Download Synopsis_2014_v3 ed 7 and 8

Version 2014-11-27 Final
Final updats from Ch 10 and onwards for ed 7and ed 8 of the textbook.
Lecture Synopsis:
Bo Sjö’s part of Financial Markets and Institutions Risk Management
I will regularly update this document with reading instructions, and suggestions for end-of-chapter
questions from the book.
About the course
The course is mixing “The History of Financial Crises” and “The Risk management of Financial
Institutions”. Given the recent financial crises, which is not over yet, this course is very up to date
with the present situation. You will get both an historical perspective and learn about the (perhaps)
insufficient tools that exists to control manage risk.
The text book by Anthony Saunders and Marcia Million Cornett is the best you can get in the area.
The authors really know what they are talking about. There is nowadays quite a number of
textbooks. The problem is that most of them too trivial and do not deal with risk management issues.
However, there a few topics you need to know before you enter into world of financial institutions. A
course in Corporate Finance is good pre-requisite, but not necessary. We will go through some basic
stuff that will help you to understand what people are talking about when they talk about financial
crises.
Background topics (not in the textbook)
Understand the basic balance sheet
Understand valuation of financial assets, the time value of money and risk
Debt instruments, different types of bonds
Bond valuation
What are interest rates and yields? I will present the following stuff:
The Flow of funds – demand and supply of loanable funds => interest rates
The yield curve and theories of the terms structure of interest rates
Duration – a measure of interest rate sensitivity of price of bonds (or debt)
This material will come up in Lecture 2/3 and Lecture 4.
Lecture 1
Ch. 1 is an introduction to my part of the course. Overview of financial markets and their role in the
economy. What are financial institutions (FI:s)? Why do FI:s exist? In what ways are they special
compared to other institutions and non-financial firms? What is meant by i) asset transformation and
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ii) delegated monitoring? (For the latter I add material in my lectures). These are critical questions.
An overview of different risks are coming up in Ch. 7.
Risk management principles, i) identify, ii) measure iii) decide about hedging
Lecture 2
Financial markets - orientation
Ch. 2-6 presents different financial institutions. Identify the major types of financial institutions,
which are they? What do they do? We go through these chapter briefly in class. The material is
meant for self-studies. It is important to understand the different institutions and what they do on
the markets. We are not interested in US markets per se, we are interested in the role of different
institutions since they operate in all economies. These institutions often have different regulations,
though they share many risks factors.
Ch. 7 presents a number of different risks. These risks are dealt with in the textbook, but we have
time only for the big risks. You should name and explain the different risks talked about in Ch 7.
Most of these risks are highly relevant for the current crisis in EU, of course you should be able to
explain this. Of course, we will look deeply into interest rate risk, which comes in two shapes.
Refinancing and reinvestment risk
Most of the risks mentioned in Ch 7 can be understood by looking at a stylized balance sheet of an FI
(or a bank to put it simply). Notice that most of time we talk about the real balance sheet in real
economic values, not the accounting balance sheet based on book values. It is important to
understand the difference between the real economic balance sheet and the accounting one since
economic decisions are and should be based on the former.
Problem Sets and solution #1
Lecture on Bonds and Debt Contracts see my Power Points
Lecture 3 here I will go outside the Book and present interest rates and Bond Markets
Concepts:
Capital Markets and Money Markets, Money Market instruments,
Interest rates. The flow of funds theory, the basics of supply and demand for loanable funds (or
bonds) and what is causing interest rates to change.
Zeroes, coupon bonds, zeros, face values, valuation of bonds, default risk premiums
Bond ratings, the most important factors behind the rating
Yield curves, implicit forward rates, theories of the yield curve and the terms structure of interest
rates.
Memo “What is the Interest Rate” + Appendix 8B p 227-233
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Lecture 4 etc
Ch 8 Interest Rate Risk I (Repricing Model)
The repricing model, explain what it is.
What is rate sensitive assets and liabilities.
Basic calculations using: NII = GAP r
Typically: Look at the accumulated gap figure over a year
Ed 7: Pages: 204-210, p 216-218,
Ch 9 Interest Rate Risk II (Duration)
Book value accounting, market value accounting, marking to market.
Duration, modified duration, interest rate risk and duration and expected losses and gains in interest
rate sensitive assets and liabilities, Duration gap, interest rate risk management with duration, how
to measure the effect on assets, liabilities and equity. What is duration? What can you do with
duration? Immunization, Difficulties with the duration measure convexity
Ed 7 Ch. 9 pages 234-264
Ch. 10 Market Risk (VaR) ed. 7
Ch 15 Market Risk in ed 8.
Concepts: Market risk, Value at Risk models, in particular calculating market risk exposure from
interest rate changes on reserves and equity.
Metods for measuring market exposure VaR, Back simulation (explain), Monte Carlo simulation (not
covered)
For 2014: We don’t cover foreign exchange risk or (equities) equity risk, since that is covered in other
courses.
Basic concepts DEAR and VaR (basis point changes in interest rates),
DEAR calculated under different
Briefly explain the Historic (Back simulation) model and its weaknesses
Briefly about BIS regulation briefly, the principles.
Ed 7. Ch 10. Pages: 283-290, 296-300, 308-310 (The basic principles. How do big banks determine
their reserves?)
Ed 8. Ch 15 pages 438-445,450-454 (Historic back simulation – explain what it is), 461-468 (The basic
principles. How do big banks determine their reserves?)
We do not cover the option approach
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Ch. 11 Credit Risk Individual Loan Risk in ed 7.
Ch 10 Credit risk: individual Loan Risk ed 8
Types of loans, secured loan, unsecured loan, commercial paper, whole sale and retail loans, the
contractually promised return on a loan, LIBOR, k = 1 +(r +m), expected return on a loan E(r) = p(1+k)
+ (1-p) x 0, or E(k) = E(r), credit rationing and Figure 11-4
Measuring credit risk, Qualitative models & borrower specific factors – reputation, implicit contract
Quantitative models, credit scoring models, linear discriminant models (=Altman’s z-score model).
The basic factors identified by Altman (We don’t apply the model as such with actual numbers, but
we need to know how it works and some factors by which we can asses the probability of default.)
RAROC models
Ed 7, Ch 10: pages: 317-333, 335(Breifly on factors in Qualitative models), 337-341, 349-352.
Ed 8, C11: pages 274-291, 292-293 (Breifly on factors in Qualitative models), 294-298, 307-310.
We do not cover the option approach
Ch. 12 Credit Risk: Loan Portfolio and Concentration Risk ed 7.
Ch 11 Credit Risk: Loan Portfolio and Concentration Risk ed 8.
Two simple models, migration analysis and loan mix, concentration risk and concentration limits. .
Loan portfolio diversification geographical (domestic and international) and economic sectors. Avoid
concentration risk, set limits.
Micro and macro hedging of credit risk, credit default insurance (or derivatives) individual loans or
loan portfolio.
The basic question how in principle can you handle Loan portfolio and concentration risk? We don’t
go into the details in this chapter, we discuss the main solutions. See power points.
Ed 7 p. 369-371, 383-384 (We don’t do portfolio theory in this class)
Ed 8. 326-328, 339-340.
Ch 13. Off-balance Sheet Risk ed 9
Ch 16 Off-balance Sheet Risk ed 8
Contingent assets and liabilities, definition of OBS, examples of typical OBS activities (Table 13-1) and
OBS risk comes from trading in derivatives, types of derivatives (Table 13-3) + memo on derivatives.
The accounting problem (a valuation problem). Definition of TARP.
Ed 7 Ch. 13 pages 396-402, 411-412 (the basic derivatives)
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Ed 8 Ch 16. Pages 474-479, 488-490 (the basic derivatives)
In my power point on OBS risk, I cover the basic derivative instruments. Forwards, futures swaps and
options.
Ch 22-23 (ed 7) Futures and Forwards, Options Caps Floors and Collars
Ch 22-23 (ed 8) Futures and Forwards, Options Caps Floors and Collars
In these two chapters (which we cover briefly) we focus on some definitions of basic contracts. I have
covered them briefly in the Power Point related the OBS risks, and in the lecture after.
The basic derivate instrument is the FRA. This is a forward contract between two partners. Agree on
a future interest rate, a maximum sum, lending or borrowing. This instrument can then be made into
futures, swaps and option. We defined three basic option contracts building on FRA.
The basis of hedging is that we identify a position (and thus an exposure) long or short. A derivative
contract can hedge that exposure by offering an opposite position that nullifies the original position.
What are the typical derivatives, definitions o forwards, futures, swaps and options. (See hand-out).
The typical swap contract exchanges both currencies and exchanges floating for fixed interest rates in
the same deal. (It can be fixed for floating depending on which side of the contract we talk about.
Firms that engage in long term international business deals need repeated forwards on foreign
exchange. At the same time they might have a maturity gap that they want to reduce.
A maturity gap coming from fixed vs floating can reduced by swapping fixed for floating or the other
way around.
If time allows we calculate how many futures contract are needed to hedge a position.
Ch 19 Deposit Insurance and … ed 7 & 8
Principal instruments to create confidence in the banking system:
Discount borrowing,
Deposit Insurance
Insurance against bank default (let bank build up funds)
Government purchase of bad loans from banks
And, of course, transparent regulation, reserves – how much?
Owner’s think it is a waste, too much protection. But, how to set the
reserves. The idea is to set reserves in relation to risk, but how to do without getting to complicated.
What is a bank run? Why is it so problematic?
Causes of liquidity risk, (economic problems => affects banks, interest rate risk and market risk or
credit risk => changes asset values => expectation of insolvency => less credibility => bank run,
systemic risk, bank panic deposit drains, bank run.
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What are bank runs so problematic? How can they be solved.
The dilemma: Protecting the system (and the poor) without creating moral hazard for bank
management and owners.
How have protection and let the owners take responsibility (=let banks default and go bankrupt so
that owners suffers, without hurting the system and the poor? If banks are too big to fail, that leads
to moral hazard, nobody, especially not the owner will care about risk taking.
Discuss dilemmas and solutions.
Moral Hazard, what is it? What does it mean in this context?
EU financial crisis and Debt Crisis (My power points)
The basic problem of a government debt crisis and the basic solution of a debt crisis from a
macroeconomic perspective.
http://en.wikipedia.org/wiki/Eurozone_crisis
http://www.businessinsider.com/the-european-economic-crisis-explained-in-just-two-charts-2013-7
Discuss the basic cause of the problem. Discuss its principal solution, by using some equations, see
combination of austerity and supply side politics. If you spend too much on borrowed money, you
need to pay back from you income, but how?
Again, the Moral hazard problem with debt forgiveness.
IF time allows: Ch. 26 Securitization
Definition and give example of securitization, Bowie bonds, CMO:s. What was the setup in the US to
transform mortgages to ABS (CMO). Shadow banking what is it?
Principles of regulation, monitoring, macro problems, imbalances leading to financial wrong
decisions …
That is it!
Final Lectures will be repetition and calculations
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