale Insure

of illiquid against

assets default

• After a 10 million outflow in deposits the bank has still enough reserves (10 million >

10% x 90 million)

Assets Liabilities

Loans 80 Bank Capital 10

Securities 10

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Prof. Dr. Bernd Scherer

Liquidity Management

• What happens if reserves are not high enough? Example: 10 million reserve loss.

Assets Liabilities

Loans 90 Bank Capital 10

Securities 10

Assets Liabilities

Loans 90 Bank Capital 10

Securities 10

• The bank has a reserve requirement of 9 million, (10% from 90 million), but no

reserves. What can it do?

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Prof. Dr. Bernd Scherer

Assets Liabilities

Deposits 90

Required Reserves 9

Borrowing 9

Loans 90

Bank Capital 10

Securities 10

2. Sell securities. Liquidity crisis becomes a solvency crisis when assets need to be sold

on fire sales terms.

3. Borrow from the Central bank using securities as collateral (not all securities qualify!)

• Banks will hoard cash (excess reserves) when the costs of from making up

for deposit outflows are high.

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Prof. Dr. Bernd Scherer

• Avoid default

• Invest in liquid assets

• Diversify

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Prof. Dr. Bernd Scherer

• Deposits

• Ensure funding is not too volatile: Short term funding might cease in a crisis

(difficult to rollover) while long term funding is expensive.

times of market stress (for example if the issuer is a bank the condition may

be that it will convert to equity if the issuer's tier one capital falls below a

limit. The automatic conversion will then re-capitalise the bank)

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Prof. Dr. Bernd Scherer

Loans 90 Bank Capital 10 Loans 90 Bank Capital 4

Assets Liabilities Assets Liabilities

Loans 85 Bank Capital 5 Loans 85 Bank Capital -1

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Prof. Dr. Bernd Scherer

Bank Capital

net profit after taxes

ROA =

assets

• ROE (return on equity) tells us how well the owners are doing (in an

accounting sense)

net profit after taxes

ROE =

Equity

Assets

= ROA ⋅

Equity

• Lower bank capital yields higher returns for bank owners (ROE); trade-off

versus safety

• Bank need to hold capital for regulatory reasons as bank default imposes an

externality on the economy.

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Prof. Dr. Bernd Scherer

2. Banking Regulation

– Deposit Insurance

– Restrictions on bank assets

– Capital requirement

– Chartering

– Risk management

– Disclosure

– Consumer protection

– Restriction on Competition

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Prof. Dr. Bernd Scherer

banking from deposit taking

– Regulator wants to protect depositors and ensure financial stability as a prerequisite for

growth

– Regulatory capital aims at avoiding bank failure

– Imprudent banks find it difficult to attract capital and might experience runs

– Shareholders are disciplined by market forces

– Banks set their economic capital to avoid default (in most situations) as frictional

bankruptcy costs are high

– Affects allocation efficiency (shareholder need fair return)

– Regulation assumes static exposure while banks can react

– Banks can not manage systemic risks; this should be done by the central bank

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Prof. Dr. Bernd Scherer

Deposit Insurance

• Suppose a bank looks troubled. Short term finance will not get rolled over and the

creditors withdraw funds, deposits, nobody wants to trade with that bank; bank needs

to sell illiquid securities at fire-sale prices and liquidity crisis becomes solvency

problem.

information costs on banks if deposits are explicitly insured. There is no market

discipline.

• Deposit insurance also creates an adverse selection problem. Bad risks are likely too

benefit from deposit insurance so its difficult to price.

• Too big to fail (banks take on even bigger risks and morph into “too big to save”)

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Prof. Dr. Bernd Scherer

• For commercial banks a minimum capital is needed as buffer against large

unexpected losses

• Tier I capital

– Book equity (difference in liquidation value of assets and liabilities)

– Includes capital injection, retained earnings, …

• Tier II capital (supplementary capital)

– Undisclosed reserves, valuation reserves

– Subordinated debt with more than five years maturity

– Subordination means it is a buffer for depositors

– Limited to a maximum of 50% of bank capital

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Prof. Dr. Bernd Scherer

– Banks must maintain risk capital of at least 8% of risk weighted assets

– Risk weighted assets are assets weighted by a risk factor

Weights

(%) Assets

Claims on OECD banks, US

20 government Agencies

All other claims such as all

100 corporate bonds, EMD,…

• Example: 100 million AAA bonds and 100 million B bonds and 100 million US treasury bonds

amount to risk weighted assets of 200 million. For this the bank needs at least 16 million in

capital from which at least 4 million must be tier 1

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Prof. Dr. Bernd Scherer

– Loan book: not marked to market: continue with risk weightings

– Trading book: daily marked to market and for most large banks risk capital was

calculated with internal models that accounted for correlations and proprietary risk

models

– VaR is the maximum of today’s and the last 60 days trailing VaR, k is a multiplier set by

the regulator and SRC is a specific risk charge (to account for idiosyncratic risks)

• Total capital needed is now 8% on credit risk weighted assets plus market risk weighted

assets)

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Prof. Dr. Bernd Scherer

• Three Pillars

– Regulatory requirement (risk based capital charges)

– Supervisory review (expanded role for supervisors)

– Enforcing market discipline (disclosure rules, that yield to large shareholder

and depositor scrutiny)

– Incentive to come up with rating agency sponsored fake ratings

– “AAA” bonds that have yields like BBB bonds

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Prof. Dr. Bernd Scherer

independent of Rating)

– Incentive to lower credit quality to align regulatory and economic capital

more closely

in trading book where the same assets get a lower risk weighting

– Groundwork for today’s crisis

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Prof. Dr. Bernd Scherer

Why Regulation?

– Systemic risks

– Government bailout put (too big to fail)

• Deposit insurance

– Liquidity gap between assets and liabilities (sounds familiar?)

– Bank run becomes self fulfilling

– Regulation needed because of double moral hazard

– Bank side: increase the risk and put it to the deposit insurance company if bust

– Customer side: don’t check banks and simply go for highest rates

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Prof. Dr. Bernd Scherer

• The crisis started off as a solvency crisis. Falling (less strongly rising) house prices

meant that subprime borrowers could no longer borrow against rising house as a

result of rising interest rates.

– tightening standards rising foreclosures, falling value of collateral, …

Fallof Subprime Mortages, Economic Letter

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Prof. Dr. Bernd Scherer

• Investors did not know how the losses (everybody knew were there) were distributed

among banks. CDS made it difficult to figure out which banks took the hit – a massive

adverse selection problem stopped the interbank market as a source of liquidity.

House price decline

& adverse selection

Anticipation of firesales

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Prof. Dr. Bernd Scherer

• Paulson Plan – provide liquidity. Fed, ECB pumped massive liquidity into the

financial system

– Banks took the cash and hoarded it. Nobody wanted to lend to a failing

institution

• Collapse of AIG, Lehman – It became clear this was a solvency crisis, Banks

had to be recapitalized (stress test) to start lending again.

– Invest directly into banks

– Takeover failed institutions (Fannie and Freddie are US government

companies)

– Expand liability insurance

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Prof. Dr. Bernd Scherer

– Survivors enjoy oligopoly rents

– Total loss in market discipline! Moral hazard is encoraged

• Debasing of Currencies

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Prof. Dr. Bernd Scherer

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Prof. Dr. Bernd Scherer

Literature

Markets, Pearson

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Prof. Dr. Bernd Scherer

200 years ago one Euro into Equities

would (assuming a 10% return per

Stock annum) sit on 189 million Euros today

Market

With 5% return (bonds) tbis would

accumulate to 17.000 Euro instead.

This shows the advantage of equities

Real Factories Financial and the advantage of a investing

Assets Human Assets pensions into equities. The whole

Capital, etc.

society should do this.

Bond

Market • Why is this statement wrong?

– Survivor bias

– Economic leverage changes and so change

the returns on equity

• The real side and the financial side of

the economy are tightly linked.

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Prof. Dr. Bernd Scherer

Understanding Returns

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Prof. Dr. Bernd Scherer

Understanding Returns

– 1928 - 2009

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Prof. Dr. Bernd Scherer

• Given that financial assets just represents claims against real assets we can plot

financial assets against real assets to see whether the former are inflated.

Bubble

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Prof. Dr. Bernd Scherer

• Expected Productivity of Capital Goods (goods that are used to produce other goods)

– Mines, roads, canals, machinery, power stations, patents

– The higher the productivity the higher the interest rate (=slope of production function)

– Equities represent a claim on to the return on capital

– Risk premium rises

• Time Preferene

– The greater the preference for current consumption, the higher the interest rates in the economy

• Risk Aversion

– Rising risk aversion leads to a larger equity risk premium

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Prof. Dr. Bernd Scherer

P P P P

ln n = ln n n−1 ... 1

P0 Pn−1 Pn−2 P0

P P P P

= ln n + ln n−1 + ln n−2 + ⋯ + ln 1

Pn−1 Pn−2 Pn−3 P0

= rn + rn−1 + rn−2 + ⋯ + r1

Var (∑ )

r = Var ( rn ) + Var ( rn−1 ) + ⋯ + Var ( r1 )

i =1...n i

= nVar ( r )

= nσ 2

zero. In this sense we can observe volatility, which is assumed

unobservable for low frequency data (daily, weekly, ...)

• Note that the same is not true for returns!

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Prof. Dr. Bernd Scherer

Basics of Long Term Risks and the Central Limit Theorem (CLT)

• The CLT says that for independent (no autocorrelation in first or second

moment) and identically (can be non-normal as long as they have finite

variance) distributed random variables

– their sum is normal

– their product is log-normal

• If you look at diversified (little „factor risk) stock market investments over a

long period of time the distribution of log returns is likely to be close to

normal; this is not the case for short term risks on concentrated portfolios!

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Prof. Dr. Bernd Scherer

• Investors with long horizon overpay for something they dont need (receive)

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Prof. Dr. Bernd Scherer

Calculate the probability that an asset looses more than 10% in value by

year end.

– Change your return calculations from discrete to continuous returns and calculate

expected value and volatility.

– For example

P P µ = 9.71%

ln ( 1 + R ) = ln 1 + 1 − 1 = ln 1

P0 P0 σ = 19.48%

– Convert the target return of -10% in a continuos return of ln(1-10%)

– Calculate the standardised difference between continuous mean and target return

−10.54% − 9.71%

= −1.04

19.48%

– Calculate the coresponding value from the cumulative standard normal; in EXCEL: Normdist(-

1.04; 0; 1; 1)=14.9%

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Prof. Dr. Bernd Scherer

• The key to investment risk is the positive correlation with consumption; assets

that pay off well if consumption is down (your marginal utility from extra wealth is

high) should require a lower risk premium (recession hedges).

r −c

= γ ⋅ σ ( ∆c ) ⋅ corr ( ∆c, r )

σ

• This is a genral asset pricing model as we do not need the covariance of asset

returns with a market portfolio

• For realistic values of risk aversion, consumption volatility and correlation the

derived SHARPE-ratio is inconsistent (factor 100) with the observed SHARPE-ratio

– Main culprit: consumptioni too smooth: too low volatility and correlation

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Prof. Dr. Bernd Scherer

– low cost, zero to low turnover, transparent, standardised

– Represent capital marketequilibrium, (by definition)

– Poor mans CAPM, difficult to beat

– Only portfolio that we can invest into without distorting relative prices, only portfolio all investors

can invest

– Some are too narrow and underdiversified

– Inefficient

– Inclusion rules are momentum driven Momentum

– Exclusion resembles stop loss

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Prof. Dr. Bernd Scherer

– Some sharpe drawdowns are not even visible (1987) due to the annual view

Risk Premium

Stocks - T.Bills Stocks - T.Bonds

60.00%

1928-2009 7.53% 6.03%

1960-2009 5.48% 3.78% 40.00%

20.00%

Standard Error

Annual Return

Stocks - T.Bills Stocks - T.Bonds 0.00%

1928

1933

1938

1943

1948

1953

1958

1963

1968

1973

1978

1983

1988

1993

1998

2003

2008

1928-2009 2.28% 2.40%

1960-2009 2.42% 2.71% -20.00%

-40.00%

t-value

Stocks - T.Bills Stocks - T.Bonds -60.00%

Years

1928-2009 3.31 2.51

1960-2009 2.26 1.39

2000-2009 -0.24 -0.59

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Prof. Dr. Bernd Scherer

Styles

• Sorting equities on stock specific charactersitics turned out to earn superior risk

adjusted returns not explained by the market portfolio in the CAPM.

– The most popular characteristics are value and size

– FAMA/FRENCH use these portfolios to create a portfolio based asset pricing model

• Value: Bad firms (low growth, i.e. Low price to book) outperform good firms (high

growth companies)

• Although the empirical evidence is far from clear it is more likely that these return

advantages are a compensation for risk.

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Prof. Dr. Bernd Scherer

in times of economic crisis 35

30

risk

– Are value stocks just the sickest 25

puppies in the stock universe? VALUE

20

15

VALUE SIZE

(HML) (SMB)

Mean 0.403 0.237

10

Volatility 3.590 3.336

SIZE

t-value 3.558 2.249

Sharpe-ratio 0.389 0.246 5

Skewness 1.838 2.187

Kurtosis 15.557 22.233

Minimum -13.450 -16.850 0

JB-Test (p-value) 0.000 0.000 1930 1940 1950 1960 1970 1980 1990 2000

TIME

Table 1: Summary for monthly returns on investment styles, 1927 to 2009

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Prof. Dr. Bernd Scherer

• Consider the following game. One coin is beeing tossed. If it turns out head the

player doubles his initial holding and can decide to continue or stop playing. If it

turns out number the player looses everything. What is the expected value of the

game?

• The expected value of this game is infinite. However most player would offer very

little to participate in this lottery. This is called St. Petersburg Paradox.

value = exp ( z )

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Prof. Dr. Bernd Scherer

Log-Utility

• This utility function exhibits constant relative risk aversion (The optimal percentage

allocation into the risky asset remains the same whatever the level of wealth)

10

8

U til ity

4

0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000

Wealth

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Prof. Dr. Bernd Scherer

Example

• An investor with log-utility can participate into a lottery. He will win 100 with

50% likelihood and he will win 1000 also with 50% likelihood. What is his

expected utility?

U = 0.5 ln ( 100 ) + 0.5 ln ( 1000 ) = 5.76

• How much would you have to pay the investor to not engage into this bet?

In other words: what safe profit does the investor need to give up his right

to participate in the lottery?

• We need to pay 316.23 for sure. This is called the security equivalent.

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Prof. Dr. Bernd Scherer

• Unter the following assumptions SAMUELSON has shown that the optimal allocation into equities

does not depend on the investment horizon

– Investoren exhibit CRRA

– Equiyt returns show no patterns, i.e. No mean reversion or aversion

– Investors do not have human capital

• 4 Period Example (Market goes up 33% or falls 25% with equal probability)

237.04

177.78

133.33 133.33

100.00 100.00

75.00 75.00 0.25 ⋅ ln ( 177.78 ) + 0.5 ⋅ ln ( 100 ) + 0.25 ⋅ ln ( 56.25 ) = 4.605

56.25

42.19

Periode 0 1 2 3

Nutzen 4.605 4.605 4.605 4.605

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Prof. Dr. Bernd Scherer

• Regression of five year αmarket ,h 7.51 14.81 22.80 31.44 39.45

1.37 1.52 1.79 2.09 2.30

rolling returns for major Market

βmarket ,h -0.82 -0.79 -0.77 -0.78 -0.72

-0.77 -0.85 -1.02 -1.19 -1.27

asset classes. R2 0.02 0.03 0.05 0.07 0.07

1.46 1.72 2.03 2.19 2.30

HML

• Cash is best hedge. βHML,h 0.08

0.12

-0.09

-0.14

-0.11

-0.18

-0.06

-0.12

0.02

0.04

R2 0.00 0.00 0.00 0.00 0.00

• Commodities only provide SMB

αSMB,h

-0.74 -1.35 -1.68 -1.99 -2.44

0.57 1.02 1.32 1.56 1.78

significant short term βSMB,h

1.10 1.59 1.93 2.41 3.22

R2 0.02 0.08 0.16 0.25 0.37

hedge.

αCOM ,h -8.07 -4.40 -0.26 4.63 12.51

-1.17 -0.46 -0.02 0.34 0.82

Commodity 2.70 1.47 1.01 0.69 0.35

βCOM ,h

• Equities show significant R2

1.99

0.10

1.40

0.06

1.12

0.04

0.89

0.03

0.51

0.01

negaative correlation

αCASH ,h 2.92 5.75 8.69 11.54 14.19

5.46 4.12 3.63 3.29 3.09

CASH βCASH ,h 0.61 0.63 0.63 0.64 0.66

6.07 4.79 4.18 3.81 3.67

R2 0.39 0.40 0.41 0.42 0.44

Table 1: Inflation beta for FAMA/FRENCH factors, commodities and cash for 1926:7 to

2009:12. For each return series I run a BOODOKH/RICHARDSON (1993) OLS regression

with overlapping data

89

Prof. Dr. Bernd Scherer

• Stylized evidence

for alternative

time horizons

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Prof. Dr. Bernd Scherer

Inflation and Equities?

• In the US, there is substantial empirical evidence that high inflation is associated with

a high equity risk premium and declining stock prices.

• The Proxy Hypothesis: This view, more fully put forward by Fama (1981), argues that

the relationship between high rates of inflation and future real economic growth

rates is negative.

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Prof. Dr. Bernd Scherer

2. Access to Equity

3. Stock Portfolios

4. Equilibrium Returns

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Prof. Dr. Bernd Scherer

1. Equity Valuation

• Earnings versus Dividends

• Impact of Dividend Policy

• Real Life Methods: Shillers P/E

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Prof. Dr. Bernd Scherer

expected future cash dividends at the risk adjusted discount rate k (more

on this rate later in this chapter)

D1 + P1

Po =

1+k

D2 + P2

D1 +

Po = 1 + k = D1 + D2 + P2 = ...

1 + k (1 + k )

2

1+k

D1 D2 D3

= + 2 + 3 + ...

1 + k (1 + k ) (1 + k )

∞

Dt

=∑

t =1 (1 + k )

t

cash flows to the firm using WACC

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Prof. Dr. Bernd Scherer

D1

Po =

k −g

change in stock prices (after dividends have been paid out)?

P1

−1 = ?

Po

D2

D (1 + g )

P1 = 1

k −g 1 (1 + g )

=P

D1

k −g

P1 P (1 + g )

−1 = o −1 = g

Po Po

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Prof. Dr. Bernd Scherer

Earnings

• Let us redefine

∞ ∞ ∞

Dt Et It

Po = ∑ t = ∑ (1 + k ) −∑

(1 + k ) (1 + k )

t t

t =1 t =1 t =1

• The value of the firm is the present value of earnings minus the present

value of the fraction of earnings that needs to get reinvested to keep the

business going.

– Do not double count earnings!

– In an expanding industry net investments are positive

• Let us break up the firm into two parts: (a) the present value of current

earnings as a perpetuity (no growth) and the present value of growth

opportunities.

E1

Po =

+ NPV of future investments

k

• How do value and growth stocks differ?

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Prof. Dr. Bernd Scherer

Do Dividends Matter?

1. The naive view: yes as it affects the cash flows to be discounted in the

DDM. Earlier cash flows are more valuable.

receiving dividends and reinvestment and keeping the money in the firm.

This assumes a world without frictions (in particular no differential tax

treatment)

– Differential taxes

– Information effects from issuing new equity

– Information content of dividends (increase in dividends is a good sign)

– Investment banking fees

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Prof. Dr. Bernd Scherer

• CAPE compares share prices with average earnings during the past decade,

rather than to the most recent year's earnings.

– This evens out bumps in earnings multiples caused by the profit cycle, and has proved to be a

great market timing vehicle - highs and lows for this metric have overlapped almost perfectly

with highs and lows for the market.

50 20

2000

45 18

1981

40 16

1929

35 14

30 1901 12

Cyclically Adjusted PE

1966

25 Price-Earnings Ratio 10

22.04

20 8

1921 You are here

15 6

10 4

Long-Term Interest Rates

5 2

0 0

1860 1880 1900 1920 1940 1960 1980 2000 2020

Year

http://www.econ.yale.edu/~shiller/data.htm

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Prof. Dr. Bernd Scherer

2. Access to Equity

• Shareholder Value and Corporate Governance

• IPOs and Underpricing

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Prof. Dr. Bernd Scherer

Types of Equity

(Exemptions are dual class common stock)

firms earnings that must be paid before dividends on common stocks can

be paid. Dividends are fixed in advance.

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Prof. Dr. Bernd Scherer

Shareholder Value

maximize their own total value

that don’t maximize shareholder value are taken over by firms that will do)

– If monopolies exist on input or output markets

– If there are negative externalities

externalities: regulation and competition policies, internalize external costs

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Prof. Dr. Bernd Scherer

Private Equity

• Objective: Exit (going public) with a profit

• Long term horizon

• Sales pitches claim PE to provide an extension of the traditional

equity universe (Large cap, small cap, etc.) ? Questionable as same

risk factor runs through all equity products

• Motives

– Diversification (questionable)

– Premium for illiquidity (probably for venture but not for buyouts, i.e. you do not

earn an extra return from buying something liquid and transform it into

something illiquid. The opposite is true)

– Reduction of agency costs (management and owner are the same)

– Reduction of negative effect of information asymmetries with capital markets

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Prof. Dr. Bernd Scherer

Going Public

• Efficient stock markets allocate capital to its best use and therefore create

growth

costs) and venture capitalists to exist. This is a competitive advantage for

young firms.

• Benefits

– Lower capital costs due to better access to markets, increased liquidity and the fact that

owners can now diversify better

– employees can sell their stocks

– External monitoring

• Disadvantages

– Expensive: 10% in lawyer, investment banking and underwriting fees + 15% underpricing (see

next section) = 25%

– Information revealed to competition

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Prof. Dr. Bernd Scherer

investors.

public, the shares they sell tend to be underpriced, in that the share price

jumps substantially on the first day of trading.

– Since the 1960s this ‘underpricing discount’ has averaged around 19% in the United States,

suggesting that firms leave considerable amounts of money on the table. Underpricing has

tended to fluctuate a great deal, averaging 21% in the 1960s, 12% in the 1970s, 16% in the

1980s, 21% in the 1990s, and 40% in the four years since 2000 (reflecting mostly the tail-end of

the late 1990s internet boom).

account are sold at too low a price, while the value of shares retained after

the IPO is diluted. In dollar terms, IPO firms appear to leave many billions ‘on

the table’ every year in the U.S. IPO market alone.

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Prof. Dr. Bernd Scherer

curse, which is an application of Akerlof’s (1970) lemons problem.

• Rock assumes that there are two type of investors. Informed investors bid only

for attractively priced IPOs, whereas the uninformed bid indiscriminately. This

imposes a ‘winner’s curse’ on uninformed investors: in unattractive offerings,

they receive all the shares they have bid for, while in attractive offerings, their

demand is partly crowded out by the informed.

• Thus, the return uninformed investors earn conditional on receiving an allocation

is below the simple average underpricing return.

– In the extreme case, the uninformed are rationed completely in underpriced IPOs and receive 100

percent allocations in overpriced IPOs, resulting in average returns that are negative.

• When conditional expected returns are negative, uninformed investors will be

unwilling to bid for IPO allocations, so the IPO market will be populated only with

(equally) informed investors.

– Rock assumes that the primary market is dependent on the continued participation of uninformed

investors, in the sense that informed demand is insufficient to take up all shares on offer even in

attractive offerings

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Prof. Dr. Bernd Scherer

• This requires that conditional expected returns are non-negative so that the

uninformed at least break even.

• In other words, all IPOs must be underpriced in expectation. This does not

remove the allocation bias against the uninformed – they will still be crowded

out by informed investors in the most underpriced offerings – but they will no

longer (expect to) make losses on average, even adjusted for rationing.

• Beatty and Ritter (1986) argue that as repeat players, investment banks have an

incentive to ensure that new issues are underpriced by enough lest they lose

underwriting commissions in the future. Investment banks thus coerce issuers

into underpricing. Of course, they cannot underprice too much for fear of losing

underwriting market share.

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Prof. Dr. Bernd Scherer

3. Stock Portfolios

• Basic Portfolio Theory

• Basic Risk Decomposition

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Prof. Dr. Bernd Scherer

• Suppose you are given two assets with the following scenarios and

respective scenario probabilities

1 0.167 10 5

2 0.167 20 -5

3 0.167 -15 -4

4 0.167 30 4

5 0.167 5 7

6 0.167 -15 -3

covariances?

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Prof. Dr. Bernd Scherer

1 1

E (RA ) = ∑ i =1 pi RA,i = ∑

6 6

R = (10 + 20 + ... − 15) = 5.83

i =1 A,i

6 6

1

pA,i (RA,i − E (RA,i )) =

2

∑ (10 − 5.83) + ... + (−15 − 5.83) = 18.28

6

Var (RA ) =

2 2

i =1

6

6 2

1

= [(10 − 5.83)(5 − 0.67) + ... + (−15 − 5.83)(−3 − 0.67)] = 80.5

6

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Prof. Dr. Bernd Scherer

• This is the right approach if investors only care about standard deviation to

measure risks.

— Returns are multivariate normal

— Preference (utility functions) only care about variance

academics) continue to look at standard deviations. Why?

– Deviations from normality are unstable and difficult to estimate

– Lack of credible alternative (many will tell you about better risk measures, but they will not

tell you the side effects)

– Central limit theorem will help us in many applications (large n, diversified and factor neutral

portfolios)

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Prof. Dr. Bernd Scherer

RP = wARA + wB RB

E (RP ) = E (wARA + wB RB ) = wAE (RA ) + wB E (RB )

Var (RP ) = Var (wARA + wB RB ) = wA2Var (RA ) + wB2Var (RB ) + 2wAwBCov (RA, RB )

1 0.167 10.0 5.0 7.5

2 0.167 20.0 -5.0 7.5

3 0.167 -15.0 -4.0 -9.5

4 0.167 30.0 4.0 17.0

5 0.167 5.0 7.0 6.0

6 0.167 -15.0 -3.0 -9.0

Standard deviation 18.28 5.24 10.44

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Prof. Dr. Bernd Scherer

Diversification I

20

18

16

Portfolio Standard Deviation

14

12

10

4

What is the return on this portfolio?

2

0

100%

95.00%

90.00%

85.00%

80.00%

75.00%

70.00%

65.00%

60.00%

55.00%

50.00%

45.00%

40.00%

35.00%

30.00%

25.00%

20.00%

15.00%

10.00%

5.00%

0.00%

Weight in Aset B

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Prof. Dr. Bernd Scherer

• We would go upwards left (but can not) while we could go downward right

(but should not)

5

Portfolio Return

0

0 5 10 15 20 25

Portfolio Risk (Standard Deviation)

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Prof. Dr. Bernd Scherer

Risk Contributions

n

σ2 =

dσ2

= wi σi2 + ∑ i ≠`j w j σi j

dwi

risk!

• How does this relate to the beta of a security?

Cov ( ri , rp ) Cov ( ri , ∑ i =1 wi ri )

n

wi σi2 + ∑ i ≠`j w j σi j

βi = = =

σp2 σp2 σp2

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Prof. Dr. Bernd Scherer

σp2 = n ( n1 ) σ 2 + n ( n − 1)( n1 ) ρσ 2 = + (1 − n1 ) ρσ 2

• Assume equal return 2 2 σ2

correlation volatility n

σp2 = 0 + ρσ 2

volatility for large number of

assets?

• Restriction on correlations:

σ2

+ (1 − n1 ) ρσ 2 > 0, σn > − (1 − n1 ) ρσ 2

2

weighted random variables σp2 = n

can not have negative

variance ρ > − n 1−1

µ S

• What is the maximum Sharpe Sp = 1

= 1

Ratio? ( σ2

n + (1 − n1 ) ρσ 2 ) 2

( n1 + (1 − n1 ) ρ )2

1

lim S p = 1 S

n →∞ ρ 2

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Prof. Dr. Bernd Scherer

4. Equilibrium Returns

• Determinants of the Risk Premium on market Portfolio

• Using the CAPM in Portfolio Selection

• Using the CAPM in Valuation

• Empirical Validity

117

Prof. Dr. Bernd Scherer

for taking on systematic, i.e. un-diversifiable risk.

– In equilibrium assets can not be diversifying and offer high returns at the same time (beware

those pitch-books)

– Investors hold inefficient portfolios at their peril

– The risk premium for an asset is unrelated to the assets stand alone risk

– All investors agree in their forecasts of expected returns, risks and correlations and tehrefore

optimally hold the same relative proportion of individual stocks (note that this can be relaxed if

we are willing to assume the capital market is complete)

– No capital market frictions

• Result

– All investors hold the market portfolio (in varying proportions with cash due to their risk

aversion)

– Practically investors should hold a money market fund and an index fund (ETF)

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Prof. Dr. Bernd Scherer

• THE CML represents the best risk reward combination available to all

investors

E (rm ) − c

E (r ) = c + ⋅ σr

E r , E (rm )

( ) σ m

Market portfolio

E (rm ) − c

c

σm

σr , σm

• The slope of the CML is the famous SHARPE ratio named after Nobel price

winner Bill SHARPE. Interestingly it is most of the time misapplied to

individual investments!

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Prof. Dr. Bernd Scherer

• The risk premium on the market portfolio is the great unknown in CAPM

calculations

• We can think of the risk premium on the market portfolio be driven by the

index of risk aversion (within the economy) denoted by A as well as the

riskiness of the market portfolio (its variance)

E (rm ) − c = Aσ 2

(stock market capitalization). If wealth is falling risk aversion is likely to rise.

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Prof. Dr. Bernd Scherer

i.e. the standardized the covariance between a securities returns and

market returns

σim σi σm ρi σi

βi = = = ρi

σm2 σm2 σm

• This makes sense as the diversifiable risk diversifies away and the risk

contribution to the market portfolio equals its beta (the sum of betas add

up to 1)

(security market line)

E (ri ) − c = βi E (rm ) − c

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Prof. Dr. Bernd Scherer

returns.

portfolio (usually a broad based cap weighted index)

4. Regress the time series of security excess returns against the time series of

market excess return (include an intercept or your result will be biased)

– At this stage you can add Bayesian procedures to deal with parameter instability or mean

reversion in betas if you wish

rate

122

Prof. Dr. Bernd Scherer

• Diversification Advice

– Diversify your portfolio to get rid of unsystematic risks

– Best to hold a combination of cash and market portfolio

• Investment advice

– The CAPM provides a breakeven return

– Ensure that you have good reason to believe the market is out of equilibrium and

inefficient enough not to have returned to the fair price.

– Regress the risk premium of your fund against the risk premium of the market

portfolio to see whether the fund earns in excess (alpha) of the rturn rquired to

compensate for systematic risks.

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Prof. Dr. Bernd Scherer

• Capital Costs

– Calculate the beta of a project to calculate the required hurdle rate (costs of

equity, i.e. return requirement for the provider of equity capital)

• Regulation

– Calculate the fair return for a regulated entity

• Court

– Calculate the stocks return in the absence of insider trading, information release,

etc.

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Prof. Dr. Bernd Scherer

Empirical Evidence

• Small Caps earn more than they should under the CAPM; this lead to new

model that added a small CAP and a value premium (FAMA/FRENCH model)

Size Decile 10

Small Cap Stocks

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Prof. Dr. Bernd Scherer

5. Execution Costs

• Components

• Approaches to Reduce Execution Costs

126

Prof. Dr. Bernd Scherer

– Commissions are generally negotiable; some are paid for particular services: research

• Market impact

– Bid, ask spread widening as larger orders are placed

– VWAP (volume weighted average price as benchmark for trading desk

– Issues with VWAP: close to useless if the trade in question represents a large trading volume,

does not take opportunity costs into account

• Opportunity Costs

– Loss or gain in performance as a result of failure to trade a decision

– Very important for high frequency trading with rapid information decay

127

Prof. Dr. Bernd Scherer

• Internal Crossing

– Not always possible, difficulty to set fair transaction price

• External Crossing

– Might take too long (opportunity costs)

• Principal trade

– Trade though a dealer that guarantees price. Dealer acts as a principal, i.e. acts

on firm price.

– Fast, but with large hidden execution costs

• Agency trade

– Trader works the order against a trading benchmark

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Prof. Dr. Bernd Scherer

1. Futures

2. Options

3. Principal Protection

129

Prof. Dr. Bernd Scherer

Literature

130

Prof. Dr. Bernd Scherer

1. Futures

• Arbitrage relations

• What information can and can not be inferred from futures?

131

Prof. Dr. Bernd Scherer

• Forward contract

– Parties agree to exchange an item at a delivery price agreed now.

– The forward price is defined as the delivery price that equates the market value of the

contract with zero.

– The face value of the contract is the quantity specified times the forward price.

– The buyer (seller) of a forward is called long (short)

– Forward contracts are bespoke agreements betweeen two parties (traded OTC)

• Futures contract

– Exchange traded contracts

– Exchange specifies exact underlying (quality, etc), contract size, delivery point

– Easy to close out, i.e. To terminate the position befor delivery date.

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Prof. Dr. Bernd Scherer

Margin Account

• EXAMPLE DJIA 3 month Futures, Futures price 10220 (allows you to buy 10 „shares“ of

the DJIA portfolio)

– Initial margin: USD 4000, i.e. 4%

– Maintenance margin: USD 3000, i.e. 3%

• Daily realization of profits and losses minimizes the probability (and severity) of

counterparty default.

• Futures markets are used by individuals whose credit rating is costly to be chsecked

• Forward marketis OTC between counterparties with high and easy to verify credit

ratings.

133

Prof. Dr. Bernd Scherer

Financial Futures

futures price for delivery in a month must (in the absence of dividends) be

the same.

– Action 1: Buy indext today at 100. Cash Flow in a year is S1.

– Action 2: Buy future todat at F. Put F/(1+r) in the bank to yield F at delivery. You

receive a stock worth S1 and pay F from your accumulated cash account. Yor cash flow

in year 1 is again S1.

Ft ,t +1 = S (1 + r1 )

Ft ,t +1 = (S − PV (Dividend ))(1 + r1 )

Futures price is lower

as there is an advantage to hold

the stock

134

Prof. Dr. Bernd Scherer

• Assume the gold price to be 300 USD, storage costs are 2% and interest

rates are 8%.

• Return on stored gold is

S1 − S 0

rgold = −s

S0

• Return on synthetic gold (buy futures and invest PV of futures price into

cash)

S1 − F

rgold = +c

S

135

Prof. Dr. Bernd Scherer

price risk (to speculator, so speculation is socially usefall after all!)

• Let S be the spot price (of wheat for example) and Cj the storage costs of

the j-th producer. As usual F is the Future price.

Cj < F −S

⇒ carry the wheat (store and sell later )

¨spread

• The future and forward markets create an economic structure where the

most cost efficient distributor would do the physical storage.

• Example: Suppose you are a distributor of corn (you store it!). The spot pice

is 3 USD/bushel and the futures price for 1 month delivery is 3.10

USD/bushel. Your costs of carrying (storing) corn is 0.15. WHat should you

do.

136

Prof. Dr. Bernd Scherer

spend time and money to obtain and process information that allows them

to forecast prices: Is this socially useful?

• Speculators

– Provide liquidity. For every hedger there must be a speculator to take the opposite

position

– Price discovery. Speculators ensure that relevant information enters the price

Example: US housing market: If speculators would have been able to sell short

thet bubble might not have developed and popped earlier with less severe

consequences

137

Prof. Dr. Bernd Scherer

• General arbitrage condition (futures price can not exceed spot price by

more than cost of carry, cost of carry can vary over time)

F −S ≤C

inequality. In this case the forward price reveals some information about

the spot price, i.e. There is information in the future price that is not already

in the spot price.

arbitrage. The above condition holds with equality. Future and spot price

contain the same information.

– We can estimate the cost of carry. If the cost of carry is negative (backwardation)

there are benefits from holding the commodity physically (convenince=ence yield)

138

Prof. Dr. Bernd Scherer

Backwardation

• Backwardation means: spot prices are higher than futures prices, and/or

prices for near maturities are higher than for distant.

– Backwardation occurs if convenience yield exceeds storage cost (inventories are low)

139

Prof. Dr. Bernd Scherer

• The hedge ratio is the number of futures used to hedge a unit exposure to the

risk of spot price. With basis risk, how do we choose optimal hedge ratio?

– Basis risk arises from mismatch of underlying asset (an investment bank shorts index futures

to hedge the risk in underwriting a large stock issue) or mismatch of maturity (roll over short

contracts to hedge long term risks) Basis risk leads to imperfect hedge. Use linear regression

(minimizes basis risk)!

∆S = a + b∆F + e

140

Prof. Dr. Bernd Scherer

2. Options

• Binomial Trees

• BLACK/SCHOLES Formula

• Greeks (Sensitivities)

• Delta Hedging

• Where do we find option payoffs?

141

Prof. Dr. Bernd Scherer

Options

buy (sell) something at a prespecified exercise price (strike)

– Options are so called contingent claims, i.e. their payoff dependon the outcome

of an uncertain event.

– The simplest building blocks are European (can only be exercised at maturity)

calls and puts. We will focus on these.

• Equity is a long call on the companies assets with strike equal to the principal

value of outstanding bonds

• Company is short a put option on the pension fund surplus

142

Prof. Dr. Bernd Scherer

• Example

Call = max [S − X , 0]

Put = max [X − S , 0]

Time value: 3.26 - 2.5=0.76

What factors will affect the time value?

143

Prof. Dr. Bernd Scherer

Payoffs

• Insure a portfolio with a protective put (buy put option to cut off the

downside

• It looks like stock plus put (left picture) give you the same payoff than cash

plus call with same strike (right picture).

– Arbitrage: If two assets A and B, have same future payoffs with certainty, then they should sell

for the same price now.

– Option pricing theory is about relative pricing (makes no statement whether the stock is priced

correctly)

144

Prof. Dr. Bernd Scherer

Put-Call Parity

• IBM stock currently sells for $34 per share. There are call and put

options available with a strike price of $36 and an expiration date

of one year. The price of the IBM call option is $5, and the risk-free

interest rate equals 4%. What is the price of the put option?

36

P + 34 = 5 +

1.04

Bond ¨

PV of strike

P = 5 + 34.62 − 34 = 5.62

145

Prof. Dr. Bernd Scherer

• Assume a two period example. The share price of 100 today can move to 115 or fall to

95. What is the value of a call on the stock price with strike 100, i.e. the value of

max[S-100,0] today?

[ ]

ր 115

100 c

ց ց

95 max [ 95 − 100, 0 ] = 0

• Suppose we buy 0.75 shares and sell 1 option. Whatever happens to the stock price

we would arrive at

0.75 ⋅ 95 − 0 = 71.25

¨risk −free payoff

71.25

= 1 + 5% ⇒ c = 7.143

0.75 ⋅ 100 −

c

investment

146

Prof. Dr. Bernd Scherer

d ⋅ S ⋅ up − cup = d ⋅ S ⋅ down − cdown

cup − cdown

d=

S (up − down )

=1+r ⇒c =

d ⋅S −c 1+r

m= 1+r −down

up−down

• The option value is simply the discounted expected value of final payoffs

under risk neutral probabilities.

– The risk neutral probabilities are pseudo probabilities that fix the likelihood of up and down

movements such that the expected rate of the return on the stock equals the risk free rate.

147

Prof. Dr. Bernd Scherer

ր 132.25 ր 32.25

115 cup

ր ց ր ց

100 109.25 ⇒ c 9.25

ց ր ց ր

95 cdown

ց ց

90.25

0

i.e. its expected value under the risk neutral distribution.

148

Prof. Dr. Bernd Scherer

Calculations

m ⋅ cup,up + (1 − m )cup,down

cup = = 19.76

1+r

cdown = 4.41

c = 11.508

stock price?

up = e σ t , down = e −σ t

149

Prof. Dr. Bernd Scherer

Delta Hedging

stocks.

∑ d ( St − St ) + ∑ n =1 rn −1 ( dt St − C 0 )

T T

( max [ ST − K , 0 ] − C 0 ) −

n =1 t

n −1 n

n −1 n −1

n −1

Payoff from long call rebalanced interest earned on

minus cos t from long call delta equivalent proceeds from

short stock

Call-Delta

150

Prof. Dr. Bernd Scherer

Delta-Hedged Gains

Using a Call on IBM on January 3, 2006

Closing Price DTM Call Hedging Interest

Call Price ($) 2.95 Date DTM St Volatility Delta Profits Payments

Risk Free Rate (r ) 0.05 3-Jan-06 17 82.06 0.194 0.753

Date of Maturity 20-Jan-06 4-Jan-06 16 81.95 0.191 0.750 -0.08 0.01

Strike Price (K ) 80 5-Jan-06 15 82.50 0.189 0.809 0.41 0.01

6-Jan-06 14 84.95 0.191 0.953 1.98 0.01

9-Jan-06 11 83.73 0.257 0.860 -1.16 0.02

10-Jan-06 10 84.07 0.239 0.905 0.29 0.01

11-Jan-06 9 84.17 0.211 0.944 0.09 0.01

12-Jan-06 8 83.57 0.192 0.944 -0.57 0.02

13-Jan-06 7 83.17 0.187 0.940 -0.38 0.02

17-Jan-06 3 83.00 0.167 0.993 -0.16 0.01

18-Jan-06 2 83.80 0.153 1.000 0.79 0.02

19-Jan-06 1 83.09 0.164 1.000 -0.71 0.02

20-Jan-06 0 81.36 -1.73 0.02

Delta-Hedged Gain

Dollar Gain ($) -0.20 Terminal Call Cost Hedging Interest Profit π

As a % of Spot Price S 0 -0.24% Payoff ($) C 0 ($) Profits ($) Payments ($) ($)

As a % of Call Price C 0 -6.81% 1.36 2.95 -1.22 0.17 -0.20

151

Prof. Dr. Bernd Scherer

• Assumptions

– Returns are lognormal and distribution is known

– No transaction costs, continuous hedging feasible

– Known and constant interest rates

– No early exercise, no dividends

• Don’t worry if you don’t like the assumptions. Most have been relaxed and

effectively dealt with in derivatives research.

not quite resolved issue

152

Prof. Dr. Bernd Scherer

BLACK&SCHOLES Equation

Normal distribution

Probability: Look it up in statistical

Tables or in EXCEL

S

log + rt + 21 σ 2t

X

d1 = , d2 = d1 − σ t

σ t

S : stock price

X : strike

σ : volatility (annualized )

r : interest rate

t : maturity

153

Prof. Dr. Bernd Scherer

Some Interpretation

c = S − e −rt X

• For (σ = 0) the option price will be a weighted average of stock and zero bond

100

Probability the stock ends in the money log + 0.08 ⋅ 0.5 + 21 ⋅ 0.32 ⋅ 0.5

110

d1 = = −0.1547

0.3 ⋅ 0.5

d2 = d1 − 0.3 ⋅ 0.5

N (d1 ) = 0.4384

N (d2 ) = 0.3568

c = 100 ⋅ 0.4384 − 110 ⋅ e −0.08⋅0.5 ⋅ 0.3568 = 6.13

p = c − S + e −rt = 11.82

154

Prof. Dr. Bernd Scherer

Sensitivities – Delta

• The delta expresses the share equivalent of an option: How much does the option

price move if the (underlying) stock moves?

– Rule of thumb: The delta of an ATM call is about 0.5

– The delta of a deep in the money option is one (used as directional market play with little notional

exposure)

dc dp

∆c = = N (d1 ) = 0.4384, ∆p = = N (d1 ) − 1 = −0.5616

dS dS

• If deltas are known we can aggregate them and calculate the directional exposure

of an options portfolio.

• We can also calculate an options elasticity …

dc S

εc = = delta ⋅ leverage

dS c

• … or its beta

dc S

βc = βS = delta ⋅ leverage ⋅ stock − beta

dS c

155

Prof. Dr. Bernd Scherer

Sensitivities – Delta

• We can plot the delta of an option to see how the sensitivity changes when yhe

underlying price changes.

0.9

0.8

0.7

0.6

D e lta

0.5

0.4

0.3

0.2

0.1

Busted 0

60 80 100 120 140

Stock Price

156

Prof. Dr. Bernd Scherer

• Gamma is the second derivative of the call value function and measures the

speed at which the slope changes

dc 1 −12d12

d e

d 2c

0.02

γc = dS = 2 = 2π

0.018 dS dS Sσ t

0.016 1 −12(−0.1547)2

e

0.014

= 2π

0.012 100 ⋅ 0.3 0.5

= 0.0186

Gamma

0.01

0.008

0.006

0.004

0.002

0

60 70 80 90 100 110 120 130 140

Stock Price

0.4384 moves to 0.4570 if the share price moves from 100 to 101

157

Prof. Dr. Bernd Scherer

– Volatility as a risk measure is insufficient as a long call will not experience a three sigma event

(a long call positions los s is limited to the call premium)

– Problem: works only for infinitesimal changes (not what risk management is usually interested

in)

dc d 2c

∆c ≈ ∆S + 12 2 ∆S 2 + O

dS dS

– Simulate distribution of stock prices in 1 month time and re-evaluate the option. This gives a

distribution of one month option prices

– Problem: computationally expensive for complex options

158

Prof. Dr. Bernd Scherer

Implied Volatility

• Implied volatility contains a risk premium over expected future realized volatility due

to the impossibility to delta hedge correctly.

• Option prices rise as the world gets riskier

159

Prof. Dr. Bernd Scherer

• Equities as options

• Corporate bonds

– Government bond + short put on operating assets

• Projects as options

– make sequel or movie, expand mining operation, etc.

• …

160

Prof. Dr. Bernd Scherer

3. Portfolio Insurance

• CPPI strategies

161

Prof. Dr. Bernd Scherer

• How are options sold? How do you make most money as an investment banker?

• Sell risks that clients (wrongly) dont perceive as risks! Exploit clients behavioural biases!

• Capital guarantee in high return currency that is thought to appreciate

• Sell digital payouts on dual events that never ever happenend before

• Etc. ...

– Buy portfolio insurance If you have a higher risk aversion than the market or If you have

higher return expectation than the market

– Dont buy path dependent products when you are a long term investor? Path dependency

creates excess dispersion in final wealth

162

Prof. Dr. Bernd Scherer

• Buy and forget products (no dynamic trading, but beware the credit risk!)

– Good choice if you believe realized volatility will be higher than implied volartility

• Derived from Put-Call parity: Equity plus put (protective put) equals cash plus

call (fiduciary call), Typically perceived as too expensive. Variations exist

– Capital guarantee in foreign currency

– Averaging option rather than end of period price

– Sell protection, ..

distribution channel

163

Prof. Dr. Bernd Scherer

CPPI

• CPPI offers principal

protected exposure

by dynamically

allocating the initial

investment between Constant Proportion Portfolio Insurance (“CPPI”) offers principal protected exposure by

a risky and riskless dynamically allocating the investments of a portfolio between two assets: a risky asset (such as

asset an equity index or fund) and a riskless asset (such as a government bond). As the value of the

• Hence, exposure risky asset increases, the allocation to the risky assets increases; as the value of the risky asset

towards the risky decreases, the allocation to the riskless asset increases. At any given time, the minimum portfolio

asset is variable value (the “floor”) must equal the present value of the minimum amount guaranteed at maturity.

• The more the To determine the amount allocated to the risky asset, the excess of the portfolio value over the

market increases,

the more client floor (the “cushion”) is multiplied by a predetermined figure (the “multiple”).

participates in

future market

increases

• The more the

market decrease, Graphical Representation For example, an investor with a €100

Example

the more client

reduces his portfolio value, a floor of €90 and a

Assumptions multiple of 5 will allocate €50 (5 * (€100 -

exposure to the

Initial Portfolio

market Value = 100

Cushion = 10

Risky €90)) to the risky asset and €50 to the

(excess of Portfolio Assets = 50

Floor = 90 Value over the Floor) riskless asset.

(Cushion x

• The dynamic nature Multiple = 5 Multiple)

Floor = 90

of the CPPI means (present value

The floor, initial cushion and multiple are

of the

that the final minimum defined according to the investor's risk

participation level guaranteed Riskless Assets =

cannot be pre-

payoff at

maturity)

50 tolerance and are exogenous to the

(Portfolio Value

specified less Risky Assets) model.

Calculate Allocations

164

Prof. Dr. Bernd Scherer

CPPI

In theory, the allocation between risky and riskless assets is calculated continuously as the

value of the risky asset changes. An increase in the cushion allows for more funds to be

allocated away from the riskless asset into the risky asset. A decrease in the cushion indicates

there is less safety margin and that more funds will be allocated into the riskless asset. If the

CPPI level approaches the price of the riskless asset (=floor), the cushion will tend towards zero

and the investment will be fully allocated into the riskless asset.

This ensures that the minimum guarantee is paid out to the client at maturity.

Return: -10%

Assets = Assets = 5 Assets =

50 45 Calculate New 25

Allocations

Risky Asset =

cushion x

Riskless Riskless multiple Riskless

Assets = Assets = Floor = 90 Assets =

Assume no Riskless Asset

50 change 50 70

=

Portfolio Value

less Risky Asset

Portfolio Value = 100 Determine Floor and Cushion of the Portfolio Value = 95

Portfolio Value

165

Prof. Dr. Bernd Scherer

CPPI

• Performance of

CPPI Portfolio vs.

Underlying Risky

Asset

• Proportion of (starting value of 100) Maturity

Portfolio in Risky 120

Assets 100

90

• Whenever the Price of safe Asset (Floor)

80

market increases,

the more client 70 Portfolio Value Risky Asset Performance Minimum Guarantee at Maturity Floor

participates in future 60

market increases

125%

Risky Assets Riskless Assets

• The more the market

100%

decrease, the more

client reduces his

exposure to the 75%

market

50%

25%

0%

166

Prof. Dr. Bernd Scherer

• First scenario

• As the cushion

approaches zero, the

CPPI

allocation to the risky

asset approaches

zero. In continuous

Risky Assets

time, this dynamic Return: -20%

rebalancing keeps the Risky

Risky

portfolio value from Assets = Assets =

20

falling below the floor. 25

At this point all the Floor = 90 Risk-

Risk- Calculate Floor

Risk- New less

investment is fully less (thus, no Only =

less Allocations Assets =

allocated into the Assume no Assets = cushion left) 90

Assets = change

90

riskless asset. This 70

70

ensures that the

minimum guarantee is

paid out to the client Portfolio Value = 90 Portfolio Value = 90

Portfolio Value = 95

at maturity

Risky Assets

Return: -40%

Risky

• Second Scenario Assets =

Shortfall

will fall below the floor Assets=15 Floor = 90 Calculate New

Allocations Risk-

if there is a very sharp Risk- (thus, no less

Floor

drop in the market Risk-less less cushion left +5 Only =

Assets =

Assets = Assume no Assets = and there is 90

before the allocation 70 Issuer contributes 5

90

change 70 a shortfall

between risky and to make up for

shortfall

riskless assets can be

rebalanced. This risk

(which is equal to the Portfolio Value = 95 Portfolio Value = 85 but at Portfolio Value = 90

any given time, it should be

cushion) is known as at least 90

the “Gap Risk”.

• Note that the “Gap

Risk” is taken by Assumptions: Multiple = 5, Floor = 90 (assume no change)

Morgan Stanley when

managing the CPPI

167

Prof. Dr. Bernd Scherer

CPPI

Risky Assets Risky

• There is usually a Return: 80%

25 25

Assets =

maximum value Risky 45 Risky Assets

Assets = = 115

that will be (cushion x

25

allocated to the Calculate

multiple =

Risk- Floor = 125, but the

risky asset that is less 90 New

allocation is Floor =

Risk-less Allocations 90

defined as a Assume no Assets = capped by

Assets = change 70

percentage of the 100% of the

70

portfolio

Portfolio Value. value)

• Assume in the

example that the Portfolio Value = 95 Portfolio Value = 115 Portfolio Value = 115

allocation to the

risky asset is

capped at 100% of Assumptions: Multiple = 5, Floor = 90 (assume no change), Risky Asset Allocation Capped at 100% of Portfolio Value

the Portfolio Value.

168

Prof. Dr. Bernd Scherer

Gap Risk

• If the risky asset falls by more than 1/multiplier without the ability to adjust

positions (overnight or when markets are closed) the portfolio will fall below

the floor value

CPPI Costs

• Costs arise from rebalancing, i.e. buying high and selling low. These costs

become larger if wither volatility or multiplier becomes larger

• Costs are path dependent, i.e. they differ from path to path

Volatility Risks

• CPPI is short vega, i.e. it will under-perform its projections if market volatility

increases heavily

Performance Measure

• Skewed distribution makes average return less likely than median return

• Performance is path dependent

169

Prof. Dr. Bernd Scherer

– Efficient allocation of risk

• Lower costs

– Low costs access to baskets

• Limited liability

– Easier investments in risky assets; allows to protect subsistence levels

• Access to diversification

– Some asset classes can best be accessed by derivatives (commodities)

• Standardisation increases liquidity

• Price discovery

– Bubbles are less likely to develop if investors can short the underlying markets

170

Prof. Dr. Bernd Scherer

3. Swaps

171

Prof. Dr. Bernd Scherer

Literature

• BRITTON –JONES (1999), Fixed Income and Interest Rate Derivative Analysis ,

Butterworth-Heinemann

172

Prof. Dr. Bernd Scherer

Zerobonds

• s(t,T) spot rate with maturity T at time t.

1

B ( t ,T ) =

( 1 + s ( t,T ) )T −t

• Natural fixed income building blocks, even though they are hardly traded in the

market

173

Prof. Dr. Bernd Scherer

Forward Rates

• Forward rate is an interest rate which is specified now (t=0) for a loan that will

occur at a specified future (T1) date over the period T2-T1

Time 0 T1 T2

(1+ f ( 0,T ,T ) )

T2 −T1

Payment - -1 1 2

( 1 + s ( 0,T2 ) )T2

f ( 0,T1,T2 ) = T2 −T1 −1

( 1 + s ( 0,T1 ) )T1

s ( 0, T1 ) f ( 0, T1 , T2 )

s ( 0, T2 )

174

Prof. Dr. Bernd Scherer

Example

s ( 0, 2 ) = 2.6%

( 1 + 2.6% )2

f ( 0,1, 2 ) = − 1 = 3%

( 1 + 2.2% )1

175

Prof. Dr. Bernd Scherer

• From the current spot rates we can derive the path of furure spot rates (as implied

by the current spot rates)

• What happens if next periods spot rates ae eaual to this periods forward rates

(ecpectations hypothesis? All bonds earn (over next period) the same, i.e. the

curren spot rate.

B ( 1, 2 ) = 1 (

1+ f ( 1,2 ) , B 0, 2

) = 1

( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) )

s ( 0,1 )

dB = B ( 1, 2 ) − B ( 0, 2 ) = 1+ f ( 1,2 ) − ( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) ) =

1 1

( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) )

dB s ( 0,1 )

= 1

( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) ) ( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) )

= s ( 0,1 )

B

176

Prof. Dr. Bernd Scherer

Couponbonds

• Tn : Maturity

• Coupons: C

• Valuation (portfolio of zero bonds)

177

Prof. Dr. Bernd Scherer

Example

Maturity 1 2 3 4

B(0,T) 0.98 0.95 0.92 0.89

Maturity 1 2 3 4

B(0,T) 0.98 0.95 0.92 0.89

B(0,T)C 2.94 2.86 2.77 91.91

178

Prof. Dr. Bernd Scherer

C1 Cn 100

−BC ( 0,Tn ) + + ... + + =0

( 1 + y ( 0,Tn ) ) ( 1 + y ( 0,Tn ) )n ( 1 + y ( 0,Tn ) )n

• Why is the yield of a ten year zero bond higher thqn the yield of 10 year coupon

bond if the term sructure is rising?

179

Prof. Dr. Bernd Scherer

Par Bonds

• Par Bonds sind Kuponanleihen, die zu pari (100) notieren, d.h. die Rendite des

Par Bonds entspricht seiner yield to maturity.

• Wie berechnet man den Kupon eines Par Bonds, bei gegebenen Nullkupon-

anleihen?

100 = C ⋅ ∑ i B ( 0, i ) + 100B ( 0,Tn )

100 ( 1 − B ( 0,Tn ) )

C /100 = ,

∑i B ( 0, i )

180

Prof. Dr. Bernd Scherer

• How can we calculate s(0,2)? Calculate B(0,2) and solve for s(0,2).

BC ( 0, 2 ) = C ⋅ B ( 0,1 ) + (C + 100 ) ⋅ B ( 0, 2 )

BC ( 0, 2 ) − C ⋅ B ( 0,1 )

B ( 0, 2 ) =

(C + 100 )

181

Prof. Dr. Bernd Scherer

Example

103 0

0

100 3 1 3.0% B = B ( 0, 2 ) = 98 C = 3 103 0

C C

98 3 2 3.5% BC ( 0, 3 ) 99 4

4 104

99 4 3 4.4%

BC = CB

100 1 0 0 B ( 0,1 ) B ( 0,1 )

=

( ) =

( ) + ( )

98 3 103 0 B 0, 2 3B 0,1 103 B 0, 2

99 4 4 104

B ( 0, 3 ) 4B ( 0,1 ) + 4B ( 0,2 ) + 104B ( 0, 3 )

B = BC C−1

0,009708738 100

0 0 0,970873786

= -0,000282779 98 = 0,923178433

0,009708738 0

-0,000362537 -0,000373413 0,009615385 99 0,879074915

182

Prof. Dr. Bernd Scherer

Duration

• Question: what happens to the price of a coupon bond if interest rates are

changing?

C1 C2 Cn 100

BC ( 0,Tn ) = + + ... + n +

( 1 + y ( 0,Tn ) ) ( 1 + y ( 0,Tn ) )2 ( 1 + y 0,Tn

( ) ) ( 1 + y ( 0,Tn ) )n

dBC ( 0,Tn )

= −1C 1 ( 1+y( 10,T ) )2 − 2C 2 ( 1+y( 10,T ) )3 − 3C 3 ( 1+y( 10,T ) )4 − ... − nC n 1

( 1+y ( 0,Tn ) )n +1

dy ( 0,Tn ) n n n

dBC ( 0,Tn ) 1 + y ( 0,Tn ) 1C 1 (1+y ( 0,T ) )1 + 2C 2 ( 1+y( 0,T ) )2 + 3C 3 (1+y( 0,T ) )3 + ... + nC n ( 1+y( 0,T ) )n

1 1 1 1

= − n n n n

dy ( 0,Tn ) BC ( 0,Tn ) C

( 0,Tn )

B

<0

183

Prof. Dr. Bernd Scherer

Duration

dy ( 0,Tn )

B ( 0,Tn )

C

y ( 0, Tn )

184

Prof. Dr. Bernd Scherer

Duration Types

dBC

∆B$C = ∆y = D$C ∆y

dy y =y

dBC 1 DC

DCmod = ⋅ C = $

dy y=y B BC

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3. Swap Market

Main Issues

• Definition of swaps

• Applications of swaps

• Fixed for fixed currency swaps

• Fixed for floating interest rate swaps

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Prof. Dr. Bernd Scherer

Definition

• A swap is a transaction where at the time of the contract’s initiation the two

parties agree to exchange two cash-flow streams of equal present value. The

deal is structured as a single contract, with a right of offset.

• Example: Fixed for Floating Swap (receive a fixed rate and pay a floating rate) is

equivalent to a long position in a fixed bond and a short position in a floating

rate note. Swap spread creates equal present value.

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Prof. Dr. Bernd Scherer

Application of Swaps

and commodity prices.

differ across countries;

differ in treatment of capital gains and income.

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Prof. Dr. Bernd Scherer

• Suppose you want to swap a 7 year 18 million HC loan into a FC loan. The current

exchange rate is S = HC/FC = 1.8

• Why would a company want to do this? Get better loan in HC (better known by

domestic banks, less monitoring and screening costs).

par bond (to pay off your HC loan) and short a FC par bond (which is the FC loan

you swapped the HC loan into)

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Prof. Dr. Bernd Scherer

1 1

∑ i =1 1.44 ( 1 + 0.08 )i

7

PVDC = + 18 = 18mDC

( 1 + 0.08 )7

1 1 FC

⋅ = [ ]

S 1.8 DC

1 1

∑ i =1 0.7 ( 1 + 0.07 )i

7

PVFC = + 10 = 10mFC

( 1 + 0.07 )7

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Prof. Dr. Bernd Scherer

– the domestic yield curve

– the foreign yield curve

– and the exchange rate

1

V = PVHC ( r1, r2 ,... ) − PVFC ( r1* , r2* ,... )

S

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Prof. Dr. Bernd Scherer

• Valuation: Floating-rate note cash-flows consist of a series of one-year forward

rates, derived from the current term structure. However discounting these

payments at the current spot rates will yield to a value of 1

Time t1 t2 t3 t4 … tn

Cash Flow 1

B ( 0,t1 )

−1 1

B ( t1 ,t2 )

−1 1

B ( t2 ,t3 )

−1 1

B ( t3 ,t4 )

−1 … 1

B ( tn −1 ,tn )

−1

Discount

B ( 0, t1 ) B ( 0, t2 ) B ( 0, t3 ) B ( 0, t4 ) … B ( 0, t3 )

Factor

for year 3 Forward (zero bond price):

at the end of year 2

B ( 0, t2 ) B ( t2 , t3 ) = B ( 0, t3 )

B ( 0, t3 )

B ( t2 , t 3 ) =

B ( 0, t2 )

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Prof. Dr. Bernd Scherer

• Valuation

1

FRN ( t0 + dt ) = B ( t0 + dt , t1 ) 1 + − 1

value

B ( t0 , t1 )

after

known

reset Coupon

• Suppose a floating rate note starts to contain some credit risk. It has been issued

with Libor + 0 bps, but the credit risk rises to Libor plus 50bps.

– How is the FRN affected?

– Can you use the formula above?

– Is the impact large or small?

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Prof. Dr. Bernd Scherer

coupon) and a short position in a floating rate note (pay floating) the value of

this portfolio is

V = BTC − FRN T

1

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Prof. Dr. Bernd Scherer

• Learn how to price fixed income options / fixed income contingent claims

• Which capital market products contain fixed income options?

• What can we use fixed income options for?

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Prof. Dr. Bernd Scherer

• Suppose interest rates for 6 and 12 month maturity are 10%. Suppose

further rates fall to 8% or increase to 12% during the next 6 month. Whats

the value of a call options (strike 95.5) on a zerobond with 6 month

maturity in?

1

2 ր 12% 1

2 ր 94

10% 1 ⇒ 95 1

2 ց 2 ց

8% 96

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Prof. Dr. Bernd Scherer

• The call payoffs are given by max[B-X,0], i.e the payoff is either 0 (if B=94)

oder 0.5 (if B=96). The investor has two traded instrumentds to replicate

the payoff from this call:

– One year zerobond that costs 90 and pays off either 94 or 96 in 6 month

– Six month zero bond that costs 95 and pays off 100 for sure

• Find a portfolio of these two bonds that replicates the payoff from our call

option.

φ1100 + φ2 94 = 0

φ1100 + φ2 96 = 0.5

100 94 φ1 0

= ⇒ φ2 = 0.25, φ1 = −0.235

100 96 φ2 0.5

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Prof. Dr. Bernd Scherer

preferences, risk aversion, etc. was made

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Prof. Dr. Bernd Scherer

Multi-period valuation

• The real worl is not binomial and sometimes we need the whole interest rate

path to evaluate options (early exccise).

from the last period).

• We asssume we already calibrated an interest rate tree (i.e. A tree that correctly

prices a set of reference options in a risk neutral world)

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Prof. Dr. Bernd Scherer

• Interest rate and price trees – calculate value of a 3 period zero bond from

belows interest treee

• First we calculate the values of a 3 year zero bond in period 2 (trivially its 100 in

period 3)

100

1

ր 14% 1

ր = 87.72

2

12% 1

2

12% 1 1.14

1 1

2 ր 2 ց 2 ր

ց 100 2

10% 1 10% ⇒ 10% 1 = 90.01

2 ց 1

2 ր 2 ց 1

2 ր 1.1

8% 1 8% 1 100

2 ց 6% 2 ց = 94.34

1.06

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Prof. Dr. Bernd Scherer

• In the „up“ state of year 1the risk free rate is 12% (see previous slide). Given

that the binomal tree represents the risk neutral world (all calims can be

replicated arbitrage free), the expected return also eaquals 12%.

1.12 =

x

0.5 ( 87.72 + 90.01 )

x = = 79.95

1.12

0.5 ( 90.91 + 94.34 )

y = = 85.76

1.08

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Prof. Dr. Bernd Scherer

• New price-tree

1

2 ր 87.72

1

79.95 1

2 ր 2 ց

10% 1 1

90.01

2 ց 2 ր

85.76 1

2 ց 94.34

• We can now calculate todays value for the three year zero bond

z = = 75.23

1.1

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Prof. Dr. Bernd Scherer

Exercise

• We want to value the option to buy a one year zero bond at a strike of 90 in two

years from now. Assume the previous interest rate tree.

1

2 ր 0

1

?1

2 ր 2 ց

?1 1

0.01

2 ց 2 ր

?1

2 ց 4.34

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Prof. Dr. Bernd Scherer

HO/LEE - Model

• Recombining interest rate tree for the die „short rate“, Allows us to price

long bonds, opttions,etc.

• (2,2) denotes the state of the world where rates rose twice in a row.

1

2 ր ...

( 3, 3 )

1 1

2 ր 2 ց

( 2, 2 )

1

2 ր 1

2 ց 1

2 ր ...

( 1, 1 ) ( 3, 1 )

1 1 1 1

2 ր 2 ց 2 ր 2 ց

( 0, 0 ) ( 2, 0 ) ...

1 1 1 1

2 ց 2 ր 2 ց 2 ր

( 1, -1 ) ( 3, -1 )

1 1 1

2 ց 2 ր 2 ց ...

( 2, -2 )

1 1

2 ց 2 ր

( 3, -3 ) ...

1

2 ց

s ( ti , j ) = s ( 0, 0 ) + ( ∑ tt =1 at )dt + j σ

i

dt

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Prof. Dr. Bernd Scherer

prices assumed to be correct (option valuation is relative valuation)

1

2 ր ...

1

s + (a1 + a 2 + a 3 ) + 3σ 1

2 ր 2 ց

s + ( a1 + a 2 ) + 2σ

1

2 ր 1

2 ց 1

2 ր ...

1

s + a1 + 1σ 1 1

s + ( a 1 + a 2 + a 3 ) + 1σ 1

2 ր 2 ց 2 ր 2 ց

s s + ( a1 + a 2 ) + 0σ ...

1 1 1 1

2 ց 2 ր 2 ց 2 ր

s + a 1 − 1σ 1 1

s + ( a 1 + a 2 + a 3 ) − 1σ 1

2 ց 2 ր 2 ց ...

s + ( a 1 + a 2 ) − 2σ 1 1

2 ց 2 ր

s + (a1 + a 2 + a 3 ) − 3σ 1 ...

2 ց

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Prof. Dr. Bernd Scherer

Example tree

1

ր8

5 + 0 + jσ

2

1

7 1

1

1

= 5 + 2 ⋅1 = 7

2 ր 2 ց

6

1

2 ր 1

2 ց 1

2 ր 6

5 1 1

5 1

ց ր ց

2

4

2 2 4 5 + 0 + jσ 1

1

= 5 −1⋅1⋅ 1

1

=4

1 1

2 ց 2 ր

3 1

2 ց 3

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Prof. Dr. Bernd Scherer

1 + 8 /100

100

92.5925926

87.3515024 100

83.9918293 94.3396226

82.3449307 90.7111756 100

88.9325251 96.1538462

94.2684766 100

98.0392157

100

0.5 ⋅ 94.33 + 0.5 ⋅ 96.15

t=0 t=1 t=2 t=3 t=4 1 + 5 /100

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Prof. Dr. Bernd Scherer

1 + 8 /100

100

96.2963

94.5838803 100

92.8884448 98.1132

94.8054713 94.3396226 100

98.2030449 100.0000

101.922711 100

101.9608

100

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Prof. Dr. Bernd Scherer

Option Valuation

1 + 3 /100

0

0

0.25917479 0

0.7152017 0.54945055

1.24274878 1.15384615

2.03546691 max ( 98.03 − 95, 0 )

3.03921569

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Prof. Dr. Bernd Scherer

Problems

• No mean reversion

• Constant interest rate volatility

• From here a very rich literature of term structur models developed (not the

objective of our course)

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Prof. Dr. Bernd Scherer

• Callable bonds: gives the issuer the right to buy back the bond at a given

price (for example at par, i.e. at 100)

– If interest rates fall, bond prices rise and the value of the call rises

– Callable bond has the same downside but a lower downside (duration

compression) as a straight bond.

– Higher coupon (collect premium from short call)

– Government sponsored entities, mortgage financing.

– Hedge against free option given to borrower (take out new loan and pay back the

old loan)

• Suppose you are a pension fund with 30 year duration liabilities. You buy a

30 year duration mortgage bond. Is this a good hedge?

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Prof. Dr. Bernd Scherer

• Caps are interest rate call options on interest rate (hedges against rising

rates). Payoff:

Cap = max [ r − cap, 0 ]

• Can you value a cap with cap = 5 for the below tree?

1

2 ր8

1

71

2 ր 2 ց

61

1

2 ր 2 ց 1

2 ր6

51 1

51

2 ց 2 ր 2 ց

41 4

1

2 ց 2 ր

31

2 ց3

• Caps help limit exposure to rising rates yet allow the borrower to benefit

when rates fall;

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Literature

instruments, Elsevier

214

Prof. Dr. Bernd Scherer

1. Credit Risk

• Equity based approach

• Credit correlation

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Prof. Dr. Bernd Scherer

• Default risk: risk an obligor does not repay parts of his financial obligation

• Credit deterioration risk: risk that the credit quality of the debtor

decreases.

– Downgrade to a lower rating category

– Spread widening leads to mark to market losses

– Forced selling due to rating constraints; can no longer be used as collateral

counterparty to another counterparty.

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Credit Risk

rating“.

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Prof. Dr. Bernd Scherer

• Rating agencies (the biggest are MOODYS, S&P, FITCH) create ratings on bonds in

accordance with their default probability.

• AAA represents the best rating (smallest likelihood to default in a given period), AA

represents the second best rating, …

• One way to measure credit risk is to model the transition between rating caegories.

This is usually done with a transition matrix where it is assumed that transition

probabilities follow a MARKOV process (see next slides).

– Rating changes are autocorrelated (Markov process assumes no memory)

– Rating changes will be regime dependent (transition matrix changes over time)

– Transition matrices are derived from observable bonds. Might be misleading to

apply to loans, given that covenqats, collateral etc. might induce different

behaviour in the loans market.

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Prof. Dr. Bernd Scherer

• The probability for a AAA bond stay AAA in one year time is 90.82%. It will

migrate to BB (within a year) with a 0.07% probability.

AAA 90.82% 8.27% 0.74% 0.07% 0.07% 0.01% 0.01% 0.01%

AA 0.66% 90.89% 7.70% 0.58% 0.06% 0.07% 0.30% 0.01%

A 0.08% 2.42% 91.31% 5.23% 0.68% 0.23% 0.01% 0.04%

BBB 0.04% 0.32% 5.88% 87.46% 4.96% 1.08% 0.11% 0.15%

BB 0.04% 0.13% 0.64% 7.71% 81.16% 8.40% 0.97% 0.95%

B 0.02% 0.11% 0.26% 0.52% 6.86% 83.49% 3.89% 4.80%

CCC 0.13% 0.12% 0.42% 1.20% 2.69% 11.71% 64.48% 19.25%

D 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 100.00%

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Prof. Dr. Bernd Scherer

AA bond to be single B after

10 years? There are multiple ∑ j

pij = 1

paths to arrive there. How

do we calculate all of them?

pAAA, AAA pAAA, AA … pAAA,D

p p … p

P = P0,1 = AA , AAA AA, AA AA, D

⋮ ⋮ ⋱ ⋮

0 0 1

T

P0,n = P ⋅ P ⋅… ⋅ P ⋅ P = PT

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Prof. Dr. Bernd Scherer

• Assume we know the price of two zero bonds. One without credit risk B(0,T)

and one with credit risk BAA(0,T). In a risk neutral world we would expect

B( 0,T ) − BAA ( 0,T ) 1

qAA =

B( 0,T ) 1−δ

• Here, qAA denotes the risk neutral probability to default any time between

time 0 and time T in Konkurs

• In this example qAA denotes the second element of the last column in Q0,T (T-

Period transition matrix with risik neutral probabilities)

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Prof. Dr. Bernd Scherer

• We need to transform the real world transition matrix P via a choice of Π to Q. The

matrix Π contains risk premia to adjust real world to risk neutral probabilities

Qt,t+1 =I+Πt ( P-I)

Π(1) 0

1

1 0 Π( 2) 0 0

I= ,Π = 0 ⋱ 0

0 ⋱ t

Π( k ) 0

1

0

0 0 0 1

BAA ( 0,1) = (1− qAA ) ⋅1⋅ B( 0,1) + qAAδ B( 0,1)

– For period one we fit k risk premia to k rating categories according to the above

– As in bootstrapping we continue to work ourselve through the term structure for all

further periods

– With these estimates we can then price credit derivatives (see later section)

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Prof. Dr. Bernd Scherer

AAA 96.48% 92.71% 88.13% 83.44% 78.43%

AA 96.43% 92.63% 88.03% 83.28% 78.24%

A 96.37% 92.49% 87.81% 83.00% 77.91%

BBB 96.26% 92.24% 87.43% 82.52% 77.32%

BB 95.86% 91.33% 85.97% 80.48% 78.35%

B 95.30% 90.12% 84.01% 77.85% 71.43%

CCC 94.48% 88.27% 81.04% 73.94% 66.69%

C

BBB ( 0,5) = 4.4⋅ 0.9586+ 4.4⋅ 0.9133+…+104.4⋅ 0.7835

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Prof. Dr. Bernd Scherer

B( 0,2)

B( 0,1)

= 0.9648

0.9271

= 0.9609

AAA 96,09% 91,35% 86,48% 81,80%

AA 96,06% 91,29% 86,36% 81,65%

A 95,98% 91,12% 86,11% 81,37%

BBB 95,83% 90,82% 85,72% 80,84%

BB 95,27% 89,68% 83,96% 78,58%

B 94,56% 88,15% 81,70% 75,69%

CCC 93,42% 85,77% 78,25% 71,52%

• What is the price for a 5 year BB corporate bond in one year, i.e. with 4 years

remaining live?

C

BBB (1,5) = 4.4 + 0.9527 ⋅ 4.4 + … + 104.4 ⋅ 0.7858 = 100.79

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Prof. Dr. Bernd Scherer

• Distribution of credt risk is asymmetric. There are much more potentially bad than

good news for a AAA bond (market risk is symmetric, credit risk is not)

• Calculated from previous tables (please replicate)

AAA 0.04% 101.85

AA 0.13% 101.68

A 0.64% 101.37

BBB 7.71% 100.79

BB 81.16% 98.27

B 8.40% 95.06

CCC 0.97% 90.40

D 0.95% 52.00

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Prof. Dr. Bernd Scherer

• Still asymmetric

Portfoliorendite ( x 1000)

226

Prof. Dr. Bernd Scherer

Normal(0,0073082; 0,0030345)

-10 -5 0 5 10 15 20

Portfoliorendite (mal 1000)

227

Prof. Dr. Bernd Scherer

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Prof. Dr. Bernd Scherer

• We can apply the BLACK/SCHOLES model to price the value of firm equity, where

V represents the firms assets, D its outstanding debt, r the risk free rate, T

time to maturity, and σV the volatility of assets. The value of equity is given by

E 0 = V0N ( d1 ) − De −rT N ( d2 )

d1 =

ln (VD ) + ( r + 1 σ2

2 V )T

, d2 = d1 − σV T

σV T

V0 dV

σe = σ

E 0 dE V

• The credit spread is given by the excess yield (over risk free) from the risky

corporate bond

• We can determine V0 and σV from the two equations above.

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Prof. Dr. Bernd Scherer

Credit Correlation

• Credit (default) correlation describes the tendency for two companies to default at

the same time.

– Similar industry, leverage

– Similar business risk

• Non-zero default correlation is the reason why credit risk does not completely

diversify away (and we real world and risk neutral default probabilities are not the

same)

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Prof. Dr. Bernd Scherer

• Define t1 and t2 as the time to default for company 1 and company 2. Both

can (and will) be highly non-normal with cumulative distribution Q1 ( t1 ) and

Q2 ( t2 ) . These could be taken from a migration matrix.

years of time to be 1%, 3%, 6%, 10% and 15% for both companies. Use a

percentile to percentile distribution, i.e. use

−1

xi = N (Qi ( ti ) ) .

inverse of

cummulative

standard

normal

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Prof. Dr. Bernd Scherer

This allows us to first draw x i and then work out ti . For example if we draw

non-normal default times.

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Prof. Dr. Bernd Scherer

zi (individual default factor) are standard normal, while ai is the correlation to the

common default factor (could use stock market correlation)

x i = ai M + 1 − ai2 zi

Default happens if

N −1 (Qi (T ) ) − ai M

zi <

1 − ai2

N −1 (Qi (T ) ) − ai M

Qi (T | M ) = N

1 − ai2

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Prof. Dr. Bernd Scherer

0.06

0.04

0.02

0.0

universe

0 10 20 30 40

234

Prof. Dr. Bernd Scherer

• Equity Default Swaps

• Total Return Swaps

• Credit Spread Products

• Collateralized Debt Obligation

235

Prof. Dr. Bernd Scherer

• CDS buyer makes a periodic payment to the seller of the default swap. The

default swap seller promise to make a payment in the event of default of a

reference bond or loan.

• This is more like a put option rather than a swap.

Periodic

Premium

CDS

CDS

Buyer

Seller

Contingent

payment

• Cash settlement (CDS buyer receives the difference between the price of

defaulted bond and 100)

• Physical settlement (CDS buyer delivers bond and receives 100))

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Prof. Dr. Bernd Scherer

CDO Structure

• Cash flows can be structured to cater risk aversion with the claim to create

value (departure from neoclassical finance and wrong)

• Offers high upside limited liability exposure to low rated bonds

• Success of CDO depends on selling the risky equity tranche

– Long call on underlying asset pool

AAA,3%

AA, 4%

A, 5%

BBB, 9%

Equity, 15%

237

Prof. Dr. Bernd Scherer

• Mostly B rated assets have been transformed into higher rated assets

under the critical assumption of low correlation (i.e. zero systemic risk)

238

Prof. Dr. Bernd Scherer

Credit Indices

American investment grade companies.

American investment grade companies.

239

Prof. Dr. Bernd Scherer

Single Tranching

• Each tranche can be traded on its own.

240

Prof. Dr. Bernd Scherer

• Regulatory Arbitrage

• Hedging

• Yield Enhancement

241

Prof. Dr. Bernd Scherer

financial institution must hold because of regulatory requirements.

insulate banks from losses.

and soundness of banks. Why?

• The question is how much capital should be required, and the key concept

is risk-based capital.

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Prof. Dr. Bernd Scherer

• The theory is simple: for any asset hold an amount of capital proportional

to its risk. The tricky thing is putting this into practice:

– The potential complexity of financial transactions far exceeds the

ability of regulators to specify rules for every one.

international standards for risk-based capital requirements.

– Banks have to hold capital equivalent to 8% of their risk-weighted

assets. Each type of asset has a risk weight that reflects its riskiness.

– OECD government bonds have a zero risk weight – theoretically, they

have zero risk, and hence require zero capital.

– Problem: Singapore (AAA) but non OECD has 100% risk weighting while

MEXICO (A) OECD member only has 0% risk weighting, Capital is

misallocated to OECD countries

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Prof. Dr. Bernd Scherer

Basel I: example

loans have a 100% risk weight.

• If a bank held $100 in Treasuries (0 weight), $100 in home mortgages (50%

weight , and $100 in commercial loans (100% weight) it would have $300 in

assets, but only $150 in risk-weighted assets (0% * $100 + 50% * $100 +

100% * $100); therefore would have to hold $12 in capital (8% * $150).

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Prof. Dr. Bernd Scherer

• Regulatory capital arbitrage happens because, all other things being equal,

banks would like to hold less rather than more capital. The reason is that, in

general, bank profits are proportional to the amount of assets that they

hold.

– One main source of banking profits is interest margin: the spread

between the interest charged on loans and the interest paid on

deposits and other sources of funding. For any given interest margin,

profits will be strictly proportional to loan volume (assets).

– The same logic applies to banks’ principal investment and trading

businesses; for any given strategy, doubling the size of the position will

double the expected profit. So to increase profits, you have to increase

assets. If a bank wants to increase its assets, it can do so either by

increasing its leverage (lowering its capital as a percentage of assets) or

increasing its capital; the former is preferable, because the latter

requires issuing new shares, which dilutes current shareholders. (Also,

issuing new shares results in lower earnings per share, lowering the

stock price.)

245

Prof. Dr. Bernd Scherer

• Our bank earlier had $100 in mortgages, for which it had to hold $4 in

capital.

mortgages.

– It sells them to a special-purpose vehicle (SPV) that issues bonds to investors;

these bonds are backed by the cash flows from the monthly mortgage payments.

• The bonds are divided into a set of tranches ordered by seniority (priority),

so the incoming cash flows first pay off the most senior tranche, then the

next most senior tranche, and so on.

• If these are high-quality mortgages, all the credit risk (at least according to

the rating agencies) can be concentrated in the bottom few tranches

(because it’s unlikely that more than a few percent of borrowers will

default), so you end up with a few risky bonds and a lot of “very safe” ones.

246

Prof. Dr. Bernd Scherer

• Getting sufficiently high credit ratings for the senior tranches, the bank can

lower the risk weights on those assets, thereby lowering the amount of

capital it has to hold for those tranches.

– The risky tranches will require more capital, but it is possible to do the math so that the lower

capital requirements on the senior tranches more than outweigh the higher requirements on

the junior tranches.

• The passive side of the CDO will have a lower risk weighting than the

active side of a CDO (up to 50% in some cases)

onto others. In this way, a bank can end up with assets that have a high

degree of economic risk but a low risk weight for capital purposes.

• All this is possible because the rules setting capital requirements are lumpy

while there is an infinite range of actual financial assets.

247

Prof. Dr. Bernd Scherer

• Recall from session 2: Basel II introduces VaR based methods as well as a finer grid

on credit risk (recall Basel I was very crude). Below are two reasons Basel II failed

methodologies (Basel II) increased the potential for regulatory arbitrage.

– In VaR, the riskiness of any asset is determined by a model based on the historical

attributes of the asset. In theory, this is an improvement, because it gets around the

problem of lumpy fixed percentages, and tailors the risk weight to the unique

characteristics of the asset itself.

historical data from periods during which, for example, subprime loans rarely defaulted

because rising housing prices always made it possible to refinance. By underestimating

the risk of certain assets, these models underestimated the capital required to support

these assets.

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Prof. Dr. Bernd Scherer

• Basel I: 100% risk weight for non OECD, i.e. regulatory capital amounts to

• Basel II: BBB risk weighting is 50%, AAA banks have 20% risk weight, Residual risk

from CDS hedge (contractual risks, enforceability, …) is 15%

= 19600

1000000 ⋅ 15% ⋅ 50% + (

1-15% ) ×20%

BBB risk weight

CDS risk weight

after hedge

249

Prof. Dr. Bernd Scherer

• Collateralized Debt Obligation

250

Prof. Dr. Bernd Scherer

• Example: Government bond yields 4%, CDS premium is 2%, Corporate bond

trades at 7%. Is there arbitrage?

– Only works for par bonds, what happens when interest rates change.

What happens to interest rate sensitivity close to default?

– Counterparty risk?

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Prof. Dr. Bernd Scherer

• Start with risk neutral default probabilities (for example from transition

matrix)

Time (T)

in year T survive year T

1 0.0200 0.9800

2 0.0196 0.9604

4 0.0188 0.9224

5 0.0184 0.9039

⋅ 0.02

0.9604 = 0.0192

survive default

to T −1 in T

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Prof. Dr. Bernd Scherer

• Assume continuous compounding with a risk free rate of 5%

• Assume 40% recovery rate

• Unknown premium (spread) s

Probability to PV of e−0.05⋅2

Time Expected Discout

survive year expected

(T) Payment Factor

T Payment

1 0.9800 0.9800s 0.9512 0.9322s

2 0.9604 0.9604s 0.9048 0.8690s 0.9604 ⋅ s ⋅ 0.9084 = 0.8690s

3 0.9412 0.9412s 0.8607 0.8101s

4 0.9224 0.9224s 0.8187 0.7552s

5 0.9039 0.9039s 0.7788 0.7040s

4.0704s

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Prof. Dr. Bernd Scherer

PV of

Prob to default in Recovery Expected Discount

Time (T) Expected

year T Rate Payoff Factor

Payoff

0.5 0.0200 0.4 0.0120 0.9753 0.0117

1.5 0.0196 0.4 0.0118 0.9277 0.0109

2.5 0.0192 0.4 0.0115 x 0.8825 = 0.0102

3.5 0.0188 0.4 0.0113 0.8395 0.0095

4.5 0.0184 0.4 0.0111 0.7985 0.0088

0.0192 ⋅ ( 1 − 0.4 ) ⋅ 1

0.0511

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Prof. Dr. Bernd Scherer

end of year you have to pay the premium for the first half)

PV of

Prob to default Expected Discount

Time (T) expected

in year T Accrual Factor

accrual

0.5 0.0200 0.0100s 0.9753 0.0098s

1.5 0.0196 0.0098s 0.9277 0.0091s

2.5 0.0192 0.0096s 0.8825 0.0085s

3.5 0.0188 0.0094s 0.8395 0.0079s

4.5 0.0184 0.0092s 0.7985 0.0074s

0.0426s

s = 0.0124

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Prof. Dr. Bernd Scherer

• Equities, Fixed Income, Currencies – no reason to assume counterparties

are better informed

better informed

• Banks buy protection against default (is this decision done by risk manager

or speculator)

happened to AIG?

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Prof. Dr. Bernd Scherer

CDO Pricing

• The value of the CDO must be the sum of the bond values (asset side of the

balance sheet)!

• CDO pricing is about pricing the relative value of different stakes (tranches).

Each tranch holds options against other tranches. Industry practice of rating

based discount rates is wrong!

• Example: 5 years n-th to default basket. Assume 100 bonds with 2% default

probability over 5 years.

– With zero default correlation the likelihood that one or more bonds default is

86.74% (1-0.98^100), while the likelihood that 10 or more default is 0.0034%

– First to default is valuable, while 10th to default is not

– If correlation increases the likelihood of one or more declines while the

likelihood of 10 or more increases

– For perfect correlation there will be no difference between 1st and nth to default

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Prof. Dr. Bernd Scherer

1. Spot Market

2. Forward Market

4. International Diversification

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Literature

Finance, Pearson

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Prof. Dr. Bernd Scherer

• Key Questions

– How is the market for trading spot exchange organized?

– How are spot exchange rate quoted?

• Motivating Problem

– You work for a large multinational firm that has its headquarters in Paris.

The multinational firm has subsidiaries in 2 countries—Japan and Canada.

All foreign sales are made through these subsidiaries. Each month, the

subsidiaries remit to the Paris office their income over the month. This

income is in the local currency of the country in which the subsidiary is

located (JPY and CAD). The exchange rates that are quoted to you are in

terms of the USD; that is, USD/JPY and USD/CAD.

• How do you find the rates in terms of EUR. If the inflows are JPY 100 m and

CAD 10 m, what is their total value in terms of EUR?

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Prof. Dr. Bernd Scherer

Definition

• The spot rate is the amount of home currency one pays/receives in

exchange for one unit of foreign currency today.

Exchange of HC and FC at t = 0

St ST

Example

– If one needs USD 100 to buy a copy of the textbook, then the exchange rate

is USD 100/textbook.

– If one receives USD 2000 when selling a computer, then the exchange rate

USD 2000/computer.

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Prof. Dr. Bernd Scherer

Quotation

– This quote tells us the price of the FC.

– If the so quoted currency goes up, what does this mean?

– Thus, statements about buying or selling will always refer to the currency in the

denominator (the “foreign” currency).

– This convention, standard in continental Europe, is called the direct quote.

– To keep things clear, you should remember that the object of interest (the currency

that we are buying or selling) is the one that is in the denominator.

• Example

– 30.000 USD/car—is the price for a car with the ”item” being bought or sold, in this case

a car, in the denominator

– 2.03 USD/GBP is the price for one British Pound, i.e. you need to pay 2.03 USD for one

GBP. Where is the exchange rate today?

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Prof. Dr. Bernd Scherer

USD as FC USD as HC

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Prof. Dr. Bernd Scherer

Market Organization

– In contrast to stock markets and futures markets, trading is not limited to a

particular time, there is no centralized clearing mechanism, and contracts are not

standardized.

• The currency market consists of

– a wholesale tier, (an informal network of about 500 banks and currency brokers

that deal with each other and with large corporations), and

– a retail tier.

• Most interbank dealing is done electronically

• Many players in the wholesale market act as market makers.

• Market maker makes a two-way quote (that is, bid and ask quotes), you

don’t have to reveal whether you intends to buy or sell. Limits to the market

maker’s commitment to this quote.

– Time, i.e. immediate execution (Why?)

– Size, quote is only good for a limited amount (Why)

• Deal via a broker (tries to shop around for a commission, about half the

market)

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Prof. Dr. Bernd Scherer

Market Statistics

• Size:

– The daily volume of trading on the exchange market (including the currency

futures, options, and swaps markets) is more than USD 1800 billion.

– It is about five to ten times the daily volume of international trade in goods and

services.

• Location

– The major markets are, in order of importance, London, and New York, with less

important markets being Singapore, Zurich, Hong Kong, and Frankfurt.

• Currencies

– The most important markets, per currency, have been USD/EUR and the USD/JPY;

together they represent over half of the world trading volume.

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Prof. Dr. Bernd Scherer

• Spot Market

– the exchange market for payment (of home currency) and delivery (of foreign

currency) ”today”.

– In practice, ”today” means the same day only when you buy or sell notes or coins

(and this part of the market is very small).

– For ’electronic’ deposits, delivery is within two working days for most currencies,

and one day between Canada and the US

• Forward Market: exchange market for contracts signed today but payment

and delivery take place at some future date.

– The forward market consists of many sub-segments corresponding to different

delivery dates, with each sub-segment having its own price.

– The most active forward markets are for 30, 90, 180, 270, and 360 days, but

bankers nowadays quote rates up to ten years forward.

Note that months are indicated as 30 days.

A 30-day contract is settled one month later than a spot contract, and a 180-day

forward contract is settled six months later than a spot contract—each time

including the two-day delay convention.

You can always obtain a price for non-standard maturities, too, for instance 64 days

(two months and four days), or for a specific date.

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Prof. Dr. Bernd Scherer

• We first look at the simple (but unrealistic) case where there are no transactions

costs; then, we consider the case with bid-ask spreads.

• See TABLE 1:

– One needs USD 0.83 to buy one AUD; thus, the exchange rate is USD/AUD 0.83.

– The fourth column treats the USD as the HC and the other currency as the FC.

– The third column treats the USD as the FC and the other currency as the HC. Thus, the

numbers in the third column are the inverse of the numbers in the fourth column.

– USD/AUD = 0.83 which implies that AUD/USD = 1/0.83 =1.20

– Given an exchange rate HC/FC (which is a quote for FC since it is in the denominator),

we can get the quote for the HC by inverting this exchange rate.

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Prof. Dr. Bernd Scherer

Cross Rates

• All the quotes in the third and fourth columns of TABLE 1 are in terms of the USD.

But one may also wish to make spot transactions between other currencies

without going through the USD. The rate at which one can exchange two non-

USD currencies directly is called the cross rate.

HC

• The cross exchange rate for CAD/EUR is 1.4416 and the cross exchange rate for

EUR/JPY is 0.0063.

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Prof. Dr. Bernd Scherer

• To calculate the cross rate between two non-USD currencies simply note:

FC 1 FC 1 USD

= ⋅

FC 2 USD FC 2

= ⋅ = 1.0388 ⋅ 1.388 = 1.4416

EUR USD EUR

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Prof. Dr. Bernd Scherer

typically have to pay more for it than the price we would get for selling it.

– Ask price: the price paid to buy the object (this is the seller’s asking price).

– Bid price: the price received when selling an object (this is the buyer’s bid price).

– The difference between the ask price and the bid price is called the bid-ask spread?

– The spread is the ”market-maker’s” commission for executing the trade. This

spread compensates the market-maker for taking a position that she may not

desire.

– Markets where the trading volume is small will typically have larger spreads; this is

because in these markets it is more difficult for the market-maker to get out of an

undesirable position.

– Bid ask spreads are rising when volatility is rising. Why?

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Prof. Dr. Bernd Scherer

• The spot ask exchange rate is the amount of HC one requires to buy one unit of

the FC today, and the spot bid exchange rate is the amount of HC that one

receives when selling one unit of the FC today.

• TABLE 3: FX Spot bid and ask

– If you live in the U.K. and are planning a holiday to the U.S and wish to buy USD, then

the you have to pay GBP/USD 0.4927. This is the ask rate for USD (the currency in the

denominator).

– If you have some dollars left over after your holiday, when you sell them you will

received the bid rate, GBP/USD 0.4917, which is less than what you paid to purchase

dollars.

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Prof. Dr. Bernd Scherer

• The spot bid-ask quotes in TABLE 3 are in terms of FC. To get the inverse quotes,

that is the quotes in terms of USD/FC, we need to invert the bid-ask quotes. To

get the inverse bid quote we invert the FC/USD ask quote; to get the inverse ask

quote, we invert the FC/USD bid quote.

• The reason why we invert the USD ask quote to get the inverse bid quote is that,

to preclude arbitrage, the bid quote must always be smaller than the ask quote.

• Thus, to get the inverse bid quote to be the smaller number we need invert the

(larger) direct ask quote; similarly, the inverse ask quote will be larger than the

inverse bid quote only if it obtained by inverting the (smaller) direct bid quote.

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Prof. Dr. Bernd Scherer

Example

• Table 4: Foreign exchange spot bid and ask rates as of 11 September 2007

• In Table 4, the sixth column (bid per US$) is obtained by inverting the ask quotes in

the fifth column; the eighth column is obtained by inverting the quotes in the third

column. Consequently, the bid per quotes in column 6 are smaller than the

corresponding ask quotes in column 8.

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Prof. Dr. Bernd Scherer

Summary

• Currencies are not traded on an organized exchange; instead trading takes place

via banks (market-makers) and brokers.

• The market for currencies is very deep—over USD 1.8 trillion is traded daily,

– with most of the trade being in the spot and forward markets, and

– a majority of this being unrelated to trade in goods and services.

• Quotes for spot exchange rate are typically against the USD (direct).

– Indirect quotes can be obtained by inverting the appropriate direct quote.

– Cross rates can be obtained by computing the effective rate if one transacted via the

USD.

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Prof. Dr. Bernd Scherer

• Key Questions

– Understanding forward exchange contracts.

– Relation between spot and forward exchange rates.

– Valuation of forward contracts

• Motivating Problems

1. Suppose you work for Sony (Japan) in the division that exports computer games to

Britain. You receive GBP 100 m for these exports at the end of each quarter. You are

worried about the possibility of a decrease in the JPY value of the GBP. How can you

hedge your position against such a decrease?

2. You work in the treasury office of BC Gas in Vancouver, Canada. It is 6 AM, and you

have yet to see your first cup of coffee. The Chief Financial Officer has told you, Marie,

that there is a cash shortfall, and that to buy gas you need to borrow USD 10 m, for 1

month. How do you decide where to finance this loan—in the US or the Canadian

money market.

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Prof. Dr. Bernd Scherer

• Definition: The forward exchange rate between two currencies, is the price

agreed upon today (t) at which one currency can be exchanged for the

other currency at a certain future date (T).

Ft ,T previously agreed price

t T

• Some Observations

– The rate at which the transaction will take place is determined today;

thus, there is no uncertainty about the price (it is not random).

– The actual transaction (settlement) takes place at a future date, T, in

contrast to a spot transaction, which is settled on the same date (t).

– There is no exchange of cashflows today.

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Prof. Dr. Bernd Scherer

Example

– The spot and forward rate will typically not be the same.

– If the forward rate for the FC (the currency in the denominator) is larger than the spot

rate, then the FC is said to be trading at a premium otherwise, it is at a discount. From

the last column, we see that the Euro is at a premium relative to the USD.

– If the FC is at a forward premium, then the HC is at a discount, and vice versa.

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Prof. Dr. Bernd Scherer

Example (continued)

– You agree today to sell your house after 3 months for USD 1 m. Thus, the 3-month

forward exchange rate for your house is USD/house 1 m. This

– implies that: no exchange takes place today; After 3 months you will receive USD 1 m

and will transfer ownership of your house.

– Suppose you are a resident of the U.S. You are planning a vacation to Japan in 6 months

time. Your budget for the holiday is JPY 1 m. To buy this amount forward, the amount

of USD you need in 6 months time is given by the current USD/JPY 6-month forward

rate in TABLE 1:

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Prof. Dr. Bernd Scherer

Hedging FC Cash-Flows

• FC outflows at a future date can be hedged by buying FC forward.

• Hedging allows us to translate

– a future outflow of FC, whose HC value would depend on the future random spot rate

– into an outflow of HC whose value is the current forward rate which is known today

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Prof. Dr. Bernd Scherer

Example

• Suppose that you live in the US and intend to vacation in London (UK) twelve

months from today. You expect to spend GBP 1 M (monetary unit ☺ ) on your

vacation. You are worried, however, that if there is an increase in the value of the

GBP, you will either have to cut back on what you spend, or you will need

additional USD to keep the same expenditure in GBP. How can you use forward

contracts to hedge your position?

• Your position is short forward GBP. You can hedge this by going long forward GBP

(buying GBP forward). From the data below, we see that the price for buying 12-

month forward GBP would be: USD/GBP = 2.0080.

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Prof. Dr. Bernd Scherer

Invest in HC

( 1 + rt,T )

1 1 ⋅ ( 1 + rt ,T )

Ft,T

Exchange in FC Change into HC

( 1 + rt*,T )

1

st 1

St ⋅ ( 1 + rt*,T )

Invest in FC

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Prof. Dr. Bernd Scherer

CIP (cont.)

Rate Parity (CIP):

( 1 + rt,T )

Ft,T = St ⋅

( 1 + rt*,T )

– Hedging transforms foreign cash into home cash (taxman might view capital gains from

a forward position different than interest rates)

– This is a pure arbitrage argument. It does not imply that the forward rate is

determined by the spot rate.

– Holds extremely close in empirical data (do not confuse with UIP! See later)

• Memory tip

EUR ( 1 + rtEUR

,T )

Ft,T = St USD

⋅

( 1 + rtUSD

,T )

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Prof. Dr. Bernd Scherer

• From the above, in frictionless markets (no transactions costs, no taxes etc.): Can

you save money by borrowing in one currency rather than another?

• No, according to CIP, once you hedge exchange rate risk, borrowing cost will be

the same across currencies.

1

S

( 1 + rt*,T ) Ft,T = (

1 + rt,T )

t

borrowing at hom e

borrowing abroad

– Example: Credit risk is assessed differently in different markets

• If you are not allowed to use forward contract you can replicate them via the

local money markets

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Prof. Dr. Bernd Scherer

– a long position in a foreign zero bond and

– a short position in a domestic zero bond

1 1

Vt +1 = St +1 ⋅ − Ft ,T ⋅

1 + rt*+1,T 1 + rt*+1,T

1 + rt*+1,T

St +1 = Ft +1,T

1 + rt +1,T

1 + rt*+1,T 1 1

Vt +1

= Ft +1,T ⋅ − Ft ,T ⋅

1 + rt +1,T 1 + rt +1,T

* 1 + rt +1,T

1 1

= Ft +1,T ⋅ − Ft ,T ⋅

1 + rt +1,T 1 + rt +1,T

1

= ∆F

1 + rt +1,T

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Prof. Dr. Bernd Scherer

Summary

but via banks and brokers.

between the current forward rate and the rate at which the forward contract

was initiated.

• The value of a just-issued forward contract is zero. After this it moves with the

discounted P&L.

• Covered Interest Parity implies that one cannot profit by borrowing in one

currency and lending in another. With frictions, one can always save money: it

will always be cheaper to borrow in one currency rather than another, even

after hedging against exchange rate risk.

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Prof. Dr. Bernd Scherer

rate (say one-month or three-months in the future) given the

current and historical values of the spot exchange rate? In

practice, do past exchange rates help us to forecast future

exchange rates?

2. In theory, should the forward exchange rate today for a contract

maturing in 90 days (or 360 days) tell us what the future value of

the spot exchange rate will be in 90 days (or 360 days)? In practice,

does the forward exchange rate today tell us what the future spot

exchange rate is going to be?

3. How should one identify the present value in home-currency terms

of a foreign-currency cash flow that is to be received one year

from now?

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Prof. Dr. Bernd Scherer

Main Issues

Question Answer

that is, is the real exchange rate constant?

2. Can one forecast accurately the future spot exchange rate using past No

values of the exchange rate (weak form of predictability).

the current forward rate (Unbiased Expectations Hypothesis; semi-strong

form of predictability).

4. Can one forecast the exchange rate accurately using other variables No

suggested by macroeconomic theories of exchange rate determination

(semi-strong form of predictability).

5. Can one forecast the future spot exchange rate using private information Maybe

(strong form of predictability).

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Prof. Dr. Bernd Scherer

Motivating Problems

– You work in the treasury office of International Harvester, a manufacturer of heavy

equipment. Its main competitor is a Japanese firm, Komatsu, which has only a small

market share. When you talk to your boss about hedging against changes in the

USD/JPY exchange rate, your boss replies that, “Hedging is not important because in

the long run changes in the exchange rate are offset by changes in relative prices; thus,

it all averages out in the long run.”? Do you agree with the opinion of your boss?

– It is your first day of work at Fletcher Challenge, a forestry firm in Canada. As you walk

into the office, your boss introduces you to the other members of the Fletcher

Challenge treasury team. You are beaming brightly in your new business attire,

dreaming about how you are going to spend your signing bonus.

– Two minutes later, you hear a voice say that, ”Our new recruit will now tell us what the

value of CAD/NZD will be a year from now. We will use this estimate for capital

budgeting decisions.” Your boss looks at you expectantly. You are seeking help (and

cover), but the only thing you can hide yourself under is today’s Financial Times. What

is your response?

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Prof. Dr. Bernd Scherer

• The real exchange rate is defined as the nominal exchange rate, deflated by the

domestic and foreign price level.

Pt* HC FC

et = St

Pt FC HC

• If commodity prices offset perfectly the change in the exchange rate, then the

real exchange rate will be equal to 1

• If below (above) one a currency is said to be under (over) valued.

• Main issue: do price changes (at home and abroad) and exchange rate changes

offset each other.

– If yes, then do not have to worry about fluctuations in the nominal exchange rate, for

they will be offset by changes in prices implying that the real effect is zero.

– If not, then changes in the exchange rate will have real effects—exchange rate

fluctuations will change the relative prices of goods at home and abroad; that is, there

is real exchange rate risk.

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Prof. Dr. Bernd Scherer

• Suppose that the current price of gold is USD 330 and the Pound exchange rate is

USD/GBP is 1.65. Then, to preclude arbitrage opportunities the gold price in Sterling

must be:

[USD ] 330

= [GBP ] 200

[ GBP ]

USD 1.65

• That is, the price of the gold in the US must be the same as Britain, after translation

into USD.

• Another way of stating this is that the relative price of gold in the US and in Britain

must equal the exchange rate.

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Prof. Dr. Bernd Scherer

price of commodity k at time t in one country, must equal the price of the same

commodity in another country, expressed in terms of the same currency:

Pkt = St ⋅ Pkt*

• Clearly, if CPP holds for all goods produced in an economy then we need not care

about fluctuations in nominal exchange rates.

• Answer: While CPP may hold for easily traded and homogenous commodities such as

gold and silver, it is unlikely to hold for other commodities such as cars or houses

which are difficult to trade across countries.

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Prof. Dr. Bernd Scherer

– Transactions costs;

– Tariffs and non-tariff barriers to trade, which constrain arbitrage;

– Imperfect competition arising from exclusive dealership contracts, costs for entering new

markets, etc.

– Would you expect CPP to hold for the Big Mac hamburger? See The Economist magazine

for comparison of Big Mac prices in different countries.

– Would you expect CPP to hold for The Economist magazine itself? Compare the price of The

Economist magazine in different countries (given on the front cover) with the exchange

rates (published on the last few pages of The Economist).

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Prof. Dr. Bernd Scherer

• Question

– Even if CPP does not hold, is the general price level in one country related to the price

level in another country, after being translated into a common currency? That is, is one

country more expensive than another?

• Definition

– The absolute version of the Purchasing Power Parity (PPP) hypothesis states that the

price of a representative basket of goods at time t in a particular country, should equal

the price of a representative basket of goods in another country, translated into a

common currency:

Pt = St ⋅ Pt*

• Empirical evidence

– shows that there are large violations of Absolute PPP because the prices of identical

goods in the two baskets may vary across countries (violations of CPP); The

composition of the representative baskets might be different across countries.

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Prof. Dr. Bernd Scherer

PPP appear to hold closely in

the short run.

long-run average and when

there are large movements in

relative prices.

between producer price than

between consumer price

indices.

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Prof. Dr. Bernd Scherer

• Tests of relative PPP seem to do better when inflation is high (when economic

agents are more responsive to price changes). But even in these studies, there

are substantial period-by-period deviations from relative PPP.

• Relative PPP is also more likely to hold in countries where wages are indexed (for

example, Israel in the 1970s).

• Conclusion:

– Relative PPP may have some power in the long run (several years rather than several

months), and in times of high inflation,

– but in the short run there are large deviations that tend to persist for aslong as 3-6

years.

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Prof. Dr. Bernd Scherer

good ingredients

• Distorted by costs for local

(nontraded)) assets like rental

or labour costs.

• In lower income countries

non-traded goods tend to be

cheaper due to lower wages.

• Brand value of MCDonalds the

same in US and China?

• Long run concept and in the

long run prices could simply

take the burden of adjstment

(in particular for a fixed

exchange rate)

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Prof. Dr. Bernd Scherer

USD

= PPorsche

USD EUR

PPorsche [USD ] St

EUR

• If Euro appreciates by 10% (exchange rate pass through) versus USD will Porsche

be 10% more expensive?

– Accept smaller profit margins?

– Cost reduction as imports become less expensive?

– Price elasticity of demand < 1?

– Cost reactions and efficiency gains

• Less than 100% exchange rate pass through exposes a firm to economic currency

exposure (risk)

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Prof. Dr. Bernd Scherer

• Local Production

• Flexible Sourcing

• Diversification across markets (currencies)

• Lowering price elasticity (product differentiation, create monopolistic positions)

• Hedging with financial instruments

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Prof. Dr. Bernd Scherer

• Question

– Even if the level of prices is not the same across two countries, are changes in the price

level in one country related to changes in the exchange-rate adjusted price level in

another country?

• Definition

– According to the relative PPP hypothesis, changes in the price of a representative

basket of goods at time t in a particular country, should equal the changes in the

exchange-rate adjusted price of a representative basket of goods in another country:

Pt +1 St +1 Pt*+1

= ⋅ *

Pt St Pt

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Prof. Dr. Bernd Scherer

Pt +1 St +1 Pt*+1 St +1 Pt*+1

ln = ln ⋅ = ln + ln

Pt St *

Pt S *

Pt

t

S

ln t +1 = πt +1 − π *

+1

St

t

percentage change percentage change

percentage change in domestic prices in foreign prices

in exchange rate

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Prof. Dr. Bernd Scherer

• There are large, frequent, and persistent deviations from PPP, implying that there

is real exchange rate risk;

– that is, changes in the nominal spot rate are not completely offset by changes in prices

at home and abroad.

• Hence, changes in the nominal spot rate will have an impact on the competitive

position of firms.

• Also, changes in the nominal spot rate will have an impact on the returns realized

from investing in foreign-currency denominated securities.

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Prof. Dr. Bernd Scherer

• Weak form tests - those that forecast the future exchange rate on the basis of

the past exchange rate; these are tests of technical models.

• Semi-strong form tests - those that predict the exchange rate on the basis of

other available information, in addition to realized exchange rates. This is called

fundamental analysis.

– The fundamental variables may include the inflation rate, money supply, industrial

production and the forward exchange rate.

– The forecasts based on these fundamentals may be made using an econometric model,

or on a judgmental basis.

• Strong form tests - forecasts made by

– professional forecasting agencies who may be better than individuals at interpreting

information, and

– central banks, who may have more information than that available to the typical

investor.

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Prof. Dr. Bernd Scherer

Autocorrelation Models

• Autocorrelation models are similar to regressions where one regresses the left-

hand side variable on its lagged values.

S S

ln t +1 = a + b ln t + εt +1

St St −1

• Autocorrelation tests on the exchange market generally find

– small, and typically significantly positive autocorrelations;

– autocorrelation coefficients are frequently larger than for common stocks.

• Conclusion: For floating exchange rates the information content of past exchange

rates is low: the R2 statistics from such tests rarely exceed 5%, so the

predictability of the change in the exchange rate, based on past changes, is not

economically significant

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Prof. Dr. Bernd Scherer

Filter Rules

observing an x% rise from a “low” would, on average, generate profits;

• if price-drops tend to be followed by more down-ticks, then selling after

observing an x% fall from a “high” would again pay, on average.

• The percentage x used is called the size of the filter. The filter is meant to detect

significant changes as opposed to meaningless changes generated by temporary

fluctuations in demand and supply.

• Conclusion: While there is some persistence in exchange rates, of the more than

580 filters tested

– less than 10% of the rules produced profits that are significant at the 10% level before

transaction costs; and,

– only 0.3% of the rules were profitable after transaction costs.

304

Prof. Dr. Bernd Scherer

• The conjecture that the future spot rate is equal to the current forward rate is

called the Unbiased Expectations Hypothesis (UEH)

E ( Sɶt +1 | Ωt ) = Ft ,t +1

– all investors were risk neutral, or

– if all exchange risk was completely diversifiable (so that investors were indifferent

between the certain forward rate and the random future spot rate)

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Prof. Dr. Bernd Scherer

S t +1 − S t Ft ,t +1 − St

= +

St a b St + εt +1

• Conclusion: Over 75 empirical studies test this regression, and reject it.

– The average value of b in these studies is -0.88. What regression coefficient would you

expect. What does this tell you?

– The R2 value is also very small, so there is little evidence of predictability in forward

exchange rates.

– What do theses results tell you about the likely success of carry strategies? How would

you optimally design those funds?

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Prof. Dr. Bernd Scherer

1. Investors are not risk neutral and that the bias in the forward rate’s prediction of the

spot rate reflects a risk premium.

2. Investors make errors in forming expectations.

3. The transactions costs may be sufficiently large to obscure the link between the

forward rate and the future spot exchange rate.

• None of these explanations get much support in the data—and this is an ongoing

area of investigation.

– Recent work finds that sign of slope coefficient depends on whether USD at

discount/premium

– slope coefficient is not negative in emerging countries.

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Prof. Dr. Bernd Scherer

• Fisher Closed: Nominal rates should react one to one to an increase in expected

inflation to protect the real rate investors require (no money illusion)

rt +1 = ρ + E ( πt ,t +1 )

• Fisher Open: The real rate of return is the same across the world. If not

investments continue. In other words, the differential in nominal interest equals

the differential in inflation rates

rt +1 − rt*+1 = E ( πt ,t +1 ) − E ( πt*+1 )

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Prof. Dr. Bernd Scherer

• Example: Nominal interest rates in Europe are 1% higher than in the US. What

does this imply for inflation differential, forward contracts and expected

exchange rate movements?

St +1 −St

UEH St PPP

Ft ,t +1 −St

E ( πt ,t +1 ) − E ( πt*+1 )

St

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Prof. Dr. Bernd Scherer

of the exchange rate.

– Interest rate differential

– Inflation differential

– Monetary growth differential

– GDP growth differential

St + 1 − St

= a + b ( rt,t +1 − rt ,t +1 ) + c ( πt ,+1 − πt ,t +1 )

* *

St

+ d ( mt ,+1 − mt*,t +1 ) + e ( gt ,+1 − gt*,t +1 ) + εt +1

• For the case of US versus Japan, the R2 statistic is 0.0098; and for the case of US

versus Germany, the R2 is 0.0118;

• None of the slope coefficients in either regression is significant even at the 10%

level.

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Prof. Dr. Bernd Scherer

• Correlation between exchange rates and explanatory variables is small and not

significant

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Prof. Dr. Bernd Scherer

• Would you sell a forecast or apply it a set of assets? How do the economics

compare? What is your prior on forecasting services?

• Forecasting services using technical models to predict the future spot rate have a

superior record compared to those analyzing fundamental variables.

initially appeared to deteriorate over time; that is, it was not the same services

that had the superior record over time.

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Prof. Dr. Bernd Scherer

orderly market and to smooth out excessive swings in exchange rates;

– they also claim that they do not try and move the exchange rate away from its

fundamental value.

– If this is true, it means that central banks must be quite good a predicting exchange

rates.

• When the profits from intervention are measured for eight central banks, it was

found that seven central banks actually made substantial losses from currency

trading.

• Studies undertaken by the Dutch central bank and the Canadian central bank find

that intervention has been modestly profitable, though there have been long

periods during which the banks incurred substantial losses.

• Conclusion: Thus, the evidence is mixed and one cannot conclude that central

banks can predict the future spot rate, even though they have access to private

information about monetary and exchange-rate policy.

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Prof. Dr. Bernd Scherer

Summary

PPP, indicating the presence of real exchange rate risk.

• The overall evidence suggests that it is quite difficult to predict future exchange

rates accurately.

– Technical forecasts seem to do better, though even their record is not impressive.

– While economic theory may be useful for explaining the past, and for making broad

predictions about the long-run effects of government policy, it has only limited

successful in making precise predictions about the exchange rate in the short run

exchange rates?

– Do fluctuations in the exchange rate influence the value of firms?

– Do changes in the exchange rate affect the payoff from investing in international

assets?

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Prof. Dr. Bernd Scherer

on the domestic stock exchanges. One can also hold international assets.

– What are the disadvantages of investing in international stocks and bonds?

– What does the data suggest: are the gains from international diversification

large or small?

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Prof. Dr. Bernd Scherer

Pt +1 − Pt + dt +1 P + dt +1

rt,t +1 = = t +1t −1

Pt Pt

( PtFC

+1 +1 ) ⋅ St +1 − Pt

+ DtFC FC

⋅ St

rt,t +1 =

PtFC ⋅ St

= ( 1 + rtFC

,t +1 ) ⋅ ( 1 + st ,t +1 ) − 1

= rtFC

,t +1 + st ,t +1 + rt ,t +1 ⋅ st ,t +1

FC

≈ rtFC

,t +1 + st ,t +1

– The approximation is good when the returns are small, and is exact for

continuously compounded returns

– Currency risk is always on TOP OF asset risk

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Prof. Dr. Bernd Scherer

rt ,t + 1 = rtFC

,t + 1 + ( 1 − h ) ⋅ st ,t + 1

,t + 1 ) + ( 1 − h ) var ( st ,t + 1 ) + 2 ( 1 − h ) cov ( rt ,t + 1 , st ,t + 1 )

2 FC

• Will currency hedging always decrease risks, i.e. what is the optimal hedge ratio?

d var ( rt ,t + 1 )

= −2 ( 1 − h ) var ( st ,t + 1 ) − 2 cov ( rtFC

,t + 1 , st ,t + 1 ) = 0

dh

∗

cov ( rt ,t + 1 , st ,t + 1 )

FC

h = 1+

var ( st ,t + 1 )

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Prof. Dr. Bernd Scherer

currency terms, and in USD terms (that is, after adjusting for exchange rates).

• But, the volatility of non-US equity markets has also been higher than that of the

US market. The variance of returns on non-US stocks in local currency terms are

only slightly lower than returns measured in USD because even though the

exchange rate has high volatility, its correlation with stock returns is quite low.

• Because the correlation among international stock markets is less than one

there are substantial gains from diversifying internationally. But, investors

typically invest only in domestic stocks and do not diversify internationally.

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Prof. Dr. Bernd Scherer

• Average returns in merging markets have been high and very variable relative to

returns in developed markets.

– The correlations among emerging equity markets are lower than those among

developed markets (about 0.1 instead of 0.4).

– Thus, there seem to be substantial diversification gains by adding emerging market

equities to ones portfolio.

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Prof. Dr. Bernd Scherer

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Prof. Dr. Bernd Scherer

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Prof. Dr. Bernd Scherer

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• Global Diversification

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Prof. Dr. Bernd Scherer

Summary

• The data seems to suggest that there are large gains from diversifying one’s

portfolio internationally.

• However note that observed portfolios are heavily weighted toward domestic

assets. It is a puzzle why investors do not diversify internationally – If its so great

why don’t investors do it?

portfolios of only domestic assets; the only difference is that now one needs to

translate returns on foreign assets into HC terms.

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Prof. Dr. Bernd Scherer

1. Volatility Returns

326

Prof. Dr. Bernd Scherer

Literature

Academic Press

Wiley

as an Asset Class, SSRN

327

Prof. Dr. Bernd Scherer

• Straddle Returns

• Variance Swaps

328

Prof. Dr. Bernd Scherer

• Example: Delta hedged long call (20% volatility), i.e. long call with delta

equivalent short position in the underlying

• If implied volatility jumps (to 30%), is the holder of the above strategy

guaranteed to make a profit?

• Note a delta hedged position leaves the investors still with three exposures

– Theta: Time decay, i.e. option sensitivity to the passage of time

– Gamma: Sensitivity of the option delta to changes in underlying

– Vega: Option sensitivity to changes in implied (expected future)

volatility

• In the next few slides we will show this is a grossly imperfect volatility

position

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Prof. Dr. Bernd Scherer

• Example: 100 Calls with 0.1 years maturity, Strike 100 and implied volatility

of 20%

100 ⋅ C = 100 ⋅ 2.52 = 252

delta = 100 ⋅ dC

dS = 51.2

2

gamma = 100 ⋅ ddSC2 = 6.3

vega = 100 ⋅ ddC

σ2

= 3152

0.09

change in

variance

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Prof. Dr. Bernd Scherer

• Vega is a function of the underlying stock price (deep ITM and OTM) “cease” to

have option value and hence have almost no vega.

35

100 ⋅ 31.52 ⋅ ( 0.09 - 0.04 ) = 157.6

30

25

20

Variance Vega

15

10

0

70.00 80.00 90.00 100.00 110.00 120.00 130.00 140.00

-5

Strike/Underlying

331

Prof. Dr. Bernd Scherer

• Sell 110% out of the money call at 30% implied volatility. Realized volatility is 27%

(prima facie good) but rises towards the end when option was at the money (and

hence had large gamma). Position lost money. Why?

332

Prof. Dr. Bernd Scherer

500%

• A dynamically hedged position

might loose its exposure to

400%

volatility and hence works no

longer as a hedge. How will a

300% static long straddle (long call

Straddle Return

200%

100%

long call and put (strike 100),

0.1 days to maturity.

0%

75 80 85 90 95 100 105 110 115 120 125

-100%

Spot Price (S) at Maturity T

333

Prof. Dr. Bernd Scherer

0.09 - 0.04 ) = 315.2

change in

variance

• All other problems remain, i.e. vega becomes very small if the underlying

moves away from the strike. Again long straddle does not isolate volatility

as source of return.

a) If increased volatility results in large realized movements (underlying

ends at 70 or 130) the long straddle holder will benefit

b) Conversely even if volatility rises a long straddle might pay nothing if

the stock finishes after violent moves at 100

334

Prof. Dr. Bernd Scherer

the underlying?

• Intuition: Vega of out of the money puts became increasingly smaller, i.e.

we need to increase the weight on OTM Calls and Puts to avoid Vega decay.

But by how much?

∑ K >K * ( K1 )C

2

OTM

(K ) + ∑

K <K * ( K1 )P

2

OTM

(K )

CALL PUT

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Prof. Dr. Bernd Scherer

Example

• 13 Options with strikes between 70 and 130, 0.0833 years to maturity, 20% volatility

and 5% risk free rate.

16

12

Vega

0

70 80 90 100 110 120 130

Spot Price (S )

336

Prof. Dr. Bernd Scherer

Example (continued)

Strike (K ) 70.00 75.00 80.00 85.00 90.00 95.00 100.00 105.00 110.00 115.00 120.00 125.00 130.00

1/K² 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

1/K² Weight 0.14 0.12 0.11 0.10 0.09 0.08 0.07 0.06 0.06 0.05 0.05 0.04 0.04

70.00 8.02 4.43 0.70 0.04 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

72.50 6.49 7.42 2.31 0.25 0.01 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

75.00 3.73 8.59 5.15 1.02 0.08 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

77.50 1.57 7.14 8.07 2.90 0.40 0.03 0.00 0.00 0.00 0.00 0.00 0.00 0.00

80.00 0.50 4.38 9.17 5.87 1.41 0.15 0.01 0.00 0.00 0.00 0.00 0.00 0.00

82.50 0.12 2.05 7.77 8.71 3.54 0.61 0.05 0.00 0.00 0.00 0.00 0.00 0.00

85.00 0.02 0.75 5.05 9.74 6.59 1.85 0.25 0.02 0.00 0.00 0.00 0.00 0.00

87.50 0.00 0.22 2.57 8.40 9.35 4.20 0.87 0.09 0.01 0.00 0.00 0.00 0.00

90.00 0.00 0.05 1.05 5.72 10.31 7.31 2.35 0.38 0.03 0.00 0.00 0.00 0.00

92.50 0.00 0.01 0.35 3.13 9.03 9.98 4.88 1.19 0.16 0.01 0.00 0.00 0.00

95.00 0.00 0.00 0.10 1.40 6.39 10.88 8.02 2.89 0.56 0.06 0.00 0.00 0.00

97.50 0.00 0.00 0.02 0.52 3.71 9.65 10.61 5.58 1.56 0.25 0.02 0.00 0.00

100.00 0.00 0.00 0.00 0.16 1.80 7.06 11.46 8.73 3.47 0.78 0.11 0.01 0.00

102.50 0.00 0.00 0.00 0.04 0.74 4.32 10.26 11.23 6.29 1.97 0.37 0.05 0.00

105.00 0.00 0.00 0.00 0.01 0.26 2.25 7.73 12.03 9.43 4.08 1.05 0.17 0.02

107.50 0.00 0.00 0.00 0.00 0.08 1.00 4.95 10.88 11.85 7.01 2.43 0.53 0.08

110.00 0.00 0.00 0.00 0.00 0.02 0.39 2.73 8.40 12.60 10.13 4.71 1.36 0.26

112.50 0.00 0.00 0.00 0.00 0.00 0.13 1.31 5.59 11.49 12.46 7.73 2.93 0.72

115.00 0.00 0.00 0.00 0.00 0.00 0.04 0.55 3.25 9.06 13.18 10.82 5.37 1.71

117.50 0.00 0.00 0.00 0.00 0.00 0.01 0.21 1.66 6.25 12.10 13.07 8.45 3.47

120.00 0.00 0.00 0.00 0.00 0.00 0.00 0.07 0.75 3.79 9.73 13.75 11.50 6.05

122.50 0.00 0.00 0.00 0.00 0.00 0.00 0.02 0.30 2.05 6.91 12.70 13.68 9.17

125.00 0.00 0.00 0.00 0.00 0.00 0.00 0.01 0.11 0.99 4.36 10.39 14.32 12.18

127.50 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.04 0.43 2.47 7.57 13.31 14.28

130.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.01 0.17 1.26 4.95 11.04 14.90

337

Prof. Dr. Bernd Scherer

Example (continued)

0.16

2.5

0.14

2.3 0.12

0.10

2.1

Weight

Vega

0.08

1.9

0.06

1.7 0.04

0.02

1.5

70 90 110 130

Asset Price 0.00

70.00 90.00 110.00 130.00

Stri ke

Prof. Dr. Bernd Scherer

difference between realized variance and a predetermined variance strike.

limited (variance swaps are hence often capped)

• Price of a variance swap depends on the price of out of the money puts. If smile is

steep, variance swaps are very expensive.

339

Prof. Dr. Bernd Scherer

340

Prof. Dr. Bernd Scherer

341

Prof. Dr. Bernd Scherer

existing assets

• Low correlation is not enough (coin flipping also has zero correlation but no

risk premium)

• Only return streams that are yet un-spanned extend the efficient frontier

further to the left.

342

Prof. Dr. Bernd Scherer

• The more pronounced the smile the more expensive the variance swap

(bigger spread below). Why (relate this to the pricing of variance swaps)?

343

Prof. Dr. Bernd Scherer

premium from long (short) volatility

insurance to the capital markets.

Payoffs

Is this a reasonable position for a

private investor?

Discrete

Returns

Log

Returns

344

Prof. Dr. Bernd Scherer

345

Prof. Dr. Bernd Scherer

conditional OLS regressions below.

346

Prof. Dr. Bernd Scherer

• Run CAPM regressions to look for risk adjusted out (under) performance.

Are variance swaps priced (spanned) by systematic risk factors?

underperformance for

long variance swap

347

Prof. Dr. Bernd Scherer

Efficient Frontiers

swaps

348

Prof. Dr. Bernd Scherer

• +/- 2 STD change in variance swap risk premium.

Contrary to popular advice (go long variance swapss to protect downside, the reults show that

investors should go short variance swaps (to collect a risk premium) and go short equities to hedge

the risk from sort variance swaps.

349

Prof. Dr. Bernd Scherer

350

Prof. Dr. Bernd Scherer

Literature

351

Prof. Dr. Bernd Scherer

Financial Operational

• Instruments: • Instruments:

– insurance contracts – standard procedures

– derivatives – safety installations

– capital structure – etc

• Aim: • Aim:

– structuring cash flows – continued operations

depending on certain and loss prevention

outcomes

i.e., derivatives are „fairly priced“ i.e., real investments may be profitable

352

Prof. Dr. Bernd Scherer

Conventional answer:

Public company

Entrepeneurial firm

to the owner-manager buying about projects with NPV = 0?

insurance.

353

Prof. Dr. Bernd Scherer

Buying Assets

Capital „fairly 60 Capital

Assets

100 100 priced“ 100

derivative Hedge

40

Conclusion

- perfect competition

- no transactions costs

- no bankruptcy costs Compare the

- no taxes assumptions of In a perfect capital market,

- no regulation Modigliani & Miller (1958) risk management is irrelevant!

- perfect information

354

Prof. Dr. Bernd Scherer

Source: Bodnar et al. (1998): Wharton/CIBC World Markets 1998 Financial Risk Management

Survey of 2000 publicly traded US firms. 399 respondents.

355

Prof. Dr. Bernd Scherer

• Direct costs

– Lawyers, management time

– Firm specific assets

– Difficulties to sell products

– Difficult to tap capital markets

356

Prof. Dr. Bernd Scherer

bc

d a

Bankruptcy costs. The costs of corporate bankruptcy (direct and indirect) indicated by bc rise if the asset

value (a) falls below the value of corporate debt (d). Costs are measured at time of bankruptcy. Asset

volatility will increase the value of this option. Source: Scherer (2005)

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Prof. Dr. Bernd Scherer

Taxes (1/2)

• The second convexity arises from corporate tax schedules. For example:

firms either pay taxes if they make profits (the more the higher profits

are) or they don’t (irrespective of the size of losses).

• Carrying losses backward and forward is typically limited. Hence there is

a natural kink of the tax function creating convexity. If earnings (e) are

100 in one year and -100 next year the tax base is on average zero (the

company left its owner with zero profits after two years), while the

company did pay 35 in taxes after year one.

• Shareholder value is created if we manage to reduce the governments

contingent claim in a company.

• In summary: a rise in earnings volatility induced by corporate leverage

will reduce the expected value of the tax shield, as this can only be used

if interest payments can be offset against profits.

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Prof. Dr. Bernd Scherer

Taxes (2/2)

0 e

Non linear tax schedule. The value of total tax payments ( τ ) increases with earnings (e), but it does not

become negative when earnings turn negative. Instead it remains zero. This resembles a long call option

on corporate earnings. Source: Scherer (2005)

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Prof. Dr. Bernd Scherer

• Liquidity (cash on hand) is valuable to firms, because raising cash in the future

might be expensive. Reasons are

– direct transaction costs (investment banking and lawyers‘ fees)

– adverse selection (Myers & Majluf, 1984)

• Adverse selection costs arise because two types of firms might raise capital

– firms that need to finance positive-NPV projects (starting the project is good

for existing investors, new investors get required rate of return)

– firms whose claims are overvalued (raising capital transfers wealth from new

investors to existing investors!)

360

Prof. Dr. Bernd Scherer

compensation contracts) and issue claims whenever they are overvalued

or a positive-NPV project emerges

• Outside investors cannot distiniguish between overvalued firms and those

with positive-NPV projects

– New investors would have, on average, a lower than required return

– Potential investors understand this, and offer to pay LESS so that the earn

their required rate of return on average

361

Prof. Dr. Bernd Scherer

• Underinvestment (positive-NPV projects are not realized because

necessary capital can only be raised at additional cost)

• Liquidity preference:

– financing projects from retained earnings is least costly

– cash reserves as such are valuable

– firms with future growth opportunities (real options) hold excess cash

• Risk management preserves cash reserves

• Case: Porsche AG hedging USD exposure

• 50% of revenues in USD, 100% costs in EUR

• USD devaluation would drain cash quickly and force Porsche to raise

expensive capital

362

Prof. Dr. Bernd Scherer

• A firm is said to be in financial distress when its income is not sufficient to cover

its fixed expenses.

• The state of financial distress can lead to bankruptcy, which of course involves

liquidation costs and other direct costs.

• Large, uncovered exposures combined with adverse exchange rate movements

may send a firm into insolvency and bankruptcy, or may at least contribute to

such an outcome.

not a corporate objective (now try to tell this a regulator ☺)

– In the absence of these costs, shareholders would just have lost control of the firm to

the bondholders, who would carry on the business as before (possibly after selling

their ownership rights to others).

– That is, in the absence of bankruptcy costs the event of insolvency would not have

affected the value of the firm as a whole.

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Prof. Dr. Bernd Scherer

• Many firms sell products for which after-sales service is needed and the firm

typically offers product warranties.

• Thus, a buyer’s decision to purchase such products will depend on her

confidence to continue to receive after-sales service.

• Such firms will sell more, and will therefore be worth more, the lower the

probability of going out of business.

• Thus hedging, by reducing the volatility of cash flows, decreases the probability

of coming uncomfortably close to bankruptcy.

364

Prof. Dr. Bernd Scherer

• Risk averse employees are likely to demand higher wages if their future job

prospects are very uncertain.

• In the event of bankruptcy, a forced change of job will generally entail monetary

or nonmonetary losses to the employee. Thus, the employee will want to

protect himself, ex ante, by requiring higher wages when working for a firm that

is more likely to be in financial distress.

• Note that this source of wage risk premium seems to hinge on imperfections in

the labour market. However, ultimately, the validity of this rationale for

corporate hedging can still be traced to imperfections in the market for risks. If

uncertainty of personal income were fully diversifiable or hedgeable, there

would not be a risk premia in wages.

365

Prof. Dr. Bernd Scherer

• Loan covenants can trigger repayment if the firm’s income falls below a stated

level. To the extent that refinancing is difficult or costly, it is useful for the firm

to reduce income volatility by hedging.

• Costs associated with refinancing include transaction costs, and especially the

indirect or agency costs of refinancing when a firm is in financial distress.

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Prof. Dr. Bernd Scherer

investors’ homemade financing decisions are perfect substitutes for the

corporate financing decisions the shareholders would have preferred.

• The term “perfect substitutes” should be read in a double sense:

– the home-made financial contracts the same effect, and*

– they are contracted at the same prices, as the corporate financial decisions they

replace.

• In practice, home-made financing decisions fail to meet both criteria because of:

– Imperfect information: In the real world, shareholders have far less information about

the firm’s exposure than the managers. If shareholders have very imprecise knowledge

of the firm’s exposure, home-made hedging will be far less effective than corporate

hedging.

– Costs of financial distress and agency conflicts: In reality, no individual shareholder can

buy a contract that perfectly hedges against the costs of financial distress.

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Prof. Dr. Bernd Scherer

• Agency costs are the costs that arise from the conflict of interest between

shareholders, bondholders and the managers of the firm.

– These agency costs can affect the firm’s wage bill, its choice of investment projects,

and its borrowing costs.

• Hedging, by reducing the volatility of a firm’s cashflows, can reduce the conflict

of interests between different claimants to the firm’s cashflows and can

– increase its debt capacity, and

– reduce its cost of capital.

368

Prof. Dr. Bernd Scherer

Regulation

D ∂c

Debt Vega = >0

∂σ

Equity

Equity holders have an incentive to engage

in high risk investments

D V

Explains the severe regulation of financial institutions,

Incentive increases with leverage

such as banks and insurance, in particular

- risk management

- asset liability management

Taking risk particularly simple with - restrictions on derivative use

financial instruments

369

Prof. Dr. Bernd Scherer

Regulation

regulatory requirements

• case: swap overlay of UK insurance assets

• Mostly, financial innovations are used to bypass

regulatory requirements

• case: structured products in German insurance industry

• loans are not marked-to-market under German GAAP („HGB“), implying no

risk of write-off

• „interest rate payments“ may depend on the return of equity portfolio

• result is economic exposure to equity without balance sheet exposure,

inflating the risk capacity of German insurers

• case: ENRON

• derivatives may be „off-balance sheet“

• value of firm‘s assets are not transparent

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Prof. Dr. Bernd Scherer

• Information costs

– risk management has potentially a multitude of objectives

– optimal strategies may be complex

• Transaction fees

– trading costs

– complex products are difficult to price: low transparency

– derivatives are complex (case: Metallgesellschaft)

– derivatives can be used for asset substitution (case: Barings)

371

Prof. Dr. Bernd Scherer

Optimum amount of

hedging

Cost

Firm value

PV(bankruptcy costs)

Extent of Extent of

hedging hedging

372

Prof. Dr. Bernd Scherer

by 200 millions

increases by 10 million

• What should the CEO do? How can he compare across business?

• What should the CEO do at bonus time? Whose profits are more

valuable?

373

Prof. Dr. Bernd Scherer

should a firm hold • „Amount of capital a bank needs to absorb losses over a certain

in order to arrive time horizon with a certain confidence level“ (HULL, 2007, p.366)

at its optimal – Example: Suppose a company decides to target a AA rating (Question: Is this decision

default probability exogenous?). Given the one year rate of default probability for ist peers (other AA) is

0.03%, the confidence level would be 99.7%.

• Allocating risk

across business • Capital is required to cover unexpected loss. (Expected loss is

units incorporated in pricing decisions)

• Performance

evaluation • We need economic capital to cover operational, market and credit

risks. Sketch the distributions. How can we aggregate these risks.

to access the markets for equity funding in times of distress.

374

Prof. Dr. Bernd Scherer

• Aggregating

economic capital • The following table shows the economic capital (main diagonal for two

business units along the categories of market, operational and credit risk.

• Hybrid approach: Off diagonal entries show correlations.

Calculate

economic capital MR-1 CR1 OR-1 MR-2 CR-2 OR-2

MR-1 30 0.5 0.2 0.4 0 0

for business units CR1 0.5 70 0.2 0 0.6 0

using non-normal OR-1 0.2 0.2 30 0 0 0

MR-2 0.4 0 0 40 0.5 0.2

distributions, EVT,

CR-2 0 0.6 0 0.5 80 0.2

… & aggregate OR-2 0 0 0 0.2 0.2 90

the marginal

distributions

• The diversification benefit is the difference between the sum of individual

using correlations

risk capital (at correlation of one) and the aggregated risk capital using

above correlations.

n n n n

DB = −

Economic

Capital

375

Prof. Dr. Bernd Scherer

be familiar to

you from dEC

∑ i =1 dI i

n

previous EC = Ii

lectures! dEC

dI i = m arg inal risk capital

Ii dEC

dI i = incremental risk capital

I i = amount invested in unit i

dEC

∑ i =1 EC i

n

EC i = I ⇒ = EC

dI i i

analytically from a large scenario matrix? Some call this non-normal

risk budgeting.

376

Prof. Dr. Bernd Scherer

RAROC

comes in many different definitions (be careful in practice what your

counterpart means). The most often used definition is:

RAROC i =

EC i

• Can you game this RAROC measure? How? What should be changed?

• Does RAROC create a procyclical behaviour?

377

Prof. Dr. Bernd Scherer

• Read the A financial firm issues claims (for example options) at a spread µ over fair market

original value (i.e. it makes economic profits!)

paper! Its

worth it! The issued claim is hedged. However, hedging comes with an error that can not be

reduced any further. We assume the hedging error follows

dh = σ ⋅ dz

In order to manage the firm risks that arise from the hedging error, the firm puts a

risk buffer in form of cash, C , aside. The buffer earns the riskless rate on cash r and

the firms assets, S , after one period are given by

S = C ⋅ (1 + r ) + h

to be covered. We also assume the firm insures against this loss. While the fair

insurance premium would amount to E ( S − ) , i.e. the cost of an option against

default, the insurance provider (for example the bondholder) requires some

monitoring costs (to avoid hidden action in the form of pumping up the risks), m .

378

Prof. Dr. Bernd Scherer

(1 + m ) E ( S − )

While we can get these insurance costs down to zero if we hold large amounts of

cash, cash itself comes with agency costs (management waste) diluting the

shareholder claim S − = max [ −S , 0 ] to

(1 − d ) E ( S + )

The present value of the firm is equal to the firms operating profit less the value of

deadweight costs (these costs depend on volatility with no beta exposure, i.e. it is

not only systematic risks that matter!!!)

firm − value = µ − [ d ⋅ E ( S + ) + m ⋅ E ( S + ) ]

deadweight costs

379

Prof. Dr. Bernd Scherer

We can calculate the deadweight costs by taking their expectation with respect to

the risk neutral distribution.

E (S + ) =

σ

1+r ((

n

C ⋅ (1 + r )

σ )

+

C ⋅ (1 + r )

σ

N (

C ⋅ (1 + r )

σ ))

E (S + ) =

σ

1+r ((

n

C ⋅ (1 + r )

σ )

−

C ⋅ (1 + r )

σ (

N −

C ⋅ (1 + r )

σ ))

where n ( ) and N ( ) are the standard normal and cumulative standard normal

distributions.

380

Prof. Dr. Bernd Scherer

Cash will decrease monitoring costs but increase agency costs. As these two effects

offset we need to find the cash allocation where

∂E ( S + ) ∂E ( S − )

d =m

∂C ∂C

∂E ( S + ) ∂E ( S − )

d −m =0

∂C ∂C

1 − q ) (

d ( 1 + r ) − mq ( 1 + r ) = 0

prob of pay off from

pay off more cash

d

q =

m +d

381

Prof. Dr. Bernd Scherer

q = F ( −C * ( 1 + r ) )

d

d +m

=N ( −C * ( 1+r )

σ ) | transform into standard normal

1−

d

d +m

=N ( C * ( 1+ r )

σ ) | use symmetry

C * ( 1 +r )

σ = N −1 ( mm+d )

C * = N −1 ( mm+d ) σ 1+1 r

Firms will hold a low cash portion if the agency costs of cash are high relative to the

monitoring costs from insurance and the other way round. If hedging were

complete, σ = 0 , no cash would be needed.

382

Prof. Dr. Bernd Scherer

If we substitute the term for C * into the expression for firm − value we get the

following

firm − value = µ − kR

R= σ

2 π ( 1+r )

2

k = (d + m )e −2[ N ( d +m ) ]

1 −1 m

R is the value of a put option to insure against hedging error. In other words: The

risk capital needed equals the price to insure against a loss. How can we see this?

We simply calculate

0 − 1 ( h )2

E ( max [ −h, 0 ] ) = ∫ -∞ h⋅ 1

1

σ( 2 π )2

e 2 σ2 ⋅ dh = σ

2π

383

Prof. Dr. Bernd Scherer

Capital Allocation

Capital allocation should aim at maximizing the net present value of the financial

firm

µ − kR

economic profits versus marginal risks:

∆µ − k ∆R > 0 or

∆µ

∆R

>k

Steps:

i.e. after risk adjusted capital costs.

2. Subtract the incremental deadweight costs, i.e. the costs of increasing

risk. Note that in a MM framework theses costs would be zero as they (in

our example) only represent noise. Note: As long as the project is small

∆R = βR , where β is the regression coefficient of project versus firm

revenues. Projects with negative correlation might be attractive even if

∆µ < 0

384

Prof. Dr. Bernd Scherer

Capital Allocation

∆µ

The expression ∆R

> k looks similar to RAROC. However the differences are:

Note all this analysis is incremental, i.e. for small projects only!

385

Prof. Dr. Bernd Scherer

m = 100%, d = 10%, σ = 150, r = 10%

70

60

50

Deadweight Costs

40

30

20

10

0

0

0

0

40

80

12

16

20

24

28

32

36

40

44

48

52

56

60

Cash Cushion

Total Deadweight Costs

386

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