Chapter 9
1.
Derivatives are financial instruments whose value
depends on (i.e., is derived from) the value of some other underlying financial
instrument or asset (these include stocks or bonds as well as other assets).
2.
A simple example is an interest rate futures contract,
which is an agreement between two investors that obligates one to make a payment
to the other depending on the movement in interest rates over the next year.
3.
Such an arrangement is very different from the purchase
of a bond for two reasons:
a.
Derivatives provide an easy way for investors to profit
from price declines, as opposed to the purchase of a bond, which is a bet that
its price will increase.
b.
In a derivatives transaction, one person’s loss is
always the other person’s gain.
4.
Derivatives can be used to speculate on future price
movements, but because they allow investors to manage and reduce risk, they are
indispensable to a modern economy.
5.
The purpose of derivatives is to transfer risk from one
person or firm to another, providing a kind of insurance.
6.
Derivatives increase the risk-carrying capacity of the
economy as a whole, improving the allocation of resources and increasing the
level of output.
7.
Derivatives also can be used to conceal the true nature
of certain financial transactions because they can be used to unbundle virtually
any group of future payments and risks.
8.
Derivatives may be divided into three major categories:
forwards and futures, options, and swaps.
1.
Of all derivative financial instruments, forwards and
futures are the simplest to understand and the easiest to use.
2.
A forward or forward contract is an agreement between a
buyer and seller to exchange a commodity or financial instrument for a specified
amount of cash on a prearranged future date.
a.
They are very difficult to resell to someone else
because they are customized.
3.
A future or futures contract is a forward contract that
has been standardize and sold through an organized exchange.
a.
A futures contract specifies that the seller (the short
position) will deliver some quantity of a commodity or financial instrument to
the buyer (the long position) for a predetermined price.
b.
No payments are made initially when the contract is
agreed to.
c.
The seller benefits from price declines in the price of
the underlying asset, while the buyer gains from increases.
4.
Before anyone will buy or sell futures contracts there
must be assurance that the buyer and seller will meet their obligations; this is
done through a clearing corporation.
1.
Futures contracts allow risk to be transferred between
buyer and seller.
2.
This transfer can be accomplished through hedging or
speculation.
3.
A futures contract fixes the price for both the seller
and the buyer and so both can use it as a hedge against unfavorable price
movements.
4.
Speculators are trying to make a profit by betting on
price movements.
5.
Futures contracts are popular tools for speculation
because they are cheap.
6.
An investor needs only a relatively small amount of
funds (the margin, which can be as low as 10 percent) to purchase a futures
contract that is worth a great deal.
7.
For example, if the margin is $2,700 to purchase a
$100,000 U.S. Treasury bond, then the investment of $2,700 gives the investor
the same returns as the purchase of the bond; it is as if the buyer borrowed the
balance ($97,300) at a zero rate of interest.
8.
Speculators can use futures to obtain very large amounts
of leverage at a very low cost.
1.
On the settlement or delivery date the price of the
futures contract must equal the price of the underlying asset, otherwise there
would be a risk-free profit.
2.
Arbitragers simultaneously buy and sell financial
instruments in order to benefit from temporary price differences.
3.
As a result of arbitrage, two financial instruments with
the same risk and promised future payments will sell for the same price.
4.
If that were not true, arbitragers would buy and sell,
changing demand and forcing the prices to equality.
5.
So long as there are arbitragers, on the day when a
futures contract is settled, the price of a bond futures contract will be the
same as the market price of the bond.
6.
Before the settlement date, the futures price moves in
lock step with the market price of the bond.
1.
Like futures, options are agreements between two
parties, a seller (option writer) and a buyer (option holder).
2.
Option writers incur obligations, while option holders
obtain rights.
3.
There are two basic options, calls (the right to buy)
and puts (the right to sell).
4.
A call option has a predetermined price (the strike
price) and a specific date.
a.
The writer of the call option must sell the shares if
and when the holder chooses to use the call option, but the holder is not
obligated to buy the shares.
b.
The holder will buy (exercise the option) only if doing
so is beneficial.
c.
The holder could also sell the option to someone else at
a profit.
Whenever the price of the
stock is above the strike price of the call option, the option is “in the
money”. (If the prices are equal it is “at the money” and if the price is less
than the stock price it is “out of the money”.)
5.
A put option gives the holder the right but not the
obligation to sell the underlying asset at a predetermined price on or before a
fixed date.
a.
The writer of the option is obliged to buy the shares if
the holder chooses to exercise the option.
b.
Puts are “in the money” when the option’s strike price
is above the market price of the stock; they are “out of the money” when the
strike price is below the market price, and “at the money” when the two prices
are equal.
6.
Many options are standardized and traded on exchanges
just like futures contracts, and the mechanics of trading are the same.
7.
There is a clearing corporation, but only writers of
options are required to post margin.
8.
There are two types of options:
American options can be exercised on any date from the time they are
written until the day they expire; European options can only be used on the day
they expire.
9.
The vast majority of options traded in the
1.
Options transfer risk from the buyer to the seller so
they can be used for both hedging and speculation.
2.
When used for hedging, a call option ensures that the
cost of buying the asset will not rise and a put option ensures that the price
at which the asset can be sold will not go down.
a.
Car insurance is like an American call option, sold by
the insurance company to the car’s owner.
3.
How options are used for speculation: if you believed
that interest rates were going to fall, you could bet on this by buying a bond
(expensive), buying a futures contract (cheap but risky), or by buying a call
option on a U.S. Treasury bond. If you are right, its value will increase; if
you are wrong all you lose is the price paid for the call option.
4.
Purchasing a put option allows an investor to speculate
on a decrease in the price of an asset.
5.
Sellers of options are speculators or are insured
against any loss that may arise because they own the underlying asset (market
makers).
6.
Options are versatile and can be bought and sold in many
combinations.
7.
Options can be used to construct synthetic instruments
that mimic the payoffs of virtually any other financial instrument.
8.
Options allow investors to bet that prices will be
volatile.
2.
An option price is the sum of two parts:
the value of the option if it is exercised (the intrinsic value) and the
fee paid for the option’s potential benefits (the time value of the option).
3.
As the volatility of the stock price rises, the time
value of the option rises with it.
4.
In general, calculating the price of an option and how
it might change means developing some rules for figuring out its intrinsic value
and the time value of the option.
5.
Since the buyer is not obligated to exercise it, the
intrinsic value of the option depends only on what the holder receives if it is
exercised.
6.
The intrinsic value is the difference between the price
of the underlying asset and the strike price of the option, or the size of the
payment, and it must be greater than or equal to zero.
7.
At expiration, the value of an option equals its
intrinsic value, but prior to expiration there is always the chance that the
price will move.
8.
The longer the time to expiration, the bigger the likely
payoff when the option does expire and thus the more valuable it is.
9.
The likelihood that an option will pay off depends on
the volatility of the price of the underlying asset; the time value of the
option increases with that volatility.
1.
At a given price of the underlying asset and time to
expiration, the higher the strike price of a call option, the lower its
intrinsic value and the less expensive the option.
2.
At a given price of the underlying asset and time to
expiration, the higher the strike price of a put option, the higher the
intrinsic value and the more expensive the option.
3.
The closer the strike price is to the current price of
the underlying asset, the larger the option’s time value.
4.
Deep in-the-money options have lower time value. Because
such an option is very likely to expire "in the money," buying one is like
buying the underlying asset itself.
5.
The longer the time to expiration at a given strike
price, the higher the option price.
IV.
Swaps
American option
arbitrage
call option
derivatives
European option
forward contract
futures contract
margin
put option
strike price
time value (of an option)
Chapter 10
1.
The exchange rate is the price paid in one currency to
obtain an amount of another currency.
2.
Exchange rates change every day.
3.
A decline in the value of one currency relative to
another is called a depreciation (of the currency whose value is falling); an
increase is called an appreciation (of the currency whose value is rising).
4.
When comparing two currencies, if one currency goes up
in value relative to the other, the value of the other currency must go down.
5.
Exchange rates can be quoted in units of either
currency; for example, as the number of dollars needed to buy one euro or as the
number of euro needed to buy one dollar.
6.
The two prices are equivalent (one is simply the
reciprocal of the other) and there is no rule for determining which way a
particular exchange rate should be quoted.
7.
In practice, most rates tend to be quoted in the way
that yields a number larger than one.
1.
The real exchange rate is the rate at which one can
exchange the goods and services from one country for the goods and services from
another country.
2.
The real exchange rate is the cost of a basket of goods
in one country relative to the cost of the same basket of goods in another
country.
3.
To compute the real exchange rate we take the dollar
price of a good in the
4.
Whenever the real exchange rate as calculated above is
greater than one (the real exchange rate has no units), foreign products will
seem cheap.
5.
The real exchange rate is more important than the
nominal exchange rate because it measures the relative price of goods and
services across countries, telling us where things are cheap and where they are
expensive.
6.
The real exchange rate is the guiding force behind
international transactions.
7.
The competitiveness of
1.
The daily volume of foreign exchange transactions is
enormous.
2.
Because of its liquidity, the U.S. dollar is one side of
roughly 90 percent of the currency transactions that occur.
3.
The most important center for such transactions is
1.
The law of one price is the starting point for
understanding how long-run exchange rates are determined.
2.
The law is based on arbitrage, the idea that identical
products should sell for the same price.
3.
If the same good did not sell for the same price in two
places there would be an opportunity for someone to profit by purchasing the
item where it is cheap and reselling it where its price is higher, but by doing
that, the relative supplies would change and move the two prices to equality.
4.
The law of one price fails almost all the time; the same
commodity or service sells for vastly different prices in different countries as
a result of transportation costs, taxes, differences in technical
specifications, differences in tastes, and that fact that some things simply
cannot be traded (like haircuts).
1.
Even with its obvious flaws the law of one price is
extremely useful in explaining the behavior of exchange rates over long periods,
like ten or twenty years.
2.
Extending the law from a single commodity to a basket of
goods and services results in the theory of purchasing power parity (PPP), which
means that one unit of
3.
PPP implies that the real exchange rate is always equal
to one.
4.
PPP implies that when prices change in one country but
not in another the exchange rate should change as well.
5.
Changes in exchange rates are therefore tied to
differences in inflation from one country to another; the currency of a country
with high inflation will depreciate.
6.
Over weeks, months, and even years, nominal exchange
rates can deviate substantially from the levels implied by purchasing power
parity. Such short-term movements
have other explanations
7.
A current market rate that deviates from purchasing
power parity results in a currency being considered undervalued or overvalued.
1.
Someone who wants to exchange dollars for another
currency supplies them to the foreign exchange markets.
2.
The two reasons for such an exchange would be to
purchase foreign goods and services or to invest in foreign assets.
3.
The more valuable the dollar, the cheaper foreign goods,
services, and assets are, and the higher will be the supply of dollars in the
foreign exchange market.
1.
Foreigners who want to purchase American-made goods,
assets, or services need dollars to do so and so represent the demand for
dollars.
2.
The cheaper the dollar the more attractive such goods,
assets, or services are and the higher the demand for dollars with which to buy
them.
1.
Equilibrium in the market for dollars occurs where the
supply and demand are equal.
2.
Fluctuations in the values of currencies are the result
of shifts in supply or demand.
1.
Shifts in supply:
the supply of dollars will increase (i.e., the supply curve shifts right)
the more Americans want to import goods and services from abroad or the higher
their preference for foreign stocks and bonds.
These can result from:
a.
an increase in Americans’ preference for foreign goods.
b.
an increase in the real interest rate on foreign bonds.
c.
an increase in American wealth.
d.
a decrease in the riskiness of foreign investments
relative to
e.
an expected depreciation of the dollar.
2.
Demand: the
demand will increase (i.e., the demand curve shifts right) if there is an
increased desire by foreigners to buy American-made goods and services or to
invest in
a.
an increase in foreigners’ preference for American
goods.
b.
an increase in the real interest rate on
c.
an increase in foreign wealth.
d.
a decrease in the riskiness of
e.
an expected appreciation of the dollar.
3.
Explaining exchange rate movements:
the supply and demand model helps to explain short-run movements in
currency values.
4.
Shifts in supply and demand can both occur at the same
time, and the movement of the exchange rate will depend on which effect is
stronger (i.e., which shift is bigger).
appreciation
Big Mac index
British pound
demand for dollars
depreciation
euro
law of one price
nominal exchange rate
purchasing power parity (PPP)
real exchange rate
supply of dollars
yen
yuan
Chapter 11 (We did not go through this chapter, but I want you to read it. I think that you know everything from experience, but reviewing your experience is still helpful. The exception is asymmetric information. Read through that carefully.)
I.
The Role of Financial Intermediaries
1.
As a general rule, indirect finance through financial
intermediaries is much more important than direct finance through the stock and
bond markets.
2.
In virtually every country for which we have
comprehensive data, credit extended by financial intermediaries is larger as a
percentage of GDP than stocks and bonds combined.
3.
Around the world, firms and individuals draw their
financing primarily from banks and other financial intermediaries.
4.
The reason for this is information; financial
intermediaries exist so that individual lenders don’t have to worry about
getting answers to all of the important questions concerning a loan and a
borrower.
5.
Lending and borrowing involve transactions costs and
information costs, and financial intermediaries exist to reduce these costs.
6.
Financial intermediaries perform five functions:
they pool the resources of small savers; they provide safekeeping and
accounting services as well as access to the payments system; they supply
liquidity; they provide ways to diversify small investments; and they collect
and process information in ways that reduce information costs.
7.
The first four of these functions have to do with the
reduction of transactions costs.
8.
International banks handle transactions that cross
borders, which may mean converting currencies.
1.
The most straightforward economic function of a
financial intermediary is to pool the resources of many small savers.
2.
To succeed in this endeavor the intermediary must
attract substantial numbers of savers.
3.
This is the essence of indirect finance, and it means
convincing potential depositors of the soundness of the institution.
4.
Banks rely on their reputations and government
guarantees like deposit insurance to make sure customers feel that their funds
will be safe.
1.
Goldsmiths were the original bankers; people asked the
goldsmiths to store gold in their vaults in return for a receipt to prove it was
there.
2.
People soon realized that trading the receipts was
easier than trading the gold itself.
3.
Eventually the goldsmiths noticed that there was gold
left in the vaults at the end of the day, so it could safely be lent to others.
4.
Today, banks are the places where we put things for
safekeeping; we deposit our paychecks and entrust our savings to a bank or other
financial institution because we believe it will keep our resources safe until
we need them.
5.
Banks also provide other services, like ATMs,
checkbooks, and monthly statements, giving people access to the payments system.
6.
Financial intermediaries also reduce the cost of
transactions and so promote specialization and trade, helping the economy to
function more efficiently.
7.
The bookkeeping and accounting services that financial
intermediaries provide help us to manage our finances.
8.
Providing safekeeping and accounting services as well as
access to the payments system forces financial intermediaries to write legal
contracts, which are standardized.
9.
Much of what financial intermediaries do takes advantage
of economies of scale, which means that the average cost of producing a good or
service falls as the quantity produced increases.
10.
Information is also subject to economies of scale.
1.
One function that is related to access to the payments
system is the provision of liquidity.
2.
Liquidity is a measure of the ease and cost with which
an asset can be turned into a means of payment.
3.
Financial intermediaries offer us the ability to
transform assets into money at relatively low cost (ATMs are an example).
4.
Financial intermediaries provide liquidity in a way that
is both efficient and beneficial to all of us.
5.
By collecting funds from a large number of small
investors, a bank can reduce the cost of their combined investment, offering the
individual investor both liquidity and high rates of return.
6.
Financial intermediaries offer depositors something they
can’t get from the financial markets on their own.
7.
Financial intermediaries offer both individuals and
businesses lines of credit, which are pre-approved loans that can be drawn on
whenever a customer needs funds.
1.
Financial intermediaries enable us to diversify our
investments and reduce risk.
2.
Banks mitigate risk by taking deposits from a large
number of individuals and make thousands of loans with them, thus giving each
depositor a small stake in each of the loans.
3.
Providing a low-cost way for individuals to diversify
their investments is a function all financial intermediaries perform.
1.
One of the biggest problems individual savers face is
figuring out which potential borrowers are trustworthy and which are not.
2.
There is an information asymmetry because the borrower
knows whether or not he or she is trustworthy, but the lender faces substantial
costs to obtain the same information.
3.
Financial intermediaries reduce the problems created by
information asymmetries by collecting and processing standardized information.
1.
Information plays a central role in the structure of
financial markets and financial institutions.
2.
Markets require sophisticated information in order to
work well, and when the cost of obtaining information is too high, markets cease
to function.
3.
Asymmetric information is a serious hindrance to the
operation of financial markets, and solving this problem is one key to making
our financial system work as well as it does.
4.
Asymmetric information poses two obstacles to the smooth
flow of funds from savers to investors:
adverse selection, which involves being able to distinguish good credit
risks from bad before the transaction; and moral hazard, which arises after the
transaction and involves finding out whether borrowers will use the proceeds of
a loan as they claim they will.
1.
Used Cars and the Market for Lemons: In a market in
which there are good cars (“peaches”) and bad cars (“lemons”) for sale, buyers
are willing to pay only the average value of all the cars in the market.
This is less than the sellers of the “peaches” want, so those cars
disappear from the markets and only the “lemons” are left.
a.
To solve this problem caused by asymmetric information,
companies like Consumer Reports provide information about the reliability and
safety of different models, and car dealers will certify the used cars they
sell.
2.
Adverse Selection in Financial Markets:
Information asymmetries can drive good stocks and bonds out of the
financial market.
1.
Disclosure of Information:
Generating more information is one obvious way to solve the problem
created by asymmetric information.
a.
This can be done through government required disclosure
and the private collection and production of information.
b.
However, the accounting scandals of 2001 and 2002 showed
that in spite of such requirements companies can distort the profits and debt
levels published in their financial statements.
c.
Reports from private sources such as Moody’s and Value
Line are often expensive.
2.
Collateral and Net Worth:
Lenders can be compensated even if borrowers default, and if the loan is
so insured then the borrower is not a bad credit risk.
a.
The importance of net worth in reducing adverse
selection is the reason owners of new businesses have so much difficulty
borrowing money.
1.
An insurance policy changes the behavior of the person
who is insured.
2.
Moral hazard plagues both equity and bond financing.
3.
Moral Hazard in Equity Financing:
people who invest in a company by buying its stock do not know that the
funds will be invested in their best interests.
a.
The principal-agent problem, which occurs when owners
and managers are separate people with different interests, may result in the
funds not being used in the best interests of the owners.
4.
Solving the Moral Hazard Problem in Equity Financing:
The problem can be solved by if owners can fire managers and by requiring
managers to own a significant stake in their own firm.
5.
Moral Hazard in Debt Finance:
Debt goes a long way toward eliminating the moral hazard problem, but it
doesn’t finish the job; debt contracts allow owners to keep all the profits in
excess of the loan payments and so encourage risk taking.
6.
Solving the Moral Hazard Problem in Debt Finance:
To some degree, a good legal contract with restrictive covenants can
solve the moral hazard problem in debt finance.
III. Financial Intermediaries
and Information Costs
1.
Borrowers must fill out a loan application that includes
information that can be provided to a company that collects and analyzes credit
information and which provides a summary in the form of a credit score.
2.
Your personal credit score tells a lender how likely you
are to repay a loan; the higher your score the more likely you are to get a
loan.
3.
Banks collect additional information about borrowers
because they can observe the pattern of deposits and withdrawals, as well as the
use of credit and debit cards.
4.
Financial intermediaries’ superior ability to screen and
certify borrowers extends beyond loan making to the issuance of bonds and
equity.
5.
Underwriting represents screening and certifying because
investors feel that if a well-known investment bank is willing to sell a bond or
stock then it must be a high-quality investment.
1.
Intermediaries monitor both the firms that issue bonds
and those that issue stocks.
2.
Banks will monitor borrowers to make sure that the funds
are being used as intended.
3.
Financial intermediaries that hold shares in individual
firms monitor their activities, in some cases placing a representative on a
company’s board of directors.
4.
In the case of new firms, a financial intermediary
called a venture capital firm does the monitoring.
5.
The threat of a takeover helps to persuade managers to
act in the interest of the stock and bondholders.
6.
In the end, the vast majority of firm finance comes from
internal sources, suggesting that information problems are problems too big for
even financial intermediaries to solve.
Terms Introduced in Chapter 11
adverse selection
asymmetric
information
collateral
deflation
free rider
moral hazard
net worth
unsecured loan
Chapter 12
I.
The Balance Sheet of Commercial Banks
A.
Assets:
Uses of Funds
1.
The asset side of a bank’s balance sheet includes cash,
securities, loans, and all other assets (which includes mostly buildings and
equipment).
2.
Cash Items:
The three types of cash assets are reserves (which includes cash in the bank’s
vault as well as its deposits at the Federal Reserve); cash items in the process
of collections (uncollected funds the bank expects to receive); and the balances
of accounts that banks hold at other banks (correspondent banking).
3.
Securities:
The second largest component of bank assets; includes U.S. Treasury securities
and state and local government bonds.
Securities are sometimes called secondary reserves because they are
highly liquid and can be sold quickly if the bank needs cash.
4.
Loans: The
primary asset of modern commercial banks; includes business loans (commercial
and industrial loans), real estate loans, consumer loans, interbank loans, and
loans for the purchase of other securities.
The primary difference among the various types of depository institutions
is in the composition of their loan portfolios.
B.
Liabilities: Sources of Funds
1.
Banks need funds to finance their operations; they get
them from savers and from borrowing in the financial markets.
2.
There are two types of deposit accounts, transactions
(checkable deposits) and nontransactions.
3.
Checkable deposits: A
typical bank will offer 6 or more types of checking accounts.
In recent decades these deposits have declined because the accounts pay
low interest rates.
4.
Nontransactions Deposits:
These include savings and time deposits and account for nearly two-thirds
of all commercial bank liabilities.
Certificates of deposit can be small ($100,000 or less) or large (more than
$100,000), and the large ones can be bought and sold in financial markets.
5.
Borrowings:
The second most important source of bank funds; banks borrow from the Federal
Reserve or from other banks in the federal funds market.
Banks can also borrow by using a repurchase agreement or repo, which is a
short-term collateralized loan in which a security is exchanged for cash, with
the agreement that the parties will reverse the transaction on a specific future
date (might be as soon as the next day).
C.
Bank Capital
and Profitability
1.
The net worth of banks is called bank capital; it is the
owners’ stake in the bank.
2.
Capital is the cushion that banks have against a sudden
drop in the value of their assets or an unexpected withdrawal of liabilities.
3.
An important component of bank capital is loan loss
reserves, an amount the bank sets aside to cover potential losses from defaulted
loans.
4.
There are several basic measures of bank profitability:
return on assets (a bank’s net profit after taxes divided by its total
assets) and return on equity (a bank’s net profit after taxes divided by its
capital).
5.
Net interest income is another measure of profitability;
it is the difference between the interest the bank pays and what it receives.
6.
Net interest income can also be expressed as a
percentage of total assets; that is called net interest margin, or the bank’s
interest rate spread.
7.
Net interest margin is an indicator of future
profitability as well as current profitability.
D.
Off-Balance-Sheet Activities
1.
Banks engage in these activities in order to generate
fee income; these activities include providing trusted customers with lines of
credit.
2.
Letters of credit are another important
off-balance-sheet activity; they guarantee that a customer will be able to make
a promised payment. In so doing, the
bank, in exchange for a fee, substitutes its own guarantee for that of the
customer and enables a transaction to go forward.
3.
A standby letter of credit is a form of insurance; the
bank promises that it will repay the lender should the borrower default.
4.
Off-balance-sheet activities create risk for financial
institutions and so have come under increasing scrutiny in recent years.
1.
Liquidity risk is the risk of a sudden demand for funds
and it can come from both sides of a bank’s balance sheet (deposit withdrawal on
one side and the funds needed for its off-balance sheet activities on the
liabilities side).
2.
If a bank cannot meet customers’ requests for immediate
funds it runs the risk of failure; even with a positive net worth, illiquidity
can drive it out of business.
3.
One way to manage liquidity risk is to hold sufficient
excess reserves (beyond the required reserves mandated by the Federal Reserve)
to accommodate customers’ withdrawals.
However, this is expensive (interest is foregone).
4.
Two other ways to manage liquidity risk are adjusting
assets or adjusting liabilities.
5.
A bank can adjust its assets by selling a portion of its
securities portfolio, or by selling some of its loans, or by refusing to renew a
customer loan that has come due.
6.
Banks do not like to meet their deposit outflows by
contracting the asset side of the balance sheet because doing so shrinks the
size of the bank.
7.
Banks can use liability management to obtain additional
funds by borrowing (from the Federal Reserve or from another bank) or by
attracting additional deposits (by issuing large CDs).
1.
This is the risk that loans will not be repaid and it
can be managed through diversification and credit-risk analysis.
2.
Diversification can be difficult for banks, especially
those that focus on certain kinds of lending.
3.
Credit-risk analysis produces information that is very
similar to the bond-rating systems and is done using a combination of
statistical models and information specific to the loan applicant.
4.
Lending is plagued by adverse selection and moral
hazard, and financial institutions use a variety of methods to mitigate these
problems.
1.
The two sides of a bank’s balance sheet often do not
match up because liabilities tend to be short-term while assets tend to be
long-term; this creates interest-rate risk.
2.
In order to manage interest-rate risk, the bank must
determine how sensitive its balance sheet is to a change in interest rates; gap
analysis highlights the gap or difference between the yield on interest
sensitive assets and the yield on interest-sensitive liabilities.
3.
Multiplying the gap by the projected change in the
interest rate yields the change in the bank’s profit.
4.
Gap analysis can be further refined to take account of
differences in the maturity of assets and liabilities.
5.
Banks can manage interest-rate risk by matching the
interest-rate sensitivity of assets with the interest-rate sensitivity of
liabilities, but this approach increases credit risk.
6.
Bankers can use derivatives, like interest-rate swaps,
to manage interest-rate risk.
1.
Banks today hire traders to actively buy and sell
securities, loans, and derivatives using a portion of the bank’s capital in the
hope of making additional profits.
2.
However, trading such instruments is risky (the price
may go down instead of up); this is called trading risk or market risk.
3.
Managing trading risk is a major concern for today’s
banks, and bank risk managers place limits on the amount of risk any individual
trader is allowed to assume.
4.
Banks also need to hold more capital if there is more
risk in their portfolio.
1.
Banks that operate internationally will face foreign
exchange risk (the risk from unfavorable moves in the exchange rate) and
sovereign risk (the risk from a government prohibiting the repayment of loans).
2.
Banks manage their foreign exchange risk by attracting
deposits denominated in the same currency as the loans and by using foreign
exchange futures and swaps to hedge the risk.
3.
Banks manage sovereign risk by diversification, by
refusing to do business in a particular country or set of countries, and by
using derivatives to hedge the risk.
4.
Banks also face operational risk, the risk that their
computer system may fail or that their buildings may burn down.
5.
To manage operational risk the bank must make sure that
its computer systems and buildings are sufficiently robust to withstand
potential disasters.
Terms Introduced in Chapter 12
bank capital
credit risk
depository institution
discount loans
excess reserves
federal funds market
interest rate spread
interest-rate risk
liquidity risk
loan loss reserves
net interest margin
nondepository institution
off-balance-sheet activities
repurchase agreement (repo)
required reserves
reserves
return on assets (ROA)
return on equity (ROE)
trading risk
vault cash