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					Off - Balance Sheet Activities




                        Drake Fin 286
                        DRAKE UNIVERSITY
                                           Drake
 Off balance sheet activities              Drake University

                                            Fin 286



Contingent assets or liabilities that impact the
future of the Financial Institutions balance
sheet and solvency.
Claim moves to the asset or liability side of
the balance sheet respectively IF a given
event occurs.
Often reported in footnotes or not reported
buried elsewhere in financial statements
                                        Drake
         OBS examples                    Drake University

                                          Fin 286



Derivatives -- Value or worth is based upon
the value of an underlying asset
Basic Examples -- Futures, Options, and
Swaps
Other examples -- standby letters of credit
and other performance guarantees
                                           Drake
   Large Derivative Losses                 Drake University

                                            Fin 286



1994 Procter and Gamble sue bankers trust
over derivative losses and receive $200
million.
1995 Barings announces losses of $1.38
Billion related to derivatives trading of Nick
Lesson
NatWest Bank finds losses of 77 Million
pounds caused by mispricing of derivatives
                                     Drake
 Large Derivative Losses             Drake University

                                         Fin 286


1997 Damian Cope, Midland Bank, is
banned by federal reserve over
falsification of records relating to
derivative losses
1997 Chase Manhattan lost $200 million
on trading in emerging market debt
derivative instruments
LTCM exposure of $1.25 trillion in
derivatives rescued by consortium of
bankers
                                          Drake
     Use of option pricing                Drake University

                                           Fin 286



One way to measure the risk of a contingent
liability is to use option pricing.
Delta of an option = the sensitivity of an
options value to a unit change in the price of
the underlying asset.
                                         Drake
             Options                      Drake University

                                           Fin 286



Call Option – the right to buy an asset at
some point in the future for a designated
price.
Put Option – the right to sell an asset at some
point in the future at a given price
                                                Drake
        Call Option Profit                      Drake University

                                                 Fin 286


Call option – as the price of the asset increases the
option is more profitable.
Once the price is above the exercise price (strike
price) the option will be exercised
If the price of the underlying asset is below the
exercise price it won’t be exercised – you only loose
the cost of the option.
The Profit earned is equal to the gain or loss on the
option minus the initial cost.
                                          Drake
                                          Drake University

         Profit Diagram Call Option        Fin 286

Profit


S-X-C

                          S       Spot
 Cost                             Price
                X
                                                Drake
     Call Option Intrinsic Value                Drake University

                                                 Fin 286

The intrinsic value of a call option is equal
to the current value of the underlying
asset minus the exercise price if exercised
or 0 if not exercised.
In other words, it is the payoff to the
investor at that point in time (ignoring the
initial cost)
        the intrinsic value is equal to
                 max(0, S-X)
                                          Drake
                                          Drake University

         Payoff Diagram Call Option        Fin 286



Payoff


  S-X

                X     S
                 X                Spot
                                  Price
                                          Drake
       Put Option Profits                 Drake University

                                           Fin 286



Put option – as the price of the asset
decreases the option is more profitable.
Once the price is below the exercise price
(strike price) the option will be exercised
If the price of the underlying asset is above
the exercise price it won’t be exercised – you
only loose the cost of the option.
                                            Drake
         Profit Diagram Put Option          Drake University

                                             Fin 286

Profit

X-S-C


             S                 Spot Price

Cost
                           X
                                               Drake
     Put Option Intrinsic Value                Drake University

                                                Fin 286

The intrinsic value of a put option is equal
to exercise price minus the current value
of the underlying asset if exercised or 0 if
not exercised.
In other words, it is the payoff to the
investor at that point in time (ignoring the
initial cost)
        the intrinsic value is equal to
                 max(X-S, 0)
                                          Drake
         Payoff Diagram Put Option        Drake University

                                           Fin 286

Profit

  X-S



             S      X        Spot Price

Cost
                                        Drake
       Pricing an Option                Drake University

                                         Fin 286



Black Scholes Option Pricing Model
Based on a European Option with no
dividends
Assumes that the prices in the equation are
lognormal.
                                        Drake
     Inputs you will need               Drake University

                                         Fin 286



S = Current value of underlying asset
X = Exercise price
t = life until expiration of option
r = riskless rate
s2 = variance
                                      Drake
 PV and FV in continuous time         Drake University

                                       Fin 286



  e = 2.71828 y = lnx x = ey
FV = PV (1+k)n for yearly compounding
FV = PV(1+k/m)nm for m compounding periods
  per year
As m increases this becomes
FV = PVern =PVert    let t =n
rearranging for PV    PV = FVe-rt
                                                   Drake
              Black Scholes                        Drake University

                                                    Fin 286


Value of Call Option = SN(d1)-Xe-rtN(d2)
    S = Current value of underlying asset
    X = Exercise price
    t = life until expiration of option
    r = riskless rate
    s2 = variance
    N(d ) = the cumulative normal distribution
(the probability that a variable with a standard
normal distribution will be less than d)
                                              Drake
     Black Scholes (Intuition)                Drake University

                                                  Fin 286


 Value of Call Option
                             -rt
SN(d1)         -        Xe            N(d2)
The expected       PV of cost    Risk Neutral
Value of S         of investment Probability of
if S > X                          S>X
                                            Drake
          Black Scholes                     Drake University

                                             Fin 286

 Value of Call Option = SN(d1)-Xe-rtN(d2)
Where:
                                          Drake
       Delta of an option                 Drake University

                                           Fin 286



Intuitively a higher stock price should lead to
a higher call price. The relationship between
the call price and the stock price is expressed
by a single variable, delta.
The delta is the change in the call price for a
very small change it the price of the
underlying asset.
                                                Drake
                 Delta                          Drake University

                                                 Fin 286


Delta can be found from the call price equation as:




Using delta hedging for a short position in a
European call option would require keeping a long
position of N(d1) shares at any given time. (and vice
versa).
                                         Drake
       Delta explanation                 Drake University

                                          Fin 286



Delta will be between 0 and 1.

A 1 cent change in the price of the underlying
asset leads to a change of delta cents in the
price of the option.
                                         Drake
         Applying Delta                    Drake University

                                            Fin 286



The value of the contingent value is simply:
      delta x Face value of the option

            If Delta = .25 and
  The value of the option = $100 million
                   then
   Contingent asset value = $25 million
                                         Drake
          OBS Options                    Drake University

                                          Fin 286



Loan commitments and credit lines basically
represent an option to borrow (essentially a
call option)
When the buyer of a guaranty defaults, the
buyer is exercising a default option.
                                        Drake
        Adjusting Delta                  Drake University

                                          Fin 286



Delta is at best an approximation for the
nonlinear relationship between the price of
the option and the underlying security.
Delta changes as the value of the underlying
security changes. This change is measure by
the gamma of the option. Gamma can be
used to adjust the delta to better approximate
the change in the option price.
                                        Drake
     Gamma of an Option                  Drake University

                                          Fin 286



The change in delta for a small change in the
stock price is called the options gamma:



Call gamma =
                                       Drake
      Futures and Swaps                Drake University

                                        Fin 286



Some OBS activities are not as easily
approximated by option pricing.
Futures, Forward arrangements and swaps
are generally priced by looking at the
equivalent value of the underlying asset.
For example: A swap can be valued as the
combination of two bonds with cash flows
identical to each side of the swap.
                                            Drake
Impact on the balance sheet                  Drake University

                                              Fin 286



Start with a traditional simple balance sheet
Since assets = liabilities + equity it is easy to
find the value of equity
         Equity = Assets - Liabilities

  Example: Asset = 150 Liabilities = 125
        Equity = 150 - 125 = 25
                                             Drake
   Simple Balance Sheet                      Drake University

                                              Fin 286



     Assets                   Liabilities
Market Value of Assets   Market Value of Liabilities
                  150                           125
                            Equity (net worth) 25
            Total 150                     Total 150
                                           Drake
Contingent Assets and Liabilities          Drake University

                                            Fin 286



 Assume that the firm has contingent assets of
 50 and contingent liabilities of 60.
 the equity position of the firm will be reduced
 by 10 to 15.
                                               Drake
     Simple Balance Sheet                      Drake University

                                                Fin 286



      Assets                     Liabilities
 Market Value of Assets    Market Value of Liabilities
                   150                             125
                              Equity (net worth) 15
MV of Contingent Assets   MV of contingent Liabilities
                     50                             60
              Total 200                      Total 200
                                           Drake
   Reporting OBS Activities                Drake University

                                            Fin 286



In 1983 the Fed Res started requiring banks
to file a schedule L as part of their quarterly
call report.
Schedule L requires institutions to report the
notional size and distribution of their OBS
activities.
                                         Drake
    Growth in OBS activity               Drake University

                                          Fin 286



Total OBS commitments and contingencies for
US commercial banks had a notional value of
$10,200 billion in 1992 by 2000 this value had
increased 376% to $46,529 billion!
For comparison in 1992 the notional value of
on balance sheet items was $3,476.4 billion
which grew to $6,238 billion by 2000 or
growth of 79%
Growth in OBS activities   Drake
                           Drake University

     Billions of $          Fin 286
                             Drake
  Common OBS Securities      Drake University

                              Fin 286



Loan commitments
Standby letters of Credit
Futures Forwards and Swaps
When Issues Securities
Loans Sold
                                        Drake
      Loan commitments                  Drake University

                                         Fin 286



79% of all commercial and industrial lending
takes place via commitment contracts
Loan Commitment -- contractual commitment
by the FI to loan up to a maximum amount to
a firm over a defined period of time at a set
interest rate.
                                       Drake
   Loan commitment Fees                 Drake University

                                         Fin 286


The FI charges a front end fee based upon
the maximum value of the loan (maybe 1/8th
of a percent) and a back end fee at the end
of the commitment on any unused balance.
(1/4 of a %).
Back end fee encourages firms to draw down
its balance -- why is this good for the FI?
The firm can borrow up to the maximum
amount at any point in time over the life of
the commitment
                                                  Drake
  Loan Commitment Risks                           Drake University

                                                   Fin 286


Interest rate risk -- The FI precommits to an
interest rate (either fixed or variable), the level of
rates may change over the commitment period.
If rates increase, cost of funds may not be
covered and firms more likely to borrow.
Variable rates do not eliminate the risk due to
basis risk
  basis risk = the risk that the spread between
  lending and borrowing rates may change.
                                           Drake
   Loan Commitment Risks                    Drake University

                                             Fin 286



Takedown Risk -- the FI must be able to
supply the maximum amount at any given
time during the commitment period,
therefore there is a liquidity risk for the firm.
Feb 2002 - Tyco International was shut out of
commercial paper market and it drew down
$14.4 billion loan commitments made by
major banks.
                                         Drake
   Loan Commitment Risk                   Drake University

                                           Fin 286



Credit Risk -- the firm may default on the loan
after it takes advantage of the commitment.
The credit worthiness of the borrower may
change during the commitment period
without compensation for the lender.
                                       Drake
   Loan Commitment Risk                Drake University

                                        Fin 286



Aggregate Funding Risks -- Many borrower
view loan commitment as insurance against
credit crunches. If a credit crunch occurs
(restrictive monetary policy or a simple
downturn in economy) the amount being
drawn down in aggregate will increase
through out the banking system
                                           Drake
        Letters of Credit                  Drake University

                                            Fin 286



 Commercial Letters of credit - A formal
guaranty that payment will be made for
goods purchased even if the buyer defaults
The idea is to underwrite the common trade
of the firm providing a safety net for the seller
and facilitating the sale of the goods.
Used both domestically and internationally
                                         Drake
        Letter of Credit                 Drake University

                                          Fin 286



Standby letters of credit -- Letters of credit
contingent upon a given event that is less
predicable than standard letters of credit
cover.
Examples may be guaranteeing completion of
a real estate development in a given period of
time or backing commercial paper to increase
credit quality. Many small borrowers are shut
out of commercial paper without these.
                                         Drake
Future and Forward contracts             Drake University

                                          Fin 286



Both Futures and Forward contracts are
contracts entered into by two parties who
agree to buy and sell a given commodity or
asset (for example a T- Bill) at a specified
point of time in the future at a set price.
                                           Drake
     Futures vs. Forwards                  Drake University

                                            Fin 286


Future contracts are traded on an exchange,
Forward contracts are privately negotiated
over-the-counter arrangements between two
parties.
Both set a price to be paid in the future for a
specified contract.
Forward Contracts are subject to counter
party default risk, The futures exchange
attempts to limit or eliminate the amount of
counter party default risk.
                                                        Drake
          Forwards vs. Futures                          Drake University

                                                         Fin 286

 Forward Contracts                Futures Contracts
Private contract between         Traded on an exchange
      two parties

  Not Standardized                      Standardized

Usually a single delivery date     Range of delivery dates

Settled at the end of contract          Settled daily

   Delivery or final cash        Contract is usually closed
settlement usually takes place     out prior to maturity
                                        Drake
      Options and Swaps                 Drake University

                                         Fin 286



Sold in the over the counter market both can
be used to manage interest rate risk.
   Forward Purchases of                 Drake
                                        Drake University

   When Issued Securities                Fin 286



A commitment to purchase a security prior to
its actual issue date. Examples include the
commitment to buy new treasury bills made
in the week prior to their issue.
                                           Drake
           Loans Sold                      Drake University

                                            Fin 286



Loans sold provide a means of reducing risk
for the FI.
If the loan is sold with no recourse the FI
does not have an OBS contingency for the FI.
The loan can have a ability to be put back to
the asset or seller in the event of a decline in
credit quality creating an OBS risk.
                                      Drake
       Settlement Risk                Drake University

                                       Fin 286



Intraday credit risk associated with the
Clearing House Interbank Transfer Payments
System (CHIPS).
Payment messages sent on CHIPS are
provisional messages that become final and
settled at the end of the day usually via
reserve accounts at the Fed.
                                         Drake
        Settlement Risk                   Drake University

                                           Fin 286



When it receives a commitment the FI may
loan out the funds prior to the end of the day
on the assumption that the actual transfer of
funds will occur accepting a settlement risk.
Since the Balance sheet is at best closed a the
end of the day, this represents an intraday
risk, this has been addressed somewhat by
new technology.
                                          Drake
          Affiliate Risk                   Drake University

                                            Fin 286



Risk of one holding company affiliate failing
and impacting the other affiliate of the
holding company.
Since the two affiliates are operationally they
are the same entity even thought they are
separate entities under the holding company
structure
                                         Drake
          OBS Benefits                    Drake University

                                           Fin 286



We have concentrated on the risk associated
with OBS activities, however many of the
positions are designed to reduce other risks in
the FI.
                                        Drake
     Credit Default Swap                Drake University

                                         Fin 286



The buyer makes an upfront payment or a
stream of payments to the seller of the swap.
The seller agrees to make a stream of
payments in the event of default by a third
party on a reference obligation.
                                                     Drake
Basic Credit Default Swap                            Drake University

                                                      Fin 286



                   Upfront Payment or
        Default    Stream of payments      Default
         Swap                               Swap
        Buyer           Payment in the      Seller
                        Event of Default
Return on
             Original
Reference
             Payment
Obligation

      Reference
      Obligation
       Issuer
                                          Drake
Credit Default Swap as an Option          Drake University

                                           Fin 286



The Credit Default Swap is basically a put
option on the reference obligation.
The default buyer owns the put option which
effectively allows the reference obligation to
be sold to the CDS seller in event of default.
                                          Drake
             Intuition                    Drake University

                                           Fin 286



Assume that the reference obligation is a
bond
If the price of a bond decreases due to a
change in credit quality, the value of the put
option increases. This implies that the value
of the CDS increases.
The CDS buyer could sell the obligation at a
premium compared to what was paid
originally.
                                         Drake
  What Constitutes Default               Drake University

                                          Fin 286



The CDS parties can agree to any or all of the
events below
  Bankruptcy
  Failure to Pay
  Obligation Acceleration
  Obligation Default
  Repudiation or deferral
  Restructuring
                                         Drake
What Does not Constitute Default         Drake University

                                          Fin 286



Downgrade by rating agency
Non Material events (error by employee
causing a missed payment etc.)
                                            Drake
    Hedge against Default                   Drake University

                                             Fin 286



In the event of a default the swap buyer is
hedged against the risk of default.
The CDS is effectively an insurance policy
against default.
The risk of default is transferred to the seller
of the CDS.
                                        Drake
Hedge against credit deterioration?     Drake University

                                         Fin 286



Since rating agency changes do not constitute
default how are credit changes hedged
If the CDS is marketed to market then the
change in value serves as a hedge against
changes in credit quality
                                       Drake
          An Example                   Drake University

                                        Fin 286


Assume that the CDS buyer owns an 7%
coupon bond and the return on a similar
maturity treasury is 5%.
Assume that both bonds have a current value
of $1 Million (equal to their par value)
Assume the buyer pays 2% per year for the
duration of the swap and receives $1 Million
in the even of default.
The combination of the CDS and 8% bond
have effectively the same payoff as the
treasury
                                                Drake
 Credit Default Swap                            Drake University

                                                 Fin 286




                  2% per year
    Default                           Default
     Swap                              Swap
    Buyer         $1 Million in the    Seller
                  Event of Default
7% per   $1 Million
  year

   Reference
   Obligation
    Issuer
                                         Drake
        Risks in the CDS                  Drake University

                                           Fin 286


The CDS seller may default
We assumed that the spread between the two
bonds stays constant over time and that the
duration and convexity of the bonds stays the
same. (unlikely especially for a bond closeto
default)
We have ignored accrued interest
There could be a liquidity premium for the
risky bond causing it to sell for less than its
true value.
                                           Drake
     Other CDS variations                  Drake University

                                               Fin 286



Binary or Digital Default Swap – Payoff is a
single lump sum often based upon recovery
rates.
Basket CDS - the reference obligation is a
basket of obligations
  N to default – default exists when the Nth
  obligatin defaults
  First to default
Cancelable DS –either the buyer (call) or
seller (put) has the right to cancel the default
                                         Drake
  CDS Variations continued               Drake University

                                          Fin 286



Contingent CDS – triggered if both the default
and a second event occur
Leveraged CDS – Payoff is a multiple of the
loss amount often the standard CDS amount
plus a % of the notional value
Tranched Portfolio Swaps – A variation of
CDOs
                                            Drake
         Benefits of CDS                     Drake University

                                              Fin 286



The risk is transferred to a financial institution
that often has better ability to hedge the risk
than the swap buyer.
Allows lenders to hedge the risk of high risk
loans without jeopardizing the lender – client
relationship
Reduction of regulatory capital.
                                         Drake
 A costless reduction in risk            Drake University

                                          Fin 286


Assume that Bank A has sold a CDS to Co X
on a 100,000,000 notional amount and is
receiving a 3% semi annual interest rate
Similarly Bank B has the same agreement
with Co Y.
Assuming both company’s have the same
credit quality
By exchanging a portion of the notional value
of the swap the banks can diversify the credit
risk without any costs.
  Credit Default Swap                                         Drake
                                                              Drake University

     Risk Sharing                                                 Fin 286



                      $50 M of CDS
        Bank          With Co X
                                             Bank
         A                $50 M of CDS
                          With Co Y              B
3% on        Payment                     3% on       Payment
$100M        If Default                  $100M       If Default


   Company                                Company
         X                                       Y

				
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