5. Bonds, credit derivatives, futures and interest rates

Question 1

“Understanding the role of debt in the financial system”

What is Efficient Market Hypothesis (EMH)?

Answer 1

EMH posits: that it stocks market no one can legally have a very substantial informational advantage for a long time and not at all without paying a commensurate price for the effort of obtaining such an advantage. Information will quickly be reflected in prices and, since prices are common knowledge, beliefs will not be biased one way or the other to permit someone with just the knowledge of prices to make money.

Question 2

“Understanding the role of debt in the financial system”

Describe two examples from real life or financial markets when transparency is avoided on purpose. What are the consequences of such opacity? (6p) 


Answer 2

1) Money market mutual funds do not have to report the daily NAV (Net Asset Value). They only have to file quarterly reports and even then the reported value is not the current NAV, but the NAV 30 days ago. It allows to avoid a continuous flow of information into the market. Why? Investors are unable to judge whether the fund is close to “breaking the buck,” which might trigger a run.
2) Credit ratings could certainly be less coarse (rough). Coarseness is more likely an effort to make approximately equal collateral look equal in the eyes of the investors. Coarse ratings promote “commonality of beliefs”. They show theoretically, that commonality is desirable because it reduces problems of adverse selection. Even small departures from common knowledge can result in big swings in market outcomes and could trigger a run.

Question 3

“The Safe Assets Shortage Conundrum”

What is “safety trap” and “liquidity trap” and how to exit them?

Answer 3

“Safety trap” - an acute shortage of safe assets creates a situation similar to a liquidity trap.
“Liquidity trap” corresponds to a situation of excess savings across asset classes.

In both types of traps, real rates cannot fall sufficiently, causing a recession. There are, however, two important differences between safety traps and liquidity traps. First, exiting a safety trap requires an increase in the supply of, or a reduction in the demand for, safe assets, regardless of the demand and supply of other assets, while the more general liquidity trap calls for a reduction in saving or a general increase in stores of value

Question 4

“The Safe Assets Shortage Conundrum”

If the public sector is unable to expand the production of safe assets, the private sector will face powerful incentives to increase their issuance. How corporations can become a safer source of return?
Name risk/drawback of private-sector’s safe assets.

Answer 4

Corporations can make themselves a safer source of return, for instance by withdrawing from investing in risky projects and instead distributing a stable dividend or buying back their own shares.

Drawback: While it is possible in principle to create private-sector safe assets with sufficient overcollateralization, this solution remains fragile since the private sector’s ability to insure against a truly systemic event is limited. Even the most senior and seemingly safe tranches on private assets may contain some irreducible tail-risk, making these assets unsafe when faced with truly systemic events.

Question 5

“The Safe Assets Shortage Conundrum”

Who are larges demanders and consumers of safe assets? For what purpose they use these safe assets?

Answer 5

For example, of the $18 trillion of outstanding US Treasuries, the quintessential liquid safe asset, more than 30 percent is stationed at central banks— two-thirds at foreign central banks and one-third at the Federal Reserve itself.

Central banks hold safe assets for two main reasons:

1) to be able to intervene in foreign exchange markets if desired, which typically involves collecting large amounts of foreign safe assets;
2) as a result of quantitative easing policies, which involves the accumulation of domestic safe assets and occasionally riskier ones.

=> The accumulation of safe assets in the form of foreign exchange reserves, reflects a precautionary motive against the occurrence of a sudden stop of capital inflows => Inefficient systemic self-insurance, could be replaced by e.g. swaps.

Question 6

“Credit Default Swaps and the Credit Crisis”

What 2 main reasons drove crisis in 2008?

Answer 6

1. Investors and financial institutions did not expect such a dramatic fall in real estate prices →
   large defaults of subprime mortgages and falls in value of mortgages-backed securities
2. Many financial institutions were operating with extremely high levels leverage and invested heavily in subprime securitizations → when these investments caused a lot of losses in led market participants to question their solvency

Question 7

“Understanding the role of debt in the financial
system”

What is called shadow banking?

Answer 7

• The new model of ”originate to distribute” rather than “originate to hold”
• A network of financial non-depositary institutions, such as investments banks, hedge funds, money market mutual funds, structured investment vehicles, mortgage companies.
• Based on loosely regulated activities

Question 8

“Understanding the role of debt in the financial
system”

What drove the demand for new products and the growth of shadow banking?

Answer 8

• The global savings accumulation → foreign investors perceived it as a “safe parking space” for money (global demand for safe assets)
• Shadow banking is highly scalable → designed to manufacture large amounts of high-quality assets, which are more widely acceptable
• State-contingent use of capital is more efficient than keeping mortgages on the books of originating banks

Question 9

“Understanding the role of debt in the financial
system”

What is authors proposed solutions for getting out of the crisis?

Answer 9

1. A crisis ends when confidence returns → back to the “no questions asked” state
   • transparency without remedial action is a prescription for disaster
   • the lack of specific information if a key element in the effectiveness of the message - ex. Governor Draghi’s words “we will do whatever it takes”
   • A detailed transparent plan to get out of the crisis might lead to a difference in opinions rather than to a convergence in views
2. Higher capital requirements and stress tests is the best road for now

Question 10

“The economics of structured finance” + other material.

In March 2016, Financial Times reported that securitization in Europe is undergoing a revival and at the same time causing political concerns. Explain: (i) how securitization works, (ii) its benefits, and (iii) the nature of risk in the resulting securities and things to be mindful of when pricing the securities. (8p)

Answer 10

answer needed

Question 11

“The Safe Assets Shortage Conundrum”

What is safe asset? Name 3 main characteristics.

Answer 11

Safe asset - a simple debt instrument that is expected to preserve its value during adverse systemic events

1) “information insensitivity” – can be transacted without much
analysis or concern for adverse selection
2) “simple” asset - have special value during economic crises that are inherently complex
3) strategic complementarity - an asset is safe if others expect it to be safe

Question 12

“Is the US public corporation in trouble?”

What are the three main reasons for a public firm to delist?

Answer 12

1) it no longer meets the listing requirements, which is typically due to financial distress
2) it has been acquired
3) it voluntarily delists.

Question 13

“Is the US public corporation in trouble?”

What are the two ways to measure the age of a firm?

Answer 13

1) from the date of incorporation (lacking in databases)
2) from the date the firm went public (downward biased)

• Aging trend is more dramatic among public firms than private firms
• Loderer, Stulz, and Walchli (forthcoming) find that older firms innovate less and are more rigid.

Question 14

“Is the US public corporation in trouble?”

Why fraction of small public firms has dropped dramatically?

Answer 14

1) firms don’t want to disclose their project to large audience
2) public markets have become dominated by institutional investors (small firms don’t have enough scale for their investment)
3) developments in financial intermediation and regulatory changes have made it easier to raise funds as a private firm
4) economies of scope hypothesis: small firms have become less profitable and less able to grow on a stand-alone basis -> better off selling themselves to a large organization that can bring a product to market faster and realize economies of scope
5) increased concentration could also make it harder for small firms to succeed on their own
6) it has become easier to put a new product on the market without hard assets (ex, Netflix)

Result: larger firms may be able to worry less about competition, and do not have to innovate and invest -> less investment, less growth, and less dynamism

Question 15

What’s the difference between bills, notes and bonds?

Answer 15

T-BILLS

• short term - one year or shorter maturity
• no coupon

TREASURY NOTES

• semi-annual coupon
• 1, 3, 5, 7 and 10 years

BONDS

• semi-annual coupon
• long-term investments with terms of more than 10 years

Question 16

What are the risks associates with investing in bonds?

Answer 16

Interest rate risk
Reinvestment risk
Call risk
Credit risk (default risk)
Liquidity risk
Exchange rate risk

Question 17

“The Economics of Structured Finance”

What are the reasons for structured finance market dramatic expansion?

Answer 17

1) offered higher yields compared to the bonds with the same rating in the period of low interest rates
2) were rated using the same scales as for bonds (easy to compare)
3) regulatory requirements fueled demand for senior (AAA-rated) tranches
4) favorable economic conditions

Question 18

“The Economics of Structured Finance”

Explain, how pooling and tranching works?

What is overcollateralization?

Answer 18

Pooling - a large collection of credit-sensitive assets is assembled in a portfolio

Tranching - prioritized claims, known as tranches, are issued against the underlying collateral pool. The
tranches are prioritized in how they absorb losses from the underlying portfolio.

Overcollateralization - the degree of protection offered by the junior claims. It plays a crucial role in determining the credit rating for a more senior tranche, because it determines the largest portfolio loss that can be sustained before the senior claim is impaired.

Question 19

“The Economics of Structured Finance”

What are the main problems related to CDOs?

Answer 19

• Structure amplifies errors - with multiple rounds of structuring, even minute errors at the level of the underlying securities can dramatically alter the ratings (especially for 𝐶𝐷𝑂2)
• Risks that are largely diversifiable are substituted for risks that are highly systematic - CDO’s do not offer their investors nearly large enough of a yield spread to compensate them for the actual systematic risks that they bear
• Claims are highly sensitive to:

1) default probability and recovery value
2) correlation of defaults
3) the relation between payoffs and the economic states that investors care about most

Question 20

“The Economics of Structured Finance”

Why is CDO rating process difficult and can be biased?

Answer 20

Previously, securities were assessed independently of each other, without considering the extent to which defaults might be correlated. But to assign ratings to structured finance securities, the rating agencies were forced to assess the entire joint distribution of payoffs (!) for the underlying collateral pool IN OTHER WORDS - determine the correlation of defaults.

Biased valuations
1) overlap in geographic locations (higher-than-expected default correlations for
mortgages)
2) errors in assumptions about default correlations and probabilities – turned out to be worse than expected
3) valuation based on wrong or not fully correct assumptions (constantly rising housing prices)
4) pricing of systematic risks in the same way as diversifiable ones
5) technical mistakes in the models

Question 21

“Credit default swaps and the credit crisis”

Describe the ways in which CDS is beneficial and the ways in which it is harmful for the market?

Answer 21

+ Credit risk can reside with the investors who are best equipped to bear it
+ Separating the cost of funding and the credit risk introduces greater transparency in the pricing of credit -> reduces the cost of capital for firms
+ More efficient way to assess a company’s credit risk → improves price discovery
+ Allowing to extract the same economic benefit as in the case of short-selling → improves price discovery

• Incentives to monitor become less powerful because creditors shift their risk to other parties
• Perverse incentives of investors (ex. If debt restructuring is not treated as an event that causes payout, an investor might be willing to drive a firm into bankruptcy and receive payout rather than engage in a refinancing plan)
• Investors take riskier positions than they otherwise would because of built-in leverage (excessive risk-taking)
• Lower regulatory capital requirements in case of protection by CDS
• Web exposure → failure of one institutions leads another one to fail as well, may cause the whole financial system to collapse (even a dealer with net net derivatives receivables can pose risks to the system)
• Counterparty risk → because default is a discrete event it can lead to large jumps in the value of CDS contracts
• Manipulation with “naked” CDS → overreaction of the market

Question 22

“Credit default swaps and the credit crisis”

What are the main differences between OTC and exchange trading?

Answer 22

OTC
• Custom-made contracts - infinite variations of amounts and maturities, can choose new derivatives or combine them in the most suitable way
• Counterparty – dealers, sometimes clearing houses
• Unknownexposure
• Provide a market for securities, which have
low liquidity on the exchange
• Provide a market for new financial products → enable innovation

EXCHANGE
• Standardized in terms of size and maturity (need to choose a contract available on the exchange)
• Counterparty – always the clearing house of the exchange
• Trade prices are publicly transparency
available →
• Regulatorscouldidentifycounterpartiesthrough the clearing house if needed → transparency
• Not flexible in terms of volume (limited resources of clearing houses)

Trade-off between OTC and exchange:
OTC market is better at finding counterparties for less liquid derivatives and new financial products, as well as that, it gives an opportunity for investors and firms to obtain contracts that exactly match their needs. In contrast, exchanges create pools of liquidity and are more efficient when there is a large volume of trading for standardized contracts.