Finance 208 Seminar in Financial Institutions

Copyright 2002-A.S.
Cebenoyan 1
Finance 208
Seminar in Financial Institutions
Professor A. Sinan Cebenoyan
Frank G. Zarb School of Business
Hofstra University
Overview Risks
Set three
Copyright 2002-A.S. Cebenoyan 2
Market Risk
Market Risk (Value at Risk, VAR): dollar exposure
amount (uncertainty in earnings) resulting from changes in
market conditions such as the price of an asset, interest
rates, market volatility, and market liquidity.
The five reasons for market risk management:
Management information (senior management sees exposure)
Setting Limits(limits per trader)
Resource Allocation (identify greatest potential returns per risk)
Performance Evaluation (return-risk per trader Bonus)
- Regulation (provide private sector benchmarks)
JPMs RiskMetrics Model
Large commercial banks, investment banks, insurance
companies, and mutual funds have all developed market
risk models (internal models). Three major approaches to
these internal models:
JPM Riskmetrics
Historic or back-simulation
Monte Carlo simulation
We focus on JPM Riskmetrics to measure the market risk
exposure on a daily basis for a major FI.
How much the FI can potentially lose should market
conditions move adversely:
Market Risk = Estimated potential loss under adverse
circumstances
Daily earnings at risk= ($ market value of position) x (Price volatility)
where,
Price volatility = (Price Sensitivity) x (Adverse daily yield move)
We next look at how JPM Riskmetrics model calculates DEaR in
three trading areas: Fixed income, Foreign exchange, and Equities,
and how the aggregate risk is estimated.
Market Risk of Fixed I ncome Securities
Suppose FI has a $1 million market value position in 7-yr zero coupons with a face
value of $1,631,483.00 and current annual yield is 7.243 .
Daily Price volatility =
) ( ) (
1
R MD R
R
D
P
dP
A = A
+
=
527 . 6
) 07243 . 1 (
7
1
= =
+
=
R
D
MD
The modified duration =
for this bond
If we make the (strong and unrealistic) assumption of normality in
yield changes, and we wish to focus on bad outcomes, i.e., not just
any change in yields, BUT an increase in yields that will only be
possible with a probability, i.e., a yield increase that has a chance
of 5%, or 10%, or 1%(We decide how likely an increase we wish
to be worried about). Suppose we pick 5 %, i.e., there is 1 in 20
chance that the next days yield change will exceed this adverse move.
If we can fit a normal distribution to recent yield changes and get a mean of 0 and
standard deviation of 10 basis points (0.001), and we remember that 90% of the area
under the normal distribution is found within +/- 1.65 standard deviations, then
we are looking at 1.65o as 16.5 basis points. Our adverse yield move.

Price Volatility = -MD (AR) = (-6.527) (.00165) = -.01077
DEaR = DEAR = ($ market value of position) (Price Volatility)
= ($1,000,000) (.01077) dropping the minus sign
= $10,770 The potential daily loss with 5% chance
For multiple N days, DEAR should be treated like o, and VAR computed as:

N DEAR VAR =
Foreign Exchange
Suppose FI has SWF 1.6 million trading position in spot Swiss francs. What is the
DEAR from this?
First calculate the $ amount of the position
$ amount of position = (FX position) x ($/SWF)
= (SWF 1.6million) x (.625) = $ 1 million
If the standard deviation (o) in the recent past was 56.5 basis points, AND
we are interested in adverse moves that will not be exceeded more than 5%
of the time, or 1.65o:
FX volatility = 1.65(56.5) 93.2 basis points THUS,
DEAR = ($ amount of position) x (FX volatility)
= ( $1million) x (.00932)
= $9,320
Equities
Remember your CAPM:
Total Risk = Systematic risk + Unsystematic risk

o o
|
o
2 2
2
2
eit mt
it
it
+ =
If the FIs trading portfolio is well diversified, then its beta will be close to 1, and
the unsystematic risk will be diversified away.leaving behind the market risk.
Suppose the FI holds $1million in stocks that reflect a US market index, Then
DEAR = ($ value of position) x (Stock market return volatility)
= ($1,000,000) (1.65 o m)
If the standard deviation of daily stock returns on the market in the recent past
was 2 percent, then 1.65(o m)= 3.3 percent
DEAR = ($1,000,000) (0.033) = $33,000
Portfolio Aggregation
We need to figure out the aggregate DEAR, summing up wont do,
REMEMBER:
2
2
)}] ( ) {( [ y x E y x E
y x
+ + =
+
o
2
2
))}] ( ( )) ( {( [ y E y x E x E
y x
+ =
+
o
))} ( ( )) ( ( { 2
)) ( ( )) ( (
2 2
2
y E y E x E x E
y E y E x E x E
y x
+
+ =
+
o
y x xy
y x y x
o o
o o o
2
2 2 2
+ + =
+
If the correlations between the 3 assets are:
Bond SWF/$ US Stock Index
Bond -.2 .4
SWF/$ .1
Then the risk of the whole portfolio, DEAR treated like o, will be
2 / 1
.
.
.
2
2 2
2
2
2
(
(
(
(
(
(
(
(
+
+
+
+ +
=
DEAR
DEAR DEAR
DEAR DEAR
DEAR DEAR
DEAR DEAR
swf
us
swf us
us
b
us b
swf
b
swf b
us
swf b
portfolio
DEAR
Substituting the values we have:

2 / 1
2 2 2
) 33 )( 32 . 9 )( 1 (. 2
) 33 )( 77 . 10 )( 4 (. 2
) 32 . 9 )( 77 . 10 )( 2 . ( 2
) 33 ( ) 32 . 9 ( ) 77 . 10 (
(
(
(
+
+
+
+ +
=
portfolio
DEAR
= $39,969
BIS Standardized Framework for Market Risk
Applicable to smaller banks.
Fixed Income
Specific Risk charge (for liquidity or credit risk quality)
General Market Risk charge
Vertical and horizontal offsets
Foreign Exchange
Shorthand method: (8% of the maximum of the aggregate net
long or net short positions)
Longhand method: Net position, Simulation, worst case scenario
amount is charged 2%
Equities
Unsystematic risk charge (x-factor): 4% against the gross position
Systematic risk charge (y-factor): 8% against the net position
Large Bank Internal models
BIS standardized framework was criticized for crude risk measurements
+ lack of correlations + incompatability with internal systems.
BIS in 1995 allowed internal model usage by large banks with
conditions:
Adverse change is defined as 99th percentile - Minimum holding
period is 10 days - correlations allowed broadly
Proposed capital charge will be the higher of the previous days
VAR, or the average daily VAR over the last 60 days times a factor
(at least 3). Tier 2 and 3 allowed up to 250% of Tier 1.
Credit Risk
Measurement of credit Risk:
Pricing of loans
credit rationing
Japanese FIs over-concentration in real estate and
in Asia
bad loans of 20 trillion yen in 1998
Japanese Life insurers exposed to these banks
by about 14 trillion Yen in loans
C & I Loans
Different size and maturities
Secured or unsecured
Fixed or floating
Spot Loans or Loan Commitments
Commercial paper (large corporations, directly or via
investment banker, sidestepping banks, lower rates)
Real Estate Loans
various features
Individual (Consumer) Loans
Revolving loans
High default rates (3-7 %)
Return on a Loan
Interest rate
fees
credit risk premium
collateral
nonprice terms (compensating balances, reserve
requirements)
Prime Rate most commonly used for longer-term loans,
fed-funds for shorter term
LIBOR

The gross return on loan, k, per dollar lent is

)] 1 ( [ 1
) (
1 1
R b
m L f
k

+ +
+ = +
Numerator is fees plus interestpromised cash flows
Denominator is net outflow from the bank
Expected return on the Loan
Default risk

) 1 ( ) ( k p r E + =
Retail versus Wholesale Credit decisions
Retail
Accept-Reject decisions
credit rationing.quantity restrictions rather
than price or interest rate differences
Wholesale
Interest rate and credit quantity used to control credit
risk
Prime plus a markup for riskier borrowers, BUT
Higher rates dont necessarily imply higher return
Measurement of Credit Risk
Need to measure probability of default
Information
Covenants
Default Risk Models
Three Broad Groups, Qualitative, Credit-Scoring, Newer Models
Qualitative Models (Expert systems)
Lack of public information leads to assembly of :
Borrower Specific information
Reputation, Long-term relationship, implicit contract
Leverage, or capital structure (D/E), threshold beyond
which probability of default increases
Volatility of earnings (stable v.s. high-tech)
Collateral
Market Specific Factors (Business cycle, Interest rates)

Credit Scoring Models
either calculate default probabilities or sort borrowers into
different risk classes, Thus:
Numerically establish the factors that explain default risk
Evaluate the relative importance of these factors
Improve pricing of default risk
Better screening of bad loan applicants
better position to calculate reserves needed to meet expected
future loan losses
Linear Probability Model

error X
ij
n
j
j
i
Z
+ =
=1
|
Example:
Suppose there were two factors influencing the past default
behavior of borrowers: the leverage or D/E and the sales/assets
ratio (S/A). Based on past default (repayment) experience, the
linear probability model is estimated as:

i i i
A S E D Z ) / ( 1 . ) / ( 5 . + =
Assume a prospective borrower has a D/E=.3, and a S/A=2.0, its
expected probability of default (Zi ) can then be estimated as:

35 . ) 0 . 2 ( 1 . ) 3 (. 5 . = + =
i
Z
) 1 ( ) (
i i
p Z E =
Also,
P is repayment probability
Problem is probabilities can lie outside of 0 to 1. Logit Model
fixes this by:

i
Z
i
e
Z F

+
=
1
1
) (
The left hand side is the logistically transformed value of Zi
The Probit Model is an extension of Logit which considers a
cumulative normal distribution rather than a logistic function.
Linear Discriminant Models
Altmans (of NYU) Z-score, uses various financial ratios in
classifying borrowers into high and low default risk classes:

5 4 3 2 1
0 . 1 6 . 0 3 . 3 4 . 1 2 . 1 X X X X X Z + + + + =
Where, X1=WC/TA, X2=RE/TA, X3=EBIT/TA,
X4=MVEq./BVLtd, and X5=Sales/TA, Low Z means high risk
Altmans Z has a switching point at 1.81.
Problems:
Only two extreme cases discussed
Are the coefficients stable over time?
Are the ratios relevant over time?
Qualitative factors ignored
Lack of data
Newer Models
Term Structure Derivation
We extract implied default probabilities on loans or bonds using the
spreads between risk-free discount Treasury bonds and discount bonds
issued by corporations of different risks
Probability of default on one-period Debt I nstrument
Assume risk-neutrality, and that the FI would be indifferent between
the corporate and the Treasury of same maturity discount bonds:
p(1+k) = (1+i)
p = (1+i) / (1+k) with i = 10% and k = 15.8%
p = (1.1) / (1.158) = .95 probability of repayment
thus, 5% is the implied probability of default given the market rates, a
5.8% risk premium ( u ) goes along with it.
u = k - i = 5.8%
If all is not lost at default, if is the proportion of the loan that can
be collected, then
(1+k)(1-p) + p(1+k) = 1 + i
the first term is the payoff to the FI if default occurs.
The fact that there will be partial recovery reduces u

) 1 (
) (
) 1 (
i
p p
i
i k +
+
+
= u =

With i= 10%, and p=.95, and =.9, risk premium u = 0.6
MULTI PERI OD WI LL BE COVERED I N CLASS!!!!!!
Mortality rate derivation of credit risk
Focus on historic default risk experience. Substitute mortality rates
for default rates.
MMR1= Ratio of total value of bonds of a certain grade defaulting in
year 1 of issue TO total value of same bonds outstdg. in year1 of issue
MMR2= Ratio of year 2 defaults TO total value of survivors in year2
Problems : backward-looking, period-sensitive, volume+size sensitive.

+
+
=
1
1
1
k
i
p
or
RAROC Models
Risk-adjusted return on capital, RAROC, is the ratio of loan income to
loan risk. A loan is approved if RAROC exceeds a FI established
benchmark rate (cost of capital)
Estimating loan risk is possible using a Duration-type approach

R
R
D
L
L
L
+
A
=
A
1
) 1 ( R
R
L D L
L
+
A
= A
Replacing interest-rate shocks with credit quality shocks

] 0 ) ( [ > A = A
G i
R R Max R
Examples will be done in class.
Credit Risk Continued
Option Models of Default Risk
Borrower always holds a valuable default or
repayment option. If things go well repayment takes
place, borrower pays interest and principal keeps the
remaining upside, If things go bad, limited liability
allows the borrower to default and walk away losing
his/her equity.
KMV corporation (www.kmv.com) has developed a
model called Expected Default risk Frequency EDF
used now by largest US banks.

Payoff to
stockholders
0
B
A1
A2
-S
Assets
This is the borrowers payoff function, s is the size of the initial
equity investment, B is the value of Bonds, and A is the market
value of the assets of the firm.
B
A1 A2 Assets
Payoff to
debt holders
The payoffs to the bond holders are limited to the amount lent B
at best.
Mertons model:
debt risky on yield Required ) (
)] ( ) / 1 ( ) ( ln[ ) / 1 ( ) (
premium risk default m equilibriu get the can We
borrower of risk asset
h exceeding deviation of ) (
/ )] ln( 2 / 1 [
/ )] ln( 2 / 1 [
) / ( ratio leverage s borrower'
)] ( ) ( ) / 1 [( ) (
1 2
2
2
2
2
1
2 1
=
+ =
=
=
+ =
=
=
=
+ =
t
t t
o
t o t o
t o t o
t
t
t
t
k
h N d h N i k
y probabilit h N
d h
d h
A Be d
t T
where
h N h N d Be F
i
i
On the last equation variance and leverage ratio would affect the risk
premium. But NOTICE that the key variables are A, market value of
assets, and asset risk

2
o
Neither of which are directly observable.
The KMV model uses the OPM to extract the implied market value of
assets (A), and the asset volatility of a given firm. This is done by
viewing equity as a call-option on the firms assets and the volatility
of a firms equity value will reflect the leverage adjusted volatility of
its underlying assets. We have in general form:
) (
) , , , , (
o o
t o
g
and
i B A f E
E
=
=
Where, the bars (-) denote variables that are directly observable.
Since we have 2 equations with 2 unknowns (A,o), we can solve.
The following is a graph that depicts the superior accuracy of
KMV-EDF over agency ratings in capturing expected
default probabilities.
Source KMV Corp.
Loan Portfolio Risk
We move beyond default risk measurements to
more aggregate contexts, i.e. portfolios.
I will focus on two models
A simple model : Migration Analysis
A more sophisticated model: KMV Corporations
Portfolio Manager Model
Migration Analysis
A Loan Migration Matrix measures the probability of a
loan being upgraded, downgraded, or defaulting over some
period. Historic data is used, as such it can be used as a
benchmark against which the credit migration patterns of
any new pool of loans can be compared.
In a Loan migration matrix the cells are made up of
transition probabilities.
The number of grades are generally around 10 for most
FIs.

Risk Grade at end of year
1 2 3 D=Default
Risk Grade 1 0.85 0.1 0.04 0.01
at beginning 2 0.12 0.83 0.03 0.02
of year 3 0.03 0.13 0.8 0.04
A Hypothetical Rating Transition Matrix:
If the FI is evaluating the credit risk of of grade 2 rated borrowers,
and observes that over the last few years a much higher %, say 5%,
have been downgraded to3, and 3.5% have defaulted, the FI may
then seek to restrict its supply of lower quality loans (grades 2 and
3), concentrating more on grade 1. At the very least it should seek
higher credit risk premiums on lower quality loans. Migration ana-
lysis is used on commercial, credit card, and consumer loan portfolios.
KMV Portfolio Manager Model
KMV Portfolio Manager is a model that applies
Modern Portfolio Theory to the loan portfolio.
To estimate an efficient frontier for loans as in the above figure, and
the proportions (Xi), we need to measure :

Expected return on a loan to borrower i, (Ri)
The risk of a loan to borrower i, (oi)
The correlation of default risks between loans to borrowers i and j
KMV measures each of the above as follows:
Return on the Loan:
] [ ) (
i i i i i i
LGD EDF AIS L E AIS R = =
Where,
AIS = annual all-in-spread on a loan =
(Annual Fees earned) + (Loan rate - Cost of Funds)
E(L) = expected loss on the loan
EDF = expected default frequency
LGD = loss given default
Risk of the Loan:
i i i i Di i i
LGD EDF EDF LGD UL = = = ) 1 ( o o
The Unexpected Loss (UL) is a measure of loan risk, oi. It reflects the
volatility of the loans default rate, oDi, times LGD. To measure oDi
we assume loans either default or repay (no default), then defaults are
binomially distributed, then the o of the default rate for the ith borrower
oDi, is equal to the square root of the probability of default times one
minus the probability of default, as above with EDF, (1-EDF).
Correlation : ij
Correlation between the systematic return

components of the equity returns of borrower i and j. Generally low.
A number of large banks are using this model or variants to actively
manage their loan portfolios. Some are reluctant especially if involving
long-term customers. Diversification versus Reputation.
Sovereign Risk
Large Exposure
Japan
US
Britain
France
Germany
Other
Foreign banks share of total Asian debt at the end of June
1997 (excluding Singapore and Hong Kong. Source BIS)
Prior to July 97 Thai crisis, Foreign banks had $389 billion in loans
and other debt outstanding.
Bailouts and loan restructuring packages (South Korea $57 billion
IMF organized loan package) Argentina? Turkey?
Credit Risk
Sovereign Risk should dominate
Repudiation (common before WWII) bonds
Rescheduling (common since WWII) bank loans
Relatively small number of banks (1/98 South Korea loans
just over 100 banks involved)
Same group of banks involved
Cross-default provisions
Governments view social costs of default on international
bonds less worrisome than on loans. Possible incentive
problems?
Country Risk Evaluation
Outside Evaluation Models
Euromoney Index
Institutional Investor Index
Internal Evaluation Models
Similar to our Credit-risk scoring models based on explaining
probability of a country rescheduling, like Z-scores
Common variables in CRA:
Debt Service ratio=(interest+amortization on debt)/Exports
positive relation with probability of rescheduling
Import Ratio=(Total imports/Total FX reserves)
positive relation
Investment Ratio= Real Investment/GNP
+/- relation, arguments on both sides
Variance of Export Revenue=
+ relation
Domestic Money Supply Growth= AM / M
+ relation

2
ER
o
Problems
Measurement
Population groups (a finer distinction than rescheduler or not)
Political risk factors
Portfolio aspects (systematic risk more important)
Incentive Aspects (Benefits and Costs) Read section
Stability (of variables)
Use of Secondary market for LDC Debt to measure risk
The structure of the market
Brady Bonds ($ loans exchanged for $ bonds-US Treasury bonds
are used to collateralize the bonds).
Sovereign Bonds. No US-Tbonds used as collateral
Performing Loans
Non-performing loans
LDC Market Prices and CRA
Regression analysis of price changes to key variables. LHS= periodic
changes in prices of LDC debt in the secondary markets, RHS= set of
key variables.
Once the parameters are estimated, FI can combine these with
forecasts of key variables to estimate price changes.
Has problems but hopefully reduces errors.
Dealing with Sovereign Risk Exposure
Debt-Equity Swaps (Industries like motor, tourism, chemicals
have been desirable fo outside investors.)
FI may sell $100 million loan to a company for $93, Company
negotiates with foreign gov. And swaps $100 million for $95
million worth equity in local currency. Company has $2million
buffer, country gets rid of US$ debt, company has to invest in
local markets in local currency.
MYRA (Multiyear Restructuring Agreements)
concessionality: The amount the bank gives up in present value
terms as a result of a MYRA.
Example to be done in class
Loan sales
Debt for Debt Swaps (Brady Bonds)
Capital Adequacy
Functions of capital
To absorb unanticipated losses with enough margin to
inspire confidence and enable the FI to continue as a
going concern
To protect uninsured depositors, bondholders, and
creditors in the event of insolvency and liquidation
To protect the FI insurance funds and the taxpayers
To acquire the plant and other real investments
necessary to provide financial services
The Cost of Equity Capital

+
+ +
+
+
+
=
) 1 (
...
) 1 (
) 1 (
2
2 1
0
k
D
k
D
k
D
P
If dividends are assumed to grow at a known and constant
rate g, then
g k
g D
P
+
=
) 1 (
0
0
Capital and Insolvency Risk
Capital
Net Worth a market value accounting
concept
The above can be extended to P/E and D/E ratios
The market value of capital and credit risk
Simple examples on declines on Loan values and its effects on Net
worth can be easily constructed.
The larger the FIs net worth, the more protection
The market value of capital and Interest Rate risk
Example in class.
FASB Statement No.115, requires securities classified as available for
sale to be marked to market. Regulators in 12/94 exempted banks.
The Book value of capital
Par value of shares
Surplus value of shares
Retained Earnings
Loan Loss Reserve
BV=Par value+Surplus value+Retained Earnings+Loss reserves
Book Value of Capital and Credit Risk (reluctance to recognize
losses)
recognizes partial loss
Book value of capital and Interest rate risk : No change
Discrepancy between MV/BV
Arguments Against MV Accounting
difficult to implement (dubious)
Introduces excessive variability to Net Worth (not all is held to
maturity)
Credit Crunch
Actual Capital Rules
Two different capital requirements since 1987
The Capital-Assets ratio (Leverage ratio)
L = (Primary or Core Capital) / Assets
Core capital=BV of Common + qualifying cumulative
preferred stock + minority interests in equity of consolidated
subsidiaries
Problems:
Market Value (could be massively insolvent)
Asset Risk (not all assets have same credit+int.rate risks)
Off-balance-sheet activities (no capital required)
Risk Based Capital Ratios (to improve on the previous)
The following may be changed in the next couple of years. BI S has
proposed to remove the 8% requirement and implement capital
adequacy guidelines based on ratings (S&P, Moodys, etc.)
Basel Agreement implemented two new risk-based capital ratios
Total risk-based cap ratio= Total cap / Risk-adj.assets > 8%
where Total capital= Tier I plus Tier II
and
Tier I (core) cap ratio = Core cap / Risk-adj. Assets > 4%
Calculations will be done in class examples
Criticisms of the Risk-based Capital ratios
Risk weights
Balance sheet incentive problems
Portfolio aspects
All commercial loans have equal weight
Other Risks
Competition

Interest-Rate Swap Example
(borrowed from Katerina Simons, New England Economic Review, 1989)
3 Parties involved:
A Public Utility (BBB rated)
A Finance Company (AAA rated)
A Bank (AA rated)
Starting Positions:
Utility: has low credit rating. Wants to match its LT
assets with LT fixed-rate debt. But finds it expensive
Finance Co: has good rating. Can obtain low cost fixed
rate debt, but prefers ST or floating to match ST assets.

Bank serves as middleman
Borrowing costs before swap (%):
Fixed Rate Floating Rate
Public Utility 10.00 LIBOR + .80
Finance Co. 8.85 LIBOR + .30
difference 1.15 .50
The finance co. enjoys a lower borrowing cost in both markets.
But, the public utility faces relatively lower costs in floating rate
mkt. It has a comparative advantage of 65 bp (115 - 50). This 65
bp comp. Advantage is the amount of potential savings from the
swap.
Public
Utility
(BBB)
Bank
(AA)
Finance
Company
(AAA)
Pays 9%
fixed
Pays
8.9% fixd
LIBOR
LIBOR
Borrows floating
LIBOR + .80
Borrows fixed
8.85 %
Public Utility pays bank fixed 9% and receives LIBOR. Its Total Borrowing
costs are:
9% - LIBOR + ( LIBOR + .80 ) = 9.8%
Finance Company pays Bank LIBOR and receives 8.9% fixed. Its Total borrowing
costs are:
LIBOR - 8.9% + 8.85% = LIBOR - 0.05%

In Summary:
Public Utility Finance Company
Pays 9% Pays LIBOR
-Receives LIBOR -Receives 8.9%
Borrows LIBOR + .80 Borrows 8.85%
9.8% LIBOR - .05%
Cost w/o swap 10.0% LIBOR + .30%
SAVINGS .20 % .35%
Total Potential savings from swap were .65%.
The bank takes .10 % spread as compensation for the swap.
Note:
The parties have not exchanged obligations to make principal
payments, only to make each others interest payments.
Hedges may not be perfect
This is a simple example to display the mechanics of a swap. It
does not go into risks, and exposures to the parties involved.
Interest rate movements and credit risks are very important.

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Substituting the values we have:

Correlation between the systematic return

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