Off - Balance Sheet Activities

1. Off - Balance Sheet Activities

2. Off balance sheet activities • 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

3. OBS examples • 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

4. Large Derivative Losses • 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

5. Large Derivative Losses • 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

6. Use of option pricing • 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.

7. Options • 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

8. Call Option Profit • 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.

9. Profit Diagram Call Option Profit Spot Cost Price S-X-C S X

10. Call Option Intrinsic Value • 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)

11. Payoff Diagram Call Option Payoff Spot Price S-X X S X

12. Put Option Profits • 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.

13. Profit Diagram Put Option Profit Spot Price Cost X-S-C S X

14. Put Option Intrinsic Value • 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)

15. Payoff Diagram Put Option Profit Spot Price Cost X-S X S

16. Pricing an Option • Black Scholes Option Pricing Model • Based on a European Option with no dividends • Assumes that the prices in the equation are lognormal.

17. Inputs you will need S = Current value of underlying asset X = Exercise price t = life until expiration of option r = riskless rate s2 = variance

18. PV and FV in continuous time • 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

19. Black Scholes • 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)

20. Black Scholes (Intuition) • Value of Call Option SN(d1)- Xe-rtN(d2) The expectedPV of costRisk Neutral Value of Sof investmentProbability of if S > X S > X

21. Black Scholes • Value of Call Option = SN(d1)-Xe-rtN(d2) Where:

22. Delta of an option • 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.

23. Delta • 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).

24. Delta explanation • 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.

25. Applying Delta • 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

26. OBS Options • 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.

27. Adjusting Delta • 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.

28. Gamma of an Option • The change in delta for a small change in the stock price is called the options gamma: • Call gamma =

29. Futures and Swaps • 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.

30. Impact on the balance sheet • 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

31. Assets Market Value of Assets 150 Total 150 Liabilities Market Value of Liabilities 125 Equity (net worth) 25 Total 150 Simple Balance Sheet

32. Contingent Assets and Liabilities • 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.

33. Assets Market Value of Assets 150 MV of Contingent Assets 50 Total 200 Liabilities Market Value of Liabilities 125 Equity (net worth) 15 MV of contingent Liabilities 60 Total 200 Simple Balance Sheet

34. Reporting OBS Activities • 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.

35. Growth in OBS activity • 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%

36. Growth in OBS activitiesBillions of $

37. Common OBS Securities • Loan commitments • Standby letters of Credit • Futures Forwards and Swaps • When Issues Securities • Loans Sold

38. Loan commitments • 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.

39. Loan commitment Fees • 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

40. Loan Commitment Risks • 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.

41. Loan Commitment Risks • 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.

42. Loan Commitment Risk • 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.

43. Loan Commitment Risk • 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

44. Letters of Credit • 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

45. Letter of Credit • 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.

46. Future and Forward contracts • 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.

47. Futures vs. Forwards • 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.

48. Forwards vs. Futures 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

49. Options and Swaps • Sold in the over the counter market both can be used to manage interest rate risk.

50. Forward Purchases of When Issued Securities • 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.