Guiding seminar cont. (2021) Flashcards
“Is There a Zero Lower Bound?”
Explain what the corporate channel of monetary policy is and how it works?
- Negative rates increase the cost of holding cash – discourage the corporate savings
- Firms rebalance their assets and expand their investments – economic growth
- Firms who are associated with banks who charge negative rates and are more exposed to negative rates via higher liquidity, experience higher fixed asset growth (more investment) and a decrease in liquidity (they finance it with excess cash they had before)
- Stronger effect for smaller firms (they rely more on their relationship with banks for credit, so they can’t leave easily)
“Is There a Zero Lower Bound?”
Why are investment-grade banks more effective in monetary policy implementation in a negative interest rate environment?
1) Corporate treasurers are advised to deposit liquidity in banks whose deposits have high ratings (if something happens, the money does not disappear-> linked to the safe asset idea)
2) Strong relationships with safe banks may be good insurance for firms in case their financing needs increase in the future.
3) Healthy banks are better able to transfer negative rates onto deposits
“The Safe Assets Shortage Conundrum”
Explain what a safety trap is and what its main consequences for the macroeconomic situation are.
A safety trap is a severe shortage of safe assets.
To exit from safety trap: supply of safe assets ↑, or demand for them ↓
Consequences:
The scarcity of safe assets in one country spreads to others via capital outflows, until safe rates are EQUALIZED across countries.
=> interdependence of world economy (since countries can no longer use monetary policy to protect themselves from world capital outflows).
“The Safe Assets Shortage Conundrum”
Discuss two ways to decrease safe assets shortage and the optimality of these solutions.
1) Exchange rate appreciation of the currencies in which safe assets are denominated
+ increases the real value of these assets for non-‘currency’ holders. (the stronger the currency, the bigger value of safe assets)
- BUT it depresses net exports (items produced in this country are too expensive), and potentially output.
2) Issuance of public debt (gov. bonds)
+ in a developed economy, it would expand output everywhere (because more safe assets)
- Can core economies (who produce the safe assets) fulfill a growing global demand and not weaken their fiscal capacity by supplying too many safe assets?
3) Production of private safe assets
4) Reducing the demand for safe assets
“The Economics of Structured Finance”
What is a CDO and how is it manufactured?
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.
A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.
“The Economics of Structured Finance”
How is a CDO manufactured?
Two steps of manufacturing a CDO:
1) pooling (taking many credit-sensitive assets together in one portfolio)
2) tranching (“priority line” for the pooled assets - junior tranches absorb the most losses, senior tranches absorb the least)
What is overcollateralization?
Degree of protection offered by junior assets.
It determines the largest portfolio loss that can be sustained before the senior claim is impaired.
=> Important in determining the credit rating for a more senior tranche.
“The Economics of Structured Finance”
What are the main problems related to CDOs?
1) 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
2) Risks that are largely diversifiable are substituted for risks that are highly systematic (especially concentrated in senior tranches) → senior tranches in 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
“The Economics of Structured Finance”
Why is CDO rating process difficult and can be biased?
To assign ratings to structured finance securities → you have to characterize the entire joint distribution of payoffs for the underlying collateral pool.
The valuation models were biased due to:
- overlap in geographic locations (higher-than-expected default correlations for mortgages)
- errors in assumptions about default correlations and probabilities – turned out to be worse than expected.
- downward-biased view of actual default risks
- valuation based on wrong or not fully correct assumptions (e.g. constantly rising housing prices lead to financial crisis)
- low quality of underlying assets (ex. with subprime – NINJA loans)
- pricing of systematic risks in the same way as diversifiable ones
“Exchange-Traded Funds 101 for Economists”
Discuss the main differences between ETFs and mutual funds “Exchange-Traded Funds 101 for Economists”
- ETF does not interact with capital markets directly, Mutual fund does
- Mutual funds are actively managed by a fund manager or team
- ETFs can be traded like stocks (there are different prices at different times), while mutual funds only can be purchased at the end of each trading day based on a calculated price
“Exchange-Traded Funds 101 for Economists”
What are the reasons behind the recent growth in bond ETFs?
1) Bond ETFs are traded on ELECTRONIC exchanges – convenient (unlike OTC markets for traditional bonds)
2) Offer higher TRANSPARENCY - bid/ask quotes are readily available
3) Offer greater LIQUIDITY and DIVERSIFICATION
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What is the main objective of this paper?
The main objective is to offer a perspective on the main obstacles that slow down the development of financial derivatives based on real estate prices. It also offers an insight on how these problems can be solved.
According to “A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
How do noise traders and sophisticated investors manipulate the financial market?
Noise traders have imperfectly predictable beliefs about waves of property values going up and down.
Sophisticated investors will try to predict the noise traders - and in doing so, they can magnify the size of the waves.
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What are the three channels by which house price futures may affect house prices?
1) Noise traders
2) Short selling
3) Risk-neutral investors
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What do noise traders do to affect house prices?
Noise traders are looking to benefit from momentum in prices, so they don’t even need to purchase a house, but just focus on trading the financial derivative of housing futures.
Consequences:
- depending on the noise trader’s perception of the market, it is possible for house price futures trading to trigger either an increase or decrease in price volatility
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
How do sophisticated market players affect housing prices?
They use house price futures for short-selling for the investment part of the housing asset.
(happens when noise traders are being irrational and are the only market players who have a long position on the prices)
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What happens when sophisticated (risk-neutral) investors are present in the house price futures market?
When house price futures become attractive to sophisticated investors, the volatility of house prices decreases.
Reason: their presence eliminates the imperfections and distortions (that may be caused by noise traders) in the housing market in the long run.
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What are the advantages of real estate derivatives?
1) they (futures) provide some info on where the property prices will go => focus of noise traders
2) you can hedge property risk (protect yourself against prices going up&down)
3) getting exposure to real estate without owning it (it is almost impossible to trade on the real estate spot market - you couldn’t trade a shopping center like that).
4) you can create reverse mortgages
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
Why are investment firms interested in getting real estate exposure?
They are willing to buy the property risk because they cannot plausibly claim that they are fully diversified without holding positions in property markets.
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What is “relative value trading”?
This is a way of getting exposure to real estate when investors seek to benefit from a change in the spread between the outcome of the property derivative and some other asset.
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What are the reasons of hedging property risk
a) when house prices rise
b) when house prices fall?
When housing prices rise faster than your income, it is your insurance as a young family to not get “priced out” once you’re ready to buy a house.
When housing prices fall: you don’t lose your down payment on your house and get a price guarantees on other houses (if you’re looking for one).
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What are reverse mortgages?
When you have a mortgage, you pay every x period for you house to your bank. A reverse mortgage is when your bank pays you every x period in exchange of your property being sold after your death.
This is especially beneficial for elderly families with low income, poor health and limited non-housing wealth. The existence of a PUT option would benefit this market against declines in prices.
Risk: decline in property value (damages, etc.)
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What are the reasons for a rise in the need of derivatives in the 1970s?
1) stable housing prices before WWI and a decrease in 1960s - no significant need in derivatives before that
2) Existence of securities based on a pool of mortgage loans which could be sold to investors (covered bonds)
3) Previously mortgages were balloon payments, => changed to adjustable rates, shifting the inflation risk to the buyers
4) Land price increase after WWII
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What were the obstacles in the development of real estate derivatives?
1) Index construction mismatch: there are various ways how to measure the real estate market value, while the futures contract is based on real estate index + index pricing and futures maturity dates were different
2) Negligible liquidity: it is unclear who would be the party willing to short the property and therefore provide liquidity in the market
3) Modelling considerations: pricing derivatives will be very hard & arbitrage conditions for futures, swaps, etc.
4) Regulatory issues: increased capital requirements for trading mortgage securities after 2008 crisis.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What is the main conclusion of the article?
The positive effects of the NIRP on the economy are stronger if banks are healthy and can charge negative rates on deposits.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What are the findings on monetary policy transmission (effectiveness of the monetary policy depending on the current interest rate)?
- Above the ZLB, all banks pass on most of the policy interest rate cut to commercial deposits (MECHANISM WORKS);
- Around the ZLB, little pass through, even after a year only 20% of the original cut is reflected (MECHANISM IS WEAK – support for HARD ZLB);
- Below the ZLB, pass through increases but only for financially sound banks
(MECHANISM WORKS FOR SOUND BANKS; WEAK BANKS – MONETARY PASS-THROUGH IS NOT HAPPENING).
“A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk?”
What are the advantages of derivatives? (4)
1) Provide some info on where the property prices will go
2) Hedging property risk
3) Getting exposure to real estate without owning it
4) Creation of reverse mortgages
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What is the paper about?
The paper:
- examines how effective the monetary policy is in a low and negative interest rate environment
- describes how these effects are transferred unto the economy
- describes how banks and firms are affected by negative interest rate policies.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What is the reasoning behind the paper? Why is it needed now?
Recently (in the past decades) many economies have entered a low interest rate environment, with some even deploying negative interest rate policies.
The authors examine how it occurs, and what are the consequences.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
When does zero lower bound (ZLB) occur?
It occurs when interest rates are very low
=>rates cause liquidity trap
=> monetary policy is severely limited
=> and CB’s cannot stimulate demand by lowering r
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
How do negative interest rate policies (NIRP) work?
Negative rates reduce banks’ profits and lead them to reduce lending.
NIRP provides stimulus to the economy through firms’ asset rebalancing. Firms with high cash holdings linked to banks charging negative rates increase their investment and decrease their cash-holdings to avoid the costs associated with negative rates.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
How does NIRP reflect on sound banks?
- sound banks are more likely to charge negative rates once ECB does so
- banks do not experience a decrease in deposits even if they charge negative rates
=> for sound banks that tend to offer negative rates when ECB does as well, the deposits increase
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What is the main finding of this paper?
When banks are sound, the NIRP can effectively
stimulate the real economic activity by influencing the behavior of both banks and firms.
Explanation:
1) sound banks pass the negative rates on the corporate depositors
2) the transmission mechanism is enhanced by the fact that firms whose deposits are more exposed to negative rates decrease their liquid asset holdings and start investing more in fixed assets (both tangible and intangible)
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
What happens to firms that have relationships with banks that offer negative rates?
They are more exposed to negative rates if they hold a lot of cash. These firms lengthen the maturity of the assets to improve their profitability. Thus, they decrease their short-term assets and cash and increase their fixed investment.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
When does a zero lower bound (ZLB) arise?
How does it affect sound banks?
ZLB arises only if agents lack confidence in the banking system and deposits shrink when the interest rate approaches zero.
For sound banks, the transmission mechanism appears to be unaffected even when interest rates turn negative.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
Which banks are more likely to charge negative rates?
Banks in non-stressed countries are more likely to charge negative rates on corporate deposits.
“Is there a zero lower bound? The effects of negative policy rates on banks and firms”
How does the health of the bank impact the amount of pass-through?
Conventionally weaker banks used to pass most of the effect, as they could lend more.
“Risks and returns of cryptocurrency”
Describe the data collection in this paper.
Data from Coinmarketcap.com and Coinmetrics.io
The authors focus on three major cryptocurrencies (Bitcoin, Ripple, and Ethereum) and how they relate to traditional assets (time period: 01.01.2013 – 31.05.2018).
“Risks and returns of cryptocurrency”
What are the features of cryptocurrency?
- Based on fundamentally new technology, the potential of which is not fully understood
- Yet fulfills similar functions as other, more traditional assets
- Skewness and kurtosis on the coin market is positive
- High probability of disasters and miracles
“Risks and returns of cryptocurrency”
What are disasters, and what are miracles? What are the probabilities of them happening?
- A “disaster” of the daily -20% return on Bitcoin has a 0.5% probability
- A “miracle” of +20% daily return has almost 1% probability
