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Off - Balance Sheet Activities Drake Fin 286 DRAKE UNIVERSITY
Off balance sheet activities 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 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 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 Nat. West Bank finds losses of 77 Million pounds caused by mispricing of derivatives
Large Derivative Losses Drake University Fin 286 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 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 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 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.
Drake 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) Drake University Fin 286
Drake Payoff Diagram Call Option Payoff S-X X X S Spot Price Drake University Fin 286
Put Option Profits 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 S Cost Spot Price X 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 University Fin 286
Payoff Diagram Put Option Profit X-S S Cost X Spot Price Drake University Fin 286
Pricing an Option 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 s 2 = variance Drake University Fin 286
PV and FV in continuous time 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(d 1)-Xe-rt. N(d 2) S = Current value of underlying asset X = Exercise price t = life until expiration of option r = riskless rate s 2 = variance N(d ) = the cumulative normal distribution (the probability that a variable with a standard normal distribution will be less than d) Drake University Fin 286
Drake Black Scholes (Intuition) Drake University Fin 286 Value of Call Option SN(d 1) The expected Value of S if S > X - Xe-rt N(d 2) PV of cost Risk Neutral of investment Probability of S>X
Black Scholes Value of Call Option = SN(d 1)-Xe-rt. N(d 2) Where: Drake University Fin 286
Delta of an option 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 Drake University Fin 286 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(d 1) shares at any given time. (and vice versa).
Delta explanation 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 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 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 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 Drake University Fin 286 The change in delta for a small change in the stock price is called the options gamma: Call gamma =
Futures and Swaps 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 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 Drake University Fin 286 Liabilities Market Value of Liabilities 125 Equity (net worth) 25 Total 150
Contingent Assets and Liabilities 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 University Fin 286 Liabilities Market Value of Liabilities 125 Equity (net worth) 15 MV of contingent Liabilities 60 Total 200
Reporting OBS Activities 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 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 University Fin 286
Common OBS Securities Loan commitments Standby letters of Credit Futures Forwards and Swaps When Issues Securities Loans Sold Drake University Fin 286
Loan commitments 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 Drake University Fin 286 The FI charges a front end fee based upon the maximum value of the loan (maybe 1/8 th 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 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 = the risk that the spread between lending and borrowing rates may change.
Loan Commitment Risks 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 of commercial paper market and it drew down $14. 4 billion loan commitments made by major banks.
Loan Commitment Risk 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 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 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 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 of commercial paper without these.
Future and Forward contracts 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 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 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 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 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 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 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 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 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 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 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 Buyer Return on Reference Obligation Upfront Payment or Stream of payments Original Payment Reference Obligation Issuer Payment in the Event of Default Swap Seller Drake University Fin 286
Credit Default Swap as an Option 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 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 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. ) Drake University Fin 286
Hedge against Default 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? 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 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
Drake Credit Default Swap Buyer 7% per year 2% per year $1 Million in the Event of Default $1 Million Reference Obligation Issuer Drake University Fin 286 Default Swap Seller
Risks in the CDS 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 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 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 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 Drake University Fin 286 Assume that Bank A has sold a CDS to Co X on a 100, 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.
Drake Credit Default Swap Risk Sharing Bank $50 M of CDS With Co X A 3% on $100 M Drake University Fin 286 Bank $50 M of CDS With Co Y Payment If Default B Payment If Default 3% on $100 M Company X Y