Risk Management in Financial Institutions


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Risk Management in Financial Institutions

  1. 1. Risk Management in Financial Institutions <ul><li>Managing Credit Risks </li></ul><ul><li>Managing Interest Rate Risks </li></ul><ul><ul><li>Income Gap Analysis </li></ul></ul><ul><ul><li>Duration Gap Analysis </li></ul></ul><ul><li>Hedging with Financial Derivatives </li></ul><ul><ul><li>Forward </li></ul></ul><ul><ul><li>Futures </li></ul></ul><ul><ul><li>Options </li></ul></ul><ul><ul><li>Swaps </li></ul></ul>
  2. 2. Managing Credit Risk <ul><li>Solving Asymmetric Information Problems </li></ul><ul><ul><li>1. Screening </li></ul></ul><ul><ul><li>2. Monitoring and Enforcement of Restrictive Covenants </li></ul></ul><ul><ul><li>3. Establish Long-Term Customer Relationships </li></ul></ul><ul><ul><li>4. Loan Commitment Arrangements </li></ul></ul><ul><ul><li>5. Collateral and Compensating Balances </li></ul></ul><ul><ul><li>6. Credit Rationing </li></ul></ul>
  3. 3. Benefit of Long-Term Relationship <ul><li>Reducing the cost of information collection -- check firms’ past activities </li></ul><ul><li>Reducing monitoring costs </li></ul><ul><li>Reducing borrowers’ moral hazard when they want to preserve a long-term relationship </li></ul>
  4. 4. <ul><li>Loan Commitments </li></ul><ul><li>Banks’ commitment to provide a firm with loans up to a given amount at </li></ul><ul><li>fixed interest rate or at a rate that is tied to some market interest rates </li></ul><ul><li>Promote long-term relationship </li></ul><ul><li>Collateral requirement / Secured Loans </li></ul><ul><li>Collateral is a property promised to the lender as compensation if the </li></ul><ul><li>borrow defaults </li></ul><ul><li>Reducing adverse selection </li></ul>
  5. 5. <ul><li>Compensating Balances </li></ul><ul><li>A firm receiving a loan must keep a required minimum amount of funds </li></ul><ul><li>in a check account at the bank </li></ul><ul><li>serving as collateral </li></ul><ul><li>monitoring </li></ul><ul><li>Credit Rationing </li></ul><ul><li>lenders refuse to make loans even though borrows are willing to pay the </li></ul><ul><li>stated interest rate or even a higher rate </li></ul><ul><li>two types: (1) no loan; (2) loan with restricted size </li></ul><ul><li>Deal with Adverse Selection and Moral Hazard </li></ul>
  6. 6. Managing Interest Rate Risks Income Gap Analysis Duration Gap Analysis
  7. 7. Managing Interest-Rate Risk <ul><li>First National Bank </li></ul><ul><li>Assets Liabilities </li></ul><ul><li>--------------------------------------------------------------------------------------------------------------------- </li></ul><ul><li>Reserves and cash items $ 5 m | Checkable deposits $ 15 m </li></ul><ul><li>| </li></ul><ul><li>Securities | Money market deposit accounts $ 5 m </li></ul><ul><li>less than 1 year $ 5 m | </li></ul><ul><li>1 to 2 year $ 5 m | Savings deposits $ 15 m </li></ul><ul><li>greater than 2 year $ 10 m | </li></ul><ul><li>| CDs: Variable-rate $10 m </li></ul><ul><li>Residential mortgages | less than 1 year $ 15 m </li></ul><ul><li>Variable rate $ 10 m | 1 to 2 year $ 5 m </li></ul><ul><li>Fixed rate (30 year) $ 10 m | greater than 2 year $ 5 m </li></ul><ul><li>| </li></ul><ul><li>Commercial Loans | Fed funds $ 5 m </li></ul><ul><li>less than 1 year $ 15 m | </li></ul><ul><li>1 to 2 year $ 10 m | Borrowings: less than 1 year $10 m </li></ul><ul><li>greater than 2 year $ 25 m | 1 to 2 year $ 5 m </li></ul><ul><li>| greater than 2 year $ 5 m </li></ul><ul><li>Physical capital $ 5 m | </li></ul><ul><li>| Bank capital $ 5 m </li></ul>
  8. 8. Income Gap Analysis <ul><li>identifying rate sensitive assets and liabilities </li></ul><ul><li>finding GAP = RSA – RSL </li></ul><ul><li>Income change = GAP * </li></ul><ul><li>About reinvestment risk </li></ul>
  9. 9. Income Gap Analysis <ul><li>Rate-Sensitive Assets = $5m + $ 10m + $15m + 20% x $20m </li></ul><ul><li>RSA = $32 m </li></ul><ul><li>Rate-Sensitive Liabs = $5m + $25m + $5m+ $10m + 10% x $15m </li></ul><ul><li>+ 20%x$15m </li></ul><ul><li>RSL = $49.5 m </li></ul><ul><li>i  5%  </li></ul><ul><li>ΔAsset Income = </li></ul><ul><li>ΔLiability Costs = </li></ul><ul><li>ΔIncome = </li></ul><ul><li>If RSL > RSA , i  , Income  </li></ul><ul><li>GAP = RSA - RSL </li></ul><ul><li>= </li></ul><ul><li>Δ Income = GAP x Δ i </li></ul><ul><li>= </li></ul>
  10. 10. Duration Gap Analysis <ul><li>Examining the sensitivity of market value of financial </li></ul><ul><li>institutions’ net worth to changes in interest rate </li></ul><ul><li>%  P = -DUR*  i/(1+i) </li></ul><ul><li>if we know the duration of assets and liabilities, we could </li></ul><ul><li>calculate the change in net worth due to interest rate change </li></ul><ul><ul><li>duration is additive – using market values as weights </li></ul></ul><ul><ul><li>DUR gap = DUR a - [ L / A x DUR l ] </li></ul></ul><ul><li>About interest rate risk </li></ul>
  11. 12. Example 3 (page 630) <ul><li>Interest rate rise from 10% to 15% </li></ul><ul><li>Total asset value $100 million </li></ul><ul><li>Total liability value $95 million </li></ul><ul><li>Durations for each asset and liability as illustrated in Table 1 </li></ul>
  12. 13. Duration Gap Analysis <ul><li>%Δ P  - DUR x Δ i /(1+ i ) </li></ul><ul><li>i  5%, from 10% to 15%  </li></ul><ul><li>ΔAsset Value = %Δ P x Assets </li></ul><ul><li>ΔLiability Value = %Δ P x Liabilities </li></ul><ul><li>Δ NW = </li></ul><ul><li>DUR gap = DUR a - [ L / A x DUR l ] </li></ul><ul><li>%Δ NW = - DUR gap x Δ i /(1+ i ) </li></ul><ul><li>Δ NW = </li></ul>
  13. 14. Managing Interest-Rate Risk <ul><li>Problems with GAP Analysis </li></ul><ul><ul><li>1. Assumes slope of yield curve unchanged and flat </li></ul></ul><ul><ul><li>2. Manager estimates % of fixed rate assets and liabilities that are rate sensitive </li></ul></ul>
  14. 15. Managing Interest-Rate Risk <ul><li>Strategies for Managing Interest-Rate Risk </li></ul><ul><ul><li>To completely immunize net worth from interest-rate risk, set DUR gap = 0 </li></ul></ul>
  15. 16. Hedging with Financial Derivatives <ul><li>Forwards </li></ul><ul><li>Futures </li></ul><ul><li>Options </li></ul><ul><li>Swaps </li></ul>
  16. 17. Suppose in Nov 2002, Fleet holds $10 million face value of 10%-coupon rate Treasury bonds selling at par that mature in Nov 2013.
  17. 18. How will Fleet hedge its interest rate risks?
  18. 19. Forward Contracts <ul><li>Agreements by two parties to engage in a financial transaction at a future point of time </li></ul>
  19. 20. Interest-Rate Forward Markets <ul><li>Long contract = buy securities at future date </li></ul><ul><li> Locks in future interest rate </li></ul><ul><li>Short contract = sell securities at future date </li></ul><ul><ul><li>Locks in future price, so reduces price risk from change in interest rates </li></ul></ul><ul><li>Pros </li></ul><ul><ul><li>1. Flexible </li></ul></ul><ul><li>Cons </li></ul><ul><ul><li>1. Lack of liquidity: hard to find counter party </li></ul></ul><ul><ul><li>2. Subject to default risk: Requires info to screen good from bad risk </li></ul></ul>
  20. 21. Fleet could short (sell), at today’s price and interest rate, $10 million of the Treasury bond to another party one year later (in Nov 2003) – forward contract The other party could take a short position on US Treasury bonds
  21. 22. Financial Futures Markets <ul><li>Traded on Exchanges: Global competition Regulated by CFTC </li></ul><ul><li>Financial Futures Contract </li></ul><ul><ul><li>1. Specifies delivery of type of security at future date </li></ul></ul><ul><ul><li>2. Arbitrage  At expiration date, price of contract = price of the underlying asset delivered </li></ul></ul><ul><ul><li>3. i  , long contract has loss, short contract has profit </li></ul></ul><ul><li>Differences in Futures from Forwards </li></ul><ul><ul><li>1. Futures more liquid: standardized, can be traded again, delivery of range of securities </li></ul></ul><ul><ul><li>2. Delivery of range prevents corner </li></ul></ul><ul><ul><li>3. Mark to market: avoids default risk </li></ul></ul><ul><ul><li>4. Don't have to deliver: net long and short </li></ul></ul>
  22. 23. Alternatively, Fleet could take a short position of $10 million 10% 2003 Treasury bond futures contract
  23. 25. Options <ul><li>Options Contract </li></ul><ul><li>Right to buy (call option) or sell (put option) instrument at exercise (strike) price up until expiration date (American) or on expiration date (European) </li></ul><ul><li>Hedge Fleet’s Risks with Put Options </li></ul>
  24. 27. Payoffs of Call option versus Put Options