drake drake university fin 286 off - balance sheet activities

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Drake DRAKE UNIVERSITY Fin 286 Off - Balance Sheet Activities

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Page 1: Drake DRAKE UNIVERSITY Fin 286 Off - Balance Sheet Activities

DrakeDRAKE UNIVERSITY

Fin 286

Off - Balance Sheet Activities

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Fin 286Off balance sheet activities

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

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Fin 286OBS examples

Derivatives -- Value or worth is based upon the value of an underlying assetBasic Examples -- Futures, Options, and SwapsOther examples -- standby letters of credit and other performance guarantees

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Fin 286Large Derivative Losses

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

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Fin 286Large Derivative Losses

1997 Damian Cope, Midland Bank, is banned by federal reserve over falsification of records relating to derivative losses1997 Chase Manhattan lost $200 million on trading in emerging market debt derivative instrumentsLTCM exposure of $1.25 trillion in derivatives rescued by consortium of bankers

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Fin 286Use of option pricing

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.

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Fin 286Options

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

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Fin 286Call Option Profit

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 exercisedIf 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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Fin 286Profit Diagram Call OptionProfit

Spot Cost Price

SS

S-X-CS-X-C

X

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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 tomax(0, S-X)

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Fin 286Payoff Diagram Call Option

Payoff

Spot Price

SS

S-XS-X

XX

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Fin 286Put Option Profits

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 exercisedIf the price of the underlying asset is above the exercise price it won’t be exercised – you only loose the cost of the option.

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Fin 286Profit Diagram Put Option

Profit

Spot Price

CostX

SS

X-S-CX-S-C

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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 tomax(X-S, 0)

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Fin 286Payoff Diagram Put Option

Profit

Spot Price

Cost

XSS

X-SX-S

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Fin 286Pricing an Option

Black Scholes Option Pricing ModelBased on a European Option with no dividendsAssumes that the prices in the equation are lognormal.

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Fin 286Inputs you will need

S = Current value of underlying assetX = Exercise pricet = life until expiration of optionr = riskless rate2 = variance

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Fin 286

PV and FV in continuous time

e = 2.71828 y = lnx x = ey

FV = PV (1+k)n for yearly compoundingFV = PV(1+k/m)nm for m compounding

periods per yearAs m increases this becomesFV = PVern =PVert let t =n rearranging for PV PV = FVe-rt

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Fin 286Black Scholes

Value of Call Option = SN(d1)-Xe-rtN(d2) S = Current value of underlying asset

X = Exercise pricet = life until expiration of optionr = riskless rate2 = varianceN(d ) = the cumulative normal

distribution (the probability that a variable with a standard normal distribution will be less than d)

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Fin 286Black Scholes (Intuition)

Value of Call Option

SN(d1) - Xe-rt N(d2)The expected PV of cost Risk

NeutralValue of S of investment Probability

ofif S > X S > X

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Fin 286Black Scholes

Value of Call Option = SN(d1)-Xe-

rtN(d2)

Where:

t

trXS

d

)2()ln(2

1

tdd 12

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Fin 286Delta of an option

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.

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Fin 286Delta

Delta can be found from the call price equation as:

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).

)( 1dNS

c

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Fin 286Delta explanation

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.

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Fin 286Applying Delta

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

thenContingent asset value = $25 million

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Fin 286OBS Options

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.

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Fin 286Adjusting Delta

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.

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Fin 286Gamma of an Option

The change in delta for a small change in the stock price is called the options gamma:

Call gamma = TS

e d

2

2/21

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Fin 286Futures and Swaps

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.

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Fin 286Impact on the balance sheet

Start with a traditional simple balance sheetSince assets = liabilities + equity it is easy to find the value of equity

Equity = Assets - Liabilities

Example: Asset = 150 Liabilities = 125Equity = 150 - 125 = 25

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Fin 286Simple Balance Sheet

AssetsMarket Value of Assets

150

Total 150

LiabilitiesMarket Value of

Liabilities 125Equity (net worth) 25

Total 150

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Fin 286

Contingent Assets and Liabilities

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.

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Fin 286Simple Balance Sheet

AssetsMarket Value of Assets

150

MV of Contingent Assets 50

Total 200

LiabilitiesMarket Value of

Liabilities 125Equity (net worth) 15

MV of contingent Liabilities 60

Total 200

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Fin 286Reporting OBS Activities

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.

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Fin 286Growth in OBS activity

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%

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Fin 286

Growth in OBS activitiesBillions of $

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

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Fin 286Common OBS Securities

Loan commitmentsStandby letters of CreditFutures Forwards and SwapsWhen Issues SecuritiesLoans Sold

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Fin 286Loan commitments

79% of all commercial and industrial lending takes place via commitment contractsLoan 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.

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Fin 286Loan commitment Fees

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

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Fin 286Loan Commitment Risks

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.

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Fin 286Loan Commitment Risks

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.

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Fin 286Loan Commitment Risk

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.

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Fin 286Loan Commitment Risk

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

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Fin 286Letters of Credit

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

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Fin 286Letter of Credit

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.

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Fin 286

Future and Forward contracts

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.

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Fin 286Futures vs. Forwards

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.

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Fin 286Forwards vs. Futures

Forward Contracts Futures ContractsPrivate contract between Traded on an exchange two parties

Not Standardized Standardized

Usually a single delivery date Range of delivery dates

Settled at the end of contract Settled daily

Delivery or final cash Contract is usually closedsettlement usually takes place out prior to maturity

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Fin 286Options and Swaps

Sold in the over the counter market both can be used to manage interest rate risk.

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Fin 286

Forward Purchases of When Issued Securities

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.

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Fin 286Loans Sold

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.

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Fin 286Settlement Risk

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.

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Fin 286Settlement Risk

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.

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Fin 286Affiliate Risk

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

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Fin 286OBS Benefits

We have concentrated on the risk associated with OBS activities, however many of the positions are designed to reduce other risks in the FI.

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Fin 286Credit Default Swap

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.

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Fin 286Basic Credit Default Swap

Default Swap Buyer

DefaultSwapSeller

Reference

Obligation Issuer

Upfront Payment orStream of payments

Payment in the Event of Default

Return on

Reference

Obligation

OriginalPayment

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Fin 286

Credit Default Swap as an Option

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.

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Fin 286Intuition

Assume that the reference obligation is a bondIf 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.

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Fin 286What Constitutes Default

The CDS parties can agree to any or all of the events below

BankruptcyFailure to PayObligation AccelerationObligation DefaultRepudiation or deferralRestructuring

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Fin 286

What Does not Constitute Default

Downgrade by rating agencyNon Material events (error by employee causing a missed payment etc.)

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Fin 286Hedge against Default

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.

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Fin 286

Hedge against credit deterioration?

Since rating agency changes do not constitute default how are credit changes hedgedIf the CDS is marketed to market then the change in value serves as a hedge against changes in credit quality

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Fin 286An Example

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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Fin 286Credit Default Swap

Default Swap Buyer

DefaultSwapSeller

Reference

Obligation Issuer

2% per year

$1 Million in the Event of Default

7% per year

$1 Million

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Fin 286Risks in the CDS

The CDS seller may defaultWe 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.

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Fin 286Other CDS variations

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 swap

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Fin 286CDS Variations continued

Contingent CDS – triggered if both the default and a second event occurLeveraged CDS – Payoff is a multiple of the loss amount often the standard CDS amount plus a % of the notional valueTranched Portfolio Swaps – A variation of CDOs

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Fin 286Benefits of CDS

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 relationshipReduction of regulatory capital.

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Fin 286A costless reduction in risk

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 rateSimilarly Bank B has the same agreement with Co Y.Assuming both company’s have the same credit qualityBy exchanging a portion of the notional value of the swap the banks can diversify the credit risk without any costs.

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Fin 286

Credit Default SwapRisk Sharing

Bank

A

Company

X

$50 M of CDSWith Co X

$50 M of CDSWith Co Y

Company

Y

3% on $100M

Bank

B

Payment If Default

Payment If Default

3% on $100M