Financial Derivatives, Market Mechanics, and Risk Management in Finance

Derivative

Financial instrument whose value depends on or is derived from the value of some underlying asset

ex: stocks, bonds, wheat

Forward Contract

Agreement between a buyer and a seller to exchange a financial instrument (or commodity) for a specified amount of cash on a prearranged future date. also an example of a derivative

Futures contract

a forward contract that has been standardized and sold through an organized exchange

In a futures contract, buyer are in the ____ position and sellers are in the ____ position

long; short

Interest-rate swaps

agreement between two counterparties to exchange periodic interest-rate payments over some future period, based on an agreed upon amount of principal, called the notional principal

ex. one party agrees to make payments based on a fixed interest rate and in exchange the counterparty agrees to make payments based on a floating interest rate, like bank paying fixed rate to dealer and dealer paying bank floating rate

Floating rate receiver

thinks rates will increase to level above the fixed rate being paid to the other party --> profitable

Fixed rate receiver

thinks rates will decrease the level below fixed rate they are receiving --> profitable

Credit Default Swaps (CDS)

a credit derivative that allows lenders to insure against the risk that a borrower will default.

ex: third party seller of ___ agrees to pay the buyer if an underlying loan or security defaults

Call option

the right to buy, "___ away" a given quantity of an underlying asset at a predetermined price called the strike price (or exercise price), on or before a specific date.

Put option

gives the holder the right but not obligation to sell the underlying asset at a predetermined price on or before a fixed date.

Exchange rate

price of ones currency in terms of another

Foreign exchange market

market where exchange rates are determined

Appreciation

a currency rises in value relative to another currency

Depreciation

A currency falls in vale relative another currency

Assumptions of Purchasing Power Parity

1. All goods are identical in both countries

2. Trade barriers and transportation costs are low

3. Many goods and services are not traded across borders

Types of FX trading transaction

- Spot transaction (spot exchange rate)

- Forward transaction

(forward exchange rate)

Spot transaction

immediate (two-day) exchange of bank deposits

Assumptions of Covered Interest Parity

1) Bank deposits of the two countries are perfect substitutes

2) Perfect Capital mobility (when investing in another country, you must obey their laws, including ones that may stop you from taking out all money)

Uncovered Interest Parity

Exchange rate risk is left uncovered because of no forward contract

Low quality asset

risk of default, poor information, lack of full understanding.. etc.

Implications of Low-Quality assets

1. bigger firm, more access - easier for larger firms to gain access to securities because smaller firms may not last

2. Skin in the Game - collateral (stronger incentive to pay)

3. Lots of fine print - restrictive covenants on borrowers

Why do financial intermediaries exist? (transaction costs of acquiring info that financial intermediaries work to reduce)

1. Economies of scale

2. Expertise

Economies of scale

- as you produce more of a service or good, you are able to produce it at a lower average total cost

- financial intermediaries are able to aggregate the cost of acquiring information and analyzing it

Expertise

- financial intermediaries are able to have legal and accounting talent, people from specific industries, etc. that help them aggregate their data

Asymmetric Information

one party in a financial interaction has more information that the other party

Issues with Asymmetric information

1. Adverse selection (occurs before transaction) - Because the firms know best about their own projects and bad borrowers are more willing to accept whatever they can get, so market is only filled with companies with poor prospects

2. Moral Hazard - (after the transaction) economic actors in a transaction do not bear the full cost of their decisions, leading them to change what they do with the borrowed money, maybe investing in something riskier.

Tools to help solve Adverse selection

- Private production and sale of information (FICO Credit Score, Moodys, etc)

- Governments regulation to increase information (SEC, IRS)

- Financial Intermediation (banks)

- Collateral and net worth

How does moral hazard affect the choice between debt and equity contracts?

- Principal Agent Problem

- Separation of ownership and control of the firm - managers will pursue personal benefits and power rather than the profitability of the firm

Principal-agent problem

principal (owner of the company, stockholder) has less information than agent (manager, CEO, CFO), so they don't know exactly what is going on with their money.

Tools to solve Principal-Agent Problem

- Monitoring (costly state verification and free-rider problems)

- Government regulation to increase information

- Financial intermediation (VC firm)

- Debt contracts (but borrowers have incentives to take on projects that are riskier than the lenders would like)

Tools to solve Moral Hazard

- Net worth and Collateral

- restrictive covenants

Restrictive Covenants

- Discourage undesirable behavior (loan can only be used to buy equipment discussed)

- Encourage desirable behavior (firm required to hold min. level of assets)

- Keep collateral valuable (bus. required to keep adequate insurance on collateral

- Provide information (right to inspect books at anytime)

Profit = spread =

Interest on Assets - Interest on Liabilities = Bank capital

Assets

Uses of funds

Liabilities

Sources of funds

Liquidity managent

not running out of cash

Excess reserves =

(reserves - Req. reserves)

- provides insurance for banks by making sure they don't run out of cash during deposit outflows

Solutions to liquidity problem

- Borrowing - cost incurred is the interest rate paid on the borrowed funds (federal funds rate)

- Securities (bonds) sale - the cost of selling securities is the brokerage and other transaction costs (might be selling at capital loss)

- Federal Reserve - borrowing from the Fed also incurs interest payments based on the discount rate (The Fed will be looking at bank if they need to be borrowing from them)

- Reduce loans - reduction of loans is the most costly way of acquiring reserves (antagonize customers, other banks may only buy loans for very discounted price)

Asset Management

- finding borrowers that have a low possibility of defaulting

- purchasing securities with high possible returns

- lower risk by diversifying (geographically, types of bonds like longer and shorter)

- balancing the need for liquidity against increased returns from less liquid assets

Liability management

- checkable deposits have decreased in importance as a source of banks

Net interest margin (NIM) = [(Interest income - interest expense) / Interest Earning Assets] x 100

Capital Adequacy Management

- Bank capital helps prevent bank failure

- The amount of capital affects the return for the owners of the bank

- Regulatory requirement (Capital/Assets must be less than or equal to 5% to be well-capitalized)

Interest rate risk

changes in the interest rate in the economy affecting banks

- Change in bank profits = (Rate sensitive assets - rate sensitive liabilities) x Change in rates)

- duration gap = Asset duration - (L/A x Liability duration)

- Change in Net worth/ Assets = - Duration gap x (change in r/1 +r)

Credit risk

higher rated bonds have the lowest credit risk (lowest premium) and lower rated bonds have the highest credit risk ( highest premium)

- Loan value = Fixed yearly payment/ (1+i)^n+1.... + FP/1+i^n

Managing Credit risk

- Screening and monitoring