Transcript Slide 1

Class 9 Chap 1-6, 8, 9
Introduction, Depository Institutions, Finance Companies, Insurance Companies
Mutual funds, Interest rate risk, Duration, Convexity
You are responsible for all the material presented in class
and in the book since the first day of class.
This is a review of some elements of that information.
This is not a comprehensive review of all the information
you will be responsible for on the Exam!
2
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Exam I will cover:
 Chap 1-6, 8, 9
 From the first day of class up to hedging interest
rate risk with duration gap
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Main Role of FIs in the economy
 They channel money from savers to borrowers by borrowing money
(deposits-liabilities) and lending money (loans - assets)
 We looked at a world with and without financial institution
 Financial Institutions provide value by reducing:
▪ Information Risk
▪ Moral Hazard
▪ Adverse Selection
▪ Liquidity Risk
▪ Price Risk
▪ A few other reasons
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Types
 Commercial Banks
 Savings Banks and Savings & Loans
 Credit Unions
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Borrowing and Lending Activity
 Assets – Mainly Loans (mostly mortgage loans)
 Liabilities – Deposits – in different forms
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Industry Composition:
 S&L Crisis
 Commercial bank merger wave
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Types:
 Sales Finance – provide credit to clients of parent Co.
 Personal Finance – specialize in high risk installment loans
 Business Credit – specialize in factoring
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Borrowing and lending activities
 Assets – consumer, business, and real estate loans
 Liabilities – debt to parent, commercial paper, other loans
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Advantages and disadvantages of different sources of
financing
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Types
 Open-end
 Closed-end
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Asset specialization
 Short-term: money market mutual funds
 Long-term: stock, bond, and commodity funds
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Pricing
 Net Asset Value (NAV)
 Market price
 Fee structure
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Scandals
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We only briefly touched on hedge funds, so
don't worry about this for the exam
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Types
 Property Casualty
 Life Insurance
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Risk Exposure
 Adverse selection
 Moral hazard
 High frequency low loss events
 Low frequency high loss
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History/Industry composition
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Different types of firms
 Commercial Bank Holding Company; National Full Line Firms with corporate
specialty; Large Investment banks; Regional Securities Firms; Special discount
brokers; Special Electronic trading securities firms; Venture Capital Firms; Other Firms
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Different Business Lines
 Investing; Investment banking; Market Making; Trading; Cash Management; Mergers
& Acquisitions; Bank office and other services;
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Profitability through time
 Fixed commissions
 Underwriting
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Regulation
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Underwriting – firm commitment & best efforts
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Mutual fund share valuation
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Repricing GAP – the change in NII
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Bond Pricing
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Duration
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Convexity
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Duration GAP
Exxon oil decides to raise capital to develop a new oil well in the Gulf of Mexico by issuing $100M in noncallable 10-year notes. They higher JP Morgan to underwrite the issue. Calculate the total proceeds from the
issue received by Exxon and JP Morgan's under the following agreements
 JP Morgan sells 95% of the issue in a best efforts agreement with a target price of $734.00 per bond
($1,000 face value). JP Morgan charges an underwriting fee of $0.025 per dollar of face value.
 JP Morgan sells 80% of the issue for $750.00 in a firm commitment agreement with target price of
$720.00.
Mutual Fund Share Valuation
Primus funds manages a closed-end mutual fund. The fund holds 300 shares of Google priced at $132/share
2000 shares of Bank of America priced at $16/share , 1200 shares of Amazon priced at $36/share.
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Calculate the net asset value of the fund if there are 3200 fund shares outstanding
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If the price of Google decreases to $90/share and BoA increases to 20, how many shares would need to
be issued/retired (in a secondary offering) to keep the fund’s NAV constant?
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At what price can shares in the fund be purchased/sold?
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Estimates the difference between the value of assets maturing
and the value of liabilities coming due over a particular horizon
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Positive GAP = reinvestment risk
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Negative GAP = refinancing risk
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Can be used to estimate the change in net interest expense for
assets and liabilities over a particular horizon
Repricing GAP
Use the balance sheet to calculate the expected change
in net interest income for assets and liabilities at the oneyear horizon. Assume that the rate on RSA increases by
3% and the rate on RSL increases by 1%
Assets
Cash
C&I Loans (3- year)
residential loan (6 m)
Treasury Notes (5-year)
Adjustable rate mortgages
(adjusted every 6 m)
Liabilities
100
320
150
220
deposits
commercial paper (90 day)
General collateral Repo (10 day)
bank loans (10-year)
250
129
307
231
175
965
Equity
48
965
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Measures the sensitivity of the asset’s price to changes in the
interest rate (YTM)
1,000
0
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40
40
40
40
40
40
40
40
40
0.5
1
1.5
2
2.5
3
3.5
4
4.5
40
5
With a bond you receive your value in increments over many
different time periods
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Measures the sensitivity of the asset’s price to changes in the
Time value
interest rate (YTM)
1,000
On average you receive the value of
your bond 4.72 year after purchase
0
at D years
40
40
40
40
40
40
40
40
40
0.5
1
1.5
2
2.5
3
3.5
4
4.5
40
5
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With a bond you receive your value in increments over many
different time periods
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Duration asks on average when do you receive the full value
of the bond.
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Refers to the non-linear (curved) relationship between bond price and YTM
Duration is also the slope of the
tangent line at a certain point (YTM)
Bond Pricing , Duration & Convexity
Calculate the duration and convexity for a three-year bond with face value of $1,000, annual
coupon of 15% and YTM of 12%.
Use duration and convexity to estimate the change in bond price if the YTM increases to 13%
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Used to measure the sensitivity of equity capital to
changes in interest rates
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Can also be used to hedge equity capital against
movements in interest rates.
 Immunize – routine hedge
 Partial hedge – selective hedge
Duration GAP
Lantek bank hires you to evaluate its exposure to interest rate risk. That is, they would like to know by how
much their equity capital ratio will change if interest rates decrease from 8% to 7.5%.The duration of the
banks asset portfolio is 7 years and the duration of their liabilities is 2 years. Additionally, they hold 500M in
total assets financed with 470M in liabilities. They would also like to know what duration of liabilities will
make equity capital immune to changes in the interest rate.