Risk Management Flashcards
Subprime mortgage crisis
- House owners gave MBS to bank –> bank sold MBS to investment banks –> IB group MBS into “pools” –> Pool generates cash, different tranches sold –> investors
- Banks refinanced existing mortgages with prime customers and subprime customers (don’t know them well)
- Subprime house owners couldn’t pay back mortgage –> houses to bank, banks want to sell them –> prices drop –> pool generates no cash, no tranches, no investors –> whole system crashes
Lehman case
Liquidity risk, went bankrupt –> banks had liquidity problems, didn’t give out any loans
Authorities did:
- cut interest rates to make money cheaper
- emergency funding: central bank as lender of last resort
- change in legal framework Basel 3: 30-day liquidity buffer and higher equity ratio
Risk and risk management
–> risk is a deviation from our expectation (can be good or bad)
Tolerate, Treat (and reduce its impact), Transfer, Terminate (activity causing risk)
Types of risk
Credit risk: customer might not pay loan –> transfer risk (insurance), demand collateral (mortgage)
Operational: human error, fires…. –> train employees, insurance, SOPs
Market: everything that happens on the market, interest rate… –> insurance
Why is insurance mostly above fair price?
Expenses and Profit: insurance company want to earn money
Adverse selection: insider information, have more info than insurance company
Moral hazards: less careful if insured
Independent vs common risk
Common: overall market, affecting all securities
Independent: risk affecting particular security (risk premium is 0)
–> Diversification: averaging out independent risk in large portfolio
Efficient portfolio
Portfolio containing only systematic risk –> no way of reducing volatility without reducing rehung
Independent risk is diversified out
Efficient frontier: minimising risk or maximising return
Beta
Relationship of individual stock’s sensitivity to overall market
–> if market goes up by 1%, stock changes by beta %
b=1 –> stock behaving like the market (oil related, big companies
b<1 –> stock moves less than market, less sensitive (anti cyclical industries)
b>1 –> stock moves more than market, more sensitive (cyclical industries)
High beta: luxury goods
neutral: oil industry
low: every-day stuff
Bonds
= securitised loan –> if you own a bond, you lend them money
If bond price goes up, yield goes down (inverse relationship)
Yield curve
comparing different yield across different contract lengths with similar credit risk
Steep: high interest rates expected because of inflation (overheating economy)
Flat/Inverse: low rates expected due to deflation and weak economy
Quantitative easing: central banks buying bonds –> price goes up, yield goes down –> get flat yield curve to support economy (cheap loans, people invest instead of save)
Forward rate agreement
contract that fixes interest rate today for loan/investment in the future
Spot FX transaction
= agreement between two parties to buy one currency against selling another currency at agreed price for settlement on spot date (now)
FWD Rate
Forward exchange rate: exchange rate in a currency forward contract applying to a future exchange
FWD = spot * (interest 2nd currency / interest 1st currency)
Swap points
Banks never quote the FWD (spot rate changes all the time, FWD depends on spot rate)
–> just quote the difference = swap points
(FWD - Spot) * 10.000
“Overnight” market
Maturity transformation: e.g.: fund myself for 5 years, but for customer 10 years –> shorter maturities are cheaper (interest rate risk)
Overnight: borrow today, repay tomorrow for the next 10 years –> cheapest –> everyday interest rate risk
–> liquidity risk: might not be able to pay back in one day
