Topics 8-10

Question 1

Asset-backed commercial paper (ABCP)

Answer 1

Commercial paper is created when nonfinancial firms with high credit ratings raise capital by issuing short-term debt. ABCP is the bundling of longer-term debt from mortgages, credit card receivables, and other loans. When ABCP reaches its maturity date, it is rolled over and bundled into new ABCP.

Question 2

Bank run or “run”

Answer 2

A bank run occurs when depositors withdraw cash from a bank thinking the bank is about to fail. A run can also be used as a generic term describing the withdrawal of cash by investors from any type of financial intermediary [e.g., a pension plan (depositor) withdrawing cash from a money market mutual fund (MMF)]. This example would be a run on the MMF.

Question 3

Shadow bank

Answer 3

A shadow bank is a financial institution other than a regulated depository institution. Examples of regulated depository institutions are commercial banks, thrifts, and credit unions. Examples of shadow banks are private equity funds, investment banks, hedge funds, mortgage lenders, and insurance companies.

Question 4

Haircut

Answer 4

A haircut is the amount of collateral in a repo agreement in relation to a deposit. For example, if an institutional investor deposits $90 million with a shadow bank and the investor receives collateral worth $100 million, the haircut is 10%.

Question 5

A banking crisis can be characterized by

Answer 5

A banking crisis can be characterized by either o f the following occurring:

• a run on banks that leads to a merger, takeover by the government, or closure of a financial institution, or
• merger, takeover, government assistance, or closure of a financial institution that spreads to other financial institutions.

Question 6

Distinguish between triggers and vulnerabilities that led to the financial
crisis and their contributions to the crisis

Answer 6

The main trigger of the financial crisis was the prospect of losses on subprime mortgages.

In the first half of 2007, housing prices in the United States started to decline, causing several subprime mortgage lenders to file for bankruptcy and subsequently fail.

These losses became amplified as they had a ripple effect that spread to the main vulnerabilities of the crisis, asset-backed commercial paper (ABCP) and repurchase agreements.

Question 7

Describe the main vulnerabilities of short-term debt especially repo
agreements and commercial paper

Answer 7

When housing prices declined and homeowners defaulted on their mortgage loans, it reduced the value and prices of ABCP. These declining prices resulted in bank runs on shadow banks and money market mutual funds (MMFs) and signaled the start of a liquidity crisis.
The liquidity crisis continued to spread into repo agreements with the average haircut going from near zero at the beginning of 2007 to 25% by September of 2008 (Lehman Brothers bankruptcy).

Question 8

Assess the consequences of the Lehman failure on the global financial
markets

Answer 8

The Lehman Brothers bankruptcy filing in September 2008 is considered the tipping
point in the financial crisis. It eroded confidence and caused a run on MMFs. This lack of confidence spread across markets and countries, amplifying losses in the subprime mortgage market.

Question 9

Describe the historical background leading to the recent financial crisis

Answer 9

The recent financial crisis was not unique compared to previous banking crises. It followed a similar pattern of increased public and private debt, increased credit supply, and increased housing prices preceding and leading to the crises

Question 10

Distinguish between the two main panic periods of the financial crisis and
describe the state of the markets during each

Answer 10

The two main panic periods o f the financial crisis were August 2007 and September 2008 through October 2008. The first panic period in August 2007 occurred when there were runs on ABCP. The start o f the second panic period was September 2008 when Lehman Brothers filed for bankruptcy.

Lehman’s failure caused a run on a particular MMF called Reserve Primary, which
contained commercial paper issued by Lehman. The run on Reserve Primary spread to other MMFs, which started a contagion effect that spread to other assets that were falling in price in tandem with rising haircuts.

Question 11

Assess the governmental policy responses to the financial crisis and review
their short-term impact

Answer 11

The International Monetary Fund (IMF) studied 13 developed countries and their
responses to the financial crisis. This resulted in 153 separate policy actions that
were divided into 5 subgroups consisting of interest rate change, liquidity support,
recapitalization, liability guarantees, and asset purchases.

To measure the impact of interest rate cuts, the IMF used the economic stress index (ESI) and the financial stress index (FSI). Liquidity support was measured using interbank spreads and the FSI. Recapitalization, liability guarantees, and asset purchases were measured using the FSI and an index of credit default swaps (CDSs) on banks.

The evidence suggests that the most effective measures taken were the liquidity support stabilizing the interbank markets before the Lehman failure and recapitalization (capital injections), which was considered the most effective tool after the Lehman failure.

Question 12

Describe the global effects of the financial crisis on firms and the real
economy.

Answer 12

Studies done on the effects of the global financial crisis on corporations and consumers pointed out that as the global recession strengthened, the demand for credit decreased.

Question 13

The role of risk management ​(tasks)

Answer 13

The role of risk management involves performing the following tasks:

• Assess all risks faced by the firm.
• Communicate these risks to risk-taking decision makers.
• Monitor and manage these risks (make sure that the firm only takes the necessary amount of risk).

Question 14

The main objective of risk management

Answer 14

The main objective of risk management should not be to prevent losses.

However, risk management should recognize that large losses are possible and develop contingency plans that deal with such losses if they should occur.

Question 15

The process of risk management can fail if one or more of the following events occur

Answer 15

The process of risk management can fail if one or more of the following events occur:

• Not measuring known risks correctly.
• Not recognizing some risks.
• Not communicating risks to top management.
• Not monitoring risk adequately.
• Not managing risk adequately.
• Not using the appropriate risk metrics.

Question 16

Risk mismeasurement

Answer 16

Risk mismeasurement can occur when risk managers do not understand the distribution of returns o f a single risky position or the relationships of the distributions among different positions.

Understanding the distribution of a given position means being able to identify the underlying return distribution and the probabilities associated with that particular distribution.

Understanding the relationships among return distributions means being able
to identify how risky positions are correlated. In both cases, it is crucial to understand the degree to which return distributions and/or correlations can change over time.

It is well known, for example, that correlations tend to increase during times of stress.

Question 17

Importance of correlations among risk factors during the crisis

Answer 17

Another risk that is often ignored is increasing correlations during a time of crisis.

Not recognizing the possibility of increasing correlations could potentially lead to large losses.

Consider, for example, the correlation between credit risk and market risk for banks. In the recent credit crisis, market risk caused decreases in security values issued through securitization, and credit risk caused decreases in the utilization of securitization. The important point is that firms must use all available data to adequately measure all risks and relationships among risks.

Question 18

Heisenberg Principle

Answer 18

It is also important to understand that the act of monitoring and managing risk can change the nature of risk. The Heisenberg Principle says that increasing the certainty for one variable may introduce uncertainty for another variable. Marking to market in one firm, for example, may start a chain reaction of adjustments in other firms which changes the risk characteristics o f those firms and the overall market, thus, increasing market risk.

Question 19

Shortcomings of VaR

Answer 19

VaR is a widely used risk metric that is narrow in scope in several ways:

• Over a year, a firm may have zero daily losses greater than daily VaR, but it could end up with an annual loss in the event that most days incurred losses (without exceeding VaR). Furthermore, for a firm that exceeds its VaR for a certain number of days, the VaR approach does not indicate the size of those losses. It is well known that VaR does not capture the implications of extremely large losses that have a very low probability of occurring.
• One misuse o f VaR is choosing a time period (e.g., daily or weekly) that does not correspond to the liquidity of the assets in the portfolio. Using daily VaR on a portfolio where the assets cannot be effectively traded within a day is clearly not appropriate.
• VaR also assumes the distributions of losses are not correlated over time. In the recent financial crisis, huge losses on one day led to drastic falls in liquidity, which led to large losses on the following day. The fact is that a crisis can change the nature of a return distribution for a given period as well as across periods.
• Another complication is that a given firm’s losses can exacerbate the risk in the overall market. This is related to an earlier discussion on how the marking to market of one firm can lead to adjustments in other firms. The point is that a firm with large losses in a given market can influence the activity in that market. This firm can also fall victim to predatory trading. Predatory trading occurs when other firms in a market see that a large player in the market is in trouble and the other firms attempt to push the price down further in order to hurt the large player. Such activity is difficult to incorporate into risk metrics.

Question 20

Explain how risk management failures can arise in the following
areas: measurement of known risk exposures, identification of risk exposures,
communication of risks, and monitoring of risks

Answer 20

Mismeasurement can occur when management does not understand the distribution of returns of a single position or the relationships of the distributions among positions and how the distributions and correlations can change over time. Mismeasurement can also occur when managers must use subjective probabilities for rare and extreme events. The subjective probabilities can be biased from firm politics.

Failing to take known and unknown risks into account can take three forms:

1. ignore a risk that is known,
2. failure to incorporate a risk into risk models, and
3. not finding all risks.

All three of these are variations of the same concept and can have similar results (e.g., failure to measure overall risk or expanding operations to areas where risk is not being properly measured).

Senior managers must understand the results of risk management in order for it to be meaningful. Unless senior managers have the correct information to make decisions, risk management is pointless.

Risk managers must recognize how risk characteristics change over time. Many securities have complex relationships with market variables. Having an adequate incentive structure and firm-wide culture can help with the risk monitoring and managing process.

Question 21

Variance of a two-asset portfolio

Answer 21

The variance of a two-asset portfolio equals:

σ_p² = w₁² σ₁² + w₂² σ₂² + 2w₁w₂ Cov_1,2

where:
σ_p = variance of the returns for Portfolio P
σ₁ = variance of the returns for Asset 1
σ₂ = variance of the returns for Asset 2
w_i = proportion (weight) of the portfolio allocated to Asset i
Cov_1,2 = covariance between the returns of the two assets

Question 22

Correlation coefficient, variance of two-asset portfolio through correlation coefficient

Answer 22

Question 23

Portfolio possibilities curve

Answer 23

The graph of the possible portfolio combinations is referred to as the portfolio possibilities curve

Question 24

The minimum variance portfolio

Answer 24

The minimum variance portfolio is the portfolio with the smallest variance among all possible portfolios on a portfolio possibilities curve

Figure below illustrates the minimum variance portfolio for Caffeine Plus and Sparklin’ (point A).

Question 25

Portfolio possibilities curve for two perfectly correlated assets

Answer 25

Question 26

Diversification effect for two assets with perfect negative correlation

Answer 26

Question 27

Diversification effect for two assets with zero correlation

Answer 27

Question 28

Effects of Correlation on Portfolio Risk

Answer 28

Question 29

Shape of the Portfolio Possibilities Curve

Answer 29

A concave function is one where the function lies above a straight-line segment connecting any two points on the function.

A convex function lies below a straight-line segment connecting any two points on the function.

Combinations of assets with lower correlation will always lie to the left of that line

Question 30

Efficient Frontier

Answer 30

Plotting all risky assets and potential combinations of risky assets will result in a graph similar to the Figure.

All portfolios lying on the inside of the curve are inefficient.

Portfolios such as D and E are called efficient portfolios, which are portfolios that have:

• Minimum risk of all portfolios with the same expected return.
• Maximum expected return for all portfolios with the same risk.

The efficient frontier is a plot of the expected return and risk combinations of all efficient portfolios, all of which lie along the upper-left portion of the possible portfolios

Question 31

Short Sales and the Efficient Frontier

Answer 31

When allowing for short sales, the efficient frontier expands up and to the right.

By shorting, it is possible to create higher return and higher volatility portfolio combinations that would not be possible otherwise.

Theoretically, with no limitations on shorting, it would be possible to construct a portfolio with infinite return.

Question 32

Combining the Risk-Free Rate with the Efficient Frontier

Answer 32

By adding the risk-free asset to the investment mix, a very important property emerges: the shape of the efficient frontier changes from a curve to a line.

When the risk-free asset is combined with the risky Portfolio P, the efficient frontier becomes a line with:

• The intercept equal to the risk-free rate, and
• The slope equal to the reward-to-risk ratio for the risky portfolio.

Note that the capital market line is tangent to the efficient frontier. The point of tangency, Portfolio P, is known as the market portfolio.

If all investors agree on the efficient frontier (i.e., they have homogeneous expectations regarding the risks and returns for all risky assets), they will hold a combination of the market portfolio and the risk-free asset. Risk-averse investors will create lower risk portfolios by lending (i.e., investing in the risk-free asset). More risk-tolerant investors will increase portfolio return by borrowing at the risk-free rate. This result is known as the separation theorem.

Question 33

CAPM Assumptions

Answer 33

In the derivation of any economic or scientific model, simplifying assumptions regarding the market, which the model represents, must be made. The CAPM has a number of underlying assumptions:

1. Investors face no transaction costs when trading assets. This assumption simplifies the computation of returns. If transaction costs were considered, returns would be a function of transaction costs, which would then have to be estimated.
2. Asets are infinitely divisible. It is possible to hold fractional shares.
3. There are no taxes; therefore, investors are indifferent between capital gains and income or dividends.
4. Investors are price takers whose individual buy and sell decisions have no effect on asset prices. The market for assets is perfectly competitive.
5. Investors’ utility functions are based solely on expected portfolio return and risk. This assumption provides a framework for how investors make investment decisions.
6. Unlimited short-selling is allowed. Investors can sell an unlimited number of shares of an asset short.
7. Investors can borrow and lend unlimited amounts at the risk-free rate.
8. Investors are only concerned about returns and risk over a single period, and the single period is the same for all investors.
9. All investors have the same forecasts of expected returns, variances, and covariances.This is known as homogeneous expectations.
10. All assets are marketable, including human capital.

Question 34

The capital market line (CML).

Answer 34

Assuming investors have identical expectations regarding expected returns, standard deviations, and correlations of all assets, there will be only one tangency line, which is referred to as the capital market line (CML).
Under the assumptions of the CML, all investors agree on the exact composition of the optimal risky portfolio. This universally agreed upon optimal risky portfolio is called the market portfolio, M, and it is defined as the portfolio of all marketable assets weighted in proportion to their relative market values.

The key conclusion of the CML can be summarized as follows: all investors will make optimal investment decisions by allocating between the risk-free asset and the market portfolio.

The CML is useful for computing the expected return for an efficient (diversified)
portfolio; however, it cannot compute the expected return for inefficient portfolios or individual securities. The CAPM must be used to compute the expected return for any inefficient portfolio or individual security.

Question 35

Beta, portfolio beta

Answer 35

The beta of a portfolio is the sum of the weighted individual asset betas within a portfolio.

Question 36

Derivation of the CAPM

Answer 36

Question 37

Apply the CAPM in calculating the expected return on an asset

Answer 37

If through the valuation of an asset an analyst determines that the expected return is different from the required rate of return implied by CAPM, then the security may be mispriced according to rational expectations. A mispriced security would not lie on the security market line. In general:

• An overvalued security would have a required rate of return (computed by CAPM) that is higher than its expected return (computed by the analyst’s valuation). An overvalued security would lie below the security market line.
• An undervalued security would have a required rate of return (computed by CAPM) that is lower than its expected return (computed by the analyst’s valuation). An undervalued security would lie above the security market line.