Bonds, Banking and Financial Crisis

Question 1

Term Structure

Answer 1

This is the study of bonds with different terms to maturity that come from the same place. Ex. Bank of Canada 1 year, 3 year, 5 year, and 10 year bonds.

Question 2

Yield Curve

Answer 2

It is widely regarded as the best predictor for I.S Recessions. This is a curve that plots the interest rate that is expected on securities with different terms to maturity that come from the Central Bank.

Question 3

Three Empirical Facts about Term Structure

Answer 3

• Interest Rates on Bonds with different maturities tend to move together
• When current short term rates are low, the yield curve is more likely to slope upward. Conversely when current short term rates are high, the yield curve is likely to be flat or inverted.
• Yield curves slope upward most of the time

Question 4

What explains our Three Empirical Facts?

Answer 4

The Liquidity Premium and Preferred Habitat Theories

Question 5

Liquidity Premium Theory

Answer 5

The interest rate on a bond 3 years from now is calculated by taking the average of one year bonds for the next 3 years alongside the addition of a Liquidity premium, which can be thought of as compensation for waiting longer to receive your money back.

Interest rate for 3 yr bond = (IR for 1 yr bond next year, + expected IR for a 1 yr bond two years from now + expected IR for a 1 year bond three years from now) + Ln(t) (This is the Liquidity Premium)

Question 6

One period Valuation Model of Stocks

If you plan on selling your stocks next year

Answer 6

P(o) = Div(1) P(1)
——— + ——-
(1+ke) (1+ke)

You can also write it as:

P(o) = (Div(1) + P(1))
——————-
(1+ke)

Question 7

Dividend Valuation of Stocks

If you plan on holding your stocks for an undisclosed amount of time

Answer 7

P(o) = Div(1) Div(2) Div(n) P(N)
——— + ——- + …… + ———- + ———
(1+ke) (1+ke)^2 (1+ke)^n (1+ke)^N

Typically, if N is large, and ke is positive, the last term is said to drop out.

Question 8

Gordon Growth Model

Answer 8

This is the fully flushed out version of evaluating stocks.

Div(1)(1+g) Div(2)(1+g)^2 Div(n)(1+g)^N P(N)(1+g)^N ————— + —————– + ——————– + —————-
(1+ke) (1+ke)^2 (1+ke)^N (1+ke)^N

all of this is = P(0)

g

Question 9

Equity Premium

Answer 9

Relatively riskier assets should offer higher interest rates than less risky assets such as treasury bonds, that is because higher risk means higher chance of defaulting. Thus you should be compensated better for taking the chance on less stable companies, industries, governments etc.

Ex:
interest on $1000 of Geico Stock: 0.05%
Interest on $1000 on 1 year US Gov’t Bond: 0.02%

The Equity Premium is: 0.05% - 0.02% = 0.03% which is compensation for investing into something riskier.

Question 10

Gordon Growth Model Understanding

Answer 10

We can use the Gordon Growth model and apply it to the S&P 500 index in order to understand the U.S. Economy. it is important to note that the EPS and the real GDP growth tend to move together.

Question 11

Stock vs. Bond Key Takeaway #1

Answer 11

Stocks tend to do better than long term treasury bonds.

Equity Premium: 4% over the last 100 + years
recently this has been 3% since the 1960s

The average from 1871 - 2015 is 3.95%

Question 12

Stock vs. Bond Key Takeaway #2

Answer 12

Stocks are Riskier.

There are periods where stocks substantially under perform bonds.

There are years where the 10 year return for stocks were negative. This very seldom happens to bonds.

Question 13

Stocks vs. Bonds: Why is Equtiy Premium usually in favor of stocks? - Family Example

Answer 13

Stocks are like your “Beer Buddies”. When times are good, they provide you very high returns, but when times are bad they give you low returns.

Bonds are like “Good Family Members”, both when times are good they do not both too much and give lower returns, but when times are bad they help out and give you high returns.

Question 14

Rate of Return on a Stock

Answer 14

RET (from yr 1-2) =

Div(2) / Price (1) + (Price(2) - Price(1)) / Price(1)

Question 15

EPS

Answer 15

You can think of it as the amount of profit per share. You’re essentially figuring out, if all the profit was distributed to shareholders (excluding the dividends that have already been paid out), how much money would each shareholder receive.

Calculated by:

Average # of Shares for that Year

We use the average because we assume it is possible that the firm might have administered more shares as the year went onward.

Question 16

Price to Earnings Ratio

Answer 16

This is where you evaluate how much investors are willing to spend on a stock for each dollar of earnings it has to show for its stockholders.

You achieve this by:

Earnings Per Share

Question 17

Note to self regarding Price to Earnings Ratio (P/E Ratio)

Answer 17

You should expect different industries to have different P/E averages! Also, you can use the P/E ratio to predict and compare the prices of stocks in the same industry.

Question 18

Earnings Yield

Answer 18

This is achieved through the inverse of the Price to Earnings Ratio. Essentially you are trying to evaluate the interest rate return you expect to receive on the amount of money you invest in a company, in order to receive $1 Earnings per share.

  1 ------------ P/E Ratio

gives you this rate. You should compare this rate to the return offered on long term securities such as ten year treasury bonds. You can subtract the two interest rates (normally stock returns should be higher) and the difference can be thought of as an equity premium.

Question 19

Shiller’s CAPE

Answer 19

Shillers Cyclically Adjusted Price Earnings Ratio:

Used to provide a P/E Ratio for the S&P 500 as a whole.

I think but I’m not sure that:

You can think of it as a P/E for the most diversified portfolio within the US economy. You can somewhat use it to estimate the P/E stocks in America.

Question 20

Sources of External Funds for non financial Businesses

Answer 20

We can break this down into two categories

Indirect Finance:
Bank Loans + Non Bank Loans

Direct Finance:
Stocks + Bonds

Question 21

Indirect Finance

Answer 21

Bank Loans + Non Bank Loans

Question 22

Direct Finance

Answer 22

Stocks + Bonds

Question 23

Which type of external financing is larger?

Answer 23

Indirect Finance > Direct Finance

Question 24

Debt Financing

Answer 24

Consists of:

Bank Loans + Non Bank Loans + Bonds

Question 25

Equity Financing

Answer 25

Consists of: Just stocks

Question 26

Which for of financing is larger?

Answer 26

Debt Financing is larger than Equity financing Debt Financing > Equity Financing

Question 27

Financial intermediaries have reduced there costs through:

Answer 27

- Economies of Scale | - Expertise

Question 28

Asymmetric Information

Answer 28

The two big problems of asymmetric information are: - Adverse Selection (Before a Contract) - Moral Hazard (After a Contract)

Question 29

Adverse Selection Example

Answer 29

The Lemons Problem (Relates to Kijiji) Good Quality sellers exit the market because consumers in a market without perfect information tend to pay the average price between good products and bad products. As a result of knowing what they have, all the good product sellers exit. As a result, the market shrinks and the problem starts all over again with the medium quality sellers exiting again as there product is still better than the new market average. This problem persists until proper information can be set in place. It even has the potential to collapse a market.

Question 30

Adverse Selection in Banking

Answer 30

Adverse selection can be found in banking. If a Bank is not aware how likely the average borrower is to repay them (assuming imperfect information) they might be incentive to charge a relatively high interest rate in order to compensate for the risk of not knowing. As a result, this may actually curve off good borrowers because they are borrowing with a purpose and the new interest rate will exceed there limitations. Bad borrowers do not care because they do not have any incentive to pay back the money anyways (assuming very little repercussions), as a result, the market of people borrowing is saturated with worse and worse borrowers as the interest rates go up.

Question 31

Free - Rider Problem

Answer 31

People who do not purchase information compete against those who do pay for the information by observing the latter's activities.

Question 32

Dealing with Adverse Selection for Banking

Answer 32

Collateral Requirements > This lowers the bank's risk and allows them to lower the interest rate, whilst driving away bad borrowers as they have higher consequences. Net Worth Requirements: Net Worth = Assets - Liabilities This means that bad borrowers will simply not get loans because they have no assets to lose. All the solutions to adverse selection problems result from providing more information to the disadvantaged party.

Question 33

General Ways to Deal with Adverse Selection

Answer 33

- Public Information - Enforcing requirements (as is the case in banking) - Government regulation

Question 34

Moral Hazard Example

Answer 34

The Principle - Agent Problem This is a problem that occurs when the ownership and the management of a firm are separated. Which thus leads to opportunities for the agent to profit off of asymmetric information. A CEO of a company is very separate from its ownership. As a result, the CEO might make the company purchase smaller companies that his company might not even need. This is called empire building and it can lead to corruption as CEOs may be making decisions that do not even benefit the business in order to inflate their own salaries. They might also hire more staff than necessary to inflate their salaries (i..e look at how many people work for me, i must be competent af)

Question 35

Traditional Mortgage Lending

Answer 35

This can be also written as Originate to hold. It is when banks keep the mortgages on there balance sheet, (Draw the diagram)

Question 36

Originate to Distribute

Answer 36

Banks do not hold the mortgage securities they own themselves but rather they break them into mortgage backed securities that investors of the bank can purchase. This type of mortgage lending is partially responsible for the Financial Crisis. (Draw the diagram) This actually leads to adverse selection on behalf of the borrowers and moral hazard on behalf of the bank!

Question 37

*** With O to D Banking comes ...

Answer 37

With originate-to-distribute model: - Banks have few incentives to screen borrowers (Moral Hazard) - Home buyers have incentive to borrow without good credit > b/c the banks are so keen on higher volumes of mortgages (Adverse Selection) - Credit Rating agencies are paid for rating the MBS superior (Conflict of Interest) - Banks and Funds managers were not taking good care of the money of their clients (Principle - Agent Problem)

Question 38

Bank Liabilities

Answer 38

Demand Deposits = Chequable Deposits that you can withdraw at any time Notice Deposits = Before you withdraw your money, you have to give them notice (This is not often enforced though) Fixed Term Deposits = Longer term deposits, if you withdraw your money before the term is over, you may lose your interest Advances from the Bank of Canada = Self Explanatory Borrowings = Borrowed money from other people, you can think of Bank of America and Warren Buffet Bank Capital = Also called the shareholders equity, this is the Banks overall net worth once all of the liabilities are taken care of. It is expressed by: Assets - Liabilities = Bank Capital

Question 39

Liabilities Fact

Answer 39

It is important to note that 65% of all the liabilities of a Bank are a result of Demand Deposits + Notice Deposits and Fixed Term Deposits

Question 40

Bank Assets

Answer 40

Reserve and Cash Items: Reserves are defined as settlement balances + Vault cash, They are used to satisfy unexpected outflows. Securities Loans (Non Mortgage + Mortgage) (Non Mortgage > Mortgage) Other Assets

Question 41

Bank Capital Equation

Answer 41

Bank Capital = Assets - Liabilities

Question 42

How does a Bank make Money?

Answer 42

Using the money earned from low interest deposits in order to finance high interest investments such as loans and securities. Simplest Form: Selling low interest deposits Buying high interest investments

Question 43

Desired Deposit Ratio

Answer 43

This is a % of reserves that the Central Bank enforces all commercial banks to keep. It is done so out of safety and to avoid bank runs.

Question 44

Net Interest Margin

Answer 44

(Interest Income - Interest Expense) / Assets

Question 45

Banks and Interest Rate Sensitivity

Answer 45

Often Banks will have more interest rate liabilities than they will have interest rate sensitive assets. (Why? b/c Liabilities are deposits which have floating exchange rates whilst Assets are fixed term mortgages and securities which have fixed exchange rates) Ultimately that means then, - A rise in IR reduces Bank Profits A fall in IR raises Bank Profits

Question 46

GAP Analysis

Answer 46

We use GAP to analyze the difference between the interest rate sensitivity of assets and the interest rate sensitivity of liabilities. GAP is a good indicator of Banks health and ability to generate profits

Question 47

GAP Equation

Answer 47

GAP = RSA - RSL ``` RSA = Risk Sensitive Assets RSL = Risk Sensitive Liabilities ```

Question 48

Bank Income as a result of Interest Rate Changes

Answer 48

Change in Income = Gap * Change in Interest Rate

Question 49

*** History from the 80s

Answer 49

S&L Bank held a large portion of fixed term mortgages that were largely financed by short term deposits. Well we know Fixed Rate Mortgages = Not very sensitive to interest rate Short Term Deposits = Extremely sensitive to interest rate fluctuations Therefore: GAP = RSA - RSL < 0 In the 80s, inflation went up, this led to an increase in the interest rate (Fisher Eq'n verifies this), as a result there was a need for government bailouts as the banks were collapsing. This is because Banks like S&L were taking excessive risks. Luckily S&L survived, however over 1,000 banks failed (between 1980-1984) and cost the tax payers > $100 Billion

Question 50

Return on Assets

Answer 50

Return on Assests (ROA) = Net Profit After Tax / Assets

Question 51

Return on Equity

Answer 51

ROA * Assests / Bank Capital = Net Profit After Tax / Assets * Assets / Bank Capital = Net Profit After Tax --------------------------------- Bank Capital

Question 52

Equity Multiplier

Answer 52

This is: Assets / Bank Capital Note: For the same ROA, when you increase B. Capital, you will reduce the equity multiplier, which will decrease ROE.

Question 53

Bank Capital Requirements

Answer 53

Common Equity should be > 7% for all member countries For Canada, it is 8% for the big six It is Bank Capital / Assets

Question 54

Why are Bank requirements important?

Answer 54

They are important because the equity multiplier is impactful enough of the economy to significantly negatively affect the financial system and can lead to a crisis. If Banks have enough money, they can survive bank runs and asset price depreciation.

Question 55

*** Raising assets for Banks during recessions

Answer 55

This is often difficult to do because of four main reasons 1. It is difficult to issue new stocks (investors view it as a sign of weakness and lose some of there trust) 2. Fewer Earnings to retain: Because all the money is tied up in assets 3. Cutting Dividends could lead to a backfire: Similar to issuing new stock, it is a sign of weakness that hurts investor confidence ALL OF THIS MEANS THAT: The bank may have to reduce asset size (make less loans) if they can not raise more money. When you apply the equity multiplier, this has a serious negative impact on the economy as a whole. Think about the example that Haifung showed us in class!

Question 56

Gordon Growth Model Formula

Answer 56

Po = Do * (1+g) / ke-g

Question 57

Equity Premium Averages

Answer 57

From 1871 to 2015: 3.95; From 1960 to 2015: 2.78; From 1980 to 2015: 2.33