risk management in financial institutions

Risk Management in Financial Institutions 1

Risk Management in Financial Institutions

• Managing Credit Risks

• Managing Interest Rate Risks

• Income Gap Analysis

• Duration Gap Analysis

• Hedging with Financial Derivatives

• Forward

• Futures

• Options

• Swaps


Managing Credit Risk

Solving Asymmetric Information Problems

1.Screening

2.Monitoring and Enforcement of Restrictive Covenants

3.Establish Long-Term Customer Relationships

4.Loan Commitment Arrangements

5.Collateral and Compensating Balances

6.Credit Rationing


Benefit of Long-Term Relationship

• Reducing the cost of information collection -- check firms’ past activities

• Reducing monitoring costs• Reducing borrowers’ moral hazard when they

want to preserve a long-term relationship


Loan Commitments

• Banks’ commitment to provide a firm with loans up to a given amount at

fixed interest rate or at a rate that is tied to some market interest rates

• Promote long-term relationship

Collateral requirement / Secured Loans• Collateral is a property promised to the lender as compensation if the

borrow defaults

• Reducing adverse selection


Compensating Balances

• A firm receiving a loan must keep a required minimum amount of funds

in a check account at the bank

• serving as collateral

• monitoring

Credit Rationing• lenders refuse to make loans even though borrows are willing to pay the

stated interest rate or even a higher rate

• two types: (1) no loan; (2) loan with restricted size

• Deal with Adverse Selection and Moral Hazard


Managing Interest Rate Risks

Income Gap Analysis

Duration Gap Analysis


Managing Interest-Rate RiskFirst National Bank

Assets Liabilities ---------------------------------------------------------------------------------------------------------------------Reserves and cash items $ 5 m | Checkable deposits $ 15 m |Securities | Money market deposit accounts $ 5 m less than 1 year $ 5 m | 1 to 2 year $ 5 m | Savings deposits $ 15 m greater than 2 year $ 10 m | | CDs: Variable-rate $10 mResidential mortgages | less than 1 year $ 15 m Variable rate $ 10 m | 1 to 2 year $ 5 m Fixed rate (30 year) $ 10 m | greater than 2 year $ 5 m

|

Commercial Loans | Fed funds $ 5 m

less than 1 year $ 15 m |

1 to 2 year $ 10 m | Borrowings: less than 1 year $10 m

greater than 2 year $ 25 m | 1 to 2 year $ 5 m

| greater than 2 year $ 5 m

Physical capital $ 5 m |

| Bank capital $ 5 m


Income Gap Analysis

• identifying rate sensitive assets and liabilities

• finding GAP = RSA – RSL

• Income change = GAP *

• About reinvestment risk

i


Income Gap AnalysisRate-Sensitive Assets = $5m + $ 10m + $15m + 20% x $20m

RSA = $32 m

Rate-Sensitive Liabs = $5m + $25m + $5m+ $10m + 10% x $15m

+ 20%x$15m

RSL = $49.5 m

i 5% ΔAsset Income =

ΔLiability Costs =

ΔIncome =

If RSL > RSA, i , Income GAP = RSA - RSL

=

ΔIncome = GAP x Δi

=


Duration Gap Analysis

• Examining the sensitivity of market value of financial

institutions’ net worth to changes in interest rate

• %P = -DUR* i/(1+i)

• if we know the duration of assets and liabilities, we could

calculate the change in net worth due to interest rate change

• duration is additive – using market values as weights

• DURgap = DURa - [L/A x DURl]

• About interest rate risk


Example 3 (page 630)

• Interest rate rise from 10% to 15%

• Total asset value $100 million

• Total liability value $95 million

• Durations for each asset and liability as illustrated in Table 1


Duration Gap Analysis%ΔP - DUR x Δi/(1+i)

i 5%, from 10% to 15%

ΔAsset Value = %ΔP x Assets

ΔLiability Value = %ΔP x Liabilities

ΔNW =

DURgap = DURa - [L/A x DURl]

%ΔNW = - DURgap x Δi/(1+i)

ΔNW =


Managing Interest-Rate Risk

Problems with GAP Analysis

1. Assumes slope of yield curve unchanged and flat

2. Manager estimates % of fixed rate assets and liabilities that are rate sensitive


Managing Interest-Rate Risk

Strategies for Managing Interest-Rate RiskTo completely immunize net worth from interest-

rate risk, set DURgap = 0


Hedging with Financial Derivatives

• Forwards

• Futures

• Options

• Swaps


Suppose in Nov 2002, Fleet holds $10 million face value of 10%-coupon rate Treasury bonds selling at par that mature in Nov 2013.


How will Fleet hedge its interest rate risks?


Forward Contracts

Agreements by two parties to engage in a financial transaction at a future point of time


Interest-Rate Forward MarketsLong contract = buy securities at future date

Locks in future interest rate

Short contract = sell securities at future date

Locks in future price, so reduces price risk from change in interest rates

Pros

1. Flexible

Cons

1. Lack of liquidity: hard to find counter party

2. Subject to default risk: Requires info to screen good from bad risk


Fleet could short (sell), at today’s price and interest rate, $10 million of the Treasury bond to another party one year later (in Nov 2003) – forward contract

The other party could take a short position on US Treasury bonds


Financial Futures MarketsTraded on Exchanges: Global competition Regulated by CFTC

Financial Futures Contract

1. Specifies delivery of type of security at future date

2. Arbitrage At expiration date, price of contract = price of the underlying asset delivered

3. i , long contract has loss, short contract has profit

Differences in Futures from Forwards

1. Futures more liquid: standardized, can be traded again, delivery of range of securities

2. Delivery of range prevents corner

3. Mark to market: avoids default risk

4. Don't have to deliver: net long and short


Alternatively, Fleet could take a short position of $10 million 10% 2003 Treasury bond futures contract


Options

Options Contract

Right to buy (call option) or sell (put option) instrument at exercise (strike) price up until expiration date (American) or on expiration date (European)

Hedge Fleet’s Risks with Put Options


Payoffs of Call option versus Put Options

risk management in financial institutions

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