Appunti financial markets, credit and banking Unicatt, Appunti di Finanza

Scarica Appunti financial markets, credit and banking Unicatt e più Appunti in PDF di Finanza solo su Docsity! CHAPTER 1 WHY STUDYING FINANCIL MARKETS AND INSTITUTIONS? For an economy to reach its potential growth rate, mechanisms must exist to effectively allocate capital (which is a scarce resource) to the best possible use, while evaluating the riskiness of the opportunities available. Markets and institutions have been created to facilitate transfers of funds from economic agents with excess funds, to economic agents in need of such funds. For an economy to maximise its growth potential, it must create methods to attract savers’ excess funds and to allocate those funds to the best uses possible. The funds transfer must occur at the lowest cost possible, to ensure maximum economic growth, and to allow the growth of individual and social wealth. SAVERS AND SPENDERS: Financial markets and institutions allow transfer of funds from persons or business without investment opportunities, i.e. lenders-savers (households, business firms, government, foreigners), to ones with investment opportunities, i.e. borrowers-spenders (business firms, government, households, foreigners). There are 4 economic categories, which can be savers and spenders at the same time. Households savings flow to financial markets (such as banks and other financial institutions that link savers and borrowers). INSTITUTIONAL SECTORS AND FINANCIAL BALANCES Starting from the left, we can see where a saver can invest: pension funds, different deposits, stocks, bonds, securities, insurances etc. all these instruments are then invested directly or indirectly into the economy in terms of loans, shown on the right: large and small business, venture capital, construction, investment etc. SIX PARTS OF THE FINANCIAL SYSTEM: These parts are: Money: to pay for purchases and store wealth; it has changed from gold/silver coins to paper currency to eventually electronic funds. Today, cash can be obtained from an ATM anywhere in the world and bills are paid and transactions are checked online Financial instruments: to transfer resources from savers to investors and to transfer risk to those best equipped to bear it (risk and information are key in the financial market). They have been created along with the financial markets to let the economic agents with surplus funds to enter into direct contracts with economic agents in need of funds, buying and selling bonds or stock. At first, the possibility was open just to wealthy people, but today the possibility is open to everyone thanks to online systems. The finance is much more democratic today than in the past. Financial markets: to buy and sell financial instruments; they are organizations that facilitate the trade of financial securities. At first, they were all physical (like the NYSE), while today they are mostly automated (like NASDAQ). Financial institutions: to provide access to financial markets, collect information and provide services; they are corporations that provide services as intermediaries of a financial market. There are three major types: depository institutions (that manage deposits and make loans, including banks, mortgage loans companies etc); contractual institutions (insurance companies etc); and investment institutions (brokerage firms etc.) Regulatory agencies: to provide oversight for financial system; they have been introduced by the federal government after 1929, at first to analyse and supervise the safety and stability of financial institutions; then performing consumers protection functions with the FDIC (federal deposit insurance corporation) and the SEC (security and exchange commission). Similar institutions exist in the EU as well (ex. CONSOB in Italy). Central banks: to monitor financial institutions and stabilize the economy. The FED It’s responsible of influencing liquidity and overall credit conditions. Its primary monetary policy tool is the possibility of open market operations, that control the buying and selling of US treasury and federal agency securities. Such purchases and sales determine the federal fund rates and alter the level of reserves available. The federal reserve board is responsible for regulating and supervising the US banking system, which is intended to provide financial stability in the us. Same goes for the ECB. FIVE CORE PRINCIPLES OF MONEY AND BANKING: 1. Time has value: interest is paid to compensate the lenders for the time the borrowers have their money. Every financial transaction is based on this. 2. Risk requires compensation: The higher is the risk, the higher is the compensation. 3. Information is the basis for decisions: The more important the decision, the more information we gather. The collection and the processing of information is the foundation of the financial system. 4. Markets determine prices and allocation resources: They are the core of the economic systems because they channel resources and minimize the costs of gathering information and making transactions. The better developed is the financial market, the faster the country will grow. 5. Stability improves welfare: A stable economy reduces risks and improves welfare, while instability triggers downturns. METHODS OF FUNDS TRANSFER: • Direct financing: borrowers borrow directly from lenders in financial markets by selling financial instruments, which are claims on the borrowers’ future income or assets, without the help of an intermediary. In such case, society relies on primary market to initially price the issue, and then secondary markets to update the prices and provide liquidity. • Indirect financing: Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets. The intermediary and the borrower negotiate the terms and costs. The intermediary is usually responsible for monitoring the contractual conditions or updating the costs. FUNCTION OF FINANCIAL SYSTEMS: All trades on the goods market involve both the real sector and the financial sector. The financial sector is important to macroeconomics because of its role in channelling savings back into the circular flow that we see described in the picture: MARKET EFFICIENCY: DIFFERENT MEANINGS: • Completeness efficiency: in economic, a complete market has the following conditions: transaction costs are negligible, and every asset in every state of the world has a price. (Arrow-Debreu) • Information efficiency: the degree to which market prices reflect all available relevant information. If markets are efficient then the info is already incorporated into prices, so there is no way to outperform the market because there are no overvalued or undervalues securities available (Fama). Forms of efficiency are weak, semi-weak, strong. Weak-form tests study the information contained in historical prices. Semi-strong form tests study information (beyond historical prices) which is publicly available. Strong-form tests regard private information. • Fundamental efficiency: the prices that are formed are the economic foundations of the value of financial assets. The prices are derived from a discounting of future cash flows (dividends, cash flow, …). Fundamental Value does not mean objective value but simply the value that expresses the expected future cash flows and rates of return required. In the short term, the fundamental value FV may differ from market price. REQUIREMENTS FOR MARKET EFICIENCY: • Width: have large order volumes • Thickness: have a thick price distribution with a lot of buyers and sellers at different price levels • Elasticity: for a small change in price there will be a reactivity in terms of orders. Price discovery should be considered the central function in any marketplace. The market brings sellers and buyers together, each one having different reasons for trading. By allowing these counterparties to interact, a consensus price is established. Price discovery is influenced by a wide variety of factors, among which there are structure, security type, info available in the market… the parties with the freshest information have an advantage on others. When new info arrives, it can change the prices. Too much transparency can be detrimental to a market. TYPES OF BROKERAGE SERVICES: • BROKERS: who work exclusively for third parties by facilitating the search for trade partners and making it possible to cross between supply and demand. They can offer information services. He acts as an intermediary for buyers and sellers for a fee or a commission. • DEALERS: who operate on their own account and perform the function of making liquid the market of particular financial assets, ensuring the continuity of trades. They hold their own portfolio of financial asses they use to respond promptly to the trading needs of other operators, expressing the purchase price and the selling prices • MARKET MAKERS: are operators acting on their own account and who are committed to make public pricing conditions at which they are willing to negotiate: quoting prices at which they wish to purchase and sell minimum lots of financial assets. They are committed to make a market. They typically are large banks or financial institutions. They help to ensure there’s enough liquidity in the market. THE ACTIVITIES OF THE FINANCIAL INTERMEDIARIES IN THE MARKETS: THE PROVISION OF INVESTMENT SERVICES: Under Security Market Law (art. 1) "Investment services and activities" we mean the following tasks when pertaining to financial instruments: • proprietary trading: a firm or bank that invests for direct market gain rather than earning commissions by trading on behalf of others. It may involve the trading the trade of stocks, bonds, commodities etc. • execution of orders on behalf of clients: conclude agreements to buy and sell financial instruments on behalf of clients (broker) • underwriting and / or placement on a firm commitment or with residual commitment to issuers (dealer) • c-bis) placement without firm or residual commitment to issuers (dealer) • portfolio management • reception and transmission of orders • advice on investments to educate and inform an investor • management of Multilateral Trading Facilities (MTFs): self-regulated financial trading venue. These are alternatives to the traditional stock exchanges where a market is made in securities, typically using electronic systems DEPOSITORY AND NON-DEPOSITORY FINANCIAL INSTITUTIONS: • A depository institution is a financial institution such as a saving bank, commercial bank, etc… that is legally allowed to accept deposits from consumers. • A non-depository institution (insurance company, investment trust…) serves as intermediary between savers and borrowers but doesn’t accept deposits. Both are supervised and authorized agents. The structure of the financial system: The savers are linked to the spenders through either the depository institutions (banks) and finance companies (credit intermediaries), or through the institutional investors (such as mutual funds or insurances), that pass through the markets (such as money market, capital market, FX market and derivative market). Financial Institutions exist because of: 1. Economies of scale on transaction costs, such as search, screening, production, monitoring costs. 2. Provision of liquidity services 3. Risk sharing provision (which grants asset transformation and portfolio diversification) 4. Asymmetric information (screening and monitoring aimed to minimize informational asymmetries Risks faced by FIs are financial and operational. With financial risks we mean: • credit, foreign exchange, country or sovereign, interest rate, market price and volatility, liquidity, bank insolvency, off balance sheet etc. With operational risks we mean: • technologies, human error, fraud, reputation, natural disaster, legal etc. they face such risks on behalf of the investors, which repays the FI by getting low returns. FINANCIAL ASSETS/CONTRACTS The exchange of funds is based on instruments such as bonds, deposits, etc. they are called financial assets: a contractual relationship in which both performances are denominated in a given currency and expire at different times. It implies a transfer of purchasing power in different moments. They could be based on private or public information. The underlying nature of such contracts could be debt, stock, insurance, derivatives etc. MATURITY OF FINANCIAL CONTRACTS: They could be short term, of maximum one-year, low risk and liquidity is high; for example, Italian BOTs, treasury bills etc. or medium/long term, where liquidity is lower and risk is high; mortgages, corporate bonds etc. RISK OF FINANCIAL ASSETS: There are two types of risks: • Financial: similar to the ones we saw for the financial institution (insolvency, price changes, interest changes, lack of liquidity…) • Non-financial: legal, human, political… FINANCIAL ASSETS AND INFORMATION: The evaluation of the various types of risks during the life of financial contracts depends on the information available to the parties involved. The information is both input and output of intermediaries and financial markets. It is an input as the decision-making processes of the operators are based on information (grant or not grant credit, to buy or not to buy a security). It is also output because the price of each financial asset incorporates information, as it is the result of the decision-making process itself. THE YIELD OR RETURN TO MATURITY: The return depends on different factors, for example interest rates, FX changes, dividends, price changes etc. We need to estimate the difference between the amount invested and what I could get. I need to discount the future cash flows with a yield: the yield to maturity, that allows me to evaluate in percentage the return of the investment. The yield is based on the understanding that an investor purchases the security at current price and keeps it until maturity, and all the coupons are invested at the same date. Ex post yield show what the investor will earn. It’s the difference between the market price minus the price the investor paid. It shows the performance of an assets but excludes probabilities and projections, while ex-ante yield shows an estimated value. GLOBALIZATION OF FINANCIAL MARKETS AND INSTITUTIONS: Recently the financial markets have been globalized. The reasons are: • The pool of savings from foreign investors is increasing and investors look to diversity globally more than ever. • Information on foreign markets and investments is becoming readily accessible and deregulation across the globe is allowing even greater access • International mutual funds allow diversified foreign investment with low transactions costs • Global capital flows are larger than ever • Regulations REGULATION OF FINANCIAL INSTITUTIONS: If a financial institution goes default, the lives of many people would be at stake, and that is why the government imposes many laws to the FI. These regulations are paid by the customers under the form of lower yields (in exchange of a higher safety). The supply of funds increases when IR goes up, while demand goes up when IR go down. The theory is widely used by central banks such as the FED or the Central Bank to estimate the dynamics of supply and demand from specific groups of agents, that are households, businesses, government and foreign sources. They analyse the flows of funds that such agents display through time. The interaction of such agents with a specific Economic Environment will determine the dynamics of IR. Some agents will ask for funds, some others will give funds. To identify the key groups of agents, the market regulator (I.E Central Bank) defines criteria to create homogeneous groups that are financially independent and that have their own bookkeeping. There are: • Non-financial firms: state owned or private non-financial firms with more than 5 employees • Financial firms: banks, finance companies, investment firms, insurances etc. • Public administration: government and municipalities • Households: families or family businesses with less than 5 employees. Based on this classification, the CB can determine an accounting scheme to see how each institutional agent manages its own stock and flow of money and to trace and detect the dynamics of supply and demand of money, based on the surplus and deficit each institutional agent shows from time to time. The households are one of the largest suppliers of loanable funds, while businesses are demanders. SUPPLY SIDE OF FUNDS: DETERMINANTS OF HOUSEHOLDS SAVINGS: 1- Households tend to save more when their income or wealth grows 2- Every culture has different attitudes about saving and borrowing 3- Families tend to save less when credit is largely available 4- Job security and belief in soundness influences the saving habit 5- Interest rates are factors for saving habits 6- Taxation on savings influence saving habits Determinants of households’ savings can also be analysed taking into consideration income and consumption habits. Savings are the difference between income and consumption. Agents may want to set Saving s as a specific goal and adjust Consumption accordingly. SUPPLY SIDE: FOREIGN FUNDS INVESTORS: They tend to exploit the attractiveness of the USA’s environment to invest there, because they have high interest rates and the strength of the dollar tends to encourage investors. They also have low political and economic risk. The last reason is that foreign central banks have reserves in USA dollars in case major disruption happens. Foreign funds suppliers examine the same factors as he US suppliers, except that they must also factor in the expected changes in currency values. DEMAND SIDE: DETERMINANTS OF GOVERNMENT DEMAND: They need money because they have to fund the government they run. For example, they could need it to fill the gap between revenues and expenses. Nowadays, governments are rushing to raise new capital, through the issuance of new debt instruments, because the revenues of the state don’t make up for the health system expenses we are facing. Governments normally try to reduce the debt they owe to creditors. The governments tend to increase the level of the debt the lower the cost of it goes. DEMAND SIDE: DETERMINANTS OF BUSINESS DEMAND: 1- The level of interest rate: when the cost is high, businesses tend to finance internally 2- Expected future profitability vs. risk: the greater the number of profitable projects available to the business, the greater the demand for loanable funds 3- Expected economic growth A SCHEME FOR FINANCIAL BALANCE: Each institutional agent is thought as running its own Financial Balance: For each institutional agent, we can write the balance of the fiscal balance: Example: What happens to the interest rate when we shift the supply curve for loanable funds? If the supply increases, the curve shifts to the right. If demand doesn’t change, the interest rate will decrease. Factors that affect the supply are: DIRECT IMPACT: • Interest rate • Near-term spending needs • Risk of financial security INVERSE IMPACT: • Total wealth • Monetary expansion • Economic conditions If the demand increases, the D curve shifts to the right. If the supply doesn’t change, the interest rate will increase. Factors that affect the demand are: DIRECT 1- Interest rate 2- Utility derived from asset purchased with borrowed funds 3- Economic conditions INVERSE: 4- Restrictiveness of nonprice conditions HOW CAN NOMINAL INTEREST RATES DECOMPOSED? It’s a function of several key ingredients, namely: 1. IP: inflation: higher expected inflation triggers high interest rates. 2. RFR: real risk-free interest rate and the Fisher effect: I = inflation + risk free interest rate 3. DRP: default risk premium: DRPj= ijt-iTt, namely the difference between the interest rate on security j at time t and the interest rate on similar maturity Treasury Security T at time t 4. LRP: liquidity risk premium, which increases as the maturity of the security increases that the creditor is “short” a call option, meaning he has given up on the control of the maturity date of the bond, in exchange of a higher interest rate paid by the bond over its non-call period. 4- Structured bond: it is a debt obligation that also contains a derivative component with characteristics that adjust the security’s risk/return profile. The return performance of a structured note will track that of the underlying debt obligation and the derivative embedded within it: a. Reverse convertible: the bond contains a derivative that allows the issuer to put the bond to bondholders at a set date prior to maturity, in exchange of existing debt or shares of an underlying company, that need not be related in any way to the issuers’ business. These bonds have shorter maturity and higher yields, because the risk they carry is high: the investor is “short” a put option, which means he gives up the possibility to receive the principal of the bond whenever he wants for whatever reason. Through its sale, the investor aims to enhance the yield on its bond investment. b. Covered bond, Linked, Reverse floater 5- Cum warrant 6- Step up/step down BOND COVENANTS: Bond covenants are the legal terms that determine how the bond will behave in different circumstances; they are listed in a document called “final terms”. The most common covenants are: • Use of proceeds: what is the issuer going to do with the money raised • Change of control: what happens if the issuer’s ownership of the debt changes over time • Limitation of dividends: the company might be obliged to pay interest on bonds before dividends • Reports: the issuer must prepare financial statements for the counterparty • Limitation on debt levels: limits how much debt the borrower can raise, to prevent the company from taking up too much debt • Safeguard clauses KEY BOND RISKS: The drivers of the overall bond return are: • Credit Risk: at issuance and throughout its contractual life, the yield of an obligation reflects the credit worthiness of its issuer. • Liquidity Risk: at issuance and throughout its contractual life, the yield of an obligation reflects the liquidity (i.e. the possibility to sell away one’s holdings) of the obligation. • Rate (market) risk: at issuance and throughout its contractual life, the yield of an obligation will tend to reflect/move that of the broader debt market. BOND RATINGS It’s an assessment made by a specific rating agency (S&P, Fitch, Moody’s) that defines the perceived default risk of the bonds. Based on this, the bonds could be given an investment or speculative grade rating, which answers the question: will the issuer entity be alive when the bond comes to maturity? NB: investment grade and speculative grade are different because not all investors can buy speculative grade instruments, and as such, the overall interest paid to investment grade investors is lower than the one paid to speculative grade instruments. A high-grade rating means: low probability of default, low yields, high likelihood for the entity to survive over a given time horizon. Every bond is also given a rating based on the possibility of it remaining on the same level for a certain period. Ex: a AAA bond has 100% probability of remaining AAA the year after, while a CCC bond has 49% of probability of remaining as such after ten years. It’s called survivorship. Every rating also shows the possibility for the issuer to improve or worsen over time: it’s called migration. TREASURY BILLS, NOTES AND BONDS – USA The USA Treasury is the office in charge to issue debt instruments: • T-Bills: short term securities maturing in one year or less. Sold at discount and redeemed at par. • T-notes: maturities from 1 to 10 years. • T-bonds: maturities over 10 years. • TIPS: treasury inflation-protected security: maturity over 5, 10 and 30 years. Their coupon is indexed to the actual inflation rate They are issued in minimum denomination of 100 dollars. They could be either fixed coupons or inflation indexed. They trade in percentage points of the face value (not in currencies). They are highly traded in the secondary markets, where prices are quoted as percentages of face value, as clean prices. The final price is the dirty price, which is the sum of the clean price and the accrued interest. TREASURY BILLS, BONDS AND NOTES – ITALY In Italy, the treasury is called Ministry of Economy and Finance. It determines the regular issuance of six categories of government securities, available for both the private and the institutional investors: 1- Treasury bills (BOTS) 2- Zero coupon treasury bonds (CTZS) 3- Treasury certificates (CCTS/CCTEUS) 4- Treasury bonds (BTPS) 5- Treasury bonds linked to the eurozone inflation (BTP€IS) 6- Treasury bonds linked to Italian inflation (BTP ITALIA) They are issued in minimum denominations of 1.000 euros; they might be zero coupon, fixed or inflation indexed. They are actively traded in the secondary markets; their prices are quoted as percentages of face value; prices are clean for coupon-bearing bonds, dirty for zero coupon bonds or bills. Tax rate on returns is 12,5%. For ZCB, the tax is charged when you purchase the bond. For coupon bearing bonds, the tax is charged on the day of the coupon is paid. Currently, the interest rates are negative. It means that investing today, would give you a return that is less than what you invested initially. MARGINAL AUCTION – ITALIAN DEBT: It’s the mechanism that allows treasury to issue debt. The Italian treasury adopts three different auction procedures. The simplest one is the one used for BTP ITALIA: the government issues the demanded quantity ad a pre-set price. The other bonds are issued with are two other systems: the marginal auction and the competitive auction. Marginal auction: it’s the placement system for government securities with a maturity of over 12 months. The marginal auction process determines the marginal price at which successful bidders are entitled to be assigned the submitted amount of the issue. Each participant may submit a maximum of 5 different requests in term of price. The minimum required is 500,000 euros, while the maximum amount that can be requested is equal to the quantity offered by the Treasury at auction. The marginal price is determined by meeting the offers from the highest price until the quantity demanded is equal to that offer. The price of the last bid that is accepted determines the marginal price. The prices offered vary from a minimum amount of one-thousandth for CTZ and one cent for other stocks. ACCRUED INTEREST AND PRICES: Accrued interest: must be paid by the buyer of a bond to the seller of a bond if the bond is purchased between interest payment dates. If one decides to sell a bond before the following coupon is paid, the buyer will have to refund to the seller the “accrued interest”, which is the interest he has earned from the day the last coupon was paid, up to the day of the sale. This price is called “dirty price”, which is the price of the bond as calculated as the percentage of the face value, called clean price, and the accrued interest. The accrued interest is calculated as: (coupon rate/ n. of coupons paid a year) * (number of days since last payment/ actual number of days in coupon period) x 100 CHAPTER 8 The types of shares that make the overall equity component are the common shares and the preferred shares. The difference exists because of their relative cost: preference shares and convertible debt are more expensive, but often necessary. Their issuance depends on the availability of capital. TYPES OF STOCKS: • Common stock: Common stock is the fundamental ownership claim in a public or private corporation. It has indefinite duration. They constitute the capital (Common Equity) of the company, that is the number of shares multiplied by the share nominal value (or market nominal value in case of listed companies). They confer the owner economic rights (profits distribution in the form of dividends and repayment of capital in case of bankruptcy once senior claimants are satisfied) and periodic remuneration under the form of dividends, that are discretionary and not guaranteed. The company could decide to distribute the retained earnings, or to put them into capital, with an action called internal financing. The total compensation they grant is made of dividends and capital gains. Common stockholders have the lowest priority claim in the event of bankruptcy (i.e., a residual claim), and limited liability, which implies they can lose no more than their original investment. They also have control over the firm’s activities indirectly by exercising their voting rights in the election of the board of directors. Moreover, a proxy vote allows stockholders to vote by absentee ballot (e.g., by internet or by mail). • Preferred stocks (cumulative or non-cumulative) are shares that constitute the equity capital of a given company but are more senior than common shares, that means that who invested in it is paid before common shareholders. In case of cumulative preferred stocks, if dividends aren’t paid every year, they are cumulated when the dividends are paid. • Stocks with no voting rights: those shareholders can’t vote; we can see them as high paying bonds. • Stocks in favour of employees: used to strengthen the bond between employees and the company and to involve them more in the business of the firm. It isn’t unusual to be paid in the form of stocks, in big companies. In such way, you will profit if your shares grow in value, hence you will be more prone to work hard for the company. The issuance of «Employees Stocks» mandates the company to increase its Capital by an amount equal to the Face Value of newly issued stock multiplied by the number new shares. • Tracking stocks: shares issued by a business unit of a big company. The bylaws define the costs and revenues that are attributable to that specific sector. The risk is that the individual company unit might be fine, but the company wraps up the year with an overall loss. The law states that dividends cannot be distributed to tracking stocks in case of absence of earnings at the «parent» company level. • Bonus shares or script-issues: is an offer of free additional shares to existing shareholders. A company may decide to distribute shares as an alternative to increasing the dividend pay-out. For example, a company may give one bonus share for every five shares held. Companies give away bonus shares to shareholders when companies are short of cash and shareholders expect a regular income. Shareholders may sell the bonus shares and meet their liquidity needs. Bonus shares may also be issued to restructure company reserves. Issuing bonus shares does not involve actual cash flow: it increases the company’s share capital but not its net assets as capital reserves get converted into new shares. Companies low on cash may issue bonus shares rather than cash dividends as a method of providing income to shareholders. Because issuing bonus shares increases the issued share capital of the company, the company is perceived as being bigger than it really is, making it more attractive to investors. In addition, increasing the number of outstanding shares decreases the stock price, making the stock more affordable for retail investors. STOCK SPLITS VS BONUS SHARES: Stock splits and bonus shares have many similarities and differences. When a company declares a stock split, the number of shares increases, but the investment value remains the same. Companies typically declare a stock split as a method of infusing additional liquidity into shares, increasing the number of shares trading and making shares more affordable to retail investors. When a stock is split, there is no increase or decrease in the company's cash reserves. In contrast, when a company issues bonus shares, the shares are paid for out of the cash reserves, and the reserves deplete. AMERICAN DEPOSITORY RECEIPTS: They represent a way for investors to buy shares of companies outside the US, that are not listed on the US stock exchange. It is a US-dollar denominated title representing ownership of a foreign stock, listed on a U.S. secondary Stock Market and issued by an International Bank. ADRs were meant to facilitate direct investment from U.S. investors into foPreign corporations at times when information dissemination on non-U.S. Corporations was hard to find. Each ADR is a claim on a specific number of shares. A broker can buy the shares of a foreign company traded on their home exchange market and deposit such shares in a bank abroad; in the US, the broker will have another bank, called depository bank, that will issue shares called receipts, on the basis of the shares he has abroad. Such depository shares can be traded on the secondary market just like normal shares: they pay dividends, they are evaluated in dollars etc. GDRs (Global Depository Receipts) are similar to ADRs but are traded globally. GDRs and ADRs do not increase the original Corporation’s capital but they enhance market participants ability to invest into it, thus potentially increasing its visibility and market value. Depending on the degree of transparency and regulation they follow, there can be Level I, Level II and Level III ADRs, the former being the least transparent/traded and the latter the more transparent/widely traded over regulated markets. STOCK RETURNS: The stock return is given by the capital gain, which is the percentage difference between the sale price and the purchase price, and the dividends paid overtime, which is the percentage of the dividends you get over time. Tax rates are very important in this case, because it can decrease the total value by a lot. PRE-EMPTIVE RIGHT: The pre-emptive right aims to prevent pre-existing share-holder base to get diluted in the event of a new issue of company shares. It allows to each shareholder to subscribe the new shares in proportion to the shares already held. Pre-emptive rights may be excluded for contributions in kind, main interest of the company, assignment of Employees' shares. The pre-emptive right has a great value. It is the difference between the market price before the capital increase, minus the theoretical value of the stocks after the capital increase. The theoretical price is given by: , where: IP: issue price of new stocks; MP: Market Price of Existing Stocks before announcement of New Stocks issuance; OS: number of old stocks to buy new stocks; Ns = number of new stocks against old stocks. TYPES OF MARKETS: PRIMARY STOCK MARKETS: are markets in which corporations raise funds through new issues of stock, most of the time through investment banks. Investment banks can act in two ways: as distribution agents in best effort underwriting or as a principal in firm commitment underwriting (when they buy the newly issued shares). A syndicate is a group of investment banks working in concert to issue stock. The lead underwriter is the originating house. An initial public offering (IPO) is the first public issue of financial instruments by a firm (when a previously private company sells on the market its shares, becoming public). IPOs, even if very praised, aren’t as much high-capital-raising as their follow-ons. A seasoned offering is the sale of additional securities by a firm whose securities are already publicly traded. Pre-emptive rights give existing stockholders the ability to maintain their proportional ownership thus avoiding the otherwise inevitable dilution effect that ensues a seasoned offering. A red herring prospectus is a preliminary version of the prospectus that describes a new security issue. Shelf registration allows firms to offer multiple issues of stock over a two-year period with only one registration statement. SECONDARY MARKET: Markets in which pre-existing stocks are traded among investors. Trading can be quote-driven or order-driven, or a combination of the two. Quote-driven means the bid/ask process are automatically formed by the Exchange by sorting quotes submitted by Market Makers or Dealers and other market participants. Order driven means that the bid/ask prices are only those submitted by authorized market makers or dealers. Important secondary stock markets in the US: NYSE, NASDAQ; Bats/Direct Edge. TYPE OF MARKET ORDERS: How does one buy and sell on the secondary market? Every market actor sends orders, that are instructions that one sends to the market regulator about his desire to buy or sell: • A market order is an order to transact at the best price available when the order reaches the trading post. • A limit order is an order to transact at a specified price. Specialists transact for their own account. • Program trading is the simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million using computer programs to initiate the trades. Circuit breakers are temporary regulatory measures that give investors time to make informed choices during periods of high market volatility. They automatically stop trading when prices hit predefined levels. Circuit breakers operate both for broad market indices (e.g. S&P500) and single name stocks. FLASH TRADING: In flash trading, traders are allowed to see incoming buy or sell orders milliseconds earlier than general market traders. Then, they use computerized statistical analysis to generate trading strategies executed by computers. CHAPTER 3 The price of a security can be thought of as the Present Value of the finite (bonds) or infinite (stock) stream of future cash flows it will yield to the investor. , where: • CF is the cash flow at time t • N is the number of periods • R indicates the discount factor. For Bonds, it is often referred to as Yield to Maturity, while for Stocks it is often referred to as Required Return The interest rates can be called with different rates depending on the standing point. It can be: • R, or required rate of return: the rate calculated using the fair value. We plug it into the equation to get the fair present value. (you use it when you decide the rate you want to use to find the fair price) (it’s what we used in financial mathematics) • Er, or expected rate of return: the rate calculated using the current market price. It is the unknown of the equation, found inputting the price that you observe in the market. The key underlying assumption for the investor to earn the E(r) is that all coupons must be reinvested at the same rate. • Rr, or realized rate of return: the rate earned on the investment. It is used to calculate the rate of return based on the money you earned. • (The coupon rate is a periodic cash flow a security promises to pay to the investor) When you solve the security price formula for the discount rate you are implicitly assuming the cash flows will be reinvested at that discount rate. At maturity, the assumption will prove correct or wrong depending on whether interim cash flows have or have not been actually reinvested for the remainder of the security’s life at the discount rate. Therefore, the use of the Realized Return formula is reasonable only when you have no other information about the actual reinvestment rate, and you assume the same constant rate has been used through time. ROE: divide (P/BV) / (P/E) (price to book value/ price over earnings) to get E/BV, the Return on Equity. If the ROE is low, the share is overvalued, which is a good investment for growth investors, while if ROE is high, the share is undervalued, which is a good investment for value investors. ROE measures the amount of income after taxes earned for each dollar of equity capital contributed by the bank’s stockholders: It can be broken down as: , where: • Return on Assets (ROA) determines the net income produced per dollar of assets; Higher ROA values identify stronger income generation per unit of Asset deployed. • Equity Multiplier (EM) measures the dollar value of assets funded with each dollar of equity payments. The higher this ratio, the more leverage or debt the bank is using to fund its assets. STOCK VALUATION, DISCOUNT-BASED: NO GROWTH Up to now we have talked about market based multiple model; now, we talk about the discount-based model. The present value of stock, assuming zero growth of dividends, can be written as: , where D is the constant dividend paid at the end of every year; Pt is the stock’s price at the end of the year t and Rs is the interest rate used in the discount factor. In other words, the present value of the stock is evaluated as the infinite sum of dividends evaluated at discount. The convergence of the expression is D/R. STOCK VALUATION, DISCOUNT-BASED: CONSTANT growth or GORDON MODEL In such case, the present value is given by: , where D0 is the current dividend per share, Dt is the dividend per share at times different from the current, g is the constant dividend growth rate and R is the interest rate. In other words, the present value of the stock is evaluated as the infinite sum of the current dividend times (1+g)^t, divided by the difference between r and g. STOCK VALUATION, DISCOUNT-BASED: NON-CONSTANT GROWTH To make the analysis more consistent, we assume that the growth of dividends is not constant but happens at a supernormal speed for a given period. To compute: 1- You find the present value of dividends during the finite period of time t, where the dividends grow at a supernormal rate, and discount each one of such dividends by the required rate of return. 2- Find the PV of the dividends paid after the end of the supernormal period by. a. find the present value of dividends during the subsequent period (perpetuity) of normal dividend growth, by using the perpetuity formula with the company required rate of return b. discount the value a) b the company’s required rate of return over the period of supernormal dividend growth 3- sum 1 and 2 STOCK VALUATION, DISCOUNT-BASED: NO DIVIDEND: To calculate the present value of a share that doesn’t pay dividends, we use: , where Nt is the n. of outstanding shares at time t and Vt is the value of the firm at time t, calculated as with FCF as the firm’s free cash flow at time t+1, WACC as the firm’s weighted cost of capital and g as the firm’s growth rate. SENSITIVITY OF GORDON MODEL TO G The Gordon model is very sensitive to r when it’s too close to g. Example: let’s suppose we have two stocks A, that has g= 7% and B, that has g= 6%. In both cases, r is 8%, and both pay 1 dollar. PVA= (1*(1+0.06))/ (0.08-0.06)= 107 while PVB= (1*(1+0.07))/(0.08-0.07)= 53 B is twice as valuable as stock A! However, when the dividend growth rate g is less than r, the difference in the value of two stocks is smaller. Example: suppose this time gA Is 2% and gB is 1%, and the other data stay the same: PVA= (1*(1+0.02)/(0.08-0.02)= 17 while PVB(1*(1+0.01)/(0.08-0.01)= 14,43 In this case, the difference is much lower! LIMITATIONS OF THE GORDON MODEL: • The main limitation of the Gordon growth model lies in its assumption of a constant growth in dividends per share. It is very rare for companies to show constant growth in their dividends due to business cycles and unexpected financial difficulties or successes. Therefore, the model is limited to firms showing stable growth rates. • The second issue has to do with the relationship between the discount factor and the growth rate used in the model. If the required rate of return is less than the growth rate of dividends per share, the result is a negative value, rendering the model worthless. • If the required rate of return is the same as the growth rate the value per share approaches infinity. HOW TO ESTIMATE G: • By looking at past dividends pay-out to see how they grow • Get the ROE and multiply it by b, where b is the plowback ratio, which is (net income – dividends)/ net income, and that measures how much earnings are retained after dividends are paid out RETURNS: The return r is calculated in different ways: • The return on a stock with 0 dividend growth, if bought at current price P0, can be written as D/P0 • The return on a stock with constant dividend growth, if bought at price P0, can be written as (D1/P0)+g TO SUM UP: • Multiplier models: easy to compute but problems with selecting a peer group of companies • PV MODELS: provides a direct computation but input uncertainty can lead to poor estimate BOND VALUATION WITH ANNUAL COUPON: The present value of a bond with annual coupon is calculated as: , where par is the face value of the bond, INT is the coupon, T is the number of years the bond lives and r is the annual interest rate. BOND VALUATION WITH SEMI-ANNUAL COUPON: The present value of a bond with semi-annual coupon is calculated as: , where everything must be divided by two. BOND VALUATION: • Premium, if present value is higher than the par and the coupon rate is higher than the interest rate • Discount, if present value is lower than the par and the coupon rate is lower than the interest rate • Par, if present value is equal to the par and the coupon rate is equal to the interest rate IMPACT OF INTEREST RATE CHANGES ON DEBT SECURITY VALUE: There are three key elements that can change the present value of a debt: • Interest rates: There is a negative relation between interest rate changed and present value: when interest rates go up, present value goes down and vice versa. The impact on the price of an interest change also depends on the level of the initial interest rate: the response of the price will be smaller, the higher the level of initial interest rate. • Time remaining to maturity: For any given change in market interest rates, the impact on the security price will be larger, but at a decreasing rate, the longer the time to maturity. • Coupon rate: For any given change in market interest rates, the impact on the security price will be smaller the bigger the size of its coupon DURATION: It is the weighted average time to maturity (measured in years) on a financial security: ex. we say bond x has 5,3 yeast duration and 7 years contractual maturity. It means that the bond will take 5,3 years to repay what you initially invested. Duration captures all of the three risk factors affecting security price (coupon, maturity, interest rate). Because Bond Prices move inversely to Rates, duration can be thought of as the equilibrium between rates and price. Depending on the “size” of the duration for each bond, identical changes in market rates will trigger different «price responses» on each different bond. A derivative is a financial contract between two parties whose value is based on some underlying asset price. As the price of the underlying asset increases or decreases, so does the value of the derivative. In a derivative contract, the two counterparties agree, at a given time, to exchange a standard quantity of an asset at a predetermined price at a specific date in the future. Derivatives have been existing for a long time: • First traces of forward contracts during the Roman period, used to fix the purchase price of Egyptian agricultural commodities. • The option contracts are traced back to trading of tulip bulbs in Holland during the 17th century. • The first wave of modern derivatives were foreign currency futures introduced by the International Monetary Market (a subsidiary of the Chicago Mercantile Exchange) following the Smithsonian Agreements of 1971. • The second wave of modern derivatives were interest rate futures introduced by the Chicago Board of Trade (CBT) with the increase in interest rate volatility in the late 1970s. • The third wave of modern derivatives occurred in the 1980s with the advent of stock derivatives. • The fourth wave occurred in the 1990s with credit derivatives. • The fifth wave in the 2000s include weather derivatives and energy derivatives. TYPES OF UNDERLYING ASSETS: Financial assets: • Stocks • Interest rates related to treasury bonds • Other interest rates • Exchange rates • Stock indexes Non-financial assets: • Commodities (oil, agricultural products, precious metals, etc) Derivatives can also be distinguished in: • Option based contracts (for example options, caps, floors, collars, warrants, covered warrants). They are asymmetric contracts, which means the owner of the contract can incur in a gain due to the increase of the value of the underlying asset but isn’t exposed to losses due to the decrease of the value of the asset. It’s possible to limit the losses. • Forward based contracts (for example futures, forwards, FRAs, swaps). They are symmetric contracts, which means their value increases and decreases as the value of the asset does. It isn’t possible to protect the investor from losses. DERIVATIVES’ USE: Derivatives are leveraged instruments where participants put up a small amount of money (ex. the premium of the option) and obtain the gain or loss on a larger position, without having to buy the asset. Derivatives are used for: • Speculation: Buying or selling a derivative contract in order to earn a leveraged rate of return • Hedging: Entering into a derivatives contract to reduce the risk associated with positions or commitments in their line of business, for example interest rate risks. • Creation of synthetic securities: To change the nature of a financial position without bearing the costs of selling the portfolio and repurchase another one DISTINCTION ACCORDING TO THE MARKETABILIY: There are two types of derivatives: • Exchange based contracts: in this case, we have derivative contracts which are traded into regulated exchanges, such as the Italian Derivative Market. There are specific rules concerning the trading. In such cases, specific assets are underlying. Early termination is possible prior to contract expiry. In this case, the risk of default of the counterparty is mitigated by the financial institution called clearing house, which works as a medium. • Over the counter contracts: contracts are not traded in organized markets but usually created by financial intermediaries, which are also involved in the trading of this financial tools. Contracts are not standardized but created on the basis of specific requirements, in terms of underlying assets, maturity etc. the negotiation is private, hence it isn’t possible to know the details of OTC trading. Early termination is much more difficult, because the contracts are not standardized, so when a party wants to sell the derivative, it isn’t easy to find a counterparty which accepts the initial conditions of the contract. THE OTC DERIVATIVES REFORM: Since 2008, new regulations on both sides of the Atlantic make the promotion of Central Counterparties (CCPs) which acts as counterparty of derivative trades and mitigate the counterparty risk. CCPs are regulated and supervised financial institutions, aimed to replace the bilateral relationships in OTC derivative markets and consequent counterparty risk. They create centralized multilateral relationships. The sellers of OTC derivatives sell the contracts to the CCP and the buyers buys the contract from the CCP. The CCP can stipulate the required collateral to both counterparties and monitor the positions of the two parties under the regulatory rules. In 2012 in the US was enacted the Wall Street Reform &Consumer Protection Act (widely termed the “Dodd-Frank Act” or DFA). In Europe, in 2010 was enacted the European Markets Infrastructure Regulation (EMIR). Similar regulations were developed in other continents. OPTIONS An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price (exercise price or strike price) within a specified period of time. The two counterparties define the conditions at which the contract will be stipulated. They define the underlying asset, the price, the maturity and the options. There are two types of options: • Call options: the buyer has the right to buy the underlying asset at a specified price • Put option: the buyer has the right to sell the underlying asset at a specified price In order to get the option, the buyer has to pay a premium in advance. Options can be exchange traded or over the counter options, also called “exotic options”, which are very customizable. In option contracts, it’s necessary to specify the type of options, the maturity date of the option, which is usually short in the exchange traded options, or longer in OTC options, the strike price or the way to calculate it, the type of settlement (physical or cash), and the premium, thought as an upfront fee. There are two kinds of options: • European: the right to buy or to sell the asset can be exercised only at a given date which is contractually identified. • American: the right to buy or to sell the asset can be exercised any time before the maturity date of the option. For this reason, they are more expensive. PROFITS AND LOSSES FOR CALL OPTIONS The buyer of the call option, in red, pays a pr., gets the right to buy the asset at a specified price. The seller (blue), who cashes the pr. has the obligation to sell the asset and to receive the strike price. The buyer gains if the price of the asset increases above the strike price, because he pays less than he would if he tried to buy it on the market. If the price of the asset goes below the strike price, the buyer can decide not to exercise the option and buy the asset from the market. In this case, he will suffer the loss of the premium he paid initially. For him, the gain can be potentially infinite. On the contrary, the seller suffers a loss when the price of the asset increases above the market price, because he is obliged to sell it, receiving less than he would if he sold the asset on the market. He gains the total amount of the premium if the price of the asset goes below the strike price, because in the buyer would not buy anymore, giving up what he paid for the option. The gain is equivalent to the premium. We call break-even point the price from which the buyer starts making money and the seller losing it. IN, AT AND OUT OF THE MONEY The call option can be: • In the Money: when the option's strike price is below the market price of the underlying asset. • At the Money: when the option's strike price is identical to the price of the underlying security. • Out of the Money: when the option’s strike price is above the market price of the underlying asset. THE PUT OPTION: In the put option, the buyer has the right to sell to the writer of the option the asset at a specified price, represented by the strike price. To acquire this right, the buyer has to pay a premium. In red, we see that the buyer will gain if the market price of the asset is below the strike price, while the seller of the put option will gain if the market price is above the strike price. We say that the put option is: • In the Money: when the strike price is above the market price of the underlying asset. • At the Money: when the strike price is identical to the price of the underlying security. • Out of the Money: when the strike price is lower than the market price of the underlying asset INTRINSIC VALUE AND TIME VALUE: The components of the premium (what is paid in advance by the buyer and received by the seller) are time value + intrinsic value. the intrinsic value of options depends on whether we are dealing with a call or a put option: The intrinsic value will increase if the market price increases or if the strike price decreases. When the intrinsic value increases, so does the premium. The intrinsic value will increase if the strike price increases or if the market price decreases. When the intrinsic value increases, so does the premium. The intrinsic value must be greater or equal than zero. The time value of an option is the portion of an option's premium that is attributable to the amount of time remaining until the expiration of the option contract. The longer the amount of time for market conditions to work to an investor's benefit, the greater the time value. A collar is a position taken simultaneously in a cap and a floor (usually buying a cap and selling a floor). It’s made to minimize the costs. Remember, the seller has to pay an initial premium. Example: An interest rate cap is an agreement between the seller or provider of the cap and a borrower to limit the borrower’s floating interest rate to a specified level for a specified period of time. These agreements are used by financial institutions useful to limit their exposure to interest rate floats. If market rates are above the cap rate, then the seller of the cap will make payments to the buyer. When rates are below the cap rate, no payments are made. The payoff of a cap is given by the following formula: (Market interest rate – Cap rate) x (# Days in Period / 360) x (Nominal Amount) Suppose a cap has a cap rate equal to 3% based upon 3-month Libor, a notional amount of $100,000,000 and the number of days in the period was 90. If at the settlement date the 3-month Libor rate is at 3.5%, then the cap seller would pay: (3.5% – 3%) x (90/360) x 100,000,000 = $ 125,000 If at the settlement date the 3-month Libor rate is at 2.5%, then the cap seller would make no payments. FORWARDS AND FUTURES Let’s define spot and forward contracts: • A spot contract is an agreement to transact involving the immediate exchange of assets and funds. • A forward contract is a non-standardized agreement to buy or sell an asset in the future, with the terms of the deal set when the contract is created. They lack standard terms, because they are OTC contracts. • A futures contract is a standardized, exchange-traded version of a forward contract. They differ from forwards contracts because they are marketable, have no default risk (because of the presence of a central counterparty) and require the payment of a margin (a performance bond posted by a buyer and a seller of a futures contract to the clearing house as a guarantee) and daily marking to market. With futures, we can sell an asset we don’t own already. Differently from options, where the two parties had a right to perform, in this case they have an obligation. FUTURES CONTRACTS VOCABULARY: • Long position: the purchase of a futures contract (the purchase of the underlying asset at maturity) • Short position: the sale of a futures contract (the sale of the underlying asset at maturity) • Clearinghouse: the unit that oversees trading on the exchange and guarantees all trades • Open interest: the total number of the futures outstanding at the beginning of the day. It’s important because it provides a picture of the size of the market. As it increases, trading is easier. FUTURES PAYOFFS: On the x-axis we represent the future price, while on the y axis we represent the payoff for the futures. In a long position, the investor will earn if the market price increases above the price settled. In a short position, the investor will earn if the market price decreases below the price settled. Long position is preferred if one expects the increase of the asset and wants to speculate on it and vv. They can also be used to hedge against the exposure to risks, i.e. market price decrease of a given underlying asset. For example, I can buy a stock, which is exposed the market price decrease risk, and a short position on the same stock, which gives me a method to limit the possible loss. SETTLEMENT AND CLOSURE PRIOR SETTLEMENT: We can have: • physical settlement: the seller delivers the underlying asset to the buyer at maturity. • cash settlement: the cash is transferred from the futures trader who sustained a loss to the one who made a profit. It’s also possible for the two parties, to exit the strategy prior the settlement: to do so, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position effectively closing out the futures position and its contract obligations. STANDARDIZATION OF FUTURE CONTRACTS: Futures contracts ensure their liquidity by being highly standardized, usually by specifying: • The underlying asset or instrument, which limits the hedging power of it • The type of settlement, either cash settlement or physical settlement • The amount and units of the underlying asset per contract • The currency in which the futures contract is quoted • The tick, the minimum permissible price fluctuation • In the case of physical commodities not only the quality of the underlying goods but also the manner and location of delivery are specified • The margin requirements. Margins exist to offer a protection to the counterparty risks, which they face every day from the day of the settlement to the day of the maturity date. • The last trading dates FUTURES CONTRACT MARGINS: The clearing house could be an intermediary between seller and buyer, and for this reason it can ask for a margin, in exchange for the risk borne by the counterparty. An initial margin is a deposit required on futures trades to ensure the terms of the contracts will be met. The maintenance margin is the margin a futures trader must maintain once a futures position is taken. If losses occur such that margin account funds fall below the maintenance margin, the customer is required to deposit additional funds in the margin account to keep the position open. N.B: both brokers and clearing house ask for a margin, even though the brokers’ one is usually higher. Suppose the investor buys one June contract at price 98,500. Monday’s price close is 98,3125, Tuesday’s close is 97,00. The margin account after Tuesday is: When the margin account goes below the MMR, the investor is required to make a deposit, to reach the IRM of 2530. If he doesn’t pay, the clearing house has the power to sell the futures contract and to return to the investor the balance of the margin account, that in this case represents a loss for the investor. The higher the fluctuation, the higher will the margin requirement be. The money taken out of your margin account is given to the seller of the future. HOW TO USE FUTURES TO HEDGE: A manufacturer needs to buy copper on June and wants to hedge his purchase against possible price increases. On March the spot price is 340 $ per ounce while the future price is 320$. The company will buy futures at 320$. • Case 1: on June the spot price is 325 $ The company buys copper at 325$ The company sells futures at 325$ profiting 5$ The purchase of copper costs 320$ • Case 2: on June the spot price is 310$ The company buys copper at 310$ The company sells futures at 310 $ losing 10$ The purchase of copper costs 320$ THE COMPLEXITY OF HEDGING: Hedging could be difficult because: • For it to be efficient, the underlying asset of a future contract must be the same as the one held by the investor. In future markets, that isn’t easy, because only few types of futures with standardised conditions exist on the regulated market. • The uncertainty about the moment in which the asset held has to be sold and purchased vis-à-vis the length of the future contract used for hedging purposes. • There is a maturity mismatching between the length of the hedge and the maturity of the future contracts available in the market. PRICING FORWARD CONTRACTS: By arbitrage arguments, the year T, forward price Fo or an asset So which provides no income is: Where the forward price is equal to the compound capitalization of the spot price using the Nepero with exponents equal to the product of risk free ingest rate and the time to maturity of the derivative contract that needs to be priced. It is useful for assets that provide no income. If we take into account assets providing incomes, we have to take into account these features. If the current forward/future price is higher than F0, buy the asset now, short the forward contract, and deliver the asset then. If the current forward/future price is less than F0, short the asset, go long on the forward contract, and deliver it then. Example: • Market future price = 43 € • Spot price = 40 € • Maturity = 3 months • Interest rate = 5% • Theoretical price of forward = 40 * e^(0,05*0,25) = 40,50 € STRATEGY: Sell today= +43 Borrow 40 euros at 5% for 3 months= 40,5 • Open-end mutual funds: they sell new shares to investors and redeem outstanding shares on demand at their fair market value, which is the valuation is calculated on the basis of the closing prices of the listed markets. Liquidity is never a concern in such markets. They are able to negotiate low transaction cost due to the huge amount of transactions they have, and there’s no limit on the daily supply and demand of shares. In this way, investors can have diversified portfolios for a relatively small price, as well as other benefits, including free exchange of investment between different funds. This is important if the investor wants to “rebalance” its portfolio; other services can be automatic periodic investment and reinvestment. They also keep the financial record for the individual. They only trade at par. • Closed-hand companies: shares are not redeemable. When they want to sell the shares, they sell them to others on the secondary market at the market price. They have a fixed number of shares outstanding, which means they have subscription periods, and once the shares are allocated, there’s no possibility to enter the fund. They could even be former open-end MF that decide to close, because they are so big, they can’t manage more clients. Traded at discount or premium. • Unit investment trusts, such as a real estate investment trust. They sell a fixed number of redeemable shares that are redeemed at a set termination date. They can be levered and grant a high return. The portfolio they grant is static. • Hedge funds: closed hand funds that solicit funds from wealthy individuals and other investors and reinvest on their behalf. They are exempted from public liquidity, disclosure and distribution requirements, and can use the leverage, which means invest more than the money than the fund was able to collect. They are not open to the general public, because they use “aggressive investment methods”, such as short selling, leveraging, program trading, arbitrage, use of derivatives, and usually grant high returns. More on that later. • Money market mutual funds (1972): a type of fixed income mutual fund that invests in debt securities characterized by their short maturities and minimal credit risk. They provide denomination intermediation for individuals: it means that individual investors with no large amount of money can invest as well. They offer higher rates of return. • Tax exempt money market mutual funds In September 2008, the Primary Reserve Fund - a money market mutual fund - ‘broke the buck’ and had its share value fall below the standard $1 due to losses on $785 million of commercial paper issued by Lehman brothers. This led to contagion and a run on money funds with over $200 billion outflows over the next few days. The Treasury guaranteed payments on money funds for one year to stop the runs. The insurance ran out September 19, 2009. New rules proposed by the SEC in 2010, introduced measures to make MMMF safer by reducing interest rates, credit and liquidity risk: for this reason, today the MMMF can’t hold more than a certain percentage of assets. in 2014 the SEC adopted more fundamental structural changes to the MMMF. As we can see, even products which have been designed to be safe became unsafe after the crisis of 2008. MUTUAL FUND INDUSTRY: Cash flows into MFs are highly correlated with the return on stock market: it means that when the DOW JONES goes up, investments in MFs grow, because equity mutual funds are high paying due to volatility. The primary reason people hold MF, is to provide supplemental post-retirement income. Much of the growth of MFs market comes from institutional funds, that manage retirement plans for a company’s employees. New innovations in such funds include: • target date funds called life cycles: class of mutual funds that begins investing heavier to stocks on your behalf when you are younger and heavier to bonds as you age. The asset allocation of a tar- get-date fund gradually grows more conservative as the target date nears and risk tolerance falls. • lifestyle fund: they are similar to target date funds, with the sole difference that they do not necessarily shift allocations following the life path of the individual, but they allow investors to choose a specific strategy and to maintain that approach for the life of the investment. Retirement funds occupy the 25% of all MFs. MFs are the second largest financial intermediary in the US. In mutual funds, industries manage 25% of the total. The number of open-end funds worldwide reached 118,978 in 2018. Almost half of the global mutual fund assets were concentrated in the United States. In the United States, there were 9,599 mutual funds in 2018, managing assets worth approximately 17.71 trillion U.S. dollars. In the last years, they grew exponentially, in Italy as well, even though many Italian invested in foreign funds, such as Luxembourg, because they are faster and more professional. TYPES OF FUNDS: They can be divided into short term funds (less than one year): • Money market mutual funds: consist in various mixtures of money market securities • Tax-exempt money market mutual funds: consist securities issued by tax-exempt entities, such as municipal securities, which yield a lower return than other bonds. And long-term funds (more than one year): • Equity funds • Bond funds • Hybrid funds MONEY MARKET MUTUAL FUNDS ADDITIONAL COMMENTS: Investors on MFs give up the deposit insurance but gain high rates of returns, while bank deposits are relatively less risky, but offer lower returns: the federal deposit insurance corporation ensures deposits up to 250.000 per depositor. It means that if a saver has three deposits in three banks to the amount of 200.000 each, and the banks are ensured by FDIC, the saver has a guarantee up to 600.000 deposit: the risk is low. Nowadays, households own the majority of money funds. Today, there are more than 8,000 MFs, while in 1980 there were only 600. HOW THE CHARACTERISTICS OF MUTUAL FUNDS OWNER CHANGED: MUTUAL FUND PROSPECTUS AND OBJECTIVES: MF managers must specify their fund’s investment objectives in a prospectus (a formal summary of a proposed investment), which is made available to potential investors. No investor should invest in a fund without carefully reading the prospectus. For this reason, it’s written in plain English instead of an overly legal language. It holds lists of the securities invested in by the funds, as well as the historical return information, usually for 1-year, 3-year and 5-year periods and perhaps longer. The prospectus must also show historical fees and the effect of those fees on a given investment over time. Little information on risk is usually provided INDEX FUNDS AND EXCHANGE TRADED FUNDS: An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover. An exchange traded fund is a basket of securities, designed to replicate a stock market index, that trade on an exchange. ETF share prices fluctuate all day as the ETF is bought and sold; this is different from mutual funds that only trade once a day after the market closes. They can also be traded sold short and purchased on margin. Management fees are lower than actively traded funds. INVESTOR RETURNS FROM MUTUAL FUND OWNERSHIP: Returns come from three sources: • Income and dividends: funds are required to distribute at least 90% of dividends. • Capital gains on assets bought and sold at higher prices: at least 90% of gains. • Capital appreciation on assets held in the fund: Mutual funds are marked to market daily. Managers of the fund calculate the current value of each mutual fund share by computing the daily market value of the fund’s total asset portfolio less any liabilities and then dividing this amount by the number of mutual funds shares outstanding. The net asset value (NAV) of a MF share is equal to the market value of the assets in the MF portfolio divided by the number of shares outstanding. Mutual funds shouldn’t technically go bankrupt, because they only owe the market value of their holdings, however we saw it can happen. They need cash reserves to handle cash redemption. Without reserves, the mutual funds can be obliged to sell fund holdings to redeem shares. MUTUAL FUND COSTS: MFs charge investors fees for the service they provide: • Sales load, a front-end fee paid when the investor purchases the shares. It’s like a broker fee. The max size is circa 8%. Some funds charge the back-end load instead of the front-end. It means you pay the fee when you sell the share. Today, there are a lot of different shares that charge different types of loads: o A load fund is a MF with an up-front sales or commission o A no-load is a MF that doesn’t charge the up-front sale • 12b-1 fees: fees related to the distribution cost of MF shares. Marking and distribution expenses can’t exceed 0,75% of the fund’s average net assets per year. The minimum is generally 0.25% MUTUAL FUND REGULATION: The SEC is the primary regulator (acts of ’33 and ’34, ’40, ’88, ’96) MFs are heavily regulated because they manage and invest small investor savings. INVESTORS ABUSE: There are four types of abuses: • Market timing is short-term trading of mutual funds that seeks to take advantage of short-term discrepancies between the price of a mutual fund’s shares and out-of- date values on the securities in the fund’s portfolio • Late trading involves buys and sells long after prices have been set at 4:00 pm E.T. • Directed brokerage occurs when brokers improperly influence investors on their fund recommendations • Improperly assessed fees occur when brokers trick customers into thinking they are buying no-load funds or fail to provide discounts properly GLOBAL ISSUES: • During the 1990s, mutual funds were the fasting growing financial institution in the United States • Worldwide investments (other than in the U.S.) in mutual funds have increased over 187%, from $4.916 trillion in 1999 to $14.130 trillion in 2007. This compares to growth of 75% in U.S. funds • Non-U.S. mutual funds experienced bigger losses in total assets during the financial crisis • Worldwide funds fell to 49.316 trillion (34.1%) in 2008, while U.S. funds fell to $9.603 trillion (20%) • By 2016, worldwide investments in mutual funds increased to $21.16 trillion (an increase of 127% from 2008), while U.S. investments increased to $18.13 trillion (an increase of 88.8%) Channels via which monetary policy can influence price stability and economic development: • The interest rate channel: the decisions taken by the ECB is going to affect directly the level of interest rates in the markets where short term exchanges of funds take place. Indirectly, the ECB will affect the interest rates set by the banks for loans. Money markets are very important because in these markets the economic agents are going to adjust their liquidity positions. Within the money market there’s a specific market called Interbank Markets which is important for the ECB in terms of observation. In such markets, where banks exchange deposits, the ECB can observe how the policies enacted influence the interest rates. • The expectations channel: they are important to shape the yield curve, which represents the level of yields and interest rates demanded by investors for different maturities. Based on expectations, economic agents make decisions. • The exchange rate channel: it is strongly connected with the interest rates: when exchange rates change, it can make a currency more attractive than others, influencing imports and exports. • The credit channels: o The bank lending channel: an interest rate change by the monetary policy authority will translate in a change in interest rate charged by the banks, and this will influence the profitability of the banks. o The balance sheet channel: the change in interest rate has an inverse relationship with the present value of the assets held by the firms, hence the value of collateral banks need for loans o The risk-taking channel: a change in interest rate influences the risk banks face in granting new loans The ECB instruments: • Standing facilities: only accessed by banks which are subject to the minimum reserve requirement. They have to maintain such minimum at the central bank, and they have access to standing facility and can participate to open market transactions based on standard tenders with the ECB. For outright transactions, no restrictions are placed a priori on the range of counterparties. In addition, since 2009 the ECB has implemented several non-standard monetary policy measures, i.e. asset purchase programmes, to complement the regular operations of the Eurosystem. Standing facilities are two types of transactions that the banks can make vis a vis the EBC: o Deposit facility, by which the banks can deposit excel liquidity for 24 hours. Today, the rate of deposit facility is -0,50%, which means when banks deposit, they must pay the ECB. o Marginal lending facility, where banks in need of funding can find financing at the ECB for 24 hours, provided that they collateralize such financing. For MLF, the rate is 0,25%. • Minimum reserve requirements for credit institutions: banks are required to deposit at the central banks on a monthly basis an amount calculated as follows: the banks have to calculate the 1% of all the liabilities and the stocks that they collect on a monthly basis (with agreed maturity up to 2 years), including current accounts or savings deposits, and excluding all the liabilities that single banks have vis a vis the central banks or vis a vis other banks which belong to the Eurosystems and also have to observe the MRR. From such 1%, the banks should deduct a lump sum allowance of 100.000. The resulting amount will be deposited at the central bank. That amount can be used by the banks but the average balance of MRR can’t be lower than the required amount on a monthly basis. Banks can mobilize that deposits, but the average balance can’t be lower what is due to the central bank. For the single bank, the account opened at the central bank represents an asset. On the other side, the collection of the MRR is going to represent a liability vis-à-vis the single bank. The MRR is a monetary policy tool, because the ability of banks to grant loans is conditioned by the MRR: depending on the size of the MRR, the ability of banks to grant loans will be higher or lower, following an indirect relationship. If the MRR increases, the ability of the banks to grant loans, will diminish, hence the cost of the financing provided by banks increases and vice versa. In 2019, this tool was revised, introducing the two-tier system: the ECB is remunerated at 0% to banks. If banks deposit excess liquidity by an amount that is 6 times the monthly amount required, it’s remunerated at 0.50%. The ECB requires credit institutions established in the euro area to hold deposits on accounts with their national central bank. These are called "minimum" or "required" reserves (MMR) The ECB requires credit institutions established in the euro area to hold minimum reserves. In addition, the following rules apply: o branches in the euro area of credit institutions established outside the euro area are also subject to the Eurosystem's minimum reserve requirements o branches of euro area credit institutions which are located outside the euro area are not subject to the Eurosystem's minimum reserve requirements OPEN MARKET TRANSACTIONS: Five types of financial instrument are available to the Eurosystem for its open market operations between the national banks and the ECB. The most important instrument is the reverse transaction, which may be conducted in the form of a repurchase agreement or as a collateralized loan: in other words, there’s a first transaction with the Eurosystem, and after a given period of time, this financing must be returned by banks. There are different types of assets underlying the transactions. The Eurosystem may also make use of outright transactions (sale and purchase of single assets), issuance of debt certificates, foreign exchange swaps (used for the governance of exchange rates) and collection of fixed-term deposits. Open market operations are initiated by the ECB, which decides on the instrument and the terms and conditions (length, maturity, collateral, price). It is possible to execute open market operations based on: • standard tenders: 24 hours length, made on a weekly basis. Other financial intermediaries can participate to open market transactions via standard tenders. • quick tenders: 90 minutes length • or bilateral procedures The different kinds of open market operation are: • main refinancing operations: aimed to provide temporary liquidity to banks. The tender is announced by the ECB and banks can make their bid and eventually receive the full allotment, provided that they can collateralize the financing. the funds received must be returned after one week. • long term refinancing operations: there are longer refinancing operations that last up to three months and are announced every month • fine tuning operations (collection of fixed term deposits, foreign exchange swaps, issuance of debt certificates): they are used to keep under control the level of interest rates in case of liquidity fluctuations by injecting money on the market for a very short period of time in order to relieve the pressure. • structural operations: they can be carried out by the Eurosystem through reverse transactions, outright transactions, and the issuance of debt certificates. These operations are executed whenever the ECB wishes to adjust the structural position of the Eurosystem vis-à-vis the financial sector (on a regular or non-regular basis), for example reducing or increasing the liquidity on the market.. Structural operations in the form of reverse transactions and the issuance of debt instruments are carried out by the Eurosystem through standard tenders. The main refinancing operations bear an interest of 0%. In 2008, the ECB introduced new nonstandard monetary policy measures to grant price stability after the crisis and to make the banking system more resilient. Such measures are: • LTROs: long term refinancing operations, loans with three year maturity. • TLTROs: targeted long-term refinancing operations, up to four years. They offer long-term funding at attractive conditions to banks in order to further ease private sector credit conditions and stimulate bank lending to the real economy. Banks can only use these funds to reinvest them in the real markets. In addition and since 2009, several programs of outright asset purchases have been implemented with the objective of sustaining growth across the euro area and in consistency with the aim of achieving inflation rates below, but close to, 2%: the APP, asset purchase program. The APP consists of the following: • corporate sector purchase programme (CSPP) • public sector purchase programme (PSPP) • asset-backed securities purchase programme (ABSPP) • third covered bond purchase programme (CBPP3) • pandemic emergency purchase programme (PEPP) These funds are allocated accordingly to the shares that the single states hold in the ECB. The last non regular monetary policy is the ELA: emergency liquidity assistance: Euro area credit institutions can receive central bank credit not only through monetary policy operations but exceptionally also through emergency liquidity assistance (ELA). ELA means the provision by a Eurosystem national central bank (NCB) of central bank money to a solvent financial institution, or group of solvent financial institutions, that is facing temporary liquidity problems, without such operation being part of the single monetary policy Responsibility for the provision of ELA lies with the NCB(s) concerned. This means that any costs of, and the risks arising from, the provision of ELA are incurred by the relevant NCB. THE PAYMENT SYSTEM: TARGET 2: TARGET2 is the real-time gross settlement (RTGS) system owned and operated by the Eurosystem. It’s the second generation of TARGET. It guarantees the highest level of security. The name stands for TransEuropean Automated Real-time Gross Settlement Express Transfer system. It is a payment system is used for the transfer of funds in the Eurozone and other also among other countries inside or even outside Europe. As the name says, the transactions made via TARGET 2 are made in real time. They are made on a gross basis, which means each payment is made on a one-to-one basis, without netting the transactions (ex. if bank A owes 1k to bank B and bank B owes 0.5k to bank A, bank A will give 1k to bank B, and bank B gives 0.5k to bank B. If the settlement was net, bank a would give 0.5 to bank B). the payment has immediate finality and can’t be amended. We shall consider the TARGET 2 as the payment system via which all the transactions between the central bank and other banks are made. TARGET2 settles payments related to monetary policy operations, interbank and customer payments, and payments relating to the operations of all large-value net settlement systems and other financial market infrastructures handling the euro (such as securities settlement systems or central counterparties). . International transfers among banks can be made via the TARGET 2 as well. raising funds via the interbank markets. The wholesale banking also include corporate and invest- ment banking. These banks are also active in retail banking. • Corporate banks are specialized in providing financial services to large national and multinational companies, or public entities such as municipalities, with specific financial needs. The services pro- vided to such corporate banks are quite tailored, in terms of provision of services or advisory, risk management, liquidity management, fixed income, debt structure, transactions on equity. • Investment banking: customers are public or private large customers. The service is specialized. Originally, it was focused on the provision of services related to the primary markets (engineering or originate new securities, distribution of new securities, underwriting (acquisition or subscription of new securities). Nowadays, investment banks are active in the provision of secondary market services (brokerage, dealing, market making, consulting), advisory and structuring of transactions ( M&A, LBO/MBO) and engineering finance products like OTC derivatives or structured finance, com- bining financial instruments. They’re also involved with the retail banking activity. • Merchant banking (private equity): banks acquire shares of companies facing some difficulties which need to be revitalized. In such case, the bank acquires capital stakes of the company, inject- ing capital and providing managerial competences, used to make strategic choices aimed to allow the revitalization of the company. After a period of time, the bank sells the shares. Today, invest- ment funds are more specialized in this than banks. • Private banking: banks specialized in the provision of financial services to private customers with a significant financial wealth. They need a specific attention to conserve and increase their wealth. Private banking provides portfolio management and different kinds of advisory (legal, real estate, insurance). TYPES OF BANKS BY GOVERNANCE MODEL • Shareholder-oriented banks, like commercial bank with joint stock company. Shareholders oriented banks are more focused on profits, from which the shareholders can derive their wealth. • Stakeholder oriented banks, formed as cooperative banks, saving banks or credit unions. For stake- holder-oriented banks, profits are the condition for the bank to survive, but they're not the main objective, because their main goal is to provide affordable access to the banking services to their shareholders. In this case, shareholders are representatives of small communities where SME and households are very active. These banks are quite widespread in Europe. During the nineteenth century, these banks represented a viable way to favour industrialisation and the development of the SME entrepreneurship. In Europe we can also distinguish in significant and non-significant banks: Significant banks are under the direct supervision of the ECB because of different criteria: if a bank has a total value of 30 billion, if it’s highly important in economic terms for a specific country, if it’s performing a high share of cross border activity, if it received public financial assistance during the crisis or afterwards, or if it’s one of the three most important banks of the country. In all these cases, the bank will be under di- rect supervisions. If the criteria aren’t met, the national entity can supervise them. There are also the globally systemic important banks: they are the banks with the following features: big size, complexity of the activity, high intermediation activity, high interconnectedness with other parts of the financial system, high cross border activity. Being included in this list means they will be required to hold more capital to face the risk they face, because their potential failure could have international detri- mental consequences. BANK BALANCE SHEET Assets: • Loans: they can grant them to different counterparties. Lending activity covers at least 50% of the activity of the banks, even though as capital markets continued to grow overtime, the importance of lending decreased, because companies can now raise capital otherwise. • Securities, held by banks for different reasons, including liquidity: they hold low risks (like bonds) and can easily be liquidated. They are also held to meet the collateral requirements set by the cen- tral banks for the provisions of refinancing transactions. Securities are also held for trading in the secondary market, from which to derive profits, or for investment reasons. Securities are low in re- tail banks. • Cash assets: including the reserve requirements and excess reserves • Other assets: premises, equipment, real estate etc. which are fundamental for banks to carry out their services. Liabilities: • Debt vs central banks • Debt vs other customers like firms, households, public administration, insurances, pension funds etc. The bank can raise funds via different types of contracts (transaction accounts, time deposits, repos: they all are short term) • Certificate of deposits, which cover the short and the medium term maturity • Bonds, which cover the long term maturity Equity capital, which is important and highly supervised (required to act as a buffer against losses): • Common and non common stocks • Reserves, • Retained earnings OFF BALANCE SHEET ACTIVITIES: The banks offer other financial services reported off balance sheet, including: • Guarantees, that the bank can issue in favour of its customers for a fee (i.e. letter of credit) • Loan commitments, which are arrangements for lending where the borrower can withdraw within the maturity of the contract, and until then, he’s committed to pay the bank for the availability. They are recorded off balance sheet because the banks don't have cash flow related to these activities until the guarantee is activated or the loan commitment is used. Once activated, they move to the BS. CHANGES IN EUROPEAN BANKS FROM 2008 TO 2018 Assets increased because banks focused more on their original activity after the crisis. The debt and equity remained stable, while cash grew, because they needed to have more liquidity. Other assets decreased. The deposits of households and companies increased thanks to the increase of level of insurance. Wholesale marketing funding decreased (specifically interbank transactions) as a consequence of the crisis of 2008 and 2011. Compared with other financial intermediaries ex money market funds, investment funds, insurance compa- nies, pension funds etc, the role of banks has decreased overtime. Banking is declining, but it’s unlikely that it will be replaced in the future. It’s true that the financial and technological innovation has grown, as well as the deregulation aimed to in- crease competition, but we can’t expect that the disintermediation of banks will be complete in the future, as the banks will always be intermediaries between sellers and borrower. The role played by banks is im- portant because in Europe we have a great amount of SME companies, and relying on capital market is too expensive for them, hence banks still represent an important fund provider, as well as an advisory provider, on issues such as risk management service or OTC derivatives services. We can also observe that banks are an important complement of financial markets. Nationwide Bank consolidation has pros and cons: Cons: • small companies could disappear • an increase in such consolidation may increase the risk taking of big banks, that could think they are too big to fail. Pros: • small local banks will actually survive, because small communities need them • increase competition among banks • higher diversification in the banks portfolios • lower possibility to fail. BANK SIZE AND ACTIVITIES: Common differences between large and small banks: • Larger banks generally lend to larger corporations, meaning their interest rate spreads and net in- terest margins have usually been narrower than those of smaller regional banks • Large banks tend to pay higher salaries and invest more in buildings and premises than small banks • Small banks usually hold fewer OBS assets and liabilities • Large banks tend to diversify their operations more and generate more noninterest income than small bank • Large banks tend to use more interbank markets and have fewer core deposits • Large banks tend to hold less equity than small banks do THE RISE OF SHADOW BANKING: it’s any form of credit intermediation involving entities partially or completely outside the traditional bank- ing system. It can generate risks and possible regulatory arbitrage. In other words, some banking activities are more and more performed by other intermediaries that are not subject to the degree of regulation and supervision of banks. Unlike traditional banks that finance themselves mainly through deposits and have access, if necessary, to central bank liquidity, the "unregulated shadow banks" collect through the market / investors, exposing themselves to a potential shortage of liquidity, with the risk having to forcefully sell the assets in the portfo- lio at reduced prices or ask for support from the sponsor entities (including banks). Different shadow banking measures: • MUNFI (monitoring universe of non-bank financial intermediation): securitization vehicle, specula- tive and non-speculative investment funds, financial companies active in the granting of credit, pension funds, insurance, brokers with lending functions (security lending), etc. they are allowed. • OFI (only other financial intermediaries) (all financial intermediaries minus pension funds and insur- ance companies) the risk is that shadow banking favour the interconnection of financial intermediaries, and their failure can harm banks. Such connection must be regulated and control. GOING INTERNATIONAL Many national banks went international after the 2000. The advantages can be: • diversification of portfolio, • economies of scale, • innovations, • funds source, • customer relationships, • regulatory avoidance The disadvantages are: • information and monitoring cost, • nationalization or expropriation, • high fixed costs. GLOBAL BANKING PERFORMANCE: The financial crisis of 2008 spread worldwide and banks saw losses that were magnified by illiquid markets: • The largest banks in the Netherlands, Switzerland, and the U.K. had net losses in 2008, • Banks in Ireland, Spain, and the U.S. were especially hard hit because they had large investments in mortgages and mortgage-backed securities. RELATIONSHIP BETWEEN INCOME STATEMENT AND BALANCE SHEET: The net income is the algebraic sum of the profitability earned on the asset side, for each component of the asset side, minus the cost of the liabilities held by the bank, minus the provisions for loan losses, plus the non interest income earned, minus the non interest expenses, minus the taxation Where: FINANCIAL STATEMENT ANALYSIS: It’s important for several counterparties, including banks, shareholders, investors, borrowers and banks supervisors. It’s based on accounting ratios, that can be analysed overtime using time series to assess the development of the performance over time, or on a cross-sectional analysis, which means comparing banks with similar characteristics. A combination is typically performed. INDICATORS FOR THE APPRECIATION OF THE PERFORMANCE: ROE: calculated as the ratio between the net income and the total equity capital of the bank. it can be broken down into two components: net income over total assets (ROA) times total assets over total equity capital (equity multiplier): banks with equal ROA but different equity multiplier, will achieve different ROE. The larger effect of the equity multiplier is achieved by banks with low amount of equity with respect to the total assets held. This implies a high degree of leverage, which can’t be left free, as banks are put under strict control, to avoid risks (credit risk, market risk, operating risk etc) NET INTEREST MARGIN: it measures the net interest income earned on the total earning assets. It measures the profitability on the credit intermediation activity performed, by collecting funds on which it pays interest, and investing them into assets generating interest income. SPREAD: it measures the difference between the average yield on earning assets and the average cost of interest-bearing liabilities. The higher the spread, the higher the margin that the bank can earn on the credit intermediation performance. Nowadays, the profitability has decreased due to low interest rates. MANAGERIAL EFFICIENCY: cost to income ratio, calculated as the ratio of the operating cost to the operating income. The higher it is, the lower the managerial efficiency of the bank. It’s between 45and 55%. CAPITAL: equity to total assets: the higher it is, the higher the capitalization and its ability to face potential losses. ASSETS QUALITY RATIOS: NPLs (non-performing loans) TO LOANS TO CUSTOMERS: it provides the degree of the quality of the portfolios of banks. The higher it is, the lower is the quality. Non-performing loans are loans granted to customers which are classified as: • Bad loans: exposures to debtors that are insolvent or in similar circumstances • Unlikely to pay loans: debtors might not pay in full unless the bank takes enforces guarantees • Overdrawn and/or past-due exposures not repaid in more than 90 days COST OF CREDIT OR COST OF RISK: the measure is calculated as the ratio of the amount of adjustments for the period in the income statement to the amount of loans to customers at period-end, thus providing an overview of the incidence of adjustments on the portfolio. The higher it is, the lower the quality. IMPACT OF MARKET NICHE AND SIZE: There’s a distinction between large and small banks, which present different balance sheets and income statements. For example, retail banks operate with small customers, so they tend to have a large percentage of deposits and loans to customers, while wholesales banks tend to have a large part of their funding coming from institutional investors or interbank market and to have large loans; they’re also active in the securities investment. Large banks tend to hold less equity than the small ones, and to put more into salaries, premises and other expenses than small banks. They also tend to diversify their operations and services more than small banks, and they also tend to generate more noninterest income. CAMELS: Regulators use CAMELS ratings to evaluate the safety and soundness of banks. • Capital adequacy: Evaluated in relation to the volume of risk assets; the bank’s growth experience, plan, and prospects; and the strength of management. • Asset quality: Evaluated by the level, distribution, and severity of adversely classified assets; the level and distribution of non-accrual and reduced-rate assets; the adequacy of the allowance for loan losses; and management’s demonstrated ability to administer and collect problem credits. • Management quality: Evaluated against virtually all factors necessary to operate the bank within accepted banking practices and in a safe/sound manner. • Earnings quality: Evaluated with respect to their ability to cover losses and provide adequate capital protection; trends; peer group comparisons; the quality and composition of net income; and the degree of reliance on interest-sensitive funds. • Liquidity: Evaluated in relation to the volatility of deposits; the frequency and level of borrowings; the use of brokered deposits; technical competence; availability of assets readily convertible into cash; and access to money markets or other sources of funds. • Sensitivity to market risk: Reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect an FI’s earnings or economic capital. • • For each component of the camel we have a different rate from 1 to 5: • Composite “1”—banks are basically sound in every respect. • Composite “2”—banks are fundamentally sound but may have modest weaknesses correctable in the normal course of business. • Composite “3”—banks exhibit financial, operational, or compliance weaknesses ranging from mod- erately severe to unsatisfactory. • Composite “4”—banks have an immoderate volume of serious financial weaknesses or a combina- tion of other conditions that are unsatisfactory. • Composite “5”—banks have an extremely high immediate or near-term probability of failure • • CHAPTER 19 • Management of risk is the core activity performed by financial intermediaries, and from the man- agement of such risk they derive their profitability (or loss). • Before analysing the different types of risks, we define what idiosyncratic and systematic risk are: • Idiosyncratic risk: it’s the risk of default due to specific causes linked with the borrowers such as poor managerial skills, moral hazard, fraud, technological failure. to reduce such risk, the inter- mediaries can diversify their investments, by granting loans to different clients and with differ- ent characteristics and maturities. • Systematic risk: it’s the risk that affects all the borrowers, hence cannot diversified away. Some causes could be wars, pandemics etc. • There are many kinds of risks: • Credit risk: it is the risk that the promised cash flows from loans and securities held by FIs may not be paid in full or at all. The default of the borrower triggers losses for the FI, which can undermine the profitability of the latter and eventually its survival. Debt issued by borrowers presents a high probability of being paid (limited upside return), but a potential high downside risk (if the borrower doesn’t pay back, the loss is great). The calculation of the probability of default is fundamental, be- cause it allows banks to decide whether to decide or not the risk of lending, and also because the interest rate charge depends on such probability. The effects of credit risks are evidenced by provi- sions and charge-offs. The causes of credit risk can be either systematic or idiosyncratic risk. Usu- ally, the high level of profitability of the bank is enough to absorb the loss, but in case this is not enough, the net worth of the bank will decrease (potentially driving to its failure). • liquidity risk: the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices, even if day-to-day withdrawals and loan demand are generally predictable. Due to loss of confidence in the bank’s ability to repay the debt, people can run to withdraw their deposits: that implies that banks will have to liquidate assets they hold, or to borrow additional funds provided by the central bank or the wholesales mar- ket. To face abnormal withdrawals, banks hold liquid assets i.e. excess reserves at the central bank, liquid securities (low risk security like treasury bonds, which can be easily liquidated. If liquidity risk happens, the cost of the funds borrowed tend to increase, because of the risk of the FI to default. Moreover, the provision of funds towards these FIs tend to decrease. To avoid bankruptcy, FIs might be forced to sell liquid assets at “fire-sale” prices, implying losses. • interest rate risk: changes in interest rate may cause changes in the prices of securities. Banks are exposed to the risk of maturity transformation, that is having assets with different maturities from the liabilities held. In particular, FI are exposed to refinancing risk, if the maturity of the assets is longer than that of the liabilities to finance such assets. the risk is that the cost of the substitution of the liabilities will increase due to an increase in interest rates. They also face reinvestment risk, when the maturity of the assets is lower than the maturity of the liabilities. The risk of the Fi is that the returns on the funds will be reinvested at lower interest rates if they fall. the FI can hedge or protect themselves against interest rate risk by matching the maturity of their assets and liabilities. • market risk is the risk incurred in trading assets and liabilities due to changes in interest rates, ex- change rates, and other asset prices. The wider the trading activity, the wider their exposure to market risk. except from illiquid assets such as loans, they also trade more liquid assets such as bonds, derivatives etc. FIs use sophisticated measures to evaluate their exposure, particularly the VAR (value at risk), which is a measure to asses market risk on a given holding period (year, month…). The value at risk is the maximum loss that the FI will experience on a given period with a given probability. • off-balance-sheet risk is the risk incurred by an FI as the result of activities related to contingent assets and liabilities. OBS activities do not appear on an FI’s current balance sheet since it does not involve holding a currency primary claim (asset) or the issuance of a current secondary claim (liabil- ity but can affect the future shape of FIs’ balance sheets only if some future event occurs. letter of credit (LOC) is a credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring, most notably default of the agent that purchases the LOC. • Foreign exchange risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies. FIs can reduce risk through domestic-foreign ac- tivity/investment diversification. Not all FIs have them, but most of them, especially large FIs. FIs can have a net long position, if they have more foreign assets than foreign liabilities. In such case FI loses when the Euro appreciates but gains when the Euro depreciates. FIs having a net short posi- tion in a foreign currency involves holding fewer foreign assets than foreign liabilities. They gain when the Euro appreciates and lose when the Euro depreciates. A FI is fully hedged if it holds an equal amount foreign currency denominated assets and liabilities. • Country risk is the risk that repayments from foreign borrowers may be interrupted because of in- terference from foreign governments. The typical case is when foreign government stops the con- version of a currency. The reason between this decision could be the shortage of reserves held by the government in foreign currencies. Other causes could be political events, civil wars, natural dis- asters… • Sovereign risk it’s the risk incurred when the government declares default on its obligations. CREDIT QUALITY IN RECENT TIMES: It’s rare for countries to generate substantial economic growth without private internal capital allocation methods. Sound banking systems are precursors to strong internal capital markets. The credit quality of many FIs’ lending and investment decisions has been called into question in the past 25 years: problems related to real estate and junk bond lending surfaced at banks, thrifts, and insurance companies in the late 1980s and early 1990s. Concerns related to the rapid increase of credit cards and auto lending occurred in the late 1990s. Commercial lending standards declined in the late 1990s, which led to increases in high-yield business loan delinquencies. Concerns shifted to technology loans in the late 1990s and early 2000s. Mortgage delinquencies, particularly with subprime mortgages, surged in 2006-08 and mortgage and credit card delinquencies continued to be a concern but have improved recently. HISTORY OF BANK REGULATION: Basel I was an accord published in 1988. It was introduced to establish a set of rules for banks active on the international market. The idea was to have minimum capital requirement against credit and market risk. This set of rules was then enlarged to all banks. It had rigid risk parameters that were not able to take into account the specific quality of the borrower or the credit included in the assets of the bank. Basel II (2004) had the aim to enlarge the perimeter of risk considered and improve the criteria to measure risk and capital allocation. It foresaw different ways in which risk could be estimated, introducing a standard methods where there are different risk parameters in function of the rating of the borrower or an internal rating based approach where for each loan the bank should be able to calculate different measures, i.e. expected loss, prob of default, loss given default, exposition at default and maturity. Basel III (2010) was created against institutions with too much leverage. There was the introduction of increase of capital requirement, prudential control by the regulator for each financial institution and market discipline which consisted in periodic information. In addition, the introduction of anticyclical buffers to be accumulated when the situation is sound and used when the situation is critical, and the introduction of limits to the leverage ratio. Today, we have three types of banks: • Standardized banks: they measure credit risk based on external credit ratings. They are the least sophisticated and least sophisticated capital requirements. They have the higher capital burdens. • Foundation Internal Rating Based: they use internal credit risk models, for which they are capable to formulate a probability of default for each loan. There’s more differentiation in capital requirement between safer and riskier credits. • Advanced IRB: similar to the previous one, but with a higher sensitivity to capital requirement in function of the risk associated do every loan. They have robust risk management systems. All risk factors are computed and calculated by the bank. All these banks there’s a reduction in the total regulatory capital requirement. INTRODUCTION OF INTERNAL RATING BASED: Every borrower has a pricing which is a function of the risk run by the bank. the bank assigns a rating to a borrower, calculated with internal analysis models. There’s adverse selection: risk requires a compensation, and higher the risk, higher the premium. The bank can’t understand if the borrower is a good or bad credit risk, hence the premium demanded will be based on the average risk. Borrowers who know that they are low risk withdraw from the market to avoid paying the high cost, leaving only the bad credit risks applying for the high interest rates loans. Banks address the adverse selection problem by screening loan applicants. This process allows banks to charge interest rates that differ across borrowers: the better someone's personal credit score, for example, the lower the interest rate on a loan. It is in the interest of the «good» borrower to get a good rating because in that way it will get quantity and pricing better than the average. PRICING: At the numerator we have: • The expected loss (Probability of default * loss given default) • The cost of funding (Kd), multiplied by the quantity required by the bank to fund the loan, which is (1-VaR). • The credit VaR multiplied by the cost of equity, in other words the cost of equity • Operational costs At the denominator we have: • The part of loan effectively paid to the bank (1 – the expected loss), OTHER TYPES OF INSOVENCY RISK: • Settlement risk: the risk that is determined in securities transactions when the counterparty has not fulfilled its obligation to deliver securities or pay the amounts after the expiry of the contract • Counterparty risk: the risk that the counterparty will not fulfil its contractual obligation at maturity • Concentration risk: this is the risk due to an excessive credit commitment towards an individual debtor or group of connected debtors • Country risk and sovereign risk CREDIT ANALYSIS: REAL ESTATE: Residential mortgage applications are usually very standardized because of the active secondary market for these claims. The two major factors in making the recipient reject the decision are the applicant's ability and willingness to repay the loan and the value of the borrower's collateral. In assessing the first requirement, standard ratio and/or credit scoring model may be used. The character of the borrower is very important: banks will analyse family status, time in job, savings history etc., to see if the borrower is mature enough to consider the debt as a moral obligation to repay even in difficulty. The second aspect is if the borrower will be able to repay the loan based on the following ratios: the gross debt service, equal to the annual mortgage plus taxes divided by the annual gross income. The maximum for a loan approval is 20/25%. Another indicator is the total debt service ratio, given by the annual total debt payments divided by the annual gross income. The max for approval is 35/40%. CREDIT ANALYSIS: Credit score may be calculated to provide a broader assessment of the various factors that underline the loan evaluation process. A credit score is a mathematical model that uses loan applicants’ characteristics to assist the lender in deciding whether to grant the loan or not. The scoring models can be developed by examining the characteristics of the good and bad loans the bank has previously made. The characteristics can be used to discriminate good and bad loans are annual income, total debt service ratio, history of the lender, age, residence, length of job, credit history. Based on such scores, the lenders give the borrower a minimum credit score, below which a loan will not be granted, an intermediate score at which ulterior research is needed, and a maximum score beyond which the loan is automatically granted. Credit scores provide objective low-cost evaluation methods, suitable for small loans. Another measure aspect of the analysis is the assessment of the value of the pledged asset and its suitability to serve as collateral: the lender must ensure that the house is free and clear of any lines and back taxes that could prevent seizure in the event of foreclosure (sales of the collateral in case of non- repayment of the loan, in exchange of the discharge of the debt) or power of sale (the process of sale of collateral to pay off the loan when the borrower fails to repay. In this case, an excess sale is returned to the mortgagor, and if the sale is not enough to repay the debt, the lender becomes an unsecured creditor of the difference). The process is defined as perfecting the interest. The value of the collateral will be given by an appraiser, most of which are independent. Sometimes they require a detailed inspection, and usually the price of houses depends on the prices of the houses in the neighbourhood. CONSUMER AND SMALL BUSINESS LENDING: Consumer loans are typically scored similarly to real estate loans. They will examine with greater emphasis on the capacity of the borrower to repay the loan, and his character. evaluation of small business loans is more difficult: many firms find themselves in financial difficulty, and some FI employ minimum time in business requirements to grant a loan or may include the time in business in a credit scoring model. The profitability of these loans is generally not large considering the extra time and effort needed to evaluate the loan. The life of most small businesses is a cash flow, and the credit evaluation process is likely to emphasize cash flow, the character of the borrower and the soundness of the business plan. MIDMARKET COMMERCIAL AND INDUSTRIAL LENDING: Midmarket loans consist of loans to big corporations. Loan maturity span from few weeks to eight years or more, and the amounts range from 100.000 to 1.000.000 dollars. in mid-market lending the valuation process will be more detailed and the lender will require both objectively and subjectively evaluate the application. Typically, these corporations don't have ready access to deep and liquid capital markets. Such loans are used to financial working capital needs, long term ones are used to finance fix asset purchases. Steps in the process may include meeting the applicants, procuring a credit history, application of the five Cs of creditors: character, capacity, collateral, conditions, capital. The statement of cash flow is a primary tool to assess the capacity of a borrower: it shows how the money in the company is allocated. The lender will grant the loan if the cash flows are sufficient to cover the loan. A wise lender will ask for a schedule of actual cash inflows and outflows, that result from producing and selling the products, including net income, depreciation, changes in inventory, payables and receivables and other types of cash flows. For example, declining operating cash flows would imply the company is borrowing more to sustain drops in profitability. Various ratios might be analysed, such as liquidity ratios, like current ratio and quick ratios (that measure the firm’s ability to pay its debt in the short run), asset management ratios (indicates how successfully a company is utilizing its assets), days in inventory ratios, sales to fix assets ratios, asset turnover, asset management ratios (high ratios might suggest problems in management), turnover ratios, total debt ratios, debt to asset ratio, times interest ratio, cash flow to debt ratio, gross margin, net profit margin, ROA, ROE, dividend pay-out etc. (these ratios measure the ability of the firm to repay the debt in the long run and to generate profitability). Such ratios will be provided automatically by a software. The lender must monitor the conditions and the credit needs of the borrower at least annually. Ratio analysis has some limits: they could not be available, there could be a lack of benchmark etc. LARGE COMMERCIAL AND INDUSTRIAL LENDING: it's a very competitive market and the bargaining power of the lender bank is very limited, because large firms have different alternatives. Even if banks can't charge high fees to these firms, the transactions are often large enough to grant profits and granting these loans can bring them more activities (forex activity, brokerage etc). Credit analysis for these borrowers are similar to the ones for midmarket commercial activities, but there are factors that complicate the situation: if the bank lends to a holding company whose assets are its investment in operating subsidiaries, the banks claim it’s subordinated to the debtor of the subsidiary; moreover, the corporate borrower is likely to be a large diversified firm that operates in many locations and industries, hence assessing the credit worthiness allocation is very difficult. For this kind of firms, there's a particular score model, called Altman X-score: LIQUIDITY RISK MANAGEMENT: Managers must deal with liquidity risk daily, although depository institutions have more liquidity risk than other fis. The main goal of liquidity management is to maintain just enough liquid assets in combination with liquidity funding sources to be able to meet expected and unexpected liquidity needs. Financial institutions don’t wish to hold excessive amounts of liquidity assets, because they earn to low rates of returns (or even negative). Banks have more liquidity risk than mutual funds, insurers and hedge funds, but several hedge funds have gone bankrupt. They pledge their security holdings for collateral on short term loans used to get liquidity. When the subprime problems reduce the behaviour of mortgage bank securities, lenders to hedge funds and dealers refuse to renew loans without better collateral. This is a problem because hedge fuds had a lot of mortgage backed securities in their portfolio and couldn’t get the liquidity needed anymore and had to reduce the positions, the performances collapsed, and they went bankrupt as the clients asked their money back. Liquidity Is a necessary condition for well-functioning markets and is a necessary component for successful hedging of risk. Since all hedging model assume adequate liquidity when liquidity dries up all models fail, and outcomes can be more extreme than anticipated. This is a lesson that investors who rely too much on mathematical based model to assess risk must learn. LIQUIDITY RISK CAUSES: • Liability side reason: when unexpected withdrawn of liability happens, because of unexpected withdrawals of deposits or anticipated policy claims that force the fi to sell assets or borrow more funds. if the FI doesn’t have liquidity enough or cannot borrow, it may have to liquidate long term investments, perhaps at prices below market value (firer sale price). If the liquidate asset must be priced at market value, then there could be balance sheet losses and equity write-downs. • Assed side reason: when there’s unexpected increase in assets, it could be like a drawdown or unanticipated loan demand, default of loans, unexpected payment etc. the FI may need to sell asset or borrow funds. LIQUIDITY RISK AND DEPOSITORY INSTITUTIONS: DIs’ balance sheets typically have Large amounts of short-term liabilities, such as demand deposits and other transaction accounts, that must be paid out immediately if demanded by depositors, but also large amounts of relatively illiquid (hard to sell) long-term assets, such as commercial loans and mortgages. Dis have large amount of transactions and deposits that can be withdrawn immediately. These accounts give depositors a put option with the exercise price equal to the amount of their deposit. Banks estimate the amount of called deposit and estimate expected growth deposits. Core deposits are low turnover accounts, that means relatively stable and placed at banks core convenient needs because the customer has some other relationship with the institution. Notice that the withdrawals are offset by inflow of new deposits. Net deposit withdrawals are called net deposit drains. Although they have a seasonal component, they are usually quite predictable, particularly if the bank has a substantial core deposit component. Depository institutions manage the drain on deposit in two ways: • Stored liquidity management, that is an adjustment to a deposit drain that occurs on the asset side of the balance sheet. In this case, FI liquidates some of its assets, utilizing stored liquidity, which are excess reserves in addition to reserve requirements set by the central bank. Liquidity can be stored in investing in cash or liquid security that could grant high rate of return. When managers utilize stored liquidity to fund deposit drains, the composition of the balance sheet changes: there are less deposit and less reserves, for example. Central banks impose to banks to have more liquidity than the FIs such as insurance. • Purchased liquidity management is an adjustment to a deposit drain that occurs on the liability side of the balance sheet: banks an obtain funds by borrowings additional cash. FIs Rely on the ability to acquire funds from brokered deposits and borrowings. They are Used primarily by the largest banks with access to the money market and other no deposit sources of fund. Purchased liquidity instruments include: o Market for purchased funds, such as fed funds market (overnight borrowing between banks to keep their reserve requirements) and repurchase (repo) agreement markets (short term loan with a security pledge for collateral). o Issue additional fixed-maturity certificates of deposits o Issue additional notes and bonds. o Purchased liquidity management allows FIs to maintain the overall size of their balance when faced with liquidity demands without disturbing the size/composition of the asset size of the balance sheet. It may be more expensive relative to stored liquidity and could add volatility of interest ex- pense. It is riskier for banks to depend too much on purchase of funds. LIQUIDITY RISK AND DEPOSITORY INSTITUTIONS Loan commitments and other credit lines can cause liquidity needs. As with liability side liquidity risk, asset side liquidity risk can be managed with stored or purchased liquidity. If stored liquidity is used to fund commitments, the composition of the asset side of the balance sheet changes, but not the size of the balance sheet. Earnings are lower but safer. If purchased liquidity is used to fund com- mitments, the composition of both the asset and liability sides of the balance sheet changes, and the size of the balance sheet increases. Volatility and riskier when purchased funds may be more expensive or not available. Unused loan commitments provide fee income to the bank. FINANCING GAP AND THE FINANCING REQUIREMENT o The first way to measure liquidity risk exposure is to determine the DI’s financing gap which is the dif- ference between a bank’s average loans and average (core) deposits of customers. The average loans can be seen as the uses, and the average deposits as the sources. If the financing gap is positive, the bank must find liquidity to fund the gap. The funding may come from purchase liquidity management (i.e., borrowing funds) or stored liquidity management (i.e., liquidating assets). Financing gap = Average loans – Average deposits. Financing gap = - Liquid Assets + Borrowed funds o The financing requirement is the financing gap plus a DI’s liquid assets. It the amount of funds that must be borrowed. Financing Requirement (or Borrowed Funds) = Financing Gap + Required Liquid As- sets. A liquid asset requirement is the obligation for the commercial bank to maintaining a pre-deter- mined percentage of total deposit in the form of liquid assets. An example is the liquidity coverage ra- tio. A widening financing gap can be an indicator of future liquidity problems since it may indicate in- creased deposit withdrawals and increasing loans due to more exercise of loan commitments. SOURCES AND USES OF LIQUIDITY The liquidity position of banks is measured by managers on a daily basis, if possible, through the net liquidity statement. A net liquidity statement lists sources and uses of liquidity, and, thus, provides a measure of a DI’s net liquidity position. This is a tool used by DI managers, serving as the second method by which to measure liquidity risk exposure. DI can obtain liquid funds in the following ways: 1. Sell its liquid assets, such as T-bills, immediately with very little price risk and low transaction costs, be- cause the market is very large and liquid for T bills 2. Borrow funds in the money/purchased funds market up to a maximum amount. Fed funds or certifi- cate of deposits 3. Use any excess cash reserves over and above the amount held to meet regulatory imposed reserve re- quirements NET LIQUIDITY POSITION In this case the FI can handle unanticipated liquidity needs of 7.5 billion. FI does not want to hold exces- sive amount of liquid asset because the low return is a drag on profitability and on competitiveness. PEER GROUP RATIO COMPARISON The third way to measure a DI’s liquidity exposure is to use peer group ratio comparisons Peer group ratio comparisons are when certain key ratios and balance sheet features of a DI are co pared against those same key ratios and balance sheet features of another D Key liquidity ratios are for example loans to deposits, loans to core deposits, core deposits to total lia- bilities and equity. Ratios are often compared to those of banks of a similar size and in the same geographic location. Usually a ratio like loans to deposit should below 100% and if a deposit institu- tion has also the loans to core deposit (deposit of customers) is below 100%, it is very virtuous. Usually the ratio loans to core deposit is higher than the ratio of loans to deposit because banks usually are taking deposits as well from the market. It means that they can get deposit from other banks and if there is a problem, banks are the first one stopping giving money to other banks. DI should be very careful in the quality of the deposit. The higher the percentage of core deposits, the better it is for the bank. LIQUIDITY INDEX It is the ratio of the fire sale price required to liquidate assets in emergency situations divided by the fair market value of the assets liquidated. The lower the index, the greater the liquidity risk. A final way to measure liquidity risk is to use a liquidity index, which measures the potential losses a bank could suffer from a sudden (or fire-sale) disposal of assets Example: Liquidity risk of 96.76%, pretty high The liquidity index is a better measure for the cost of the liquidity risk NEW LIQUIDITY RISK MEASURES IMPLEMENTED BY THE BANK OF INTERNATIONAL SETTLEMENT (BIS) Two regulatory standards were developed by BIS for liquidity risk supervisions. Standards are intended to “enhance tools, metrics, and benchmarks that supervisors can use to assess the resilience of banks’ liquidity cushion and constrain any weakening in liquidity maturity profiles, diversity of funding sources, and stress testing practices” The liquidity coverage ratio is the ratio of stock of highly quality assets that can be liquidated at short notice over the total net cash outflows over the next 30 days. This ratio must be =/> than 100%. The net stable funding ratio must be reported quarterly beginning 2018. This ratio is the available amount of stable funding, over the required amount of stable funding over the year. This ratio must be >100% and it is meant to limit the reliance on the short-term funding for longer term assets the Treasury 10-year fixed rate; if market interest rates rise the price of the bond will fall, resulting in a loss when the bank sells the security on the market (or simply updates the carrying value in the balance sheet). Insolvency occurs if the value of liabilities exceeds the value of assets resulting in negative equity. Insol- vency occurs for credit risk, liquidity risk and interest rate risk. Maintain sufficient equity capital and man- aging the risk FI faces provides the surest protection against insolvency. Monetary policies strongly affect interest rates REPRICING AND DURATION GAP The asset transformation function performed by financial institutions (FIs) often exposes them to interest rate risk. FIs use two main methods to measure interest rate exposure: • The repricing model (a.k.a. the funding gap model) examines the impact of interest rate changes on net interest income (NII). • The duration model examines the impact of interest rate changes on the overall market value of an FI and thus on net worth. All depository institutions are required to measure and report interest rate risk. There are two main techniques for measuring risk management of interest that have found application in the operating practices of the banks: 1. The first, referred to as the repricing gap analysis, addresses the problem of exposure to interest rate risk by analyzing the differences in the time of revision of interest rates of assets and liabilities in the financial statements and assesses their effects on the variability of short-term profit (perspective of current earnings). The focus is on the variability of net interest income in a short period of time hori- zon, usually the current year and the next. 2. The second, called duration gap analysis, instead analyzing the differences in the timing of the cash flows generated by the assets and liabilities in the financial statements in order to quantify the effects of changes in interest rates on the economic value of equity (value perspective statement). REPRICING MODEL It attempts to measure how a FI’s interest income will change relative to interest rate expense over a given time period if interest rate changes. The time period, called maturity buckets typically include 1 day, 3 months, 6 months, one year, 5 years and also greater. The model classifies assets and liabilities as fixed rate or rate sensitive, based on whether the earnings or costs will change on these accounts, during the planning period, if interest rates change. • Rate sensitive accounts are those where the cash inflows of an asset or outflows on a liability, will change at some point whiten the planning period, if interest rate change. • Accounts are classified as fixed rate, if the cash inflows on an assets or outflow on a liability will not change within the planning period even if interest rate changes. One can then compare sensitivities of the 2 sides of the balance sheet and estimate how net interest in- come is likely to change if rates change. The basic model of the gap management generally classifies assets and liabilities with respect to a time horizon of one year. For example, all of the assets or liabilities that ma- ture or undergo a revision of the contractual interest rate within one year are classified as sensitive, whereas all the items that expire or are a repricing in subsequent periods are classified as insensitive. The regrouping of items according to the criterion of sensitivity to changes in interest rates allowing you to identify some synthetic indicators of risk exposure of the bank. The gap in each bucket (or bin) is measured as the difference between the rate-sensitive assets (RSAs) and the rate-sensitive liabilities (RSLs). Rate sensitivity is the time to repricing of an asset or liability The repricing model measure the difference (gap) in sensitivity of interest income and interest expense in a given maturity bucket. • A negative gap (where RSA < RSL) exposes the FI to refinancing risk, which is the risk that the cost of rolling over or re-borrowing funds will rise about the returns being earned on asset investments • A positive gap (where RSA > RSL) exposes the FI to reinvestment risk, which is the risk that the re- turns on funds to be reinvested will fall below the cost of the funds Rate sensitivity measures the time of repricing of an asset or a liability. The cumulative gap (CGAP) is the sum of the individual maturity bucket gaps. The cumulative gap effect is the relation between changes in interest rates and changes in net interest income. We have different buck- ets and for each bucket we have a gap and the sum of these gap, gives us the cumulative gap. From the magnitude and the sign of the gap we know what the impact of an interest rate movement will be. If R is equal to the general level of interest rates, then we can predict the variation in net interest income (delta) resulting for a given variation of general level of interest rate to delta R, as follows: For example, for the 1 month we will take all the assets of 1 months, all liabilities an we will see which are the rate sensitive assets and liabilities. Take the difference and multiply it by the variation for the rate on 1 month. The change in NII over a given time period is a function of the size and of the sign of the gap, and the size and sign of the interest rate change. A negative repricing gap means that the FI is exposed to refi- nancing risk, so the institution will be hurt if interest rates increase because funding costs will increase more than assets returns, therefore reducing the net interest rate margin. A positive repricing gap implies the FI faces reinvestment risk, so the risk that rate fall and funds will have to be reinvested at lower rates, will more liabilities will retain and keep the same interest rate cost. The dollar gap for each maturity bucket is measured as the dollar quantity of rate sensitive assets minus the dollar quantity of rate sensitive liabilities. The cumulative gap is calculated by adding the gaps for subse- quent time periods. For a positive cumulative gap rising interest rates of the maturity period, will normally increase profitability and fallen interest rate will decrease profitability. In other words, interest rates and profitability move in the same direction if cumulative gap is positive. For a negative cumulative gap, rising rates will decrease profitability and falling interest rates will increase profitability. Interest rates and profitability move in opposite direction if the cumulative gap is negative. These effects are called cumulative gap effect We have 4 hypotheses of changes in interest rate. • In the first one an increase in interest rate, equal on different buckets. As the change in rate is the same for each bucket, the marginal impact the end is equal to zero. • The second we have a decrease in interest rate. The cumulated impact is again 0 • The third has different delta in interest rate. Delta interest rate is higher on the long-term bucket, this impact times the quantity, compensating the negative marginal gap of the previous bucket, is higher. The cumulative impact on NII is positive, because the delta of rate is higher on longer term bucket and this has been capable to more than compensate the negative impact on the NII on the changes in rates on the previous bucket, because they were lower. • The fourth has a negative accumulated gap. Decrease of interest rate flat over the different buck- ets. Since at the end the cumulative gap is negative, the impact on the NII is positive. For a negative cumulative gap, falling rates will increase the profitability because they move oil the opposite direc- tion if the gap is negative THE REPRICING MODEL: REMARKS Unequal changes of rate in different buckets could gave different impact. The spread between the interest income earned on the rate sensitive assets and the interest cost on the rate sensitive liabilities will cognate as rates change. The change in income is called the spread effect. • If the spread effect is positive, when intreats rates rise or fall, the spread of interest income earned on the rate sensitive asset less the interest cost on the rate sensitive liability tend to increase, con- tributing to higher NII. • If the spread effect is negative, when interest rate rise or fall, the spread of interest income earned on sensitive assets, less the interest cost on rate sensitive liabilities, tend to fall, contributing to lower NII It is superfluous to note that in the case of zero gap (if more than real school) the value of the sensitive ac- tivities is exactly equal to that of the sensitive liabilities. Positive or negative changes in market interest rates do not cause changes in net interest. A bank could actively manage its position as the gap by mismatching strategies designed to anticipate changes in interest rates in the different phases of the economic cycle. During the recovery phase the bank could implement strategies to anticipate the increase in interest rates by increasing the share of sensitive activities, giving up fixed-rate loans and at the same time increasing the collection of funds at a fixed rate. However, the gap management strategies chosen depend not only on the change in the expected direction of interest rates, but also by the degree of uncertainty in the future evolution of interest rates. The bank, when it is not in a position to act quickly on the composition of assets and liabilities in the financial state- ments in order to achieve the desired coverage to interest rate risk, may resort to hedging strategy using derivative instruments. PROBLEMS WITH THE REPRICING MODEL (RM) 1. The repricing model (RPM) measures only short term profit changes, not shareholder wealth changes. As such it suffers from the same problems as the goal of maximizing profits. In particular the RPM ignores cash flows changes that occur outside the maturity bucket and ignores the change in current value of future cash flows as interest rates change. The maturity buckets are arbitrarily chosen and can be difficult to manage. It is 2. to have a positive 3-month RS gap, a negative 6-month RS gap and a positive 1 year RS gap. Manag- ing this requires detailed forecasts of interest rate changes over the various arbitrarily chosen time periods. 3. All assets and liabilities that mature within the maturity bucket are considered equally rate sensi- tive. This is defacto not true if a spread effect exists 4. The RM ignores runoffs, that are receipts of cash that occur during the maturity bucket period 5. The RM ignores prepayments. Prepayment patterns are affected by changing interest rates and are difficult to predict. Prepayments increase with declining rates so assets that were considered fixed rate may become rate sensitive by being prepaid within the maturity bucket. 6. The RM ignores cash flows generated from off balance sheet activities. These cash flows are also often sensitive to the level of interest rates, so the RPM underestimates the interest rate sensitivity of the institution.