FIN320 Final Study Guide ：Help me complete the study guide with each questions

Risk Management and Deriva1ves

Professor Lamont Black FIN320 Week 6

Risk Management

What is your view on “risk management”?

2

Managing Bank Risk

•  Banks are in the business of risk management

•  Liquidity risk •  Credit risk •  Interest rate risk

3

Managing Liquidity Risk •  Liquidity risk: the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost

•  How to manage? –  Asset side: liquid assets

•  Federal fund loans •  Reverse repurchase agreement

–  Liability side: borrow to cover withdrawals •  Deposits vs. wholesale funding

•  This is a “Treasury management” func1on

4

Managing Credit Risk •  Credit risk: the risk that borrowers might default on their loans –  (related to informa1on asymmetries)

•  How to manage? –  Diversifica1on (type of loan, industry, region) –  Credit-risk analysis (predict probability of default) –  Collateral (secured loan, pledged assets) –  Credit ra1oning (restric1ng credit at any rate) –  Monitoring and restric1ve convenants (financial ra1os or restrict ac1vity)

–  Long-term business rela1onships (rela1onship banking)

5

Managing Interest Rate Risk •  Interest rate risk: the effect of a change in market interest rates on a bank’s profit or capital

•  Gap analysis (GAP): difference in amount of variable-rate assets and liabili1es – Sensi1vity of bank profitability to market rates

•  Dura9on analysis (DURATION GAP): difference in average dura1on of bank’s assets and liabili1es – Sensi1vity of bank capital to market rates

6

Hypothe1cal Balance Sheet

7

Blank Blank Polktown Na9onal Bank Blank Assets Blank Liabili9es plus bank capital Blank

Fixed-rate assets $350 million Fixed-rate liabili1es $250 million

Reserves Blank Checkable deposits Blank Long-term marketable securi1es

Blank Savings deposits Blank

Long-term loans Blank Long-term CDs Blank Variable-rate assets $150 million Variable-rate liabili1es $210 million Adjustable-rate loans Blank Short-term CDs Blank

Short-term securi1es Blank Federal funds Blank Blank Blank Bank capital $ 40 million Total assets $500 million Total liabili9es plus bank capital $500 million

Hypothe1cal Balance Sheet

•  GAP = -$60M •  How will a rise in rates affect profitability?

•  Is DURATION GAP nega1ve or posi1ve? 8

Blank Blank Polktown Na9onal Bank Blank Assets Blank Liabili9es plus bank capital Blank

Fixed-rate assets $350 million Fixed-rate liabili1es $250 million

Reserves Blank Checkable deposits Blank Long-term marketable securi1es

Blank Savings deposits Blank

Long-term loans Blank Long-term CDs Blank Variable-rate assets $150 million Variable-rate liabili1es $210 million Adjustable-rate loans Blank Short-term CDs Blank

Short-term securi1es Blank Federal funds Blank

Blank Blank Bank capital $ 40 million Total assets $500 million Total liabili9es plus bank capital $500 million

Gap and Dura1on Analysis

•  Think about why rising rates can decrease bank capital

•  Relate this to the S in CAMELS

9

Most banks have … so an increase in market interest rates will …

and a decrease in market interest rates will …

1. a nega1ve gap, decrease bank profits, increase bank profits and

2. a posi1ve dura1on gap, decrease bank capital, increase bank capital.

Deriva1ves and Deriva1ve Markets

•  “Trading”

•  Specula1on vs. hedging

•  Risk sharing benefits…

•  “Deriva1ves are weapons of mass destruc1on” (Buffeh 2002)

•  The Chicago trading community –  Speculate: to place bets on movements in asset prices

10

Deriva1ves, Hedging, and Specula1ng

•  Financial deriva9ve: securi1es whose value depends on an underlying financial asset –  Stock op1ons –  S&P futures –  Treasury futures

•  Hedge: To take ac1on that reduces risk –  Long vs. short –  Classic example: the farmer –  Also: the porjolio manager

•  Commodity futures and the history of Chicago 11

Forward Contract •  Forward contract: an agreement to buy or sell an asset at

an agreed-upon price at a future 1me

•  “Forwards” give the firm/investor an opportunity to hedge the risk on transac1ons that depend on future prices

•  Spot price: the current price to buy or sell

•  SeQlement date: the date of future delivery specified in a forward contract

•  Counterparty risk: the risk that counterparty will default

12

Futures Contracts •  Futures contract: a standardized contract to buy or sell a

specified amount on a specific future date

•  Chicago Board of Trade (owned by CME Group)

•  Futures contracts typically specify a quan1ty of the underlying asset to be delivered but do not fix the price on the sehlement date –  The price changes con1nually as contracts are bought and sold on the exchange

•  The exchange serves as a clearinghouse and is the counterparty in the transac1on

13

Hedging with Commodity Futures •  Short posi9on: the right and obliga1on of the seller to sell or deliver the underlying asset on the specified future date

•  Long posi9on: the right and obliga1on of the buyer to receive or buy the underlying asset on the specified future date

•  Buyer’s P&L = Spot price at sehlement – futures price at purchase

•  Seller’s P&L = Futures price at purchase – spot price at sehlement

14

Hedging Wheat Prices

15

Blank Wheat farmer Manager at General Mills

Concerned about … lower wheat prices higher wheat prices

Hedges risk by … selling futures contracts buying futures contracts

Posi9on in futures market is … short long

Posi9on in spot market is … long short

If wheat prices rise … loses in the futures market but gains in the spot market

gains in the futures market but loses in the spot market

If wheat prices fall … gains in the futures market but loses in the spot market

loses in the futures market but gains in the spot market

Hedging Interest Rates

16

Blank Investor who owns Treasury notes

Pension fund manager who intends to buy Treasury notes in six months

Concerned about … lower Treasury note prices (higher interest rates)

higher Treasury note prices (lower interest rates)

Hedges risk by … selling futures contracts buying futures contracts Posi9on in futures market … short long

Posi9on in spot market … long short

If Treasury note prices rise (interest rates fall) …

loses in the futures market but gains in the spot market

gains in the futures market but loses in the spot market

If Treasury note prices fall (interest rates rise) …

gains in the futures market but loses in the spot market

loses in the futures market but gains in the spot market

Reading Treasury Futures Prices

•  Quota1ons are for a standardized contract of $100,000 in face value of notes paying a 6% coupon.

•  The first column states the contract month for delivery. The next five columns show price informa1on.

•  Futures prices are lower for December 2016 than for September 2016, meaning that futures market investors expect the Treasury interest rates to rise.

17

Month Last Chg Open High Low Volume Openlnt

Sep 2016 133.250 0.266 133.031 133.922 132.984 1,306,807 2,753,697

Dec 2016 132.406 0.359 132.156 132.406 132.156 58 174

Leverage and Risks

•  Margin requirement: minimum deposit required to buy or sell

•  Marking-to-market: daily sehlement transferred into or out of margin account based on price of contract

•  New futures: Bitcoin futures (CBOE and CME)

18

Two Sides of Futures Market

19

Buyer of a futures contract Seller of a futures contract

Has the obliga1on to buy the underlying asset on the sehlement date.

Has the obliga1on to deliver the underlying asset on the sehlement date.

Can use buying a futures contract to hedge if the buyer is someone who intends to buy the underlying asset and wants to insure against the price rising.

Can use selling a futures contract to hedge if the seller is the owner of the underlying asset and wants to insure against the price falling.

Can use buying a futures contract to speculate if the buyer believes that the price of the underlying asset will rise.

Can use selling a futures contract to speculate if the seller believes that the price of the underlying asset will fall.

Op1ons

•  Call op1on: the right to buy the underlying asset at a set price (strike price)

•  Put op1on: the right to sell the underlying asset at a set price (strike price)

•  Op1on premium is the cost of the op1on

•  The VIX

20

Op1on Payoffs

21

Op1on Payoffs

22

Blank Call op9on Put op9on Buyer Has the right to purchase the

underlying op1on at the strike price on or before the expira1on date

Has the right to sell the underlying asset at the strike price on or before the expira1on date

Seller Has the obliga1on to sell the underlying asset at the strike price if the buyer exercises the op1on

Has the obliga1on to buy the underlying asset at the strike price if the buyer exercises the op1on

Who would buy it? An investor who wants to bet that the price of the underlying asset will increase

An investor who wants to bet that the price of the underlying asset will decrease

Who would sell it?

An investor who wants to bet that the price of the underlying asset will not increase

An investor who wants to bet that the price of the underlying asset will not decrease

Swaps

•  Interest Rate Swaps – Managing interest rate risk – Conver1ng floa1ng rate into fixed rate

•  Credit Default Swaps – Major role in the financial crisis – Transferring default risk to a third party

23