D.1 Theory of risk capital in financial firms

Question 1

Principle financial firms (PFF)

Definitions and distinguishing features

Answer 1

-firms making financial decisions on behalf of their customers

3 distinguishing features:

1. credit sensitivity of customers puts high emphasis on solvency
   - customers prefer solvency so contracts stay intact
2. opaqueness to customers and investors
   - agency + information costs
3. profitability is highly sensitive to the cost of risk capital

Question 2

Risk capital vs other definitions of capital

Answer 2

risk capital - the smallest amount that can be invested to insure the value of the firms net assets against a loss in value relative to the rfr investment of those net assets

Next assets = gross assets - customer liabilities

regulatory capital - capital according to a particular accounting standard

cash capital - up front cash required to execute a transaction

working capital - financing of operating expenses (salary, rent, etc)

Question 3

How to determine amount of risk capital

Answer 3

go to video…

Question 4

concept of asset insurance

Answer 4

-asset insurance is a financial asset and a part of risk capital
-need to include the impact of asset insurance in risk capital:
ROE = (PT income - Cost of insurance) / (Cash capital + risk capital)

Question 5

economic cost of risk

Answer 5

• calculating profits ex-post: value of insurance is known
• calculating profit ex-ante: we dont know if insurance pays off
• estimates of future profits should include only the economic cost of insurance
• Economic Cost = Insurance premium paid - Actuarial FV of insurance
• the higher the economic cost of capital, the more profits are required by the firm to cover this

sources of economic cost:

• information costs
• agency risk: loss of asset value through inefficiency
• adverse selection
• moral hazard: risk increases after insured
• too much equity = higher cost of capital due to higher agency risk

Question 6

Allocate marginal risk capital

Answer 6

• diversification benefits occur when businesses are not perfectly correlated with each other
• after accounting for diversification, there will be some capital left over unallocated