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Risk Analysis for Financial Engineering

SEEM3580

Lecture1: Risks of Financial Institutions

Which organizations issue government bonds?


A ) US Federal Reserve
B) US Department of Treasury
C) US Securities and Exchange Commission

What type of institution is HSBC?


A ) Commercial bank
B) Broker
C) Dealer
D) Asset Manager
E) All
F) None
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Size of 2015 HK GDP ? In billions of USD


A)
1000 < GDP
B)
500 <GDP < 1000
C) GDP < 500
http://www.tradingeconomics.com/hong-kong/gdp
http://www.tradingeconomics.com/singapore/gdp
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Which one is correct?

Categories of Financial Institutions

Sell side: providers of financial and/or investment


services
-- brokers: bridging buyers and sellers
-- dealers: making markets for securities
-- investment banks: IPOs, advisories, researches

Categories of Financial Institutions


Buy side: buyers of assets and/or financial services
-- Mutual funds & pension funds
-- Insurance companies
-- Corporations, University endowments
-- Hedge funds

Categories of Financial Institutions


Middle side: central banks & regulators
-- US Federal Reserve Bank
-- Hong Kong Monetary Authority
-- PBoC, BoE, ECB, BoJ

Categories of Financial Institutions


Middle side: central banks & regulators
-- US Securities and Exchange Commission
-- UK Financial Services Authority
-- China Security Regulatory Commission

Topic 1. Risks of Financial Institutions


1.1 Role of Financial Institutions
1.2 Understanding risk
1.3 Risks faced by financial institutions

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1.1 Role of Financial Institutions (FIs)


Without FIs

Cash (e.g. savings)

Investors

Corporations

(e.g. households)

(e.g. Public companies)

Financial claims
(e.g. equity or debt claim)

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1.1 Role of Financial Institutions (FIs)

The following will decrease the attractiveness of the


investment to the investors:
Information cost:
Too costly for the investors to gather the information
of the corporations and sometimes even impossible to
do that. (e.g. Apple, JP Morgan)
Liquidity risk:
Difficult to sell the financial claims in the secondary
market.
Price risk:
The sale price of the financial claim will be less than
their purchase price.

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1.1 Role of Financial Institutions (FIs)


With FIs
FI
(brokers)

Investors
Cash
Financial claims
(may not be the
same as A)

FI
(asset
transformers)

Corporations
Financial
claims (A)
Cash

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1.1 Role of Financial Institutions (FIs)

FI can act as one, or both of the following:


Broker:
FI acts as an agent for investors to help them to
purchase or sale of the financial claims from
corporations and helps them to monitor the corporations.
(bridge buyers and sellers)
Asset transformer:
The FI issues financial claims (secondary securities)
that are more attractive to investors than the claims
directly issued by corporations (primary securities).
Because of the popularity, the secondary securities
usually have lower liquidity and price risks. (whole
sales), e.g. ETF

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1.1 Role of Financial Institutions (FIs)

FI helps investors to reduce


Information cost:
Delegated monitor - by grouping the funds of the
investors, FI has greater incentive to collect
information and monitor actions of the corporation.
Information producer through a wide spectrum of
secondary securities.
Liquidity and price risk:
Through the diversification, FI could reduce the
liquidity and price risk of its issued primary and
secondary securities.
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1.1 Role of Financial Institutions (FIs)


Transaction cost:
By aggregating the investors funds, FI can
purchase the assets in bulk with lower transaction
costs.
Risk of mismatching the maturities of assets and
liabilities:
By issuing new forms of financial contracts with
different maturities.

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1.1 Role of Financial Institutions (FIs)


Other special services of FIs
Transmission of monetary policy
In US, Federal Reserve Board adjust the Federal
Funds Rate (Fed Funds Rate) to control the supply
and demand of banks excess reserve and in turn the
money supply. (Open market operations)
Fed Funds rate: The interest rate at which banks lend
their excess reserve to the other banks. (short end)
Credit allocation
To finance a particular sector of economy which is
identified as being in special need of financing such
as home mortgages. (GSE)

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1.1 Role of Financial Institutions (FIs)

Intergenerational wealth transfers or time


intermediation
To transfer wealth between young and old age and
across generations. Life insurance Co. and pension
funds play a key role in it.
Payment service (clearing house, )
For example, check-clearing.
Denomination intermediation
Through the mutual fund, to allow the investors
overcome the constraints to buying assets imposed by
large minimum denomination sizes.
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1.1 Role of Financial Institutions (FIs)


Types of financial institutions
Depository institutions
Insurance companies
Securities firms and investment banks
Mutual funds and hedge funds
Finance companies

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1.1 Role of Financial Institutions (FIs)


Regulation on financial institutions
FIs play the key role for the global economic
development. Their negative news or failure would
cause serious impact to the economy over the globe.
Examples:

Bear Stearns
Lehman Brothers
Citigroup
AIG

Could you imagine what will happen to Hong Kong if


HSBC go under?
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1.1 Role of Financial Institutions (FIs)

Regulation is not costless


Net regulatory burden =
Private cost of regulations Private benefit of the
producers of financial services.
Example (volker rule, comm, mutul fund, hedge fund)
Regulations prohibit commercial banks from making
loan that exceed more than 10% of their equity capital
even though the loan is profitable.
Private cost: Banks loss the investment opportunity.
Private benefit: To safeguard the financial health of
the bank.

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1.2 Understanding risk


Definition of risk
Risk is a condition in which there is a possibility of
an adverse derivation from a desired outcome that is
expected or hoped for.
In financial risk, the desired outcome may be the
expected profit from certain assets or investments.

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1.2 Understanding risk


Why manage financial risk?
Societal view
Modern society relies on the smooth functioning of
banking and insurance systems and has a collective
interest in the stability of such systems.
The role of finance in capital market

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1.2 Understanding risk

Shareholders view
Proper financial risk management (RM) can increase
the value of corporation and hence shareholder value.

RM can reduce tax cost.


RM gave FI better access to capital markets than
individual investors.
RM can make bankruptcy less likely and reduce the
bankruptcy cost. So, the firm value can then be increased.
The bankruptcy cost is costly in the sense that the assets
have to be sold out at a price well below the fair one,
completely destroy of reputation and involving huge fees
to accountants and lawyers.
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1.2 Understanding risk

Economic capital
The economic capital is the capital that shareholders
should keep to limit the default (bankruptcy)
probability to a given reasonable level (confidence
level) over a given time horizon. A good RM could
reduce this economic capital.

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1.2 Understanding risk


Asset liability management (ALM)
ALM is to minimize the overall level of risks
inherited from the assets and liabilities of a financial
institution so as to earn adequate return and to
maintain a comfortable surplus of assets beyond
liabilities. ( how much debt to take on )

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1.3 Risks faced by financial institutions


Interest rate risk
The risk incurred by an FI when the maturities of its
assets and liabilities are mismatched. More precisely,
we should match duration instead of maturity if the
timing of cash flows is taken into consideration.
DV01

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1.3 Risks faced by financial institutions

Refinancing risk the cost of rolling over or


reborrowing funds will rise above the returns being
earned on asset investments.
Assets maturity > Liabilities maturity
Example 1.1

Liabilities

Liabilities

($100M)

($100M)

(Loan A)

(Loan B)
1

Assets
($100M)
0

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1.3 Risks faced by financial institutions


At t = 0,
FI
1. Borrows $100 million for 1 year with loan interest
rate 9% per annum (simple compounding and
compounding frequency = 1) (loan A)
2. Buys a 2-year par bond with principal $100 million
and coupon rate of 10% per annum (paid annually)

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1.3 Risks faced by financial institutions


At the end of year 1 (t = 1),
FI
1. Borrows 1-year loan of $100 million with loan
interest rate r% per annum (simple compounding
and compounding frequency = 1) (loan B)
2. Repays loan A together with its interest
3. Receives bonds coupon
Net profit
= 100M (100M + 9%100M) + 10% 100M = $1M.
It is important to note that r is not known at t = 0.
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1.3 Risks faced by financial institutions


At the end of year 2 (t = 2),
FI
1. Receives bonds principal and coupon
2. Repays loan B together with its interest
Net profit
= (100M + 10%100M) (100M + r% 100M)
= (10% r%)100M
If r% < 11%, FI makes profit.
If r% > 11%, FI incurs loss.
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1.3 Risks faced by financial institutions

Reinvestment risk the returns on funds to be


reinvested will fall below the cost of funds.
Liabilities maturity > Assets maturity
Example 1.2
Liabilities
($100M)
0

1
Assets

Assets

($100M)

($100M)

(Bond A)

(Bond B)
1

2
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1.3 Risks faced by financial institutions


At t = 0,
FI
1. Borrows $100 million for 2 years with loan interest
rate 9% per annum (simple compounding and
compounding frequency = 1) (loan A)
2. Buys a 1-year par bond with principal $100 million
and coupon rate of 10% per annum (paid annually)
(Bond A)

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1.3 Risks faced by financial institutions


At the end of year 1 (t = 1),
FI
1. Pays loans interest
2. Receives bonds coupon and principal
3. Buys 1-year par bond with principal of $100 million
and coupon rate c% per annum (paid annually)
(bond B)
Net profit
= 9% 100M + (100M + 10%100M) 100M = $1M.
It is important to note that c is not known at t = 0.
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1.3 Risks faced by financial institutions


At the end of year 2 (t = 2),
FI
1. Receives bonds principal and coupon from bond B
2. Repays loan together with its interest
Net profit
= (100M + c%100M) (100M + 9% 100M)
= (c% 9%)100M
If c% < 8%, FI incurs loss.
If c% > 8%, FI makes profit.
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1.3 Risks faced by financial institutions

One of the simple ways to hedge the interest rate risk


is to match the maturities (duration) of the FIs
assets and liabilities. However, that way is
inconsistent with the role of FI being an asset
transformer.

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1.3 Risks faced by financial institutions


Market (Trading) risk
The risk incurred in the trading of assets and
liabilities due to changes in interest rates, exchange
rates, and other asset prices.
Based on time horizon and secondary market liquidity,
the FIs asset and liability portfolio can be classified
into:

Investment portfolio contains assets and liabilities that


are relatively illiquid and held for longer periods.
Trading portfolio contains assets, liabilities and
derivatives contracts that can be quickly brought or sold
on organized financial markets.
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1.3 Risks faced by financial institutions

Banking book = Investment portfolio


Trading book = trading portfolio
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1.3 Risks faced by financial institutions

The market risk increases as the volatility of the


prices of the traded financial instruments increase.
The larger of the unhedged (open) trading position,
the higher of the market risk will be.

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1.3 Risks faced by financial institutions


Credit risk
The risk that the promised cash flows from loans and
securities held by FIs may not be paid in full.
The examples of credit event include delay, reducing
or missing of bonds coupon and/or principal.
Firm-specific credit risk the risk of default of the
borrowing firm associated with the specific types of
project risk taken by that firm.

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1.3 Risks faced by financial institutions

Systematic credit risk the risk of default associated


with general economy wide or marco conditions
affecting all borrowers. For example, the economic
recession.
Contagion credit risk the default of a firm induces
the default of the other firms. For example, if GM
collapses, it may cause financial trouble or even
bankruptcy to its suppliers.
Through portfolio diversification, only firm-specific
risk and part of contagion credit risk can be
diversified away. The systematic risk is still here.
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1.3 Risks faced by financial institutions


Off-balance-sheet risk
The risk incurred by an FI due to activities related to
contingent assets and liabilities held off the balance
sheet.
The off-balance-sheet activity (item) is defined as the
activity (item) does not involve holding a current
asset or the issuance of a current liability. The offbalance-sheet item only appear on the FIs balance
sheet when a contingent event occurs.
The advantage of off-balance-sheet item is that it can
avoid regulatory costs or taxes.
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1.3 Risks faced by financial institutions

A futures contract is an example of off-balance-sheet


item. The underlying asset of the future contract does
not appear on the FIs balance sheet when the
contract commences. The asset will only be part of
the balance sheet when the asset delivery is really
occurred.

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1.3 Risks faced by financial institutions


Foreign exchange risk
The risk that exchange rate changes can affect the
value of an FIs assets and liabilities denominated in
foreign currency.
Example 1.3
A U.S. FI makes a loan to a British Co. in pounds
sterling (). If the British pound depreciate with
respect to USD or the exchange rate (US/pound)
decreases, then the return from the loan will drop.

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1.3 Risks faced by financial institutions

To have effective hedging foreign exposure (foreign


exchange rate and foreign interest rate risk) requires
matching the amount of foreign assets and liabilities
and also their duration.

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1.3 Risks faced by financial institutions


Country or sovereign risk
The risk that repayments from foreign borrowers may
be interrupted because of restrictions, intervention, or
interference from foreign governments.
One of the examples is the European debt crisis in
2010. (Greece, Iran)

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1.3 Risks faced by financial institutions


Technology and operational risks
The technology risk refers to the risk that incurred by
an FI when technological investments do not produce
cost saving anticipated.
The operational risk is defined as the risk that existing
technology or back-office support systems may
malfunctions or break down. For example, HSBC in
London lost customer data disc in April, 2008. It may
subject to fine by Financial Service Authority (FSA).

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1.3 Risks faced by financial institutions


Liquidity risk
The risk that a sudden surge in liability withdrawals
may require an FI to liquidate assets in a very short
period of time and at low prices (fire-sale, Lehman).

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1.3 Risks faced by financial institutions


Insolvency risk
The risk that an FI may not have enough capital to
offset a sudden decline in the value of its assets.
It is a consequence or outcome of one or more the
risks described before: interest rate, market, credit
risks.

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1.3 Risks faced by financial institutions


Other risks
Discrete risks external to the FI such as sudden
change in regulation policy and natural disasters like
earthquake.
Macroeconomic or systematic risk such as increased
inflation.

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1.3 Risks faced by financial institutions


Interaction of risks
Actually, the risks described above are not
independent with each other. They interact with other
for certain degree.
If 2 risks are positively (negatively) correlated, the
sum of their individual effect will underestimate
(overestimate) their combined effect.
If the interest rate increases, the more difficult for the
borrowers to repay the loan to FI. As a result, the
credit risk of FI increases.
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