Off - Balance Sheet Activities

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Off - Balance Sheet Activities
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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

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OBS examples

• Derivatives -- Value or worth is based upon
• Basic Examples -- Futures, Options, and Swaps
• Other examples -- standby letters of credit and
  other performance guarantees

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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

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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

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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

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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

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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 wont 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.

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Profit Diagram Call Option

• Profit
• Spot
• Cost Price

S-X-C
S
X
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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)

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Payoff Diagram Call Option

• Payoff
• Spot
• Price

S-X
X
S
X
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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 wont be exercised you only
  loose the cost of the option.

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Profit Diagram Put Option

• Profit
• Spot Price
• Cost

X-S-C
S
X
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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)

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Payoff Diagram Put Option

• Profit
• Spot Price
• Cost

X-S
X
S
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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.

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Inputs you will need

• S Current value of underlying asset
• X Exercise price
• t life until expiration of option
• r riskless rate
• s2 variance

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PV and FV in continuous time

• e 2.71828 y lnx x ey
• FV PV (1k)n for yearly compounding
• FV PV(1k/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

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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)

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Black Scholes (Intuition)

• Value of Call Option
• SN(d1) - Xe-rt N(d2)
• The expected PV of cost Risk Neutral
• Value of S of investment Probability of
• if S gt X S gt X

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Black Scholes

• Value of Call Option SN(d1)-Xe-rtN(d2)
• Where

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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

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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

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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

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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

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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.

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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.

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Gamma of an Option

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

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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

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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

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Simple Balance Sheet

• Liabilities
• Market Value of Liabilities 125
• Equity (net worth) 25
• Total 150

• Assets
• Market Value of Assets 150
• Total 150

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Contingent Assets and Liabilities

• Assume that the firm has contingent assets of 50
  and contingent liabilities of 60.

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Simple Balance Sheet

• Liabilities
• Market Value of Liabilities 125
• Equity (net worth)
• MV of contingent Liabilities
• Total 200

• Assets
• Market Value of Assets 150
• MV of Contingent Assets
• Total 200

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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.

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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

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Growth in OBS activitiesBillions of
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Common OBS Securities

• Loan commitments
• Standby letters of Credit
• Futures, Forwards, and Swaps
• When Issues Securities
• Loans Sold

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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.

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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 ).
• The firm can borrow up to the maximum amount at
  any point in time over the life of the commitment

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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

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Loan Commitment Risks

• Takedown Risk --
• Feb 2002 - Tyco International was shut out of
  commercial paper market and it drew down 14.4
  billion loan commitments made by major banks.

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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.

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Loan Commitment Risk

• Aggregate Funding Risks -- Many borrowers view
  loan commitment as insurance against credit
  crunches. If a credit crunch occurs (restrictive
  monetary policy or a simple downturn in economy)

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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

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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.

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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.

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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.

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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

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Options and Swaps

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

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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.

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Loans Sold

• 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.

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Settlement Risk

• 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.

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Settlement Risk

• 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,

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Affiliate Risk

• 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

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Swaps Introduction

• An agreement between two parties to exchange cash
  flows in the future.
• The agreement specifies the dates that the cash
  flows are to be paid and the way that they are to
  be calculated.
• A forward contract is an example of a simple
  swap. With a forward contract, the result is an
  exchange of cash flows at a single given date in
  the future.
• In the case of a swap the cash flows occur at
  several dates in the future. In other words, you
  can think of a swap as a portfolio of forward
  contracts.

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Mechanics of Swaps

• The most common used swap agreement is an
  exchange of cash flows based upon a fixed and
  floating rate.
• Often referred to a plain vanilla swap, the
  agreement consists of one party paying a fixed
  interest rate on a notional principal amount in
  exchange for the other party paying a floating
  rate on the same notional principal amount for a
  set period of time.
• In this case the currency of the agreement is the
  same for both parties.

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Notional Principal

• The term notional principal implies that the
  principal itself is not exchanged. If it was
  exchanged at the end of the swap, the exact same
  cash flows would result.

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An Example

• Company B agrees to pay A 5 per annum on a
  notional principal of 100 million
• Company A Agrees to pay B the 6 month LIBOR rate
  prevailing 6 months prior to each payment date,
  on 100 million. (generally the floating rate is
  set at the beginning of the period for which it
  is to be paid)

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The Fixed Side

• We assume that the exchange of cash flows should
  occur each six months (using a fixed rate of 5
  compounded semi annually).
• Company B will pay

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Summary of Cash Flows for Firm B

• Cash Flow Cash Flow Net
• Date LIBOR Received Paid Cash
  Flow
• 3-1-98 4.2
• 9-1-98 4.8 2.10 2.5 -0.4
• 3-1-99 5.3 2.40 2.5 -0.1
• 9-1-99 5.5 2.65 2.5 0.15
• 3-1-00 5.6 2.75 2.5 0.25
• 9-1-00 5.9 2.80 2.5 0.30
• 3-1-01 6.4 2.95 2.5 0.45

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Swap Diagram

• Company A Company B

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Offsetting Spot Position
Assume that A has a commitment to borrow at a
fixed rate of 5.2 and that B has a commitment
to borrow at a rate of LIBOR .8

• Company A
• Borrows (pays)
• Pays
• Receives
• Net

• Company B
• Borrows (pays) LIBOR.8
• Receives
• Pays
• Net

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Swap Diagram

• Company A Company B
• The swap in effect transforms a fixed rate
  liability or asset to a floating rate liability
  or asset (and vice versa) for the firms
  respectively.

LIBOR.8
5.2
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Role of Intermediary

• Usually a financial intermediary works to
  establish the swap by bring the two parties
  together.
• The intermediary then earns .03 to .04 per annum
  in exchange for arranging the swap.

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Swap Diagram

• Co A FI Co B

LIBOR
LIBOR
5.2
LIBOR.8
5.015
4.985
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Why enter into a swap?

• The Comparative Advantage Argument
• Fixed Floating
• A 10 6 mo LIBOR.3
• B 11.2 6 mo LIBOR 1.0

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Swap Diagram

• Co A FI Co B

LIBOR
LIBOR
10
LIBOR1
9.965
9.935
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Managing Cash Flows

• Assume that an insurance firm sold an annuity
  lasting 5 years and paying 5 Million each year.
• To offset the cash outflows they invest in a 10
  year security that pays 6 million each year.
• The firm runs a reinvestment risk when they stop
  paying the cash outflows on the annuity a
  combination of swaps could eliminate this risk
  (on board in class)

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OBS Benefits

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