1. Functionality of Banks and Hedge Funds and Contagion Between Financial Institutions Mila Getmansky Sloan School of Management System Dynamics Colloquium April 20, 2001

2. 2 Motivation Increasing complexity of financial markets Recent financial crises and contagion Unpredictability of crises

3. 3 Goals Study crises and contagion effects in the framework of two financial institutions: a bank and a hedge fund Understand conditions under which each of the financial institutions can fail and determine when a failure in one financial institution can trigger a contagion effect that leads to the failure in another financial institution

4. 4 General Accounting Framework Assets = Liability + Equity AssetsLiabilities -Cash -Total investments -Loans Equity

5. 5 Modeling Variables CASH INVESTMENTS Low risk Medium risk High risk LOANS Short-term Long-term LIABILITIES Deposits Interest owed to depositors EQUITY Capital gains Interest payments Interest owed to depositors Defaults

6. 6 Generic Accounting Framework

7. 7 Flows: Bank Lends to a Hedge Fund Bank lends money to a hedge fund. It earns interest. Hedge fund borrows money from a bank. It has to pay interest.

8. 8 Flows: Bank Invests in a Hedge Fund Bank invests in a hedge fund. It earns returns. Hedge fund receives money from the bank and usually invests right away.

9. 9 Ways a Bank Can Fail, Equity<0 No capital gains (capital losses) Bank does not make prudent decisions in risky investments Market collapses Hedge fund makes poor investments Defaults on principal Hedge fund or another borrower defaults on loans Defaults on interest payments

10. 10 Ways a Hedge Fund Can Fail, Equity<0 Makes poor investment decisions General market conditions are bad Banks or other lending institutions decide not to lend (make new deposits), especially in crises times when liquidity is very much needed

11. 11 Rate of Return: Distribution Choice Lognormal distribution of returns are continuously compounded single-period returns, IID normal Single-period gross simple returns are distributed as IID lognormal variates Three types of returns are used: low risk, medium risk and high risk

12. 12 Rate of Return : Calculation

13. 13 Rate of Return on Investments is the rate of return on investments [$/year] is the total investments [ $ ] is the total net losses [ $ ]

14. 14 Decision Points That Can Potentially Lead to Crises and Contagion Effects Effect of a rogue trader on net losses Effect of leverage on: Liquidation Deposits Withdrawals

15. 15 Rogue Trader Limited liability option (increases the risk of a trading position) -transparent Losses (increase the probability of being a rogue trader) – less transparent Skill (increase the probability of a successful bet made by a rogue trader) – even less transparent

16. 16 Behavior of Rogue Trader

17. 17 Leverage A good indicator of the extent to which a business is leveraged is: Leverage = Assets/Equity