ECON 341 - Final

B/S Equation

Assets = Liabilities + Capital

Assets and Liabilities of a B/S

Assets = Loans, Bonds purchased, reserves

Liabilities = Deposits, bonds issued, borrowing from other banks

Bank management involves the following:

1. Asset management

2. Liabilities management

3. Capital management

4. Liquidity management

5. Risk management

Risks involved in risk management

1. Credit/Default risk

2. Interest rate risk

3. Inflation risk

4. Exchange rate risk

5. Liquidity Risk

6. Market (trading) risk

7. Insolvency risk

Asset Management Principles

1. Banks should try to find high earnings and low-risk assets

2. Assets should be diversified

What is the trade-off in asset management?

High earning assets typically come with high risk and low creditworthiness individuals

How to solve capital management

having sufficient capital (Capital Requirement)

How to solve liquidity management

having sufficient liquid assets (reserves)

Liability Management

1. Try to obtain liabilities (source of funds) at very low or 0 interest

What does sufficient capital do?

Helps prevent bank failure

Helps withstand credit risk/asset write-off

What does too much capital do?

Reduces the return per equity (the bank manager's dilemma).

Solutions for too low capital (raise capital)

1. Sell Stocks

2. Pay less dividends (if more dividends, then less retained earnings)

When a bank sells more stocks and pays less dividends, the share price goes down!

Solutions to lower capital

1. Buy back some of the stocks

2. Pay out more dividends

What is credit/default risk? (Risk management)

The risk that borrowers may default on their loans due to asymmetric information problems

How to solve liquidity risk?

Sell your other assets

Types of Reserves

1. Desired Reserve

2. Excess Reserve

Desired Reserve

Amount of reserves the banks would like to keep to satisfy their withdrawal needs

Excess Reserve

More than what they need, above and beyond the desired

= Actual Reserve - Desired Reserves

ABC bank has total deposits of $100 million, reserves of $10. If the desired reserve ratio of the bank is 2%, what is the bank's excess reserve?

= 0.02x100,000,000 = 2,000,000

= 10,000,000 - 2,000,000 = 8,000,000

Excess reserve is $8M

If a bank has excess reserves, liquidity risk is what? and what effects does this have?

Liquidity Risk isn't a problem but you won't make any money (no interest income)

If the bank doesn't have excess reserve, it can solve liquidity risks through the following:

1. Sell assets

Example: bonds, stocks

2. Borrow from another commercial bank

3. Borrow from the central bank

4. Call in loans (not advisable)

How to manage credit/default risk?

Manage asymmetric info problems

Steps of managing interest rate risk:

1. Assess interest rate risk exposure

2. Take preventative measures

Net interest income/margin equation

Net interest income/margin = Interest income - interest expense

Interest rate affects two things

1. Interest income (Assets)

2. Interest expense (liabilities)

Interest rate risk assessment

1. GAP analysis

2. Duration analysis

GAP analysis

____ = Rate sensitive assets - rate sensitive liabilities

Change in income = ____ x Change in interest

Duration analysis

Impact on net worth (Capital)

The impact of interest rate (i) changes on a bank's capital (net worth)

The impact of interest rate changes on a banks net income, depends on:

1. Amount of rate sensitive assets

2. Amount of rate sensitive liabilities

3. Magnitude of interest rate change

If you have more rate sensitive assets or liabilities, would you be more concerned about interest rate rising?

Liabilities

It's bad if interest rate increases if you have more liabilities

Suppose ABC Bank is characterized as follows:

RSA = $32M

RSL = 49.5M

If interest rate jumps from 3% to 4%, what will be the impact on the banks net income?

GAP = 32 - 49.5 = -17.5 M

= -17.5 x 0.01 = -0.175 M

GAP = (32 - 49.5) x 0.01 = -0.175

The banks income will decrease by 0.175 million (175,000)

The solution for credit is to manage...?

Asymmetric Information properly

Duration Analysis Equation

Duration GAP -> DurA - (L/A x DurL)

Δ NW = -Duration Gap x ((Δi)/(1+i) x A

Duration GAP -> DurA - (L/A x DurL)

Identify the variables

DurA = Duration of assets

DurL= Duration of liabilities

L = Total Liabilities

A = Total Assets

Example: Bank ABC is characterized by:

A = $ 100 million DurA = 2.7

L = $95 million DurL = 1.03

Supposed the interest rate jumps from 10% to 11%. What will be the impact on the banks capital or net worth?

= 2.7 - (95/100 x 1.03) = 1.72

Δ NW = -1.72 x (0.01)/(1+0.10) x $100 = ($1.56)

Δ NW = -$1.6 Million

Interest Rate Risk Solutions

Financial Derivatives

- Options

- Futures

- Swaps

- Forwards

Credit Risk Solution

Solution: Manage your asymmetric information problem

- Securitization

- Credit Swaps (Financial Derivative)

Foreign Currency Risk Solutions

Financial Derivatives

- Options

- Futures

- Swaps

- Forwards

What is the purpose of derivatives?

To allow risk to be transferred between parties

What do financial derivatives derive their value from?

Underlying assets

Who are the players in the financial derivatives markets (2)

1. Hedgers

2. Speculators

Hedgers

Minimize (hedge) risk

Examples: Banks and Pension Funds

Speculators

Risk Lovers

Examples: Hedge funds, traders, investment funds

Participants who seek quick profit from price movements by taking higher risks (risk lovers)

What kind of risks can be managed with Financial Derivatives?

1. Interest Rate Risk

2. Foreign Currency Risk

3. Credit Risk

What is a derivative?

Financial Instrument whose value is derived from the value of an underlying asset (hedge and make profit)

- Purpose is to allow risk to be transferred

- Zero Sum Game (one person win, one person lose)

Two types of transactions

1. Spot Transaction

2. Forward Transaction

Spot Transaction

Money and assets are exchanged at the spot (At the same time)

(Derivatives aren't spot transactions)

Forward Transaction

Agree on the price of the assets, but the transaction happens later

- Agreement occurs today, but assets and money are exchanged in the future

Derivative Markets

Forward Contracts

An Agreement between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now

Example: Baker and Farmer make an agreement today that the baker will buy 1 Million kgs/$10. They agree to exchange wheat and money at this price, in the future (in 3 months).

Farmer doesn't get money and baker doesn't get wheat today, they just legally agree today to sell it for that in 3 months. This is a forward contract

Pros and Cons of a Forward Contract

Pros: Flexible (Can be used to hedge interest rate risk)

Cons:

1. Liquidity Problem (Don't get money until future)

2. Subject to Default Risk

Long Position

Agree to buy securities at a future date

Hedges by locking in future interest rate if funds coming in future

Short Position

Agree to sell securities at future dates

Hedging by reducing price risk from change in interest rates if holding bonds

Futures

Specific, no negotiation

Agreed upon places and times to trade them

Margin deposits = before you sell/buy, you put deposits down so people can't back out. Even If prices aren't in your favour

Don't have default risk

Because both buyers and sellers have margin deposits

Are standardized

Can buy and sell the contract

No liquidity problem

Futures don't have what and are what...?

____ don't have default risk Because both buyers and sellers have margin deposits

_____ are standardized, Can buy and sell the contract and No liquidity problem

Financial Futures are classified as

1. Interest rate futures

2. Stock index futures

3. Currency Futures

Obligations re futures

1. Buyers have the obligation to take possession of the asset (can't back out)

Once you buy a future, you can't back out. You can sell it but can't back out

2. Sellers have the obligation to deliver the asset

Pros and Cons of a future

Cons

1. You can't back out. You are obliged to buy that amount

Pros

1. Liquid

2. Standardized

3. Can be traded again

4. Delivery of range of securities

Buyer of a future - Hedgers are Speculators are what?

To Hedge = To insure against price rising

To speculate = who believe asset price will rise

Seller of a future - Hedgers are Speculators are what?

To Hedge = producers or owners of an asset who need to insure against price falling

To Speculate = who believes that asset price will fall

Option Writer

Seller

- Has the Obligation

Option Holder

Buyer

- Has the right

Who collects the premium and who pays the premium in Options?

Buyer pays the premium

Seller collects the premium

Put Option

Gives the right to sell

Call Option

Gives the right to buy

Strike Price

Predetermined price at which the option can be exercised

In the money

Stock price > Strike Price

Out of the money

Stock price < Strike Price

At the money

Stock price = Strike Price

American Option

Can be exercise any time up to the expiration date

European Option

Can be exercised only on the expiration date

If you expect a stock to go up, how can you use your knowledge about the stock to make a profit? (3)

1. Buy apple stock

But you need lots of money up front, very expensive (50k upfront)

Very risky, it could not go up as you expect

Not advisable

2. Buy futures (on apple stock)

Margin Deposit today (partial amount of the 50k as deposit now)

You are obliged to take possession of Apple stocks, regardless of the price

Risky

3. Buy call Options on Apple Stocks

You need to pay only the premium

You don't have the obligation

You can back out if it doesn't go up as you expect

Factors affecting Option Premium

1. Time to expiration

2. Higher Strike Price

3. Price volatility of Underlying Instruments

Time to expiration

Higher premium for longer time

Higher Strike Price

Lower Premium on Call options

Higher Premium on Put Options

Expensive shares have higher premiums

Cheaper shares have lower premiums

Price Volatility of Underlying Instruments

Very volatile will be high

To lock in the price of something that's so volatile, more expensive

Suppose you're a manager of a Pension Fund. You expect that your pension fund will collect $100 million contribution next year. You want to use this pension fund contribution to invest the funds in the bond market. What type of derivative market instrument would you use?

Not good strat to buy option because they have to pay Premium

They should buy Futures to lock in the price.

Managers are worried that the prices of bonds will go up, therefore interest rates will go down. They will want to lock in the price now.Buy futures to lock in prices and protect from rate movements because interest rates and price of bonds are negatively related.Not a good strategy is to buy options because they have to pay a premium.

You currently own $100 million of apple stocks. You are planning to sell next year. How can you use the derivative market to protect yourself? (Apple stocks might be lower in a year)

Buy a PUT Option

What can Credit Risk be managed with?

Swaps

Swaps

financial contracts obligating each party to exchange a set of payments it owns for another set of payments owned by another party

Example of Swaps

Bank A has flexible mortgages (If int rate goes down = bad)

Bank B has lots of fixed mortgages. (If int rate goes down = good)

Both banks have interest rate risk. Interest change affects both the banks differently.

The banks can trade

"Let's trade based on $10 million mortgages" Bank A agrees to give Bank B $10 million worth of flexible mortgages at Prime Rate + 1% (4.45 +1 = 5.45%). Bank B agrees to give Bank A $10 million worth of fixed mortgages at 5%. They are exchanging interest rate income based on those $10 million assets

This lets them manage their interest rate risk. They only trade the financial flows associated with the asset without exchanging the assets themselves.

What do you use to analyze interest rate risk?

Duration or GAP analysis

Pros of Swaps

1. Reduces interest rate risk

2. No change in B/S

3. Longer term than futures or options

Cons of Swaps

1. Lack of Liquidity

2. Subject to Default risk

Types of Credit Derivatives

1. Credit Options

2. Credit Swaps

3. Credit Linked-Notes

Money Equation

M = C + D

Currency and Deposits

Monetary Base (High Power Money) Equation

MB = C + R

R = reserves

C = Currency

Suppose the central bank prints $100B and it stashes it away in it's vault. Do we care?

No, it doesn't affect us. As long as its not in banks, then it doesn't affect us

TO affect us, it has to come to the economy? How does it go into the economy then?

- By monetary policy tools

What do monetary policy tools do?

The bank of Canada can currently use to control the country's money supply

Open Market Oppression

The buying and Selling of bonds by _______

When the Central Bank buys bonds in Open Market Oppression

Buy bonds = takes your bond, and gives you money.

Increases the money supply

When the Central Bank sells bonds in Open Market Oppression

Selling bonds = give your money to the bank and get a bond in return

Money supply decreases

Foreign Currency Market Operation

The buying and selling of foreign currency

- If bank buys foreign currency. Buys Yen and gives out CAD, it increases the money supply

- If the bank Sells foreign Currency, the money supply decreases

Types of Monetary Policy Tools

1. Open Market Oppression

2. Foreign Currency Market Operation

3. Changing the Overnight Rate

4. Reserve Requirement (Bank of Canada doesn't use this)

Changing the Overnight Rate

1. Overnight Interest rate

2. The Bank Rate (the discount rate)

3. The Prime Rate

Prime Rate

The interest rate that commercial banks charge on loans to their most preferred customers

The Bank Rate (Discount Rate)

The interest rate that the central bank charges commercial banks

Overnight Interest Rate

The interest rate that a commercial bank charges another one in the interbank overnight loan market

If the Bank of Canada cuts the overnight rate

Money Supply Increases

If the Bank of Canada increases the overnight rate

Money Supply Decreases

Change in total deposits Equation

Change in total deposits = 1/Reserve Ratio x New Deposits