Some relevant concepts in Financial Economics

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Some relevant concepts in Financial Economics

• Kitty Moloney

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Brief Overview

• Bonds,
• Management issues and Risks for a bank
• A T account for a bank, its reserve requirement
  and its capital
• Securitisation,
• Asset backed securities
• Credit Default Swaps and Collateralised Debt
  Obligations

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What is a Bond

• A contractual obligation by a borrower (a company
  or Government) to repay an investor the principal
  amount borrowed and to pay interest periodically
  at some defined rate agreed at the outset.
• Key Features
• Maturity
• Coupon
• Principal

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Example

• Germany 4.25 7th April 2014
• Annual payment
• Final payment
• Price 103.2
• Yield of 3.62
• (See Bloomberg)

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Is this a fair price?

• PV and FV
• Risk free investment annual interest rate
• If r 4 p.a.
• 1 ? 1.04
• PV(1.04) 1 _at_ r 4

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Valuing a Bond
Price of a bond is the sum of the discounted
future cash flows.
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Valuing a Bond

• What is the discount rate market determined,
  affected by perceived risk
• As discount rates ? the price ?
• Inverse relationship between price and yield

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Valuing a Bond

• Clearly higher rates lead to a fall in price
• Also note Bond price ? par
• as bond ? maturity.

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Interest Rates

• Sensitivity of bond prices to interest rate
  changes?
• Longer dated bonds - more sensitive
• Lower coupon bonds - more sensitive

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What effects bond prices?

• Interest rates
• Coupon and Maturity
• Credit ratings, (Moodys, SP etc.)
• Economic Environment
• Flight to quality?

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Management issues and Risks for a bank

• Liquidity Management
• Asset Management
• Liability Management
• Capital Adequacy Management
• Credit Risk
• Liquidity Risk
• Interest-rate Risk

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A T account for a bank and its reserve
requirement Ample Excess Reserves
Bank A before deposit outflow Bank A before deposit outflow Bank A before deposit outflow Bank A before deposit outflow Bank A after deposit outflow Bank A after deposit outflow Bank A after deposit outflow Bank A after deposit outflow
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Reserves 20M Deposits 100M Reserves 10M Deposits 90M
Loans 80M Bank Capital 10M Loans 80M Bank Capital 10M
Securities 10M Bank Capital Securities 10M Bank Capital

• Excess reserves
• Deposit outflow does not necessitate change in
  balance sheet

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Liquidity Management Shortfall in Reserves
Bank B before deposit outflow Bank B before deposit outflow Bank B before deposit outflow Bank B before deposit outflow Bank B after deposit outflow Bank B after deposit outflow Bank B after deposit outflow Bank B after deposit outflow
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Reserves 10M Deposits 100M Reserves 0 Deposits 90M
Loans 90M Bank Capital 10M Loans 90M Bank Capital 10M
Securities 10M Bank Capital Securities 10M Bank Capital

• Reserves legal requirement
• Shortfall must be eliminated
• Excess reserves insurance against costs
  associated with deposit outflows

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What does a bank do if it has a liquidity
problem, that is a short fall in reserves?

• Borrow
• Securities Sale
• Borrow from the CB
• Reduce loans

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Capital Adequacy Management Preventing Bank
Failure When Assets Decline
Bank A High Bank Capital Bank A High Bank Capital Bank A High Bank Capital Bank A High Bank Capital Bank B Low Bank Capital Bank B Low Bank Capital Bank B Low Bank Capital Bank B Low Bank Capital
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Reserves 10M Deposits 90M Reserves 10M Deposits 96M
Loans 90M Bank Capital 10M Loans 90M Bank Capital 4M

Bank A High Bank Capital Bank A High Bank Capital Bank A High Bank Capital Bank A High Bank Capital Bank B Low Bank Capital Bank B Low Bank Capital Bank B Low Bank Capital Bank B Low Bank Capital
Assets Assets Liabilities Liabilities Assets Assets Liabilities Liabilities
Reserves 10M Deposits 90M Reserves 10M Deposits 96M
Loans 85M Bank Capital 5M Loans 85M Bank Capital -1M
Bank Capital assets minus liabilities, acts as
a cushion against insolvency
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Asset Management Four Tools

• Manage default risk
• Purchase low risk securities
• Diversify, (?)
• Trade off liquidity v maximising return on assets

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Financial Innovation and the increase in
Off-Balance-Sheet Activities

• Loan sales
• Fee income
• Trading activities and risk management techniques
• Futures, options, interest-rate swaps, foreign
  exchange
• Speculation

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Real Assets Versus Financial Assets

• Real Assets
• Assets used to produce goods and services
• Financial Assets
• Claims on real assets

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Securitisation

• Transform illiquid asset (s) into a security
• Mortgage ?
• Mortgage pool ?
• Mortgage backed Security (MBS) ?
• Tranches with different credit ratings, (Moodys,
  SP etc.) ?
• Sell in Secondary Mortgage Market.

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Asset Backed Securities (ABS)

• Similar to MBS, a financial security backed by
  assets.
• For example loans, leases, credit card debt, a
  company's receivables, royalties etc. are all
  bundled into ABSs
• Have become a popular alternative to investing
  in corporate debt.

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Figure 1.2 Asset-backed Securities Outstanding
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An example Collateralised Debt Obligations

• CDOs type of ABS,
• CDOs offer different types of debt and credit
  risk.
• These are referred to as 'tranches' or 'slices'.
• Each slice has a different maturity and risk
  associated with it.
• The higher the risk, the more the CDO pays

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Collateralised Debt Obligations
See http//www.investopedia.com/articles/07/subpr
ime-blame.asp?viewall1.
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Growth of Subprime Mortgages
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What if the counterparty defaults?Credit Default
Swaps

• Like an insurance policy
• Buyer receives credit protection,
• Seller guarantees creditworthiness of underlying
• Risk of default is transferred from the
• holder of the fixed income security to the
• seller of the swap.

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Credit Default Swaps

• On default of security, CDS buyer is entitled to
  the full value of the bond
• But what happens if the seller of the bond
  becomes insolvent!!
• Example
• AIG, US 441 billion exposure, (see The
  Economist)
• Lehmans, collapse of bank will trigger about
  US400 billion of protection payouts, (see FT)

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CDOs

• Over The Counter (OTC)
• Unregulated
• First CDS Morgan Stanley in 1995
• Mid 2007 US45 trillion,
• (according to the International Swaps and
  Derivatives Association )
• That is gt twice value of US stock market
• Sept 2008 US62 trillion, (see The Economist)
• Speculators

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Summary

1. Bonds,
2. Management issues and Risks for a bank
3. A T account for a bank, its reserve requirement
   and its capital
4. Securitisation,
5. Asset backed securities
6. Credit Default Swaps and Collateralised Debt
   Obligations

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Final Comment

• Back in 2006 Warren Buffett called derivatives
• Weapons of mass financial destruction...

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Suggested reading

1. Bloomberg, 2008, Government Bondsonline at
   http//www.bloomberg.com/markets/rates/germany.htm
   l, accessed 9th Oct.
2. Brealey, Myers Allen, Principles of Corporate
   Finance 2007 9th ed. McGraw Hill London, chap 2,
   4 and 8
3. Bodie, Z., Kane, A. Marcus, A.J., 2008,
   Investments 8th ed. McGraw Hill London, chap.
   1-3
4. Fabozzi, F.J. Choudhry, M 2004, The Handbook
   of European Structured Financial Products John
   Wiley and Sons, 2004, chap2-4
5. Mishkin, F (2007) The Economics of Money,
   Banking and Financial Markets, 8th Edition, New
   York Addison Wesley Pearson chap 8-11
6. SEC, 2008, SEC Office of the Chief Accountant
   and FASB Staff Clarifications on Fair Value
   Accounting online at http//www.sec.gov/news/
   press/2008/2008-234.htm, accessed 10th Oct. 2008
7. The Economist, 2008 Sept 18th, Derivatives A
   Nuclear Winter?onlineat http//www.economist.co
   m/finance/displayStory.cfm?sourcehptextfeaturest
   ory_id12274112 accessed 10th Oct. 2008
8. The Financial Times, 2008 Oct. 9th, page
   40,Rising CDS action increases the strain

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Useful Web links

• http//www.investopedia.com/
• http//www.investinginbonds.com/
• http//www.investorguide.com/
• http//finance.yahoo.com
• http//money.cnn.com/markets/bondcenter
• http//www.federalreserve.gov/
• http//www.ft.com/home/europe
• http//www.forbes.com/
• http//invest-faq.com/
• http//bigcharts.marketwatch.com /
• http//www.globalfinancialdata.com/
• http//morningstar.com/
• http//www.duke.edu/charvey/Classes/wpg/glossary.
  htm
• http//www.ifsra.ie
• http//www.ustreas.gov/