Guiding Seminar 5 Flashcards
Explain what is safety trap and its main consequences for the macroeconomic situation. (The Safe Assets Shortage Conundrum)
Safety trap - a severe shortage of safe assets creates a safety trap.
Global Nature of the safety trap: the scarcity of safe assets in one country spreads to others via
capital outflows, until safe rates are equalized across countries. -> the global safe interest rate drops and capital flows increase to restore equilibrium in global
and local safe asset markets. Once the zero lower bound for global interest rates is reached,
the global output becomes the adjustment variable (economy slows down globally)
Discuss two ways to decrease the safe assets shortage and the optimality of these solutions. (The Safe Assets Shortage Conundrum)
- Exchange rate appreciation of the currencies in which safe assets are denominated increases the real
value of these assets for non-’currency’ holders. Problem: it depresses net exports, and potential
output, for safe asset issuers. - Issuance of public debt. Depends on two factors:
i) the fiscal capacity of the government to borrow (& ability to commit to raising future taxes)
ii) the risk that increased provision of public safe assets may crowd out provision of private-sector safe
assets (raising taxes may reduce private sector’s capacity to issue safe assets)
Can the logic of the stock market be applied to the money market? Explain by providing the differences between them. (Understanding the role of debt in the financial crisis)
Money markets manage to provide liquidity by ensuring information symmetry rather than information transparency.
Money markets have few traders, trading is urgent, not transparent, information insensitive. The opposite is true for the stock market.
Why debt can be considered as an optimal contract? Explain informational insensitivity of debt. (Understanding the role of debt in the financial crisis)
• Debt is an optimal contract because it avoids
1) a precise assessment of the collateral value at the time of signing the contract
2) the cost of price discovery whenever debt is paid in full
• Debt is information-insensitive in three aspects:
1) Debt is information-insensitive to private information if
it is deep in the money. If it is not deep in the money, it
may cost the buyer to acquire information about
underlying collateral before buying
2) Debt is a contract that is most resilient to information acquisition. Information-insensitivity increases when a) collateral is less risky b) duration of debt is reduced c) FV of debt Is reduced d) more collateral is added
3) The value of debt is least sensitive to public information -> debt is the best collateral
What is CDO and how is it manufactured?
The Economics of Structured Finance
A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors.
1) Pooling - a large collection of credit-sensitive assets is assembled in a portfolio (special purpose
vehicle)
2) Tranching - prioritized claims, known as tranches, are issued against the underlying collateral pool.
3) Overcollateralization - the degree of protection offered by the junior claims. Important in
determining the credit rating for a more senior tranche, because it shows the largest portfolio loss that can be handled before the senior claim gets hit.
What are the main problems related to CDOs?
The Economics of Structured Finance
Structure amplifies errors - with multiple rounds of structuring, even slight changes in default probabilities and correlations can have a substantial impact on the expected payoffs and ratings of the CDO2 tranches, including the most senior claims.
Largely diversifiable risks were substituted for highly systematic risks.
CDO’s do not offer their investors large enough of a yield spread to compensate them for
the actual systematic risks they bear.
Why is the CDO rating process difficult and can be biased? (The Economics of Structured Finance)
The valuation models were biased due to:
1) overlap in geographic locations (actual correlations between mortgages were higher)
2) errors in assumptions about default probabilities and recovery values (fire sales drove down
the asset values)
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
Describe the ways in which CDS is beneficial and the ways in which it is harmful to the market?
(Credit default swaps and the credit crisis)
Pros:
Investors don’t have to bear capital risk when providing capital. Separating the cost of funding and the credit risk increases transparency in the pricing of credit -> reduced the cost of capital for firms
• The CDS market is a better place to assess a company’s credit risk than bonds market -> improved price discovery
• The CDS market is often more liquid than bonds market
• Alternative to short selling. Sell a bond at 100 (& pay protection cost at 100). When bond defaults, price down to 50 -> you receive 50.
Cons:
Fewer incentives in loan monitoring (banks shift their risk to other parties by buying protection)
• Perverse incentives of investors (E.g. if debt restructuring won’t lead to CDS payout, an investor might be willing to drive a firm into bankruptcy and receive payout rather than support refinancing)
• 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 zero net derivatives receivables can pose risks to the system)
What are the main differences between OTC and exchange trading?
(Credit default swaps and the credit crisis)
OTC:
Custom contracts, counterparty - dealers, not transparent, low liquidity, enable innovation.
Exchange:
Standard contracts, counterparty - clearinghouses, transparent, liquid, not flexible (need opposite party)
Can it be stated that the CDS market is the main reason for the financial crisis? (Credit default swaps and the credit crisis)
Dramatic problems of the financial crisis were caused neither by CDS, nor by other derivatives.
The crisis was primarily driven by two reasons:
1) Investors and financial institutions did not expect such a dramatic fall in real estate prices -> large falls and in the value of mortgage-backed securities
2) Many financial institutions were operating with extremely high levels of leverage in investing in subprime securitization → losses on these investments made market participants insolvent.
Discuss the main differences between ETFs and mutual funds. (Exchange-Traded Funds 101 for Economists)
ETF: • Does not interact with capital markets directly • ETF manager is in a legal contract with “Authorized Participants” – typically large financial institutions who interact with the market. Reduced transaction costs Market determines price Mutual fund: Interacts directly with capital markets. Investors trade fund directly Trades at the end of the day at NAV
What are the reasons behind the recent growth in bond ETFs? (Exchange-Traded Funds 101 for Economists)
They are low-cost and hold many other securities, creating diversification.
Limited capital gains tax.
Lower premium
Lower fees.
Why is it perceived that US public corporation is in trouble? Explain using the main metrics discussed in the paper. (Is the US public corporation in trouble?)
Because the number of listed firms in the US is not increasing as it has historically.
Discuss the main causes of the decrease in the number of small public firms (Is the US public corporation in trouble?)
Larger firms have more income, more equity and tend to be efficient, whereas small public firms tend to be ineffective and make losses, thus larger firms acquire the smaller firms that no longer make them publicly listed.
