Off - Balance Sheet Activities

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

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

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

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

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.

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

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.

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

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)

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

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.

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

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)

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

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.

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

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

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)

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 > X S > X

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

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.

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).

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.

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

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.

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.

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

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.

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

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

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.

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

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.

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%

Growth in OBS activities Billions of $

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

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.

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

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.

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.

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.

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

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

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.

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.

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.

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

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

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.

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. The loan can have a ability to be put back to the asset or seller in the event of a decline in credit quality creating an OBS risk.

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.

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, this represents an intraday risk, this has been addressed somewhat by new technology.

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

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.

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

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

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

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

What Constitutes Default The CDS parties can agree to any or all of the events below Bankruptcy Failure to Pay Obligation Acceleration Obligation Default Repudiation or deferral Restructuring

What Does not Constitute Default Downgrade by rating agency Non Material events (error by employee causing a missed payment etc.)

Hedge against Default In the event of a default the swap buyer is hedged against the risk of default. The CDS is effectively an insurance policy against default. The risk of default is transferred to the seller of the CDS.

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

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

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

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

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

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

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

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

Credit Default Swap Risk Sharing $50 M of CDS With Co X Bank A Bank B $50 M of CDS With Co Y 3% on $100M Payment If Default 3% on $100M Payment If Default Company X Company Y