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Off - Balance Sheet Activities
Drake Fin 129
DRAKE UNIVERSITY
Off balance sheet activities
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Drake University
Fin 129
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
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Derivatives -- Value or worth is based upon
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
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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
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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
Use of option pricing
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Drake University
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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
Options
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Drake University
Fin 129
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 129
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
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Fin 129
Call Option Intrinsic Value
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Drake University
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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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Payoff Diagram Call Option
Payoff
S-X
X
X
S
Spot
Price
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Put Option Profits
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Drake University
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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
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Drake University
Fin 129
Put Option Intrinsic Value
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Drake University
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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)
Payoff Diagram Put Option
Profit
X-S
S
Cost
X
Spot Price
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Drake University
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Pricing an Option
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Drake University
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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
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PV and FV in continuous time
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Drake University
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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
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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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Black Scholes (Intuition)
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Value of Call Option
SN(d1)
-
Xe-rt
N(d2)
The expected PV of cost
Risk Neutral
Value of S
of investment Probability of
if S > X
S>X
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Black Scholes
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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
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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
Delta
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Drake University
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Delta can be found from the call price
equation as:
Using delta hedging for a short position in a
European call option would require
Delta explanation
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Drake University
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Delta will be between 0 and 1.
A 1 cent change in the price of the underlying
asset leads to a change of
Applying Delta
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Drake University
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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
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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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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
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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
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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:
Impact on the balance sheet
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Drake University
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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
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Liabilities
Market Value of Liabilities
125
Equity (net worth) 25
Total 150
Contingent Assets and Liabilities
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Drake University
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Assume that the firm has contingent assets of
50 and contingent liabilities of 60.
Simple Balance Sheet
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Drake University
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MV of Contingent Assets
Liabilities
Market Value of Liabilities
125
Equity (net worth)
MV of contingent Liabilities
Total 200
Total 200
Assets
Market Value of Assets
150
Reporting OBS Activities
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Drake University
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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
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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 $
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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
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Loan commitments
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Drake University
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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
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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 %).
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
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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
Loan Commitment Risks
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Drake University
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Takedown Risk --
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
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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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Aggregate Funding Risks -- Many borrowers
view loan commitment as insurance against
credit crunches. If a credit crunch occurs
(restrictive monetary policy or a simple
downturn in economy)
Letters of Credit
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Drake University
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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
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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.
Future and Forward contracts
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Drake University
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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
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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
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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
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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
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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
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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.
Settlement Risk
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Drake University
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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
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Drake University
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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,
Affiliate Risk
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Drake University
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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
Swaps Introduction
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Drake University
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An agreement between two parties to exchange
cash flows in the future.
The agreement specifies the dates that the cash
flows are to be paid and the way that they are to be
calculated.
A forward contract is an example of a simple swap.
With a forward contract, the result is an exchange of
cash flows at a single given date in the future.
In the case of a swap the cash flows occur at
several dates in the future. In other words, you can
think of a swap as a portfolio of forward contracts.
Mechanics of Swaps
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Drake University
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The most common used swap agreement is
an exchange of cash flows based upon a
fixed and floating rate.
Often referred to a “plain vanilla” swap, the
agreement consists of one party paying a
fixed interest rate on a notional principal
amount in exchange for the other party
paying a floating rate on the same notional
principal amount for a set period of time.
In this case the currency of the agreement is
the same for both parties.
Notional Principal
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Drake University
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The term notional principal implies that the
principal itself is not exchanged. If it was
exchanged at the end of the swap, the exact
same cash flows would result.
An Example
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Drake University
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Company B agrees to pay A 5% per annum
on a notional principal of $100 million
Company A Agrees to pay B the 6 month
LIBOR rate prevailing 6 months prior to each
payment date, on $100 million. (generally the
floating rate is set at the beginning of the
period for which it is to be paid)
The Fixed Side
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Drake University
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We assume that the exchange of cash flows
should occur each six months (using a fixed
rate of 5% compounded semi annually).
Company B will pay:
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Summary of Cash Flows
for Firm B
Date
3-1-98
9-1-98
3-1-99
9-1-99
3-1-00
9-1-00
3-1-01
LIBOR
4.2%
4.8%
5.3%
5.5%
5.6%
5.9%
6.4%
Cash Flow
Received
2.10
2.40
2.65
2.75
2.80
2.95
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Cash Flow
Net
Paid
Cash Flow
2.5
2.5
2.5
2.5
2.5
2.5
-0.4
-0.1
0.15
0.25
0.30
0.45
Swap Diagram
Company A
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Company B
Offsetting Spot Position
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Drake University
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Assume that A has a commitment to borrow at a fixed rate of
5.2% and that B has a commitment to borrow at a rate of
LIBOR + .8%
Company A
Borrows (pays)
Pays
Receives
Net
Company B
Borrows (pays)
LIBOR+.8%
Receives
Pays
Net
Swap Diagram
5.2%
Company A
Company B
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LIBOR+.8%
The swap in effect transforms a fixed rate
liability or asset to a floating rate liability or
asset (and vice versa) for the firms
respectively.
Role of Intermediary
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Drake University
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Usually a financial intermediary works to
establish the swap by bring the two parties
together.
The intermediary then earns .03 to .04% per
annum in exchange for arranging the swap.
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Swap Diagram
5.2%
LIBOR
Co A
4.985%
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LIBOR
FI
5.015%
Co B
LIBOR+.8%
Why enter into a swap?
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The Comparative Advantage Argument
Fixed
Floating
A
10%
6 mo LIBOR+.3
B
11.2%
6 mo LIBOR + 1.0%
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Swap Diagram
10%
LIBOR
Co A
9.935%
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LIBOR
FI
9.965%
Co B
LIBOR+1%
Managing Cash Flows
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Drake University
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Assume that an insurance firm sold an
annuity lasting 5 years and paying 5 Million
each year.
To offset the cash outflows they invest in a 10
year security that pays $6 million each year.
The firm runs a reinvestment risk when they
stop paying the cash outflows on the annuity
– a combination of swaps could eliminate this
risk (on board in class)
OBS Benefits
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We have concentrated on the risk associated
with OBS activities, however many of the
positions are designed to reduce other risks in
the FI.