Topics 51-54

Question 1

Repo vs Reverse Repo

Answer 1

The term repo refers to the transaction from the borrowers side; that is, from the side that sold the security with a promise to buy it back. When we examine the same transaction from the lender’s side, the transaction is referred to as a reverse repurchase agreement (i.e., reverse repo).

Question 2

Explain common motivations for entering into repos, in cash management and liquidity management

Answer 2

Borrowers in Repos

From the perspective of the borrower, repos offer relatively cheap sources of obtaining short-term funds. Relative to unsecured borrowing, repos allow the borrower to obtain funds at favorable rates because lenders are willing to accept lower returns (relative to unsecured transactions) in favor of the security of collateral.

• Repos can also be used to obtain cash to finance a long security position.
• Repos offer secured short-term financing; however, they are considered less stable given that repos need to be repaid within a short time period, and they are subject to swings in market conditions and sentiment. By contrast, equity financing is considered the most stable financing form given that the issuing firm has no obligation to pay dividends and equity financing does not need to be paid back.
• However, given its stability, equity financing is the most expensive and requires the highest expected return. By contrast, repo financing is cheaper but less stable.
• Firms need to balance this tradeoff between the costs of funding among the various alternatives and potentially being left without financing. This is referred to as liquidity management.

Lenders in Repos

From the perspective of the lender, repos can be used for either investing or for financing purposes as part of an entity’s cash management or financing strategies.

• Lenders use repos (taking the reverse repo side) for investing when they hold cash either for liquidity or safekeeping reasons and need short-term investing opportunities to generate return on their surplus cash position.
• Investors look for liquidity and tend to favor very short-term positions in overnight repos, which provide significant flexibility to the investor.
• Investors may also transact in open repos by lending for a day under a contract that renews each day until it is canceled. Repos could have longer maturities out to several months, although typically the longer the maturity, the lower the overall demand.
• In addition to liquidity, investors also prefer higher quality collateral. Repo collateral is generally limited to high-quality securities, including securities issued or guaranteed by governments and government-sponsored entities. Because the lender is faced with the risk of a decline in collateral value during the term of the repo transaction, repo agreements often require collateral haircuts.
• Lenders may also use repos (as the reverse repo side) to finance short positions in bonds. Consider an investment management firm that has a view that interest rates will rise and bond prices will fall. It can take advantage of this view by obtaining the desired bond collateral through lending cash in a reverse repo trade. It would then short sell the bond received through the reverse repo and buy it back at the market price at a later date, hoping to benefit from the trade from a fall in prices.

Question 3

Explain how counterparty risk and liquidity risk can arise through the use of repo transactions

Answer 3

Repo transactions involve the exchange of cash as well as the exchange of collateral. As a result, both counterparty risk (credit risk) and liquidity risk are present.

• The lender can recover any amounts owed by simply selling the collateral. As a result, because repos are generally very short-term transactions secured by collateral, counterparty (credit) risk is less of a concern.
• Liquidity risk is the risk of an adverse change in the value of the collateral and can be of particular concern to the lender. This risk can be mitigated with the use of haircuts, margin calls, reducing the term of the repo, and accepting only higher quality collateral.

Question 4

Assess the role of repo transactions in the collapses of Lehman Brothers during the (2007—2009) credit crisis

Answer 4

• JPMorgan Chase & Co. (JPM) was the tri-party repo clearing agent of Lehman Brothers Holdings, Inc. (Lehman).
• In a tri-party repo agency arrangement, the repo trades are still executed between two counterparties; however, the collateral selection, payment, settlement, and repo management is outsourced to a third-party agent. Agents are essentially custodians and do not take on the risks of the transactions.
• To bridge this funding gap, JPM, as tri-party agent, was lending directly to Lehman on a secured basis during the day, typically without requiring haircuts on intraday advances. By August 2008, however, due to the increased risk in the repo markets, JPM began to phase in haircuts on intraday loans, with the loan amounts exceeding $ 100 billion in the final week of Lehmans bankruptcy.
• Both Lehman and JPM provide different viewpoints of the events leading up to Lehman’s bankruptcy in September 2008. Despite the differing accounts, it is clear that the liquidity and value of collateral pledged in repo transactions declined during the crisis, and additional collateral and additional haircuts were necessary to mitigate the risks in repos.

Question 5

Assess the role of repo transactions in the collapses of Bear Stearns during the (2007—2009) credit crisis

Answer 5

• Prior to 2007, Bear Stearns Companies, Inc., (Bear Stearns) relied on funding its borrowings primarily in the form of short-term unsecured commercial paper. By 2007, however, Bear Stearns switched from unsecured borrowing to a more stable form of borrowing through longer term, secured repo financing, which better positioned the firm to withstand market liquidity events. Given the high-quality collateral posted, the firm was able to obtain financing at favorable rates on a term basis.
• Given the events of 2007—2009, lenders during this period became increasingly less willing to provide loans in the form of repo trades, and were especially averse to providing term (rather than overnight) repos. This led to a general shortening of repo terms, requiring larger haircuts, and requesting borrowers to post higher quality collateral. In early March 2008, Bear Stearns experienced a run on the bank that resulted from a general loss of confidence in the firm. This bank run led to a massive withdrawal of cash and unencumbered assets (i.e., assets that have not been committed or posted as collateral), and lenders refused to roll over their repo trades. The rapid decline in market confidence and withdrawal of capital ultimately led to Bear Stearns’ collapse.

Question 6

Compare the use of general and special collateral in repo transactions

Answer 6

Repo trades can be secured either with general collateral or with specific (i.e., special) collateral.

General Collateral

• While lenders care about the quality of collateral delivered, under general collateral (GC), repo lenders are not concerned with receiving a particular security or class of securities as collateral. Instead, only the broad categories of acceptable securities are specified. The logic here is that when lenders are looking to receive a specific rather than generic security as collateral, this creates a demand for that security and lenders have to accept a lower return on the repo trade.
• The repo rate for trades secured with general collateral is called the GC rate. GC rates can be used for repos with U.S. Treasury collateral, and the overnight rate for U.S. Treasury collateral is referred to as “the” GC rate.
• In the United States, the GC repo rate is typically slightly below the federal funds rate, although repos with U.S. Treasury collateral are considered safer and in fact can trade below the federal funds rate. The difference between the federal funds rate and the GC rate is measured through the fed funds-GC spread.
• This spread widens when Treasuries become scarcer (the GC rate falls) or during times of financial stress, as was the case during the recent financial crisis.

Special Collateral

• When lenders are concerned with receiving a particular security as collateral, the collateral is referred to as special collateral, and the repo trade is called a specials trade.
• The repo rate for trades secured with special collateral is called the special rate.
• In specials trading, the lender of cash is concerned with receiving a particular security in order to finance the purchase of a bond (for shorting), or to finance its inventory or proprietary positions. Lenders accepting special collateral face a trade-off between receiving the desired security and lending at below GC rates to receive the desired security.
• Special rates differ by security because there is a rate for each security for each term.

Question 7

Describe the characteristics of special spreads and explain the typical behavior of US Treasury special spreads over an auction cycle

Answer 7

The difference between the GC rate and the special rate for a particular security and term is called a special spread. Special spreads are important because in the United States, they are tied closely to the U.S. government Treasury bond auctions, and the level and volatility of the spread can be an important gauge of market sentiment.

In the United States, federal government bonds are sold at auction based on a predetermined, fixed schedule. The most recent issue is called the on-the-run (OTR) or current issue, while all other issues are called off-the-run (OFR). Current OTR issues tend to be the most liquid, with low bid-ask spreads, that can be liquidated quickly even in large sizes.

Several observations can be made by looking at the special spreads of OTR Treasury securities (OTR special spreads) and the auction-driven pattern of special spreads.

• First, OTR special spreads can be volatile each day depending on the special collateral.
• Second, spreads can fluctuate over time.
• Third, and most important, OTR special spreads are generally narrower (smaller) immediately after an auction but wider before auctions. They are narrower after auctions due to the extra supply of a new OTR security, which depresses special spreads. Spreads widen before auctions due to the substitutability of the special collateral as shorts change to the new OTR security.

The influence of auctions can also be observed from the term structure of individual OTR issues based on term special spreads (the difference between term GC rates and term special rates). Term special spreads are expected to decline immediately following the issue of the new OTR security but increase closer to the dates of the new auctions.

Special spreads generally move within a band that is capped at the GC rate (implying a floor of 0% for the special rate).

The special spread can also be tied to the penalty for failed trades. Until 2009, there was no penalty for failed trades. However, in light of the financial crisis and trillions of dollars in failed OTR deliveries, regulators adopted a penalty rate for failed trades, equal to the greater of 3% minus the federal funds rate, or zero. This means that as the federal funds rate increases, the penalty falls, and when the federal funds rate declines to zero, the penalty rate reaches its maximum at 3%. As a result, the new upper limit for the special spread is the penalty rate.

Question 8

Calculate the financing advantage of a bond trading special when used in a repo transaction

Answer 8

The premium trading value of OTR bonds is due both to their liquidity and financing advantage.

• The liquidity advantage stems from the ability to sell these bonds quickly for cash.
• The financing value stems from the ability to lend the bonds at a cheap special rate and use the cash to lend out at higher GC rates. This financing value is dependent on the trader’s expectation of how long the bond will continue trading at its special rate before the rate moves higher toward the GC rate.

Question 9

Differentiate between exogenous and endogenous liquidity

Answer 9

• Exogenous liquidity refers to the bid-ask spread not being affected by the individual trades made by investors. This is more likely to be the case when the trades are relatively small.
• Endogenous liquidity refers to when a given trade can influence the liquidity risk of the trade (i.e., a trader submitting a buy or sell order that increases the spread). If an investor attempts to purchase a large block of an asset, for example, the buy order may have an impact on the spread and increase the cost over that indicated by the initial bid-ask prices.
• In both the endogenous and exogenous case, the bid-ask spread is still a function of the factors like the number of traders, the standardization of the asset, low transactions costs, etc.

Question 10

Describe the challenges of estimating liquidity-adjusted VaR (LVaR)

Answer 10

• One of the challenges of estimating liquidity-adjusted value at risk (LVaR) is choosing the best method. As in most choices, there is a tradeoff between sophistication and ease of implementation, and it is worth noting that sophistication and usefulness are not necessarily positively correlated. It is recommended to find approaches that are transparent in their assumptions and simple to implement (e.g., implementable with just a spreadsheet).
• Another challenge is liquidity adjustments that are compatible with the basic VaR approach and each other. This is because different methods look at different aspects of illiquidity, and it can be helpful to combine add-ons’ that give the best overall liquidity adjustment.
• Another challenge is to check how the liquidity adjustment changes other inputs, such as the confidence level, holding period, or any other parameters (i.e., the sensitivity of the other inputs to the liquidity adjustment).

Question 11

Describe and calculate LVaR using the constant spread approach

Answer 11

* Since liquidity risk incorporates selling the asset, not a full “round trip,” only half of the spread is used.

Question 12

Describe and calculate LVaR using the constant spread approach with lognormal VaR

Answer 12

!LVaR/VaR is also called the liquidity adjustmen1t!

Question 13

Describe and calculate LVaR using the exogenous spread approach

Answer 13

! important to note that in the formula z refers to the one-tail test, μ and σ are taken for a year (not for a day) !

Question 14

Describe and calculate LVaR using the exogenous spread approach with the lognormal VaR

Answer 14

Question 15

Describe endogenous price approaches to LVaR, their motivation and limitations, and calculate the elasticity-based liquidity adjustment to VaR.

Answer 15

Both the constant spread approach and the exogenous spread approach assume that prices do not change in response to trading (i.e., prices are exogenous). In the case of selling for example, there may be downward pressure on prices, which causes a loss. VaR should include an adjustment for the possibility of this loss. The adjustment should be larger if the market prices are more responsive to trades.

Question 16

Liquidity discount VaR

Answer 16

Jarrow and Subramanian (1997) offer a more sophisticated method called the liquidity discount VaR, where the trader maximizes expected utility by liquidating the position within a certain period of time. It incorporates both exogenous and endogenous market liquidity, spread cost, spread risk, an endogenous holding period, and an optimal liquidation policy. It does so with three modifications:

1. uses an optimal holding period based on the trader’s expected-utility optimization problem,
2. adds the average liquidity discount to the trader’s losses, and
3. has the volatility measure include the volatility of the time to liquidation and the volatility of the liquidity discount factor, as well as the volatility of the underlying market price.

Question 17

Describe liquidity at risk (LaR) and compare it to LVaR and VaR, describe the factors that affect future cash flows, and explain challenges in estimating and modeling LaR.

Answer 17

Liquidity at risk (LaR) is also known as cash flow at risk (CFaR) and is the maximum likely cash outflow over the horizon period at a specified confidence level. A positive (negative) value for LaR means the worst outcome will be associated with an outflow (inflow) of cash.

LaR is similar in concept to VaR, but instead of a change in value, it deals with a cash flow.

LaR is also distinct from liquidity-related losses, but they are related.

As an example, an investor has a large market risk position that is hedged with a futures position. If the hedge is a good one, the basis risk is small, and the VaR should be small. There is the possibility of margin calls on the futures position, however, and this means there is the possibility of a cash outflow equal to the size of that position. In summary, the hedged position has a small VaR but a large LaR. At the other extreme, European options have zero LaR until expiration, but potentially large VaR prior to maturity.

The following is a list of factors that influence cash flows and LaR:

• Borrowing or lending.
• Margin requirements on market risk positions that are subject to daily marking to market.
• Collateral obligations, such as those on swaps, which can generate inflows or outflows of cash from changes in market factors, such as interest rates.
• Short explicit options or implicit options (e.g., convertibility and call features).
• Changes in risk management policy (e.g., a change in the type of hedge), which may change mark-to-market requirements.

Two other considerations are as follows:

1. LaR can increase when the firm is facing hard times (e.g., a credit downgrade increases the rate on bank loans); and
2. there are positions that are similar in terms of market risk (e.g., a futures versus an options hedge), but are very different in terms of LaR.

Question 18

Describe approaches to estimate liquidity risk during crisis situations and challenges which can arise during this process

Answer 18

In a crisis, assumptions concerning the level of liquidity and other properties that are reasonable in a “normal” market may not hold.

Crisis-scenario analysis is an alternative to the probabilistic approaches described previously. This would involve analyzing the potential problems of a particular event (e.g., the failure of a major institution) and working through the specific details of how this might occur.

Question 19

Describe ways that errors can be introduced into models

Answer 19

• There are several ways in which errors can be introduced into models. These include bugs in the programming of model algorithms, securities valuations or hedging, variability of value at risk (VaR) estimates, or inaccurate mapping of positions to risk factors.
• Model errors in securities valuations or in hedging can create losses within a firm and lead to market risk and operational risk.
  
  • Market risk is the risk of buying overvalued (or, at a minimum, fairly valued) securities in the market that are thought to be undervalued.
  • Operational risk is the risk of recording unprofitable trades as profitable.

Question 20

Explain how model risk and variability can arise through the implementation of VaR models

Answer 20

Data preparation is crucial in risk measurement systems. There are three types of data involved:

1. Market data is time series data (usually asset prices) that is used in forecasting the distribution of future portfolio returns.
2. Security master data is descriptive data on securities, including maturity dates, currency, and number of units.
3. Position data matches the firm’s books and records but presents challenges as data must be collected from a variety of trading systems and across different locations.

Once the data is collected, software is used to compute the risk measures using specific formulas, which are then combined with the data. Results are then published in documents for reporting by managers. All of these steps can be performed in numerous ways and can lead to several issues within the risk measurement system. We focus on two of these issues: the variability of the resulting measures and the appropriate use of data.

• Variability in risk measures, including VaR, is both a benefit and a problem. Managers have significant discretion and flexibility in computing VaR, and parameters can be freely used in many different ways. This freedom in measuring VaR leads to two significant problems in practice:
  
  • Lack of standardization of VaR parameters. Given the variability in VaR measurements and managers’ discretion, parameters including confidence intervals and time horizons can vary considerably, leading to different measurements of VaR.
  • Differences in VaR measurements. Even if VaR parameters were standardized, differences in measuring VaR could lead to different results. These include differences in the length of the time series used, techniques for estimating moments, mapping techniques (discussed in the next section) and the choice of risk factors, decay factors in using exponentially weighted moving average (EWMA) calculations, and the number of simulations in Monte Carlo analysis.

Question 21

Explain how model risk and variability can arise through the mapping of risk factors to portfolio positions.

Answer 21

• Mapping refers to the assignment of risk factors to positions. Mapping choices can also impact VaR results. For example, managers have a choice between cash flow mapping and duration-convexity mapping for fixed income securities. Cash flow mapping leads to greater accuracy (each cash flow is mapped to a fixed income security with an approximately equal discount factor); however, duration-convexity mapping requires fewer and less complex computations, reducing costs and potential data errors as well as model risks.
• It may also be difficult to locate data that addresses specific risk factors.
• Incorrect mapping to risk factors can create risks such as liquidity risk and basis risk.
• Other strategies can also lead to misleading VaR estimates. For example, event-driven strategies have outcomes that are close to binary and depend on a specific event occurring, including mergers or acquisitions, bankruptcy, or lawsuits. For these trades, the range of results cannot be measured based on historical return data. Dynamic strategies are another example, where risk is generated over time rather than at a specific point in time.

Question 22

Identify reasons for the failure of the long-equity tranche, short-mezzanine credit trade in 2005 and describe how such modeling errors could have been avoided.

Answer 22

• Volatility in credit markets in the spring of 2005 caused significant modeling errors from both misinterpretation and incorrect application of models. Trades incurred losses as only certain dimensions of risks were hedged, while others were ignored.
• A popular strategy in credit markets for hedge funds, banks, and brokerages was to sell protection on the equity tranche and buy protection on the junior (mezzanine) tranche of the CDX.NA.IG index, the investment-grade CDS index.
• The critical error in the trade, however, was that it was set up at a specific value of implied correlation. A static correlation was considered a critical flaw as the deltas that were used in setting up the trade were partial derivatives that ignored any changes in correlation.
• As long as correlations remained static, the trade remained profitable. However, once correlations declined and spreads did not widen sufficiently, the trade became unprofitable.
• Therefore, while the model did not ignore correlation, it assumed a static correlation and instead focused on anticipated gains from convexity.
• The error could have been corrected by stress testing correlation or by employing an overlay hedge of going long, single-name protection in high default-probability names.

Question 23

Explain major defects in model assumptions that led to the underestimation of systematic risk for residential mortgage backed securities (RMBS) during the 2007—2009 financial downturn

Answer 23

The subprime RMBS valuation and risk models have been widely employed by credit rating agencies to assign bond ratings, by traders and investors in bond valuations, and by issuers in structuring RMBS. During the 2007-2009 financial downturn, two major defects in model assumptions became apparent:

1. Assumption of future house price appreciation. The RMBS risk model generally assumed that future house prices would rise, or at least not fall, based on relatively few historical data points. When house prices actually did drop beginning in 2007, this incorrect assumption led to a significant underestimation of the potential default rates and systematic risk in RMBS because the credit quality of the loans was dependent on borrowers’ ability to refinance without additional equity.
2. Assumption of low correlations. The RMBS model assumed low correlations among regional housing markets, implying that loan pools from different geographical regions were well diversified. When house prices declined, correlations increased and loan defaults were much higher than previously expected under the model stress scenarios.

These two model errors led to a significant underestimation of systematic risk in subprime RMBS returns.

There have been several explanations proposed for the inaccuracy of the rating models.

• First, the compensation of rating agencies by bond issuers led to a potential conflict of interest scenario that resulted in lower ratings standards.
• Second, an increase in demand for higher rated bonds with a modestly higher yield resulted in searching for yield.
• Finally, mapping problems led to misleading risk measurement results, as highly rated securitized products were frequently mapped to highly rated corporate bond spread indices.

Question 24

Differentiate between sources of liquidity risk, including balance sheet/ funding liquidity risk, systematic funding liquidity risk, and transactions liquidity risk, and explain how each of these risks can arise for financial institutions.

Explain interactions between different types of liquidity risk and explain how liquidity risk events can increase systemic risk.

Answer 24

Liquidity has two essential properties, which relate to two essential forms of risk.

Transactions liquidity deals with financial assets and financial markets. Funding liquidity is related to an individual’s or firm’s creditworthiness. Risks associated with liquidity include:

• Transactions (or market) liquidity risk is the risk that the act of buying or selling an asset will result in an adverse price move.
• Funding liquidity risk or balance sheet risk results when a borrower’s credit position is either deteriorating or is perceived by market participants to be deteriorating.
• Balance sheet risks are higher when borrowers fund longer term assets with shorter term liabilities. This is called a maturity mismatch. Maturity mismatching is often profitable for firms because short-term investors bear less risk and have a lower required rate of return.
• Funding long-term assets with short-term financing exposes the borrower to rollover risk (sometimes called cliff risk), the risk that the debt cannot be refinanced or can only be refinanced at escalating rates.
• Systemic risk is the risk that the overall financial system is impaired due to severe financial stress. With this risk, credit allocation is impaired across the financial system.

Question 25

Summarize the asset-liability management process at a fractional reserve bank, including the process of liquidity transformation

Answer 25

• Banks only expect a fraction of deposits and other liabilities to be redeemed at any point in time. As a result, they do not hold all the deposits in liquid assets, but make loans with deposits instead. For example, a bank might take in $100 of deposits, hold $10 for redemptions, and lend the remaining $90. This is known as a fractional-reserve bank and the process of using deposits to finance loans is known as asset-liability management (ALM).
• If withdrawals are greater than the bank’s reserves, the bank is forced into a suspension of convertibility. This means the bank will not be able to, as expected by depositors, convert deposits immediately into cash. In the extreme, there may even be a run on the bank.
• Structured credit products, such as asset-based securities (ABSs) and mortgage-backed securities (MBSs), match investor funding needs with pooled assets. Because these products are maturity matched, they are not subject to funding liquidity issues. However, investor financing for structured credit products can create liquidity risk when investors rely on short-term financing. This type of financing was one of the main drivers of the recent subprime crisis and the increase in leverage in the financial system leading up to the crisis. Two types of short-term financing include: (1) securities lending (i.e., applying structured credit products as collateral to short-term loans), and (2) off-balance sheet vehicles.
• Special-purpose vehicles (SPVs) serve as off-balance sheet vehicles by issuing secured debt in the form of asset-backed commercial paper (ABCP). ABCP conduits finance purchases of assets, such as securities and loans, with ABCP. They receive liquidity and credit support via credit guarantees. Structured investment vehicles (SIVs) differ slightly from ABCP conduits because they do not receive full liquidity and credit support.

Question 26

Describe specific liquidity challenges faced by money market mutual funds and by hedge funds, particularly in stress situations

Answer 26

Systematic funding risks were apparent in many market sectors during the subprime mortgage crisis. As loans become shorter term, lenders and borrowers are exposed to greater liquidity risks.

Liquidity issues arose during the recent financial crisis for a variety of investment strategies including:

• Leveraged buyouts (LBOs). Leveraged loans became the dominate type of syndicated bank loans as LBOs and private equity grew before the crisis.
• Merger arbitrage hedge funds. Hedge funds engaged in merger arbitrage experienced losses in the early stages of the subprime mortgage crisis. After a merger is announced, the target’s stock price typically increases and the acquirers price sometimes declines due to increased debt. The merger arbitrage strategy exploits the difference between the current and announced acquisition prices. Hedge funds experienced large losses as mergers were abandoned when financing dried up.
• Convertible arbitrage hedge funds. Convertible arbitrage strategies rely on leverage to enhance returns. Credit is extended by broker-dealers. When financing becomes unavailable due to market conditions, as experienced in the 2007—2009 financial crisis, convertible bond values drop precipitously. The funding liquidity problem was compounded by redemptions (i.e., a market liquidity problem). Also, because there is a limited clientele investing in convertible bonds, when the clientele develops a dislike for the product due to deteriorating market conditions, it is difficult to sell the assets without large price declines. The gap between convertible bond prices and replicating portfolios widened dramatically during the financial crisis, but it still did not bring arbitrage capital into the market.

Money market mutual fund (MMMF) investors can write checks and make electronic bank transfers. Like banks, MMMFs are obligated to repay investors/depositors on demand. In general, underlying MMMF assets are high credit quality instruments with short maturities (e.g., a few weeks to a few months). However, the values of the underlying assets in the fund, despite their relative safety, are subject to change. As such, redemptions may be limited if asset values fall. The liabilities of MMMFs are, therefore, more liquid than their investments, similar to banks.

MMMFs use a form of accounting called the amortized cost method. This means that MMMF assets do not have to be marked-to-market each day, as required for other types of mutual funds. The reason behind the difference is that extremely short-term securities are not likely to revalue based on changes in interest rates and credit spreads. MMMFs set a notional value of each share equal to $1.00. Flowever, credit write-downs cannot be disregarded and it is possible for net asset values (NAVs) to fall below $1.00. This is known as breaking the buck.

Question 27

Compare transactions used in the collateral market and explain risks that can arise through collateral market transactions

Answer 27

Collateral markets have two important purposes. First, they enhance the ability of firms to borrow money. Cash is only one type of asset that is borrowed. Securities are also borrowed in collateral markets. Second, collateral markets make it possible to establish short positions in securities.

Collateral values fluctuate and most collateralized borrowing arrangements require that variation margin be paid to make up the difference (called remargining). Variation margin is the additional funds a broker requests so that the initial margin requirement keeps up with losses. The haircut ensures that the value of the collateral can fall by a certain percentage (i.e., 5% in the previous example) and still leave the loan fully collateralized. The variation margin protects the lender.

Collateralized loans are used to finance securities or other assets or trades. The securities pledged to one firm are often loaned or pledged again, hence the collateral circulates. This process is known as rehypothecation or repledging.

Markets for collateral take the following forms:

• Margin loans. Margin loans are used to finance security transactions. The margin loan is collateralized by the security and is often provided by the broker intermediating the trade. The broker maintains custody of the securities in a street name account (i.e., securities are registered in the name of the broker rather than the owner). This structure makes it easier to seize and sell securities to meet margin calls. An added advantage to the broker is that securities in street name accounts can be used for other purposes, such as lending to other customers for short sales. Cross-margin agreements are used to establish the net margin position of investors with portfolios of long and short positions. In general, cross margin involves transferring excess margin in one account to another account with insufficient margin, resulting in lower overall margin for the investor.
• Repurchase agreements or repos.
• Securities lending. Securities lending involves the loan of securities to another party in exchange for a fee, called a rebate. The lender of the securities continues to receive the dividends and interest cash flows from the securities. Lenders of securities are often hedge funds or other large institutional investors of equities. Securities are held in street name accounts to make them available for lending to traders who want to short stocks.
• Total return swaps. In a total return swap (TRS), one party pays a fixed fee in exchange for the total return (both income and capital gains) on a reference asset, typically a stock. The advantage is that the party paying the fee can earn the return from the underlying asset without owning the asset. The party providing the return (such as a hedge fund) is, in essence, short the asset.

Question 28

Describe the relationship between leverage and a firm’s return profile, calculate the leverage ratio, and explain the leverage effect

Answer 28

A firm’s leverage ratio is equal to its assets divided by equity (total assets / equity). That is:

L = A/E = (E + D)/E=1+D/E

For an all-equity financed firm, the ratio is equal to 1.0, its lowest possible value.

Return on equity (ROE) is higher as leverage increases, as long as the firm’s return on assets (ROA) exceeds the cost of borrowing funds. This is called the leverage effect. The leverage effect can be expressed as:

r_E = Lr_A - ( L - 1 ) r_D

where:

• r_A = return on assets
• r_E = return on equity
• r_D = cost of debt
• L = leverage ratio

It may help to think of this formula in words as follows:

ROE = (leverage ratio x ROA) — [(leverage ratio — 1) x cost of debt]

Leverage amplifies gains but also magnifies losses. That is why leverage is often referred to as a double-edged sword.

Question 29

Explain the impact on a firms leverage and its balance sheet of the following transactions: purchasing long equity positions on margin, entering into short sales, and trading in derivatives

Answer 29

Purchasing stock on margin or issuing bonds are examples of using leverage explicitly to increase returns. However, there are other transactions that have implicit leverage. It is important to understand the embedded leverage in short positions and derivatives, such as options and swaps.

Gross leverage is the value of all the assets, including cash generated by short sales, divided by capital.

Net leverage is the ratio of the difference between the long and short positions divided by capital.

Derivatives include:

• Futures, forward contracts, and swap contracts. These contracts are linear and symmetric to the underlying asset price. The amount of the underlying instrument represented by the derivative is set at the initiation of the contract so values can be represented on the economic balance sheet by the market value of the underlying asset. These contracts have zero net present values (NPVs) at initiation.
• Option contracts. These contracts have a non-linear relationship to the underlying asset price. The amount of the underlying represented by the option changes over time. The value can be fixed at any single point in time by the option delta. Thus, on the economic balance sheet, the cash equivalent market values can be represented by the delta equivalents rather than the market values of the underlying assets. These contracts do not have zero NPVs at initiation because the value is decomposed into an intrinsic value (which may be zero) and a time value (which is likely not zero).

Question 30

Explain methods to measure and manage funding liquidity risk and transactions liquidity risk.

Answer 30

In order to understand transactions liquidity risk, it is important to understand market microstructure fundamentals. These fundamentals are:

• Trade processing costs. The first cost is associated with finding a counterparty in a timely fashion. In addition, processing costs, clearing costs, and the costs of settling trades must also be considered. These costs do not typically increase liquidity risk except in circumstances, either natural or man-made, where the trading infrastructure is affected.
• Inventory management. Dealers provide trade immediacy to market participants. The dealer must hold long or short inventories of assets and must be compensated by price concessions. This risk is a volatility exposure.
• Adverse selection. There are informed and uninformed traders. Dealers must differentiate between liquidity or noise traders and information traders. Information traders know if the price is wrong. Dealers do not know which of the two are attempting to trade and thus must be compensated for this lemons risk through the bid-ask spread. The spread is wider if the dealer believes he is trading with someone who knows more than he does. However, the dealer does have more information about the flow of trading activity (i.e., is there a surge in either buy or sell orders).
• Differences of opinion. It is more difficult to find a counterparty when market participants agree (e.g., the recent financial crisis where counterparties were afraid to trade with banks because everyone agreed there were serious problems) than when they disagree. Investors generally disagree about the correct or true price on an asset and about how to interpret new information about specific assets.

Liquidity risks are introduced when bid-ask spreads fluctuate, when the trader’s own actions impact the equilibrium price of the asset (called adverse price impact) and when the price of an asset deteriorates in the time it takes a trade to get done (called slippage).

In general, regulators have focused more on credit and market risks and less on liquidity risk. Liquidity risk is difficult to measure. However, since the financial crisis, more attention is being paid to measuring liquidity risks in a firm.

Question 31

Calculate the expected transactions cost and the spread risk factor for a transaction

Answer 31

Question 32

Calculate the liquidity adjustment to VaR for a position to be
liquidated over a number of trading days

Answer 32

Question 33

Measuring Market Liquidity

Answer 33

Factors such as tightness, depth, and resiliency are characteristics used to measure market liquidity.

• Tightness (or width) refers to the cost of a round-trip transaction, measured by the bid-ask spread and brokers’ commissions. The narrower the spread, the tighter it is. The tighter it is, the greater the liquidity.
• Depth describes how large an order must be to move the price adversely. In other words, can the market absorb the sale? The market can likely absorb a sale by an individual investor without an adverse price impact. However, if a large institution sells, it will likely adversely impact the price.
• Resiliency refers to the length of time it takes lumpy orders to move the market away from the equilibrium price. In other words, what is the ability of the market to bounce back from temporary incorrect prices?

Question 34

Funding Liquidity Risk Management

Answer 34

Hedge funds manage liquidity via:

• Cash
• Unpledged assets. Unpledged assets, also called assets in the box, are assets not currently being used as collateral. Unpledged assets can be sold, rather than pledged, to generate liquidity. However, in times of market stress, asset prices are often significantly depressed.
• Unused borrowing capacity. This is not an unfettered source of liquidity as unused borrowing capacity can be revoked by counterparties by raising haircuts or declining to accept pledged assets as collateral when it is time to rollover the loan.