1. Drake DRAKE UNIVERSITY Fin 129 Off - Balance Sheet Activities

2. Drake Drake University Fin 129 Off balance sheet activities Contingent assets or liabilities that impact the future of the Financial Institutions balance sheet and solvency. Claim moves to the asset or liability side of the balance sheet respectively IF a given event occurs. Often reported in footnotes or not reported buried elsewhere in financial statements

3. Drake Drake University Fin 129 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

4. Drake Drake University Fin 129 Large Derivative Losses 1994 Procter and Gamble sue bankers trust over derivative losses and receive $200 million. 1995 Barings announces losses of $1.38 Billion related to derivatives trading of Nick Lesson NatWest Bank finds losses of $77 Million pounds caused by mispricing of derivatives

5. Drake Drake University Fin 129 Large Derivative Losses 1997 Damian Cope, Midland Bank, is banned by federal reserve over falsification of records relating to derivative losses 1997 Chase Manhattan lost $200 million on trading in emerging market debt derivative instruments LTCM exposure of $1.25 trillion in derivatives rescued by consortium of bankers

6. Drake Drake University Fin 129 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

7. Drake Drake University Fin 129 Options Call Option – the right to buy an asset at some point in the future for a designated price. Put Option – the right to sell an asset at some point in the future at a given price

8. Drake Drake University Fin 129 Call Option Profit Call option – as the price of the asset increases the option is more profitable. Once the price is above the exercise price (strike price) the option will be exercised If the price of the underlying asset is below the exercise price it won’t be exercised – you only loose the cost of the option. The Profit earned is equal to the gain or loss on the option minus the initial cost.

9. Drake Drake University Fin 129 Profit Diagram Call Option Profit Spot CostPrice S S-X-C X

10. Drake Drake University Fin 129 Call Option Intrinsic Value The intrinsic value of a call option is equal to the current value of the underlying asset minus the exercise price if exercised or 0 if not exercised. In other words, it is the payoff to the investor at that point in time (ignoring the initial cost) the intrinsic value is equal to max(0, S-X)

11. Drake Drake University Fin 129 Payoff Diagram Call Option Payoff Spot Price S S-X X X

12. Drake Drake University Fin 129 Put Option Profits Put option – as the price of the asset decreases the option is more profitable. Once the price is below the exercise price (strike price) the option will be exercised If the price of the underlying asset is above the exercise price it won’t be exercised – you only loose the cost of the option.

13. Drake Drake University Fin 129 Profit Diagram Put Option Profit Spot Price Cost X S X-S-C

14. Drake Drake University Fin 129 Put Option Intrinsic Value The intrinsic value of a put option is equal to exercise price minus the current value of the underlying asset if exercised or 0 if not exercised. In other words, it is the payoff to the investor at that point in time (ignoring the initial cost) the intrinsic value is equal to max(X-S, 0)

15. Drake Drake University Fin 129 Payoff Diagram Put Option Profit Spot Price Cost X S X-S

16. Drake Drake University Fin 129 Pricing an Option Black Scholes Option Pricing Model Based on a European Option with no dividends Assumes that the prices in the equation are lognormal.

17. Drake Drake University Fin 129 Inputs you will need S = Current value of underlying asset X = Exercise price t = life until expiration of option r = riskless rate  2 = variance

18. Drake Drake University Fin 129 PV and FV in continuous time e = 2.71828 y = lnx x = e y 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 = PVe rn =PVe rt let t =n rearranging for PV PV = FVe -rt

19. Drake Drake University Fin 129 Black Scholes Value of Call Option = SN(d 1 )-Xe -rt N(d 2 ) S = Current value of underlying asset X = Exercise price t = life until expiration of option r = riskless rate  2 = variance N(d ) = the cumulative normal distribution (the probability that a variable with a standard normal distribution will be less than d)

20. Drake Drake University Fin 129 Black Scholes (Intuition) Value of Call Option SN(d 1 ) - Xe -rt N(d 2 ) The expected PV of cost Risk Neutral Value of S of investment Probability of if S > X S > X

21. Drake Drake University Fin 129 Black Scholes Value of Call Option = SN(d 1 )-Xe -rt N(d 2 ) Where:

22. Drake Drake University Fin 129 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

23. Drake Drake University Fin 129 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

24. Drake Drake University Fin 129 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

25. Drake Drake University Fin 129 Applying Delta The value of the contingent value is simply: delta x Face value of the option If Delta =.25 and The value of the option = $100 million then Contingent asset value = $25 million

26. Drake Drake University Fin 129 OBS Options Loan commitments and credit lines basically represent an option to borrow (essentially a call option) When the buyer of a guaranty defaults, the buyer is exercising a default option.

27. Drake Drake University Fin 129 Adjusting Delta Delta is at best an approximation for the nonlinear relationship between the price of the option and the underlying security. Delta changes as the value of the underlying security changes. This change is measure by the gamma of the option. Gamma can be used to adjust the delta to better approximate the change in the option price.

28. Drake Drake University Fin 129 Gamma of an Option The change in delta for a small change in the stock price is called the options gamma: Call gamma =

29. Drake Drake University Fin 129 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:

30. Drake Drake University Fin 129 Impact on the balance sheet Start with a traditional simple balance sheet Since assets = liabilities + equity it is easy to find the value of equity Equity = Assets - Liabilities Example: Asset = 150 Liabilities = 125 Equity = 150 - 125 = 25

31. Drake Drake University Fin 129 Simple Balance Sheet Assets Market Value of Assets 150 Total 150 Liabilities Market Value of Liabilities 125 Equity (net worth) 25 Total 150

32. Drake Drake University Fin 129 Contingent Assets and Liabilities Assume that the firm has contingent assets of 50 and contingent liabilities of 60.

33. Drake Drake University Fin 129 Simple Balance Sheet Assets Market Value of Assets 150 MV of Contingent Assets Total 200 Liabilities Market Value of Liabilities 125 Equity (net worth) MV of contingent Liabilities Total 200

34. Drake Drake University Fin 129 Reporting OBS Activities In 1983 the Fed Res started requiring banks to file a schedule L as part of their quarterly call report. Schedule L requires institutions to report the notional size and distribution of their OBS activities.

35. Drake Drake University Fin 129 Growth in OBS activity Total OBS commitments and contingencies for US commercial banks had a notional value of $10,200 billion in 1992 by 2000 this value had increased 376% to $46,529 billion! For comparison in 1992 the notional value of on balance sheet items was $3,476.4 billion which grew to $6,238 billion by 2000 or growth of 79%

36. Drake Drake University Fin 129 Growth in OBS activities Billions of $

37. Drake Drake University Fin 129 Common OBS Securities Loan commitments Standby letters of Credit Futures, Forwards, and Swaps When Issues Securities Loans Sold

38. Drake Drake University Fin 129 Loan commitments 79% of all commercial and industrial lending takes place via commitment contracts Loan Commitment -- contractual commitment by the FI to loan up to a maximum amount to a firm over a defined period of time at a set interest rate.

39. Drake Drake University Fin 129 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

40. Drake Drake University Fin 129 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

41. Drake Drake University Fin 129 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.

42. Drake Drake University Fin 129 Loan Commitment Risk Credit Risk -- the firm may default on the loan after it takes advantage of the commitment. The credit worthiness of the borrower may change during the commitment period without compensation for the lender.

43. Drake Drake University Fin 129 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)

44. Drake Drake University Fin 129 Letters of Credit Commercial Letters of credit - A formal guaranty that payment will be made for goods purchased even if the buyer defaults The idea is to underwrite the common trade of the firm providing a safety net for the seller and facilitating the sale of the goods. Used both domestically and internationally

45. Drake Drake University Fin 129 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.

46. Drake Drake University Fin 129 Future and Forward contracts Both Futures and Forward contracts are contracts entered into by two parties who agree to buy and sell a given commodity or asset (for example a T- Bill) at a specified point of time in the future at a set price.

47. Drake Drake University Fin 129 Futures vs. Forwards Future contracts are traded on an exchange, Forward contracts are privately negotiated over-the-counter arrangements between two parties. Both set a price to be paid in the future for a specified contract. Forward Contracts are subject to counter party default risk, The futures exchange attempts to limit or eliminate the amount of counter party default risk.

48. Drake Drake University Fin 129 Forwards vs. Futures Forward Contracts Futures Contracts Private contract between Traded on an exchange two parties Not StandardizedStandardized Usually a single delivery date Range of delivery dates Settled at the end of contractSettled daily Delivery or final cash Contract is usually closed settlement usually takes place out prior to maturity

49. Drake Drake University Fin 129 Options and Swaps Sold in the over the counter market both can be used to manage interest rate risk.

50. Drake Drake University Fin 129 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.

51. Drake Drake University Fin 129 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.

52. Drake Drake University Fin 129 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.

53. Drake Drake University Fin 129 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,

54. Drake Drake University Fin 129 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

55. Drake Drake University Fin 129 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.

56. Drake Drake University Fin 129 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.

57. Drake Drake University Fin 129 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.

58. Drake Drake University Fin 129 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)

59. Drake Drake University Fin 129 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:

60. Drake Drake University Fin 129 Summary of Cash Flows for Firm B Cash Flow Cash Flow Net DateLIBOR Received Paid Cash Flow 3-1-984.2% 9-1-984.8%2.102.5 -0.4 3-1-995.3%2.402.5 -0.1 9-1-995.5%2.652.5 0.15 3-1-005.6%2.752.5 0.25 9-1-005.9%2.802.5 0.30 3-1-016.4%2.952.5 0.45

61. Drake Drake University Fin 129 Swap Diagram Company ACompany B

62. Drake Drake University Fin 129 Offsetting Spot Position Company A Borrows (pays) Pays Receives Net Company B Borrows (pays) LIBOR+.8% Receives Pays Net 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%

63. Drake Drake University Fin 129 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. 5.2% LIBOR+.8%

64. Drake Drake University Fin 129 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.

65. Drake Drake University Fin 129 Swap Diagram Co A FI Co B 5.2%LIBOR+.8% 5.015% LIBOR 4.985% LIBOR

66. Drake Drake University Fin 129 Why enter into a swap? The Comparative Advantage Argument FixedFloating A10% 6 mo LIBOR+.3 B11.2% 6 mo LIBOR + 1.0%

67. Drake Drake University Fin 129 Swap Diagram Co A FI Co B 10%LIBOR+1% 9.965% LIBOR 9.935% LIBOR

68. Drake Drake University Fin 129 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)

69. Drake Drake University Fin 129 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.