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EXAM ii REVIEW

EXAM ii REVIEW. Lectures 10 – 15, Chap: 11,12,13,20,22, and 24 Hedging with forwards/futures → Loan Portfolio Credit Risk. Short Answers. Loan Credit Risk Off-Balance sheet activity Capital Adequacy. Lecture Outline. Hedging with Forwards/Futures Off-Balance Sheet Accounting

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EXAM ii REVIEW

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  1. EXAM ii REVIEW Lectures 10 – 15, Chap: 11,12,13,20,22, and 24 Hedging with forwards/futures → Loan Portfolio Credit Risk

  2. Short Answers • Loan Credit Risk • Off-Balance sheet activity • Capital Adequacy

  3. Lecture Outline • Hedging with Forwards/Futures • Off-Balance Sheet Accounting • Capital Adequacy • Loan Credit Risk • Loan Portfolio Credit Risk

  4. Hedging with Forwards/Futures

  5. Forwards Futures – Quick Review • Contracts that obligate a party to buy or sell a pre-specified quantity at a pre-specified price some time in the future • Forwards are custom – futures are standard (contract size …) • Prices: • Spot Price – price of underlying asset • Forward Price – current price at which a contract can be entered • Delivery Price – contract price after entering (price you “lock-in”) • Long vs short (futures position) • Long locks in a price to buy in the future – at the delivery price • Short locks in a price to sell in the future – at the delivery price • Types of Hedging • Micro – one or a few assets • Macro – the full balance sheet

  6. Zion Bank wants to hedge $7,000,000 of face value in 5-year zero-coupon treasury bonds on its balance sheet for one year. The bonds have a current market value of $5,700,000. Currently, the futures price for a 1-year contract on the 5-year zero coupon treasury note is $0.85 per $ of face value. The standard contract size is size $100,000. • Would you take a long or short position in the futures contract to hedge your position • How many futures contracts do you need to enter to fully hedged the 5-year treasuries for 1 year? • Consider 2 scenarios the YTM equals 3% and 5% in 1-year. Show that you have hedged interest rate risk for one year and find the 1-year yield that you have locked-in. a) Short b) 70 c) lock-in a sale price of 5,950,000 yield = 4.386%

  7. Baricks Inc. has total assets of 400M and current leverage ratio of 60% . The duration of their assets is 15 years and the duration of their liabilities is 3 years. The CME futures contract on the 3-year zero coupon treasury bond has a current forward price of $0.80 per dollar of face value. The standard contract size is $100,000. Interest rate on assets and liabilities is 12%. Find the number of contract the company has to buy or sell to hedge a 200 bp move in interest rates. Short 22,001 contracts

  8. Off-Balance Sheet Accounting

  9. Types of off-balance sheet items • Loan commitment agreement • Letters of credit • Futures, forward contracts, swaps, and options • When issued securities • Loans sold

  10. North Atlantic Bank enters into a 2 year loan commitment with Santa Cruz Surf Shop for $3,000,000 at 9% interest pa. The commitment has a 70bp up-front fee and a 30bp backend fee on the unused portion. Northern Atlantic negotiates a 3% compensating balance to be held in demand deposits that pay 1.1% interest pa. The Fed requires 10% of demand deposits be held in reserves. North Atlantic Will reinvest any proceeds at their cost of capital 3%. Calculate the expected return on the loan commitment if SC Surf shop is expected to take down 70% of the commitment immediately. E[R] = 20.54%

  11. Capital Adequacy

  12. Capital Adequacy • Why is capital important to regulate • Cost and benefits of regulating capital • Difference between market an book value of capital • Advantages/Disadvantages of MV vs. BV • Different measures of capital adequacy • What was the purpose of the Basel Accord • What was the purpose of risk-based capital ratios • How are the leverage and risk based capital ratios used

  13. Leverage Ratio Minority interest in equity accounts of consolidated subsidiaries Qualified cumulative perpetual preferred stock + + Par value of equity Surplus value of equity Retained earnings Core Capital = + +

  14. Calculate the leverage ratio given the following balance sheet. How should the bank be categorized with respect to capital adequacy L = 3.67% under capitalized

  15. Loan Credit Risk

  16. Loan Credit Risk Review • How to calculate expected loan return • Contractually promised return • Expected return • Required return • Measuring Credit Risk • Qualitative Factors • Quantitative Models • Credit Score Models; • Value-at-Risk (VaR) • RAROC

  17. Loan Returns • Contractually Promised Return • Defined in the loan contract includes interest earned and fees. The return that the lender will earn if the borrower does not default. • Expected Return • The return that the lender expects to receive taking into account the possibility of default and the loss in default • Required Return • The expected return required by the borrower in order for the expected profit on the loan to be positive

  18. Contractually Promised Return Rcontractual E(R) = P(1+k) + (1–P)(R) Default Probability Survival Probability (prob of payment) Contractually promised return Recovery Rate E(R) = (Survival Prob)(1+k) + (Default Prob)(R) Reserve Req.

  19. The Bank of Mexico makes a $100M 10-year loan to Victory Oil Co. The contractually promised return after taking into account fees, compensating balance, reserve requirements etc. is 12% pa. Due to the poor economy and restriction on drilling in the Gulf, Victory has a 30% probability of default over the next year. If they default, Bank of Mexico anticipates recovering only 80% of their loan value. • Calculate the expected return on the loan over the next year. • Assuming the expected return is the same for each year, find the NPV of the loan if Bank of Mexico’s cost of capital is 2% a) 2.4% b) 3,991,501.45

  20. Qualitative Credit Risk Factors Loan Interest Rate The higher the interest rate on the loan the more difficult it is to make payments and the more likely the borrower is to default. Borrower Reputation From prior borrowing experiences at the bank (high/low quality) From prior borrowing in general – timely bill, rent … payments Collateral Physical assets that can be seized an sold to recover value in default Capital The insolvency buffer capital-to-asset or leverage ratio Economic Conditions How is the borrowers ability to repay affected by the business cycle – type of business (industry), type of project, type of collateral …

  21. Qualitative Credit Risk Factors • Capacity • The capacity of the borrower to repay depends on future income • These effects are usually quantified for use in CR models • Loan interest rate →I • Borrower reputation → FICO, credit report … • Collateral → Loan-to-value ratio • Capital → Leverage, Tier I, and Total capital ratios • Exposures to economic conditions → Industry’sMarket Beta • Capacity → projected interest coverage ratio (earnings divided by interest expense).

  22. Quantitative Models • Credit Score Models • Linear Probability Model – OLS estimation • Logit Model – MLE Estimation • Linear Discriminate Model – Discriminate Analysis • Value-at-Risk • RAROC

  23. LTF Bank has estimated the following linear probability model to predict the probability of default for a borrower. Calculate the probability of default for the borrower below using the Linear Prob. and Logit models. Credit Score Linear probability = 0.02757; Logit = 0.5069

  24. VaR La Blanc Bank is planning on issuing a $10M loan to a BBB rated corporate borrower. They collect monthly returns over the past 5 years on BBB rated corporate debt and calculate the mean and standard deviation of returns to be 0.023 and 0.02 respectively. • Find the 99% Value-at-Risk of the loan. • Interpret this value VaR(99%) = $236,000 b) If La Blanc makes the loan there is a 99% chance that they will lose a maximum of 236,000 over the next month

  25. RAROC Countrywide Financial is evaluating a commercial mortgage for $500,000,000 to a company in the Chemical production industry. The average interest rate for a loan of this size in this sector is 7.2% and Countrywide will charge a 75bp servicing fee. Countrywide estimates that an extreme increase in the risk premium for Chemical produces will be 5.3%. Countrywide’s cost of capital is 4.3%. • Find the RAROC if the duration of the loan is 14 years • Should Countrywide issue the loan? RAROC = 5.273% Yes they should issue the loan

  26. Loan Portfolio Credit Risk

  27. Loan Portfolio Risk • Methods used to measure and manage loan portfolio risk • Migration analysis • Concentration limits • Portfolio Diversification • Moody’s KMV portfolio manager model • Loan Volume-Based Model Simple Models Portfolio Theory Loan Concentration

  28. Migration analysis Uses historical credit rating upgrades/downgrades to measure the expected upgrades/down grades in a portfolio over time. Example: Suppose that a loan portfolio manager is restricted to holding bonds with a BBB-B credit rating. She currently has 720 bonds in her portfolio. Given the following migration matrix: (i) How many loans would the manager expect to default by the end of the year? (ii) How many loans would the manager expect to have to sell out of the portfolio assuming that defaulted are held for their liquidation value? They would expect to sell 165.6 bonds Default = 14.4

  29. Concentration Limits DIs will set limits on the total amount of principal they can lend to a particular borrower or sector. Example: Suppose a DI sets a limit on lending to any one sector such that their expected loss given default (for the sector) is no more than 20% their own equity capital. What is the maximum amount the DI will lend to the consumer durables sector as a percent of their equity capital. Assume that, on average, lenders recover 56% of the loan value from defaulted loans in this sector. 45.5% of equity capital

  30. Portfolio Diversification & KMV DIs can manage loan portfolio risk by holding a diversified portfolio. The mean and standard deviation of the portfolio can be used to evaluate the risk and return relative to other allocations (portfolios) Example: given the following information calculate the loan portfolio return and risk (volatility) E[R] = 4.61% σ = 12.79%

  31. Loan Volume-Based Model Example: Given the following loan concentrations, which bank differs more in its lending activity from the average regional bank Measures how different a bank’s lending activity is from a benchmark Bank A differs more

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