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Chapter 7 Managing interest rate risk using off-balance-sheet instruments Chapter outline Forward and futures contracts Spot contracts Forward contracts Futures contracts Forward contracts and hedging interest rate risk Hedging interest rate risk with futures contracts Microhedging Macrohedging Routine hedging versus selective hedging Macrohedging with futures The problem of basis risk Options contracts Basic features of options Buying a call option on a bond Writing a call option on a bond Buying a put option on a bond Writing a put option on a bond Writing versus buying options Economic reasons for not writing options Regulatory reasons for not writing options Futures versus options hedging The mechanics of hedging a bond or bond portfolio using options Hedging with bond options using the binomial model Actual bond options Using options to hedge interest rate risk of the balance sheet Basis risk Interest rate swaps Swap markets The generic interest rate swap Realised cash flows on an interest rate swap Macrohedging with swaps Interest rate swaps and credit risk concerns Appendix 7A: Microhedging with futures (found at book website) Appendix 7B: Black-Scholes option pricing model (found at book website) Appendix 7C: Microhedging with options (found at book website) Appendix 7D: Setting rates on an interest rate swap (found at book website) Learning objectives 7.1 Discover the role that derivative contracts play in an FI’s activities. 7.2 Learn about forward and futures contracts and their use in hedging interest rate exposures. 7.3 Gain an appreciation of microhedging and macrohedging using futures contracts. 7.4 Understand how basis risk can reduce the effectiveness of hedging. 7.5 Learn about option contracts and the nature of payoffs from buying and selling call and put options. 7.6 Discover how to use options to manage interest rate risk. 7.7 Gain an understanding of interest rate swaps and their use in long-term interest rate risk management. Overview of chapter The rapid growth of the use of derivatives by both FIs and non-financial firms has been controversial. In the 1990s and 2000s, critics charged that derivatives contracts contain potential losses that can materialise in the short term. However, as will be discussed in this chapter, when used appropriately, derivatives can be used to hedge (or reduce an FI’s risk). However, when misused, derivatives can increase the risk of an FI’s insolvency. In this chapter, we stress that the appropriate use of derivatives assists FIs manage risk and we look at the role that futures and forward contracts, options contracts and swap agreements play in managing an FI’s interest rate risk. The chapter examines a number of useful off-balance-sheet instruments available to an FI manager to manage interest rate risk. In particular, it analyses the ways in which futures and forwards contracts, options contracts and swap contracts can be used to help FI managers manage interest rate risk. While forward and futures contracts are close substitutes, they are not perfect substitutes and are differentiated by a number of characteristics including: maturity, flexibility, marking to market and capital requirements. Options contracts are useful hedging devices as they provide asymmetric cash flows when interest rates move in opposite directions, reducing downside losses on the options contract itself. Forwards and futures and options contracts are particularly useful in hedging short-term interest rate risk. Swap contracts which are essentially a series of forward contracts at different maturities are more useful in assisting FI managers to hedge longer term interest rate risk. The complexity of FI balance sheets means that all of these products are likely to be used by an FI manager and may be used in conjunction with each other to partially or fully hedge an FI’s interest rate risk. Managing risk through physical adjustments to loan and deposit products takes time and may not be effective. Use of derivative products is relatively quick, and gives FI managers an assurance that they have effectively managed the risk required. The derivative instruments are introduced in this chapter, and while the use of these instruments in this chapter is to mitigate interest rate risk, in later chapters we learn how they can also be used to manage credit risk (Chapters 10 and 11). Chapter 7 Teaching Suggestions Chapter 7 is another long chapter. However, similar to Chapter 6, it contains introductory material which may have been covered in other courses. The focus of the chapter is the use of forwards, futures contracts, options contracts and swaps to assist FI managers reduce interest rate risk. So for completeness the four types of derivative instruments are described in some detail in this chapter prior to any examination of the ways they are used to hedge FI balance sheets. Consequently, in most situations, the introduction each of the derivative instruments is for revision only—a refresher for students. This is especially the case for forwards, futures contracts and options. If not, then there is sufficient information in the book to cover the subject matter if necessary. The material on swaps may not be as familiar, but for reasons discussed below, is very important to aspiring bankers and FI managers. Please note that the topics in this chapter should follow a discussion of the duration model (Chapter 6) as the immunisation techniques shown in the chapter draw on the duration model. Hence, this chapter is not stand alone, but follows the discussion of interest rate risk so far. There is nothing particularly challenging in this chapter and the calculations are not taxing. This is principally as the immunisation techniques draw on Macaulay duration calculation and the simple duration model. The examples in the text of hedging with futures contracts are based on actual futures contracts traded on the ASX. And as for the material in Chapter 6, the best way to reinforce the methods is by way of multiple examples of application of the techniques shown in the book. Note that for futures contracts both macrohedging (hedging the whole balance sheet) and microhedging (hedging an individual transaction) are discussed. For balance sheet risk minimisation, macrohedging is the most appropriate to ensure that the bank/FI is appropriately immunised. Basis risk is also discussed—when using futures contracts—as movements in the interest rates of the assets underlying the available futures contracts will not usually move in perfect synchronisation with the balance sheet. Once again the arithmetic enabling adjustments for basis risk is relatively simple, and again, practice in undertaking these calculations will reinforce the learning. The chapter outlines hedging of an individual bond or a portfolio of bonds using the binomial model of option valuation. Appendix 7B also covers the Black-Scholes model of option pricing for more advanced and treasury management courses. The use of the binomial model is intuitive and, with this, the mathematics (arithmetic really) are again not challenging. The mathematics involved in the hedging of the balance sheet as a whole is a little more challenging, however (see the section Using Options to Hedge the Interest Rate Risk of the Balance Sheet). For many courses, the end point in the section Macrohedging of the Balance Sheet may be discussed/identified only. However, as discussed for the technical parts of Chapter 6, I suggest that a reference to the ‘proof’ of the final formula for the number of options required in the book is provided/highlighted for the more curious students. More advanced courses may choose to run through the relatively straightforward ‘proof’. Again, I strongly suggest that you reinforce the learning (whether you go through the proof or not) through the use of examples. As for futures, basis risk is discussed when using options to hedge the balance sheet—an important aspect for those students wanting a practical course. Interest rate swaps are the final derivative instrument discussed in Chapter 7. These are less likely to have been covered in any other subject. They are, however, extremely important instruments used by banks and FIs to manage the risk at the longer end of their balance sheets. The market for swaps is large, and the largest of these are interest rate swaps. A very large part of the interest rate swap market is due to hedging. A swap is a series of forward rate contracts. I would suggest that you describe the way you can use a swap by way of example. So describe the process by taking students through an example. The general definitions otherwise are a little ‘gobbledygookish’, and will more than likely confuse students. So in my experience, the easiest way to describe a swap is to show how a swap is used. You may wish to use Examples 7.6 and 7.7 to assist with this. It is necessary that students understand the swap and how they work before you attempt to discuss how you can macrohedge using swaps. Having said this, the arithmetic involved in macrohedging with swaps is not difficult and should be easily managed by most students. What is more likely to confuse them is the swap payoff process, and this is why I suggest that you should describe the swap through the use of a practical example, and then move on to macrohedging. Example 7.8 provides a description of the use of a macrohedge, and analyses the payoffs for the FI. There is no integrated mini case study using swaps. However, there is a mini case of hedging a balance sheet using both futures contracts and options. For more advanced courses, you may also wish to refer to Appendices 7A, 7C and 7D which cover microhedging with futures, microhedging with options, and setting rates on an interest rate swap, respectively. Chapter 8 Managing interest rate risk using loan sales and securitisation Chapter outline Loan sales Types of loan sales contracts Using a loan sale to manage interest rate risk Why FIs sell loans Factors encouraging loan sales growth in the future Securitisation Converting on-balance-sheet assets to a securitised asset The pass-through security Prepayment risk on pass-through securities Prepayment models The collateralised mortgage obligation (CMO) The mortgage-backed bond (MBB) or covered bond Can all assets be securitised? Appendix 8A: Option related prepayment models (online at book website) Appendix 8B: Mortgage pass-through strips (online at book website) Learning objectives 8.1 Discover why FIs sell loans. 8.2 Learn about the types of loan sales contracts. 8.3 Understand how FIs use loan sales and securitisation to manage interest rate risk. 8.4 Learn which assets can be securitised and the types of assets most securitised by Australian FIs. 8.5 Discover how an FI can change the risk characteristics of their balance sheets using securitisation. 8.6 Be able to identify the different forms of securitisation available to FIs. 8.7 Understand prepayment risk and how this can be modelled. Overview of chapter This chapter introduces students to both loan sales and securitisation. The key focus is on the types of loan sales and securitisation assets, and the techniques used to create them. The two key loan sale contracts, participations and assignments, are discussed and compared, followed by an example of how loan sales can be used to manage interest rate risk. The reasons why FIs sell loans and the future potential for loan sale growth are also introduced. Securitisation and the ways in which FIs can convert their on-balance-sheet assets to securitised assets introduce the discussion of securitisation. Three types of securitised assets are presented—pass-through securities, collateralised mortgage obligations and mortgage-backed bonds (i.e. covered bonds). Prepayment risk is introduced as a key component of the discussion of pass-through securities. More difficult material covering the mechanics of securitisation strips and prepayment models is available for more rigorous courses in the two appendices to the chapter (‘Option related prepayment models’ and ‘Mortgage pass-through strips’). Newer types of securitisation are also discussed along with a discussion of the complex CDO development and its role in the sub-prime crisis in the US in 2007. Loan sales and securitisation are introduced in this chapter, and as the key risk area covered in this chapter is interest rate risk, the chapter discusses how these instruments can be used to manage IRR. As for derivative instruments in Chapter 7, in later chapters the benefit of derivatives, loan sales and securitisation to other types of risk mitigation (in particular credit—Chapters 10 and 11—and liquidity risks—Chapters 14 and 15) are discussed. As the poor assessment of risk in securitisation programs was an underlying cause of the global financial crisis (GFC), the GFC is mentioned often throughout the chapter, and there are a number of Industry and Global Perspectives which also focus on the crisis and the role of securitisation in particular. Chapter 8 Teaching Suggestions Similar to Chapter 7, this chapter is dense as it contains the introduction to two important concepts: loan sales and securitisation. Consequently, the chapter spends some time describing the concepts and their markets in Australia. As the risk topic of discussion at this stage of the book is interest rate risk (IRR), in each case the chapter discusses how loan sales and securitisation can be used by FI managers to mitigate IRR. However, risks discussed later in the book will refer students to loan sales and securitisation discussed in Chapter 8, and then show how these products and techniques may be used to manage both credit risk and liquidity risk. Unlike the derivative instruments discussed in Chapter 7, loan sales and syndication, and securitisation are less likely to have been covered by any other course in a finance program. As such, the descriptive content of the chapter should be covered. Before discussing the teaching suggestions, I propose that while all risks and risk techniques are important, this chapter covers more challenging material (in particular the securitisation material) which may best be left to more advanced courses. If you choose to omit the material on securitisation, then you may choose to cover the relatively simple but important concepts of loan sales and loan syndication. In this case, I would suggest that you cover these topics with your lecture on credit risk—and also refer students to the fact that such products can be used to manage both interest rate risk and liquidity risk. The chapter is easily divided—and loan sales are discussed first and in completion before securitisation is introduced. If you decide to introduce securitisation, but not the technical aspects of securitisation, then there is sufficient descriptive material on pass-through securities, covered bonds and CMOs to produce an interesting lecture. I would strongly encourage at least this short coverage of securitisation for a number of reasons, including: Securitisation is an important part of any bank’s strategy—for liquidity, credit and IR risk reasons. The problem in assessing the risk of securitisation was an underlying cause of the global financial crisis. I suspect if the traders and investors knew more about them, the impact of such a critical event may have been lessened. So if we take our roles as educators seriously, then we need to alert students to key risks of such products. Hence, including at least a discussion of securitisation in the course will help such understanding. Securitisation is a key fund-raising mechanism for Australian DIs (especially the smaller DIs) and the Australian government took measures following the GFC to ensure that the market for Australian securitised assets did not fail completely. Covered bonds are now available to be issued by Australian banks and are used for liquidity and other regulatory purposes. Hence, they may become a more important part of the bank risk management regime. Another possibility in constructing your curriculum is that rather than link securitisation to a particular risk, you could cover securitisation as a stand-alone topic (assuming that loan sales are included in your discussion of credit risk, as mentioned above). Loan sales: This topic is very straightforward and relatively simple for students. It is also a good topic to show students how banks can manipulate their products to assist in the management of various risks. Students usually get this readily. As the students by now should have a good idea of the size of the bank balance sheets, and an understanding of the regulations (as well as prudential management decisions) which restrict the proportion of lending to one particular entity, a nice way to commence the issue of loan sales and loan syndication is to ask students how banks are able to lend to large multinational companies (such as BHP-Billiton) which require very large loans. Lending to such organisations could break all of the rules—both internal lending limits as well as regulatory limits of lending. The second part of this question is—how does a bank retain its good relationship with a large multinational customer without breaking its internal and regulatory risk limits? The ensuing discussion should lead to the options of selling part of the loan, all of the loan, or sharing the loan—that is, loan sales and/or syndication. You may also want to discuss why there is a small secondary loan market in Australia, compared with other parts of the world, and why loan syndications are more usually the option for Australian banks. Having explored the different options and discussed loan sales more generally, you can then turn to the use of management of interest rate risk, and more specifically how a loan sale can change the duration of a bank’s asset portfolio—changing the elasticity of the asset portfolio to interest rate movements. Of course, in later lectures, you can refer back to Chapter 8 to discuss how loan sales can assist in the management of both credit risk and liquidity risk. Securitisation: Securitisation to loan sales is like futures contracts are to forward contracts. Loan sales and syndications are unique and related to one loan. Securitisation, on the other hand, packages a number of loans together into a relatively generic security related product which can be easily marketed. The Australian securitisation market has been very large, and while issuance almost ground to a halt during the GFC, it remains an important part of the DI’s armoury of products. How you choose to cover this topic depends on how much time you devote to it. You could leave much of the descriptive material to student reading, and then in lectures ask the question: What is the difference between a pass-through security, a covered bond and a collateralised mortgage obligation (CMO)? The discussion could draw out the key features of each type of security, how they differ and what they are likely to be used for. You may also at this stage extend the discussion to assets other than mortgages and refer students to the examples in the book—if they don’t already raise them in the discussion. The process of securitisation—and the fact that the securitisation vehicle is removed from the DI—is important in student understanding of how securitisation gets assets off the balance sheet. Further, concepts such as prepayment and fully amortised are important to draw out in the discussion. You may set an exercise for students so that they revise the cash flows associated with fully amortised mortgages and what happens if there is a large prepayment to assist in their understanding of these concepts. From this point, you can go into a great deal more detail about prepayment risk and its impact on the management of the securitisation program, liquidity issues, etc., but that depends on the extent to which the topic is covered in your lecture. If your course is advanced and you need to examine securitisation in some detail, then please also refer to Appendices 8A and 8B—which cover some complex issues relating to the measurement of prepayment risk and mortgage pass-through strips. Like loan sales, securitisation enables DIs to change the duration of their asset portfolio, and thereby the interest sensitivity of these portfolios. In addition, securitisation can assist in the mitigation of credit risk and liquidity risk—and so their introduction here is useful to draw on in the discussion of these other risks. Chapter 9 Market risk Chapter outline Calculating market risk exposure The RiskMetrics model The market risk of fixed-income securities Foreign exchange Equities Portfolio aggregation The historic (back simulation) approach The historic (back simulation) model versus RiskMetrics The Monte Carlo simulation approach Regulatory models: the BIS standardised framework Partial risk factor approach Fuller risk factor approach The BIS regulations and large bank internal models Learning objectives Understand why market risk is important. Learn about the concept of value at risk and its use in measurement of market risk. Understand how to measure market risk exposure of an FI. Learn the measurement techniques of the RiskMetrics model. Learn the back simulation approach of measuring value at risk. Learn the Monte Carlo simulation approach. Understand how regulators measure market risk exposures for capital adequacy purposes. Overview of chapter Market risk (or value at risk) can be defined as the risk related to the uncertainty of an FI’s earnings on its trading portfolio caused by changes, particularly extreme changes, in market conditions such as asset price, interest rates, market volatility and market liquidity. Thus, risks such as interest rate risk (discussed in the previous four chapters), credit risk (see Chapters 10 and 11), foreign exchange risk (discussed in Chapter 13) and liquidity risk (outlined in Chapters 14 and 15) affect market risk. However, market risk emphasises the risks to FIs that actively trade assets and liabilities (and derivatives) rather than hold them for longer term investment, funding or hedging purposes. Indeed, market risk was at the heart of much of the financial damage associated with the global financial crisis. Signs of significant problems in the US economy first arose in late 2006 and the first half of 2007 when home prices plummeted and defaults by sub-prime mortgage borrowers began to affect the mortgage lending industry as a whole and then ran through other parts of the US economy. As mortgage borrowers defaulted, financial institutions that held and actively traded these mortgages and mortgage-backed securities started incurring huge losses. Losses from the falling value of sub-prime mortgages and securities backed by them reached over US$1 trillion worldwide by mid-2009. Investment banks and securities firms were major traders of mortgage-backed securities and as mortgage borrowers defaulted, these FIs were particularly hard hit with large losses on the mortgages and the securities backing them. For example, in the middle of 2007, two Bear Stearns (a US investment bank) hedge funds suffered heavy market risk-related losses on investments in the sub-prime mortgage market. The two funds filed for bankruptcy later in 2007. Bear Stearns’ market value diminished substantially as a result, and the losses grew so large that in March 2008, JPMorgan Chase and the US Federal Reserve Bank stepped in to rescue the investment bank—the fifth largest investment bank in the US—before it failed. The market risk meltdown continued throughout 2008 and on 15 September 2008, Lehman Brothers filed for bankruptcy, Merrill Lynch was bought by the Bank of America, AIG (one of the world’s largest insurance companies) met with financial regulators to raise desperately needed cash and Washington Mutual (the largest savings institution in the US) was acquired by JPMorgan Chase. As news spread that Lehman Brothers would not survive, FIs globally moved to disentangle trades made with Lehman. Global stock markets fell dramatically and in 2012 markets are still in recovery mode. By mid-September 2008, global financial markets froze and banks stopped lending to each other at anything but exorbitantly high interest rates. Market risk was the root cause of much of this market failure and the substantial losses incurred globally by financial institutions. Conceptually, an FI’s trading portfolio can be differentiated from its investment portfolio on the basis of time horizon and liquidity. The trading portfolio contains assets, liabilities and derivative contracts that can be quickly bought or sold on organised financial markets (such as long and short positions in bonds, commodities, foreign exchange, equity securities, interest rate swaps and options). Further, with increasing securitisation of bank loans (e.g. mortgages), more and more assets have become liquid and tradeable (e.g. mortgage-backed securities). The investment portfolio (or in the case of banks, the so-called ‘banking book’) contains assets and liabilities that are relatively illiquid and/or are held for longer holding periods. Table 9.1 shows a hypothetical breakdown between banking book and trading book assets and liabilities. Note that capital produces a cushion against losses on either the banking or trading books: see Chapter 18. Income from trading activities is increasingly replacing income from the traditional FI activities of deposit taking and lending. The resulting earnings uncertainty, or market risk, can be measured over periods as short as one day or as long as a year. While bank regulators have normally viewed tradeable assets as those being held for horizons of less than one year, private FIs take an even shorter term view. In particular, FIs are concerned about the fluctuation in value—or value at risk (VaR)—of their trading account assets and liabilities for periods as short as one day—so-called ‘daily earnings at risk’ (DEAR)—especially if such fluctuations pose a threat to their solvency. Moreover, market risk can be defined in absolute terms as a dollar exposure amount or as a relative amount against some benchmark. For example, Westpac Bank’s Financial Markets and Treasury Risk Group is responsible for independently calculating and reporting value at risk (VaR), monitoring of both structural and VaR exposures against limits, approving limits within delegated authority, reviewing and maintaining market risk policies, ensuring the integrity of market risk measurement models, validating financial markets pricing models and pre-approving limit excesses within delegated authority. In recent years, the market risk of FIs has raised considerable concern among regulators as well. So important is market risk in determining the viability of an FI that since 1998, Australia’s bank regulators have included market risk in the calculation of regulatory capital that a bank must hold, and during the 2000s, these requirements have been extended to other regulated FIs. Table 9.2 summarises several benefits of measuring market risk, including providing management with information on the extent of market risk exposure, market risk limits, resource allocation and performance evaluation, as well as providing regulators with information on how to protect banks and the financial system against failure due to extreme market risk. The sections that follow concentrate on absolute dollar measures of market risk. We look at three major approaches that are being used to measure market risk: RiskMetrics, historic or back simulation and Monte Carlo simulation. The link between market risk and required capital levels is also discussed in this chapter. Chapter 9 Teaching Suggestions The issue of market risk should not be new to students of finance, but the importance of understanding the significance of it to the management of FIs is most likely to be new to them. Hence, I suggest that you approach your lecture by highlighting this significance. For example, you may like to ask the following: How many of you want to become dealers or traders in financial markets? (Many undergraduates usually do, in my experience.) What do you think you need to do if you are managing a portfolio of assets—say, bonds? What would differ if the assets were foreign currencies or equities? How do traders make their profits? What causes them to make losses? What risks must be managed in the process? What about portfolio effects? Are there strong correlations across the various financial asset markets—and if so, what impact will these have on the total risk of trading portfolios? How often should trading portfolio risk be examined—daily, weekly, yearly? A digression—I note that we haven’t yet covered FX risk, but it was introduced in Chapter 4, and most finance students should have had some exposure to it in an international finance course. If not, then you may wish to cover FX risk prior to a discussion of market risk—that is, cover Chapter 13 prior to Chapter 9. The ensuing discussion should highlight the reasons why the measurement and management of market risk—that is, changing asset market values—matters, and how FIs can be vulnerable to total market risk on trading portfolios, despite the fact that the portfolios are usually relatively small compared with total FI asset portfolio. Table 9.2 outlines the key benefits of market risk measurement. And you may wish to use the example of UBS in the Global Perspective box to illustrate the reputational effects of not understanding market risk. The chapter covers three main approaches to the calculation of market risk exposure: RiskMetrics, historic approach and Monte Carlo simulation. It is worth noting that for regulatory purposes (capital adequacy regulation) such models form the basis of internal bank model estimation of market risk. Such a reference again highlights to students that these issues are not isolated, and that any one risk-related issue in a bank is likely to be related to something else. A fundamental in the RiskMetrics model is the measurement of value at risk (VaR)—an important concept as it is a part of FI lexicon. So for the aspiring bank risk manager, it is an important concept to understand. At this juncture you may also wish to refer to the example of Westpac’s market risk and VaR limits, as reported in the Industry Perspective box. The mathematics of the RiskMetrics approach is not difficult, but is tedious—and so ensure your examples are not too long and onerous as students will be lost in the detail of the calculation and may fail to see the truth in the concepts. The importance in the lesson is not the difficulty of the calculation (arithmetic really), but in the understanding of what is being done and why. The historic approach is based on historic data, as the name suggests, whereas RiskMetrics relies on a theoretical symmetric probability distribution. It is certainly simple in concept and in application, and if you only cover one concept in class, then I would recommend this one. The Monte Carlo simulation is really an extension of the historic approach—a tool to overcome the fact that very often there is insufficient data to use the historic approach effectively. The chapter explains how the Monte Carlo approach is used in a relatively simple way, and should not tax students of any finance course. The other important issue about the measurement of market risk is its use by regulators. More correctly, regulators, including APRA, allow the use of internal models by some banks (in Australia, the large banks) for the measurement of market risk. Two approaches are allowed: the partial risk factor approach and the fuller risk factor approach. These approaches, finally agreed by the BIS, differ from the interim approved methods prior to 2013. The discussion of the regulations is a good entrée to the final section of the book which outlines the BIS regulations and internal models which are allowed for use by large banks. The latest allowed models are guided by Basel 2.5 (2012) and Basel III (2013) capital adequacy requirements. Essentially, this section sets out the parameters which underpin the particular internal model developments. This is all very dry, and so it is best to approach these issues with questions that must be solved. For example, ‘Why would large banks be allowed to use internal models whereas small banks are not allowed?’ or ‘Why don’t small DIs want to use internal models?’. Note the integrated mini case at the end of the chapter, which gives students the opportunity to reinforce their learning through the calculation of DEAR on an FI’s trading portfolio. Chapter 10 Credit risk I: individual loan risk Chapter outline Credit quality problems Types of loans Business loans Housing loans Consumer or individual loans Other loans Loan defaults Calculating the return on a loan The contractually promised return on a loan The expected return on a loan Retail versus wholesale credit decisions Retail Wholesale Measurement of credit risk Default risk models Qualitative models Quantitative models Newer models of credit risk measurement and pricing Term structure derivation of credit risk Mortality-rate derivation of credit risk RAROC models Using duration to estimate loan risk Using loan default rates to estimate loan risk Option models of default risk Appendix 10A: Credit analysis (online at the book website) Learning objectives 10.1 Understand the importance of credit quality management by an FI. 10.2 Learn the types of loans that are generally issued. 10.3 Understand the characteristics of business loans. 10.4 Discover the nature and risks associated with housing loans. 10.5 Identify consumer loans, such as personal loans and credit cards. 10.6 Learn how to price loans to achieve target expected returns. 10.7 Learn about the different models used to measure credit risk. 10.8 Understand the difference between qualitative models and quantitative models of credit risk measurement. 10.9 Understand the key components of credit scoring and related models including Altman’s Z-score model. 10.10 Understand how more modern models of credit risk measurement and loan pricing are more heavily based on finance theory. Overview of chapter In this, the first of two chapters on credit risk, we discuss various approaches to analysing and measuring the credit or default risk on individual loans (and bonds). In Chapter 11 we consider methods for evaluating the risk of FIs’ total loan portfolios, or loan concentration risk. Measurement of the credit risk on individual loans or bonds is crucial if an FI manager is to (1) price a loan or value a bond correctly and (2) set appropriate limits on the amount of credit extended to any one borrower or the loss exposure it accepts from any particular counterparty. Methods of hedging and managing an FI’s credit risk, such as the use of credit derivative swaps and options, are discussed at the end of the chapter after we learn how to measure the credit risk. The chapter begins with an examination of the main types of loans made by FIs—business loans, housing individual or consumer and other loans—as well as the characteristics of each of those loans. We then look at how both interest and fees are incorporated to calculate the return on a loan. This is followed by a discussion of how the return on a loan relative to the quantity of credit made available for lending is used by FIs to make decisions on wholesale (business) versus retail (consumer) lending. Finally, we examine numerous models used to measure credit risk, including qualitative models, credit scoring models and some of the newer models of credit risk measurement. Indeed, technological advances have been at least one driving force behind the advances in new models of credit risk measurement and management in recent years, and have improved the ability of FIs to more effectively manage credit risk. Appendix 10A, located at the book’s website, discusses cash flow and financial ratio analysis, widely used in the credit analysis process for housing, consumer and small business loans. Chapter 10 Teaching Suggestions This is a pretty dry chapter and involves a lot of descriptive material. As such, my suggestions below are those which I think work for a financial institutions or bank management course. However, if you are taking a course which has a higher concentration on credit management and loan types, etc., then you may wish to work through the detail in the entire chapter. Assuming that the course is either a FI management or a bank management course, I suggest that you concentrate on the following, and leave much of the descriptive and institutional aspects of individual loan types to student reading. Credit quality and credit risk: This was introduced in brief in Chapter 4, and touched on in the discussion of interest rate risk in Chapters 7 and 8 in particular. However, this is where the topic really begins, and so some attention to the causes and consequences of credit risk should be addressed. After all, it is one of the most important risks faced by banks, and is a direct consequence of the lending process. The balance between conservative lending practices and profitability should be raised in the discussion. Further, you may wish to compare the practices of the four major Australian banks during the global financial crisis (GFC) with the risky strategies undertaken by Bank of Scotland, for example. You may also want to compare the riskiness of housing loans in the Australian context with the risk of business loans (see Figure 10.2 which shows non-performing loans), and why banks find it attractive to use housing loans for small business lending. Other issues which should be addressed—both because they are important and also as they are referred to in later chapters—are loan commitments. Calculating the return on a loan In this discussion it is important that students realise that there is risk involved in lending and so the contractually promised return on a loan will not equal the expected return. However, the bank has to start somewhere and students should understand that a number of factors go into the calculation of the return: Fees Bank rate of interest Risk margin added to the bank rate of interest Compensating balances in usually a low or non-interest-bearing bank account So the return is not simply the rate of interest charged on the loan itself Students of finance should be familiar with the concept of the expected return on the loan, but it is important to discuss the differences with the interest charged on the loan and why there is a difference. Credit risk measurement A number of techniques are presented in the chapter. And while each is used to measure the risk of a particular loan or bond, they are not all suitable for each type of loan. I suggest that you go through each method, and in particular the ‘default risk models’, the most well known of which is the credit scoring type of model. This type of model is used extensively in banks and other DIs for small loans, mortgage type loans, personal loans, etc. They are very important as they usually form the basis of most retail lending. Whether you take students through the maths of the various models is dependent on the detail required in your particular course. However, the basic Z-score model outcome—that is, the Z-score equation—is relatively easy in mathematical terms as well as for understanding. Such models were used in the past in part for large business loans, or more correctly, the concept underlying them was used—that is, financial statement analysis. However, such analysis is backward looking and not as useful as some of the more modern approaches to credit risk measurement for large loans. Such loans put the FI at great credit risk exposure, and the advances in options theory, for example, have improved credit risk measurement and monitoring. The mathematics underlying these new models is somewhat taxing and so you may choose to simply describe them rather than go through the mathematics. The RAROC model is a relatively easy model to understand and uses duration concepts covered in Chapter 6. Hence, I would advise that at the very least, the different models could be described, and that the RAROC model be worked through. Having said this, the option models of default risk should be discussed. They are an important improvement in the management and monitoring of credit risk for large loans, and most major banks use such models. Indeed, Moody’s (the ratings agency) purchased the company which developed this model. It is a very neat model of expected default. Students can refer to end-of-chapter web question 38 and explore some of the expected default frequency graphs for Australian companies. Also see Figure 10.15. Note that there is an integrated mini case after the end-of-chapter questions which covers loan analysis and asks students to determine whether each of four loans should be accepted by the bank given the bank’s RAROC and other default criteria. Chapter 11 Credit risk II: loan portfolio and concentration risk Chapter outline Simple models of loan concentration risk Loan portfolio diversification and modern portfolio theory (MPT) Moody’s Analytics portfolio manager model Partial applications of portfolio theory Regulatory models Use of derivatives to hedge credit risk Credit forward contracts and credit risk hedging Hedging credit risk with options Credit swaps Swaps and credit risk concerns Use of loan sales and securitisation to manage credit risk Removal of credit risk Reduction of concentration risk Maintenance of customer relationships Capital adequacy regulations Moral hazard issues Appendix 11A: CreditMetrics (online at book website) Appendix 11B: Credit Risk+ (online at book website) Learning objectives 11.1 The methods for measuring levels of loan concentration. 11.2 The effects modern portfolio theory (MPT) and diversification have on a portfolio of loans. 11.3 The use of MPT and how it applies in the Moody’s Analytics model approach to lending. 11.4 The concentration of loans, loan volume and internal loan loss ratio concepts. 11.5 How regulators influence banks in measuring and managing portfolio risks. 11.6 The types of futures and options contracts that can be used to hedge credit risk. 11.7 How futures and options can be used to hedge catastrophe risk. 11.8 How credit swaps help FIs manage credit risk. 11.9 The types of credit swaps. 11.10 The credit risk concerns embedded in swap contracts. 11.11 The role that credit default swaps played in the global financial crisis. 11.12 How FIs use loan sales and securitisation to manager credit risk. Overview of chapter The models discussed in Chapter 10 describe alternative ways by which an FI manager can measure the default risks on individual debt instruments such as loans and bonds. Rather than looking at credit risk one loan at a time, FIs usually manage credit risk by assessing portfolio risk. Chapter 11 provides the FI manager with techniques to measure and manage credit risk in a loan (asset) portfolio context, by recognising the benefits of loan (asset) portfolio diversification. The risk–return characteristics of each loan in the portfolio are a concern for the FI, but the risk–return of the overall loan portfolio, with some of the risk of the individual loans diversified, affects an FI’s overall credit risk exposure. Additionally, we look at the potential use of loan portfolio models in setting maximum concentration (borrowing) limits for certain business or borrowing sectors (e.g. sectors identified by their standard industrial classification [SIC] codes). This chapter also discusses regulatory methods for measuring default risk of a portfolio. The implementation of risk-based capital models in Australia in 1989, following the introduction of Basel I capital adequacy regulations, allowed banks to allocate capital on the basis of differing risk categories. Although such a simplistic approach was a good first approximation to the treatment of risks, it failed to consider the more sophisticated portfolio effects that can be present. An example would be excessive exposures to one area, such as agriculture or residential property, where more loans within that one sector does not necessarily mean better diversification. The implementation of Basel II allowed banks the option to use a ‘portfolio approach’ to credit risk measurement. This means that some banks are able to use their own ‘internal’ models, including those such as CreditMetrics and Credit Risk+ (discussed in Appendices 11A and 11B to this chapter) and Moody’s Analytics portfolio manager (discussed in this chapter), to calculate their capital requirements against insolvency risk from excessive loan concentrations. We then shows how derivative securities (introduced in Chapter 7) may be used to assist an FI manage credit risk, and highlight the role of credit swaps in the global financial crisis. Finally, the benefits and caution of using loan sales and securitisation (both introduced in Chapter 8) to manage credit risk are explored. Chapter 11 Teaching Suggestions While the basics of credit risk are examined in Chapter 10, this chapter introduces students to the more realistic measurement and management of credit risk in FIs. Modern FIs understand the benefits of portfolio, and the impact of different correlations across the various loan groups. So do regulators. Modern portfolio theory is used to assist FIs achieve the diversification effects from their loan portfolios. Hence, this chapter is a natural extension of Chapter 10 and any discussion of diversification should follow the exploration of credit risk as covered in Chapter 10. Given that most students of FI management and/or treasury management will have a good understanding of modern portfolio theory, the issue is not covered in detail, but summarised in its own section with an example. This is really revision for students, and could be set for reading prior to the lecture. Moody’s Analytics portfolio manager model: The first portfolio model covered in detail is the Moody’s Analytics portfolio manager model—introduced in part in Chapter 10. To commence discussing why the Moody’s model is perhaps better than MPT, you may ask students to identify some of the pitfalls of using MPT. In this discussion, hopefully the fact that, in MPT, returns have to be normally distributed is one of the items identified. This is where the Moody’s model is an improvement as the assumption or normal distribution is not required. The Moody’s approach also has an estimate for loans (which are by their nature infrequently traded). The model is outlined in some detail and is an important addition to any course on bank risk management, as it is readily used by many large modern banks. The model uses expected default frequency estimates (outlined in Chapter 10), and in this way continues the discussion from that chapter. Partial applications of portfolio theory: For many smaller FIs, the Moody’s Analytics approach is difficult for cost and technical reasons. For such DIs, the partial application of MPT is possible and two such models are described in some detail in the chapter. Examples are given for each (loan volume-based models and loan loss ratio-based models). The models are very straightforward and worthy of presentation. However, for advanced courses which may wish to concentrate on the more challenging models such as Moody’s Analytics, CreditRisk and Credit Risks+ (the latter two models are discussed in the chapter appendices—available online at the book website) you may wish to leave these partial models for student reading followed by a short discussion. The section on regulatory models is important particularly in the sense that FIs have to comply with regulations requiring credit risk assessment (for capital adequacy purposes). For many smaller DIs the cost of compliance is high, and so where possible, it is best for the FI if the approach to regulatory measurement is identical to the measurement of credit risk for internal management purposes. It should be noted that Basel II does allow for correlations across loan types, and so does in some ways heed the learnings from MPT. The discussion of regulatory models does provide an opportunity to introduce the cost of such modelling and the cost of regulatory monitoring. This is a worthy discussion and you could raise the often asked question: If we have no regulations would FIs introduce internal models with the same vigour that they do when regulations require them to do so? Another way to put this is: Would market forces cause FI management to measure credit risk as well as they now do if there was no capital adequacy regulations requiring them to do so? The second half of the chapter outlines the use of derivative instruments, loan sales and securitisation by FI managers to manage credit risk. Derivative instruments: The discussion of the use of derivative instruments in this chapter assumes student knowledge of the instruments—either from Chapter 7 or from previous courses. Credit forwards are introduced first, and the discussion allows students to see that these are intuitively simple. There is also an example to assist learning. The use of options to manage credit risk is then discussed in a very descriptive way, using only words and diagrams to explain how options may be used. Credit swaps or credit default swaps (CDS) are described in a little more detail, as they are a little different from the interest rate swaps discussed in Chapter 7. The history of their development and their role in the GFC are also discussed. These are important instruments which have been growing in importance in the last decade. The discussion in the chapter is descriptive, and there is an example to assist learning. Following the general discussion of CDSs, two key types—the pure credit swap and the CDS index—are presented. The difficulty in the discussion comes from the unfamiliarity of CDSs, and not from the material presented. There is also a section on swaps and credit risk concerns, and as it is descriptive and historical in nature, it could easily be left to student reading Loan sales and securitisation: There is nothing difficult in this section, and many of the five main points should arise relatively quickly from any discussion (on the assumption that students have previously learned about loan sales and securitisation from Chapter 8). Asking the simple question ‘In what ways can an FI use loans sales and securitisation to manage credit risk?’ should produce responses in the right direction. Note that there is an integrated mini case at the end of the Chapter 11 questions which allows students to practise calculating concentration risk and using the loan volume-based model and the loan loss ratio-based model. Chapter 12 Sovereign risk Chapter outline Credit risk versus sovereign risk Debt repudiation versus debt rescheduling Country risk evaluation Outside evaluation models Internal evaluation models Using market data to measure risk: the secondary market for LDC debt and emerging market debt The structure of the market The early market for sovereign debt Today’s market for sovereign debt Appendix 12A: Mechanisms for dealing with sovereign risk exposure (online) Learning objectives 12.1 Learn the difference between credit risk and sovereign risk. 12.2 Learn about debt repudiation and debt rescheduling. 12.3 Understand the techniques for evaluating a country’s risk profile. 12.4 Learn the different ratios that can indicate the financial health of an economy. 12.5 Discover the secondary markets for the bonds issued by developing countries. 12.6 Learn the different techniques available to an FI manager to address defaults. (See Appendix 12A online). Overview of chapter During the early part of the decade, European sovereign risk was the ‘order of the day’, with months of crisis meetings of the European Union and Eurozone to establish a new treaty to ensure future stability within the Union. The crisis in Europe came to light during the global financial crisis of 2008–2010, and the events in Europe had the potential to extend the crisis for longer. While in the recent past, sovereign risk had principally coupled with developing countries, the European crisis in the developed world had the potential to cause another global financial crisis. Due to the broad-based impact of the global financial crisis, and to avoid the types of debt moratoria seen in earlier crises, national governments worldwide in conjunction with international organisations, such as the World Bank and the IMF, took steps to stem the impact of the liquidity drought. Table 12.1 in the textbook lists some of the actions taken by governments in developed countries to shore up their countries’ banking systems. Further, the IMF pledged to inject US$250 billion into the global economy to bolster countries’ reserves, of which US$100 billion would be allocated to emerging market and developing countries. Additionally, the World Bank committed US$58.8 billion in 2009 to help countries struggling due to the global financial crisis. Despite these efforts, in November 2009, Dubai World, the finance arm of Dubai, asked creditors for a delay on interest payments due on US$60 billion of the country’s debt. Dubai, which had become a centre of investment and development in the mid- to late 2000s, funded much of its development from the oil wealth of neighbouring countries. During the financial crisis, with a drop in demand from Europe, Dubai’s economy suffered a falling real estate market. Further, towards the end of 2010, Greece began showing debt fragility. Despite planned assistance by France and Germany in March 2010, the market price of Greek bonds dropped dramatically in April 2010 as the market factored in possible default. In addition, the Greek budget deficit in 2009 was found to be far worse than previously reported. Moody’s Investors Service downgraded Greek debt and warned that additional ratings cuts could occur. Greece was not the only European country impacted by debt and fiscal problems. Portugal, Spain and Italy were also viewed as significant sovereign default risks, and in conjunction with the Greek problems, there was significant pressure on the euro. In May 2010, the IMF extended an unprecedented US$147 billion to Greece in return for huge budget cuts, in an attempt to halt a widening European debt crisis. These recurring experiences confirm the importance of assessing the country or sovereign risk of a borrowing country before making lending or other investment decisions such as buying foreign bonds or equities. In this chapter, we first define sovereign or country risk. We next look at measures of country risk that FI managers can use as screening devices before making loans or other investment decisions. Appendix 12A, online, looks at the ways FIs have reacted to sovereign risk problems, including entering into multi-year restructuring agreements (MYRAs), debt–equity swaps, loan sales and bond conversions. Chapter 12 Teaching Suggestions While not credit risk, sovereign risk arises from lending to companies and governments in non-domestic markets. Consequently, it is a natural extension of the discussion of credit risk so far. The chapter highlights the difference between credit risk and sovereign risk so that the differences are clear. However, as mentioned, both risks arise from the lending process, but readers are alerted to the notion that sovereign risk should be reviewed prior to any individual credit decision. Whether you cover the topic lightly or in more depth depends on the type of course, but it should be included in all courses because of its importance. In this regard, much of the introduction to the chapter discusses recent sovereign risk issues, and in particular the European debt crisis of the early 2010s. Hence, the chapter is in part an economic history lesson—used to emphasise why sovereign risk is important both to any particular FI lending into a foreign market, but also more recently due to the impact on the local and global financial systems more generally. As it is descriptive, you may wish to leave this part of the chapter to student reading with follow-up discussion. The recent Greek sovereign debt crisis, and the potential impact on the euro, the European Union, etc. provides a ‘sexy’ backdrop to an otherwise dry topic. The actual events provide a reason for the need to examine sovereign risk, and what to do about it. The discussion of debt rescheduling and debt repudiation is also descriptive with historic examples, and I would also suggest leaving this to student reading. Country risk evaluation follows, and is divided into two types—external and internal. The discussion of the external models provides some interesting data on various countries, and one approach is to compare Australia’s position with that of other countries in our region, our main trading partners, etc., on each of the three indices (Euromoney country risk, Economist Intelligence Unit ratings, and the Institutional Investor rankings). Such identification can then be used to discuss what the rankings mean and why the various countries are rated highly or not. The correlation across the different rankings may be an interesting discussion as well. The discussion of internal evaluation models follows, and the use of statistical country risk scoring models (similar to credit risk scoring models discussed in Chapter 10). The models are relatively simple to understand and the description of the models contains very little mathematics. The key highlight of this section is to describe some of the key ratios used in the sovereign country risk evaluation models. One way to approach the learning of these factors is to ask the question: If you were an FI manager, what type of factors would you want included in the country risk evaluation model? Given the learning so far in the course, and especially in relation to credit risk, the types of factors identified by students may be industry or firm specific. Hence, it is an opportunity to broaden the discussion to economy wide factors, such as those listed in the book—factors found more from a country’s balance of payments than from firm balance sheets. Other measures of country risk are included in the chapter—for example, the Economic Freedom Index and Perceptions of Corruption Index. Again, you may be able to capture student imagination in the discussion of some of these issues—and draw the discussion to why such indices are interesting for FI managers making decisions to lend internationally. The portfolio aspect of international lending should not be ignored, and this will be apparent to the students after the discussion of the portfolio assessment of credit risk (Chapter 11). You may want to refer to Example 12.1 in this regard. Much of the discussion of the internal statistical models talks about the types of factors that have been found to be important empirically in country risk assessment and why. There is a lot of material, all of which is relatively easy to understand, and again could be covered by student reading rather than lecture format. The discussion of the secondary market for emerging country debt is also institutional and provides a background to the types of opportunities available to FIs to buy and sell foreign loans and bonds. Of particular interest may be the information in Table 12.6 which shows bank loans outstanding by a number of different countries, and the Global Perspective box which covers the impact of the European sovereign debt crisis. Appendix 12A covers mechanisms for dealing with sovereign risk exposure. If your course has a strong focus on lending and related risks, then you may also want to include the material from this appendix in your lectures. Instructor Manual for Financial Institutions Management Anthony Saunders, Marcia Cornett, Patricia McGraw 9780070979796, 9780071051590

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