Topics 8-10 Flashcards
(37 cards)
Asset-backed commercial paper (ABCP)
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.
Bank run or “run”
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.
Shadow bank
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.
Haircut
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%.
A banking crisis can be characterized by
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.
Distinguish between triggers and vulnerabilities that led to the financial
crisis and their contributions to the crisis
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.
Describe the main vulnerabilities of short-term debt especially repo
agreements and commercial paper
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).
Assess the consequences of the Lehman failure on the global financial
markets
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.
Describe the historical background leading to the recent financial crisis
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
Distinguish between the two main panic periods of the financial crisis and
describe the state of the markets during each
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.
Assess the governmental policy responses to the financial crisis and review
their short-term impact
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.
Describe the global effects of the financial crisis on firms and the real
economy.
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.
The role of risk management (tasks)
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).
The main objective of risk management
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.
The process of risk management can fail if one or more of the following events occur
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.
Risk mismeasurement
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.
Importance of correlations among risk factors during the crisis
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.
Heisenberg Principle
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.
Shortcomings of VaR
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.
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
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:
- ignore a risk that is known,
- failure to incorporate a risk into risk models, and
- 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.
Variance of a two-asset portfolio
The variance of a two-asset portfolio equals:
σp2 = w12 σ12 + w22 σ22 + 2w1w2 Cov1,2
where:
σp = variance of the returns for Portfolio P
σ1 = variance of the returns for Asset 1
σ2 = variance of the returns for Asset 2
wi = proportion (weight) of the portfolio allocated to Asset i
Cov1,2 = covariance between the returns of the two assets
Correlation coefficient, variance of two-asset portfolio through correlation coefficient
Portfolio possibilities curve
The graph of the possible portfolio combinations is referred to as the portfolio possibilities curve
The minimum variance portfolio
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).
