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Off - Balance Sheet Activities
Drake Fin 286
DRAKE UNIVERSITY
Off balance sheet activities
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Drake University
Fin 286
Contingent assets or liabilities that impact the
future of the Financial Institutions balance
sheet and solvency.
Claim moves to the asset or liability side of
the balance sheet respectively IF a given
event occurs.
Often reported in footnotes or not reported
buried elsewhere in financial statements
OBS examples
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Drake University
Fin 286
Derivatives -- Value or worth is based upon
the value of an underlying asset
Basic Examples -- Futures, Options, and
Swaps
Other examples -- standby letters of credit
and other performance guarantees
Large Derivative Losses
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Drake University
Fin 286
1994 Procter and Gamble sue bankers trust
over derivative losses and receive $200
million.
1995 Barings announces losses of $1.38
Billion related to derivatives trading of Nick
Lesson
NatWest Bank finds losses of 77 Million
pounds caused by mispricing of derivatives
Large Derivative Losses
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Drake University
1997 Damian Cope, Midland Bank, is
banned by federal reserve over
falsification of records relating to
derivative losses
1997 Chase Manhattan lost $200 million
on trading in emerging market debt
derivative instruments
LTCM exposure of $1.25 trillion in
derivatives rescued by consortium of
bankers
Fin 286
Use of option pricing
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Drake University
Fin 286
One way to measure the risk of a contingent
liability is to use option pricing.
Delta of an option = the sensitivity of an
options value to a unit change in the price of
the underlying asset.
Options
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Drake University
Fin 286
Call Option – the right to buy an asset at
some point in the future for a designated
price.
Put Option – the right to sell an asset at some
point in the future at a given price
Call Option Profit
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Drake University
Fin 286
Call option – as the price of the asset increases the
option is more profitable.
Once the price is above the exercise price (strike
price) the option will be exercised
If the price of the underlying asset is below the
exercise price it won’t be exercised – you only loose
the cost of the option.
The Profit earned is equal to the gain or loss on the
option minus the initial cost.
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Profit Diagram Call Option
Profit
S-X-C
S
Cost
X
Spot
Price
Drake University
Fin 286
Call Option Intrinsic Value
The intrinsic value of a call option is equal
to the current value of the underlying
asset minus the exercise price if exercised
or 0 if not exercised.
In other words, it is the payoff to the
investor at that point in time (ignoring the
initial cost)
the intrinsic value is equal to
max(0, S-X)
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Drake University
Fin 286
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Payoff Diagram Call Option
Payoff
S-X
X
X
S
Spot
Price
Drake University
Fin 286
Put Option Profits
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Drake University
Fin 286
Put option – as the price of the asset
decreases the option is more profitable.
Once the price is below the exercise price
(strike price) the option will be exercised
If the price of the underlying asset is above
the exercise price it won’t be exercised – you
only loose the cost of the option.
Profit Diagram Put Option
Profit
X-S-C
Spot Price
S
Cost
X
Drake
Drake University
Fin 286
Put Option Intrinsic Value
The intrinsic value of a put option is equal
to exercise price minus the current value
of the underlying asset if exercised or 0 if
not exercised.
In other words, it is the payoff to the
investor at that point in time (ignoring the
initial cost)
the intrinsic value is equal to
max(X-S, 0)
Drake
Drake University
Fin 286
Payoff Diagram Put Option
Profit
X-S
S
Cost
X
Spot Price
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Drake University
Fin 286
Pricing an Option
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Drake University
Fin 286
Black Scholes Option Pricing Model
Based on a European Option with no
dividends
Assumes that the prices in the equation are
lognormal.
Inputs you will need
S = Current value of underlying asset
X = Exercise price
t = life until expiration of option
r = riskless rate
s2 = variance
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Drake University
Fin 286
PV and FV in continuous time
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Drake University
Fin 286
e = 2.71828 y = lnx x = ey
FV = PV (1+k)n for yearly compounding
FV = PV(1+k/m)nm for m compounding periods
per year
As m increases this becomes
FV = PVern =PVert
let t =n
rearranging for PV
PV = FVe-rt
Black Scholes
Value of Call Option = SN(d1)-Xe-rtN(d2)
S = Current value of underlying asset
X = Exercise price
t = life until expiration of option
r = riskless rate
s2 = variance
N(d ) = the cumulative normal distribution
(the probability that a variable with a standard
normal distribution will be less than d)
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Drake University
Fin 286
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Black Scholes (Intuition)
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Fin 286
Value of Call Option
SN(d1)
The expected
Value of S
if S > X
-
Xe-rt
N(d2)
PV of cost
Risk Neutral
of investment Probability of
S>X
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Black Scholes
Drake University
Fin 286
Value of Call Option = SN(d1)-Xe-rtN(d2)
Where:
ln( S )  (r  s )t
X
2
d1 
s t
2
d 2  d1  s
t
Delta of an option
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Drake University
Fin 286
Intuitively a higher stock price should lead to
a higher call price. The relationship between
the call price and the stock price is expressed
by a single variable, delta.
The delta is the change in the call price for a
very small change it the price of the
underlying asset.
Delta
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Drake University
Fin 286
Delta can be found from the call price equation as:
c

 N (d1 )
S
Using delta hedging for a short position in a
European call option would require keeping a long
position of N(d1) shares at any given time. (and vice
versa).
Delta explanation
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Drake University
Fin 286
Delta will be between 0 and 1.
A 1 cent change in the price of the underlying
asset leads to a change of delta cents in the
price of the option.
Applying Delta
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Drake University
Fin 286
The value of the contingent value is simply:
delta x Face value of the option
If Delta = .25 and
The value of the option = $100 million
then
Contingent asset value = $25 million
OBS Options
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Drake University
Fin 286
Loan commitments and credit lines basically
represent an option to borrow (essentially a
call option)
When the buyer of a guaranty defaults, the
buyer is exercising a default option.
Adjusting Delta
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Drake University
Fin 286
Delta is at best an approximation for the
nonlinear relationship between the price of
the option and the underlying security.
Delta changes as the value of the underlying
security changes. This change is measure by
the gamma of the option. Gamma can be
used to adjust the delta to better approximate
the change in the option price.
Gamma of an Option
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Drake University
Fin 286
The change in delta for a small change in the
stock price is called the options gamma:
Call gamma =
e
 d 12 / 2
Ss 2T
Futures and Swaps
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Drake University
Fin 286
Some OBS activities are not as easily
approximated by option pricing.
Futures, Forward arrangements and swaps
are generally priced by looking at the
equivalent value of the underlying asset.
For example: A swap can be valued as the
combination of two bonds with cash flows
identical to each side of the swap.
Impact on the balance sheet
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Drake University
Fin 286
Start with a traditional simple balance sheet
Since assets = liabilities + equity it is easy to
find the value of equity
Equity = Assets - Liabilities
Example: Asset = 150 Liabilities = 125
Equity = 150 - 125 = 25
Simple Balance Sheet
Assets
Market Value of Assets
150
Total 150
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Drake University
Fin 286
Liabilities
Market Value of Liabilities
125
Equity (net worth) 25
Total 150
Contingent Assets and Liabilities
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Drake University
Fin 286
Assume that the firm has contingent assets of
50 and contingent liabilities of 60.
the equity position of the firm will be reduced
by 10 to 15.
Simple Balance Sheet
Assets
Market Value of Assets
150
MV of Contingent Assets
50
Total 200
Drake
Drake University
Fin 286
Liabilities
Market Value of Liabilities
125
Equity (net worth) 15
MV of contingent Liabilities
60
Total 200
Reporting OBS Activities
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Drake University
Fin 286
In 1983 the Fed Res started requiring banks
to file a schedule L as part of their quarterly
call report.
Schedule L requires institutions to report the
notional size and distribution of their OBS
activities.
Growth in OBS activity
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Drake University
Fin 286
Total OBS commitments and contingencies for
US commercial banks had a notional value of
$10,200 billion in 1992 by 2000 this value had
increased 376% to $46,529 billion!
For comparison in 1992 the notional value of
on balance sheet items was $3,476.4 billion
which grew to $6,238 billion by 2000 or
growth of 79%
Growth in OBS activities
Billions of $
Drake
Drake University
Fin 286
1992
1996
2000
Futures &
Forwards
$4,780
$8,041
$9,877
Swaps
2,417
7,601
21,949
Options
1,568
4,393
8,292
Credit
Derivatives
426
Common OBS Securities
Loan commitments
Standby letters of Credit
Futures Forwards and Swaps
When Issues Securities
Loans Sold
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Drake University
Fin 286
Loan commitments
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Drake University
Fin 286
79% of all commercial and industrial lending
takes place via commitment contracts
Loan Commitment -- contractual commitment
by the FI to loan up to a maximum amount to
a firm over a defined period of time at a set
interest rate.
Loan commitment Fees
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Drake University
Fin 286
The FI charges a front end fee based upon
the maximum value of the loan (maybe 1/8th
of a percent) and a back end fee at the end
of the commitment on any unused balance.
(1/4 of a %).
Back end fee encourages firms to draw down
its balance -- why is this good for the FI?
The firm can borrow up to the maximum
amount at any point in time over the life of
the commitment
Loan Commitment Risks
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Drake University
Fin 286
Interest rate risk -- The FI precommits to an
interest rate (either fixed or variable), the level of
rates may change over the commitment period.
If rates increase, cost of funds may not be
covered and firms more likely to borrow.
Variable rates do not eliminate the risk due to
basis risk
basis risk = the risk that the spread between
lending and borrowing rates may change.
Loan Commitment Risks
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Drake University
Fin 286
Takedown Risk -- the FI must be able to
supply the maximum amount at any given
time during the commitment period,
therefore there is a liquidity risk for the firm.
Feb 2002 - Tyco International was shut out of
commercial paper market and it drew down
$14.4 billion loan commitments made by
major banks.
Loan Commitment Risk
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Drake University
Fin 286
Credit Risk -- the firm may default on the loan
after it takes advantage of the commitment.
The credit worthiness of the borrower may
change during the commitment period
without compensation for the lender.
Loan Commitment Risk
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Drake University
Fin 286
Aggregate Funding Risks -- Many borrower
view loan commitment as insurance against
credit crunches. If a credit crunch occurs
(restrictive monetary policy or a simple
downturn in economy) the amount being
drawn down in aggregate will increase
through out the banking system
Letters of Credit
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Drake University
Fin 286
Commercial Letters of credit - A formal
guaranty that payment will be made for
goods purchased even if the buyer defaults
The idea is to underwrite the common trade
of the firm providing a safety net for the seller
and facilitating the sale of the goods.
Used both domestically and internationally
Letter of Credit
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Drake University
Fin 286
Standby letters of credit -- Letters of credit
contingent upon a given event that is less
predicable than standard letters of credit
cover.
Examples may be guaranteeing completion of
a real estate development in a given period of
time or backing commercial paper to increase
credit quality. Many small borrowers are shut
out of commercial paper without these.
Future and Forward contracts
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Drake University
Fin 286
Both Futures and Forward contracts are
contracts entered into by two parties who
agree to buy and sell a given commodity or
asset (for example a T- Bill) at a specified
point of time in the future at a set price.
Futures vs. Forwards
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Drake University
Fin 286
Future contracts are traded on an exchange,
Forward contracts are privately negotiated
over-the-counter arrangements between two
parties.
Both set a price to be paid in the future for a
specified contract.
Forward Contracts are subject to counter
party default risk, The futures exchange
attempts to limit or eliminate the amount of
counter party default risk.
Forwards vs. Futures
Forward Contracts
Private contract between
two parties
Not Standardized
Usually a single delivery date
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Drake University
Fin 286
Futures Contracts
Traded on an exchange
Standardized
Range of delivery dates
Settled at the end of contract
Settled daily
Delivery or final cash
settlement usually takes place
Contract is usually closed
out prior to maturity
Options and Swaps
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Drake University
Fin 286
Sold in the over the counter market both can
be used to manage interest rate risk.
Forward Purchases of
When Issued Securities
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Drake University
Fin 286
A commitment to purchase a security prior to
its actual issue date. Examples include the
commitment to buy new treasury bills made
in the week prior to their issue.
Loans Sold
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Drake University
Fin 286
Loans sold provide a means of reducing risk
for the FI.
If the loan is sold with no recourse the FI
does not have an OBS contingency for the FI.
The loan can have a ability to be put back to
the asset or seller in the event of a decline in
credit quality creating an OBS risk.
Settlement Risk
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Drake University
Fin 286
Intraday credit risk associated with the
Clearing House Interbank Transfer Payments
System (CHIPS).
Payment messages sent on CHIPS are
provisional messages that become final and
settled at the end of the day usually via
reserve accounts at the Fed.
Settlement Risk
Drake
Drake University
Fin 286
When it receives a commitment the FI may
loan out the funds prior to the end of the day
on the assumption that the actual transfer of
funds will occur accepting a settlement risk.
Since the Balance sheet is at best closed a the
end of the day, this represents an intraday
risk, this has been addressed somewhat by
new technology.
Affiliate Risk
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Drake University
Fin 286
Risk of one holding company affiliate failing
and impacting the other affiliate of the
holding company.
Since the two affiliates are operationally they
are the same entity even thought they are
separate entities under the holding company
structure
OBS Benefits
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Drake University
Fin 286
We have concentrated on the risk associated
with OBS activities, however many of the
positions are designed to reduce other risks in
the FI.
Credit Default Swap
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Drake University
Fin 286
The buyer makes an upfront payment or a
stream of payments to the seller of the swap.
The seller agrees to make a stream of
payments in the event of default by a third
party on a reference obligation.
Basic Credit Default Swap
Default
Swap
Buyer
Return on
Reference
Obligation
Upfront Payment or
Stream of payments
Original
Payment
Reference
Obligation
Issuer
Payment in the
Event of Default
Default
Swap
Seller
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Drake University
Fin 286
Credit Default Swap as an Option
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Drake University
Fin 286
The Credit Default Swap is basically a put
option on the reference obligation.
The default buyer owns the put option which
effectively allows the reference obligation to
be sold to the CDS seller in event of default.
Intuition
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Drake University
Fin 286
Assume that the reference obligation is a
bond
If the price of a bond decreases due to a
change in credit quality, the value of the put
option increases. This implies that the value
of the CDS increases.
The CDS buyer could sell the obligation at a
premium compared to what was paid
originally.
What Constitutes Default
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Drake University
Fin 286
The CDS parties can agree to any or all of the
events below
Bankruptcy
Failure to Pay
Obligation Acceleration
Obligation Default
Repudiation or deferral
Restructuring
What Does not Constitute Default
Downgrade by rating agency
Non Material events (error by employee
causing a missed payment etc.)
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Drake University
Fin 286
Hedge against Default
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Drake University
Fin 286
In the event of a default the swap buyer is
hedged against the risk of default.
The CDS is effectively an insurance policy
against default.
The risk of default is transferred to the seller
of the CDS.
Hedge against credit deterioration?
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Drake University
Fin 286
Since rating agency changes do not constitute
default how are credit changes hedged
If the CDS is marketed to market then the
change in value serves as a hedge against
changes in credit quality
An Example
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Drake University
Fin 286
Assume that the CDS buyer owns an 7%
coupon bond and the return on a similar
maturity treasury is 5%.
Assume that both bonds have a current value
of $1 Million (equal to their par value)
Assume the buyer pays 2% per year for the
duration of the swap and receives $1 Million
in the even of default.
The combination of the CDS and 8% bond
have effectively the same payoff as the
treasury
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Credit Default Swap
Default
Swap
Buyer
7% per
year
2% per year
$1 Million in the
Event of Default
$1 Million
Reference
Obligation
Issuer
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Fin 286
Default
Swap
Seller
Risks in the CDS
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Drake University
Fin 286
The CDS seller may default
We assumed that the spread between the two
bonds stays constant over time and that the
duration and convexity of the bonds stays the
same. (unlikely especially for a bond closeto
default)
We have ignored accrued interest
There could be a liquidity premium for the
risky bond causing it to sell for less than its
true value.
Other CDS variations
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Drake University
Fin 286
Binary or Digital Default Swap – Payoff is a
single lump sum often based upon recovery
rates.
Basket CDS - the reference obligation is a
basket of obligations
N to default – default exists when the Nth
obligatin defaults
First to default
Cancelable DS –either the buyer (call) or
seller (put) has the right to cancel the default
CDS Variations continued
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Drake University
Fin 286
Contingent CDS – triggered if both the default
and a second event occur
Leveraged CDS – Payoff is a multiple of the
loss amount often the standard CDS amount
plus a % of the notional value
Tranched Portfolio Swaps – A variation of
CDOs
Benefits of CDS
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Drake University
Fin 286
The risk is transferred to a financial institution
that often has better ability to hedge the risk
than the swap buyer.
Allows lenders to hedge the risk of high risk
loans without jeopardizing the lender – client
relationship
Reduction of regulatory capital.
A costless reduction in risk
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Drake University
Fin 286
Assume that Bank A has sold a CDS to Co X
on a 100,000,000 notional amount and is
receiving a 3% semi annual interest rate
Similarly Bank B has the same agreement
with Co Y.
Assuming both company’s have the same
credit quality
By exchanging a portion of the notional value
of the swap the banks can diversify the credit
risk without any costs.
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Credit Default Swap
Risk Sharing
Bank
$50 M of CDS
With Co X
A
3% on
$100M
Drake University
Fin 286
Bank
$50 M of CDS
With Co Y
Payment
If Default
B
Payment
If Default
3% on
$100M
Company
Company
X
Y