FIL 241 Exam #4

Coca-Cola and FX Markets

"During the three months ended September 25, 2020, fluctuations in foreign currency exchange rates unfavorably impacted consolidated operating income by 9 percent due to a stronger U.S. dollar compared to certain foreign currencies..." "During the nine months ended September 25, 2020, the Company issued U.S. dollar- and euro-denominated debt of $15,600 million and €2,600 million, respectively" Hedging strategy includes use of forward contracts, purchase foreign currency options and collars, cross-currency swaps "Our Company conducts business in more than 200 countries and territories...Our foreign currency management program is designed to mitigate, over time, a portion of the potentially unfavorable impact of exchange rate changes on net income and earnings per share."

Adverse Selection and Moral Hazard of Securitization

-Loan Originators They have a moral hazard problem in that they are less concerned with credit quality of loans if they know they are going to be securitized and sold to someone else -Borrowers With no equity or down payment in their home, they have little incentive to not walk away when home values plummeted -Financial Institutions If institutions think that they are "too big to fail" and the government will bail them out, they have more incentive to take risky bets. At the time, one might think, "There is a great return if all goes well but the government will at least save us if it turns out bad. After all, the government helped save Bears Stearns, so why wouldn't they save us too?"

MMMF and the Credit Crisis of 2008

2005-2008: Money market mutual funds (MMMFs) grew 88% MMMFs had their own crisis in 2008 after the fall of Lehman Brothers Reserve Primary Fund "broke the buck" (NAV <$1) Run on money market funds ensued U.S. Treasury temporarily offered to insure all money funds Commercial Paper market dried up MMMFs fled the CP market fearing risks Fed began purchasing commercial paper to add liquidity to the market and bring down escalating rates

Housing Prices Boom

This led to a boom in US housing prices. From 1997 to 2006 housing prices tripled!

Hungry for Returns

A consequence of the Fed's low interest rate policy was that investors hungry for investments that provided higher returns. Bonds and other low risk investments now had low returns. This led many investors to start taking more risks and given that the economy seemed to be doing well, many grew complacent and more risk tolerant. One particular area this was evident was the market for securitized mortgages which was booming.

future contracts

A futures contract is an agreement to transact involving the future exchange of a set amount of assets for a price that is settled daily. Futures contracts differ from forwards in that futures: ´Employ margin requirements ´Employ daily marking to market. ´Cash settlement b/n buyer and seller each day prices change ´How does this differ from forwards? What are pros/cons of this for traders? ´Have limits on price movements to spread extreme price fluctuations over times ´Are characterized by significantly less default risk. ´What does the exchange do?

Interest Rate Swaps

A plain vanilla interest rate swap is an exchange of fixed-interest payments for floating-interest payments by two counterparties. ´The swap buyer makes the fixed-rate payments in an interest rate swap transaction. ´Goal to go from having variable-rate liab to fixed-rate lib to better match fixed-rate assets ´The swap seller makes the floating-rate payments in an interest rate swap transaction. ´ ´No principal is exchanged. ´Payments based on "notional principal" for amounts of periodic payments

Forward Contracts

A spot contract is an agreement to transact involving the immediate exchange of assets and funds. A forward contract is an agreement to transact involving the future exchange of a set amount of assets at a set price. ´Are prices/dates set immediately or in the future? Forward contracts: ´Involve underlying assets that are nonstandardized, because the terms to each contract are negotiated individually between the buyer and seller. ´Can be based on a specified interest rate (Example: LIBOR) rather than a specified asset.

Swaps

A swap is an agreement between two parties to exchange a series of cash flows for a specific period of time at a specified interval. ´Can be used to hedge but can lead to large losses if not careful ´Types of Swaps ´Interest rate ´Currency ´Credit risk ´Commodity ´Equity ´Agreements can last long time (ex. 15 years!) ´Banks held notional value of $110.6 Trillion (2020 Q1) =>

ARMs

Adjustable rate mortgages (ARMs) also grew in popularity with very attractive starting rates. When rates began to rise, so too did monthly mortgage payments leading more to default.

The MBS market dries up

Adverse Selection Problem Financial institutions desperately wanted to sell these risky MBS Investors naturally assumed that the institutions would keep the safe MBS's themselves and were just selling the lemons The market dried up Mark-to-market accounting rules required by FASB meant financial institutions had to mark down the values of MBS, even if they were not troubled. This led to some banks violating capital requirements Banks had to sell new equity or sell existing assets MBS were one of the few things they could sell but no one would buy them Some banks failed b/c they couldn't raise enough cash Those that didn't fail hoarded cash to avoid a similar fate

Stock Market Rebounds

After a big hit to stock values at the turn of the century, that trend began to reverse in 2003 and recover all the losses following the bubble bursting. Both this & low TED spreads suggested the economy was once again doing well.

Foreign exchange rates

Argentino peso in us$ is 0.0128. Per US$ 78.3325 ´1Argentina peso is worth 0.0128 USD. Also written as 0.0128 ARS/USD ´1 USD worth 78.3325 Argentina pesos. Also written as 78.3325 USD/ARS ´Notice that (1/78.3325)=0.0128

Bear Stearns

Bear Stearns was a investment bank originally started in 1923. In 2007 it, as well as Lehman Brothers, made it on Fortune's Most Admired Companies List... http://money.cnn.com/magazines/fortune/mostadmired/2007/industries/industry_52.html Bear suffered big losses from two of its hedge funds which was heavily involved in subprime mortgages and needed bailing out from the firm in the summer of 2007 JP Morgan bought out Bear in March 2008 with emergency financing from the Fed

Credit Default Swaps

CDS also became very popular. Financial institutions and other investors felt safe investing in CDOs and MBSs because they also may have bought a CDS. It seemed unlikely that a senior tranche would default, but if it did then the CDS would provide protection AIG alone issued more than $440 billion in CDSs tied to CDOs (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aKKRHZsxRvWs&refer=home) Furthermore CDS were subject to very minimal regulation and lacked transparency. $63 trillion of CDSs outstanding by August 2008.

Dodd-Frank Act

Congress responded to the crisis by passing the Dodd-Frank Wall Street Reform & Consumer Protection Act in July 2010 Key parts: Stricter rules for bank capital, liquidity, & risk management practices Ex of unintended consequences http://www.wsj.com/articles/banks-urge-big-customers-to-take-cash-elsewhere-or-be-slapped-with-fees-1418003852?mod=WSJ_hp_Markets3up Volcker Rule limits speculative trading by banks (ex. derivatives) Increased transparency in derivatives market Created Financial Stability Oversight Council & Bureau of Consumer Financial Protection Stress Tests and Living Wills https://www.wsj.com/articles/fed-to-include-high-unemployment-in-2019-stress-test-scenario-11549402223 Office of Credit Ratings created to oversee ratings agencies. Limited Fed bailout powers: http://www.wsj.com/articles/how-the-fed-protected-its-bailout-powers-1448916675?cb=logged0.3413920773113991

Sovereign Risk

Country or sovereign risk: is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments. ´Differs from credit risk of purchasing domestic assets. ´With domestic assets, usually have some recourse through bankruptcy courts ´ ´Foreign corporations may be unable to pay principal and interest even if they desire to do so. ´Foreign governments may limit or prohibit debt repayment due to foreign currency shortages or adverse political events. ´Little can be done in such cases

Rating Agencies

Credit rating agencies, like Moody's, Fitch, and S&P, were paid to rate MBS. Even though these turned out to be very risky, the rating agencies often gave them a "AAA" rating, the highest rating possible This led many investors to believe these were safe investments. A way this was justified was Collateralized debt obligation (CDO) tranches (French translation: slices) These prioritize claims on repayments. Senior tranches paid 1st then junior tranches.

Credit Risk

Credit risk is the risk that the promised cash flows from loans and securities held by Financial Inst. (FIs) may not be paid in full. ´FIs make loans or buy bonds backed by a small percentage of capital. ´Thus, banks and insurance companies can be significantly hurt by even minor amounts of loan losses. ´Which typically has more risk: short or long term maturities on bonds/loans? ´ ´Many financial claims issued by individuals or corporations have: ´Limited upside return (with a high probability). ´Large downside risk (with a low probability). ´A key role of FIs involves screening and monitoring loan applicants to ensure only the creditworthy receive loans. ´FIs also charge interest rates commensurate with the riskiness of the borrower.

CDOs and Credit Ratings

Even though subprime mortgages were risky, senior tranches got paid in full before junior tranches. People thought it was very safe that at least the senior tranches would be paid back in full, hence AAA rating Ratings agencies used past data to estimate future defaults but with changing mortgage standards, this proved to be a poor estimator of future defaults

Forwards

Example: ´An ag producer needs to sell 1 million bushels of corn in 4 months ´General Mills needs corn for products ´Both fear price movements ´Enter into forward contract to sell corn for $4.00/bushel ´No money exchanged today ´In 4 mo, sell 1M bushels to GM for $4 ´Who benefits if the spot price in 4 mo is: ´$4.50? $3.50?

Currency swaps

Example: ´US Bank has $200M Assets and ₤100 Debt with 6% coupons (maturity in 5 yrs) ´Risk the USD depreciates ´UK Bank as ₤100 Assets and $200M Debt with 6% coupons (maturity in 5 yrs) ´Currency Swap terms: ´US Bank pays $ to UK Bank ´UK Bank pays ₤ to US Bank ´Exchange rate set up front at $2/ ₤1 ´Payments cover both interest and principle

Interest Rates

Following the burst of the Tech Bubble, the Fed responded by dropping interest rates in an attempt to stimulate the economy. The 9/11 attacks further hurt the economy and encouraged the Fed to maintain this low interest rate environment. Furthermore, the economy seemed to be picking up and stabilizing. The TED spread is the difference b/n LIBOR (rate banks borrow from each other) and T-bill rate. The wider Ted spread, the greater fears of default or "counterparty" risk in the banking sector are. This was back to low levels around 2002.

Foreign Exchange Risk

Foreign exchange (FX) risk: Impact of FX changes on value of a Fin. Inst. assets and liabilities denominated in foreign currencies. ´Importance of diversification ´Fin. Inst. expand globally through: ´Acquiring foreign firms or opening new branches in foreign countries. ´Investing in foreign financial assets. ´ ´Returns on domestic and foreign direct investments vary ´Underlying technologies of various economies differ, as do the firms in those economies. ´Exchange rate changes are not perfectly correlated across countries. ´ ´If maturities differ, may have both Foreign currency & Foreign Int. Rt. Risk

Troubled Asset Relief Program

G.W. Bush signed TARP into law on Oct 3, 2008 This authorized $700 billion in expenditures Dodd-Frank later reduced this to $475 billion The U.S. Treasury made $15.3 billion profit from TARP, selling its last holding in 2014 Allowed Treasury Dept. to purchase or insured troubled assets, many of which were related to mortgages

Growth in Subprime lending

Government Policy The Community Reinvestment Act (CRA) in 1977 Lead to policy of federal gov to expand lending, particularly in real estate, into underserved (often minority) neighborhoods The Clinton administration accelerated efforts to encourage lending to lower income borrowers In 1992, Fannie Mae & Freddie Mac were required to devote a % of lending to support affordable housing

Growth in Subprime Lending

Government Policy The Riegle-Neal Interstate Banking and Branching Efficiency Act (1994) Repealed restrictions on interstate banking Listed CRA ratings for an out-of-state bank as consideration for allowing interstate branches Fannie & Freddie began receiving gov incentive payments in 1995 for purchasing MBS which included loans to low income borrowers This accelerated their involvement into the subprime market and encouraged lenders to make such loans

Increase of Securitization

In the 1970's Fannie Mae and Freddie Mac started buying lots of mortgages and bundling them into pools that could be traded like other financial assets. These are called Mortgage Backed Securities (MBS) Fannie & Freddie eventually ended up buying over half of all mortgages originated by private sector

Insolvency Risk

Insolvency risk: risk that Fin. Inst. may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities. ´Insolvency risk due to interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and/or liquidity risk. ´ ´Generally, the more equity capital to borrowed funds an FI has (that is the lower its leverage), the less insolvency risk it is exposed to. ´ ´Both regulators and managers focus on capital adequacy as a measure of an FI's ability to remain solvent.

Credit Default swaps

Institutions like AIG were involved in backing CDS's They backed many risky CDS's in search of (short-term) profit After the fall of Lehman Brothers, AIG was on the tab to cover huge sums from these CDS contracts it sold If AIG fell, then banks would be left holding these risky MBS without the CDS insurance. Banks couldn't sell the MBS's because no one wanted to buy them This prompted the bailout of AIG

Interest Rate risk

Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile. ´Asset transformation involves an FI buying primary securities or assets and issuing secondary securities or liabilities to fund the assets. ´ ´Risk from fixed-rate assets and floating-rate liabilities (or visa versa) ´Ex. Bank has liabilities at fixed rate of 2% from issuing 2 yr CDs ´Bank has assets at floating rate of Libor+1% from a 2 yr loan made ´ ´Risk from difference in time horizons (next slides) ´If an FI's assets are longer-term relative to its liabilities, it faces refinancing risk. ´The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments. ´ ´Ex. Bank has $100M of liabilities maturing in 1 yr and $100M of assets maturing in 2 yrs ´Interest rates are 5% on assets and 4% on liabilities ´What is impact if rates change in the next year? ´What can be done to protect against interest rate risk? ´Match maturity of assets and liabilities. ´Downsides: ´May be hard to do in practice. Example: What are main options for time of mortgages in the US? ´May not be as profitable b/c limit opportunities for investments/raising money ´ ´They may match the rate sensitivity of their assets and liabilities. ´ ´They may match the duration of their assets and liabilities.

Liquidity risk

Liquidity risk is the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices. ´Day-to-day withdrawals and loan demand are generally predictable. ´ ´To meet the demand for cash by liability holders, FIs must either liquidate assets or borrow additional funds. ´Purchased funds include short-term borrowings, such as federal funds loans and brokered deposits. ´Unusually large withdrawals by liability holders can create liquidity problems. In these cases: ´The cost of purchased and/or borrowed funds rises for FIs. ´The supply of purchased or borrowed funds declines. ´FIs may be forced to sell less liquid assets at "fire-sale" prices.

Market Risk

Market risk is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices. ´Closely related to interest rate and foreign exchange risk. ´Risk from active, short-term trading strategy. ´ ´Fin. Inst. trading portfolios differ from their investment portfolios on time horizon and liquidity. ´Trading assets, liabilities, and derivatives are highly liquid. ´Investment portfolios are relatively illiquid and are usually held for longer periods of time. ´Ex. Trading of a Common Stock vs. a Muni Bond ´ ´How does market risk change during a financial crisis?

Lax Standards

Not only was there an increase in subprime mortgages, but there also were more lax standards in determining when a loan originator should give out a loan. Trend to low or no documentation loans with little verification of borrower's ability to carry a loan. By 2006, a majority of subprime borrowers borrowed the entire purchase price. With little at stake, they were quick to walk away from their houses & stop making payments.

Off-balance sheet risk

Off-balance-sheet (OBS) risk is the risk incurred from activities related to contingent assets and liabilities (e.g. derivatives). ´Examples of OBS: ´Derivatives ´In 2016, commercial banks had $15.029 trillion in on-balance-sheet items, while notional value of their off-balance-sheet derivative items was $189.832 trillion. ´Letter of Credit ´Ex. Bank guarantees pmts on a muni bond w/ letter of credit. If bond defaults, bank pays losses. If no default, bank profits from fee. These will go on income statement in the future ´ ´OBS activities do not appear on balance sheet since it does not involve holding a current primary claim (asset) or the issuance of a current secondary claim (liability). OBS activities may impact future profits

Risks at Financial institutions

One of the major objectives of a financial institution's (FI's) managers is to increase the FI's returns for its owners Increased returns typically come at the cost of increased risk, which comes in many forms: •credit risk. •liquidity risk. •interest rate risk. •market risk. •off-balance-sheet risk. •foreign exchange risk. •country or sovereign risk. •technology risk. •operational risk. insolvency risk.

Two Components of Option Value

Option Premium=Intrinsic Value+Time Value Intrinsic value: ´the intrinsic value of a call option = max{S − X, 0}. ´the intrinsic value of a put option = max{X − S, 0}. ´Can this ever be negative? ´ Time value: ´Time Value=Premium - Intrinsic Value ´Can this ever be negative?

Credit Default swaps

Residential mortgage losses were so large that credit protections where insufficient. MBS were also coupled with Credit-Default Swaps These pay out in the event of a credit event such as default For a bank holding a MBS and a CDS, there was practically no risk on paper If the borrowers defaulted on the mortgages, the CDS would pay This reduced concern over holding risky MBS's

Ex. A Money Center Bank has ´Fixed rate liabilities: Issued bonds w/ 6% fixed coupons) ´Variable assets: Made loans at LIBOR +2% ´W/o swap, if interest rates fall, income falls but liabilities are same ´By selling an interest rate swap, they make floating-rate pmts ´Now variable assets and liabilities

Savings Bank: Variable rate liabilities: Pays market rates on customer deposits Fixed rate assets: Owns fixed rate mortgages W/o swap, if interest rates rise, then liabilities increase By buying an interest rate swap, they make fixed-rate pmts Now fixed assets and liabilities

AIG Timeline

Sept 17, 2008: Federal Reserve gave $85 billion bailout in return for a 79.9% stake in the company. The Fed made the loan under unusual circumstances. If used its power to lend to nonbanks under "unusual and exigent" circumstances. It used this same power to help rescue Bear Stearns in March 2008. U.S. sold the last of its AIG shares in Dec 2012, making a $22.7 bil profit

More homeownership

Sub-prime lending pushed home ownership to all time highs of 69% in 2006 Increased housing demand pushed up prices This decreased concern about subprime lending as houses could be resold at higher prices normally This led to increased home construction Subprime originations rose from $65 Billion in 1995 to $332 Billion in 2003 They were about 10% of all mortgage originations in 2003 Securitization of sub-prime loans grew from 28.4% to 58.7% of all loans from 1995 to 2003

Dot Com Bubble

The Tech Bubble burst around 2000. Below is the NASDAQ Composite, which is tech heavy, that peaked in March 2000.

The bubble Bursts

The bubble finally burst and house prices dropped Institutions could no longer sell properties at prices to cover the loan amounts in the event of a foreclosure With their homes worth much less, many homeowners walked away from their loans & homes

Overview of FX Markets

Today's U.S.-based companies compete and operate globally. Events and movements in foreign financial markets can affect the profitability and performance of U.S. firms. ´Firms with only U.S. operations still face foreign competition. ´For example, a U.S. resort competes with European resorts even though the U.S. firm has no foreign operations. ´If the dollar strengthens against the euro, the cost to come to the U.S. resort increases for Europeans and can reduce the number of foreign visitors at the U.S. resort. ´Foreign Exchange (FX) Risk ´Potential losses from change in FX rates when exchanging cash flows ´Currency Appreciation ´Currency Depreciation ´ ´Foreign exchange, FX, Forex are synonyms ´2019 Stats from BIS Triennial Survey ´$6.6 Trillion in FX trading PER DAY. ´FX swaps had high growth ´USD involved in 88% of trades, Euro in 32% of trades ´79% of trades facilitate in UK, US, Hong Kong, Singapore, or Japan

Response in future years

Treasury Dept. Report- 5 Years later: https://www.treasury.gov/connect/blog/Documents/FinancialCrisis5Yr_vFINAL.pdf Big Banks paid $110 billion in fines ($16.65B by BOA, $5B by Goldman Sachs, $7B by Citi, $13 B JP Morgan and $3 Morgan Stanley) http://www.wsj.com/articles/big-banks-paid-110-billionin-mortgage-related-fines-where-did-the-money-go-1457557442 Duetsche Bank paid $7.2 billion and Credit Suisse $5.3 billion. http://www.cnbc.com/2016/12/23/deutsche-bank-and-credit-suisse-agree-billion-dollar-fines-with-us-authorities.html Standard & Poor's paid $1.5 billion to end litigation plus $125 million to CALPERS http://www.wsj.com/articles/s-p-to-pay-1-5-billion-to-resolve-crisis-era-litigation-1422968960 Moody's settled with CALPERS for $130 Million http://www.wsj.com/articles/moodys-to-pay-calpers-130-million-to-settle-lawsuit-1457554312 Ratings agencies now subject to SEC oversight Although the Financial Crisis Inquiry panel suggested prosecutions of individuals, none have occurred yet. http://www.wsj.com/articles/financial-crisis-panel-suggested-criminal-cases-against-stan-oneal-charles-prince-aig-bosses-1459330202

Change in the identity of Mortgage Originators

Until the 1980's Savings and Loans were a dominant provider of residential mortgages in the US Their collapse in the late 1980's left a vacuum in the provision of residential mortgage origination Commercial banks increased some in market share But mortgage bankers & brokers took much of this market share These firms resell the mortgages shortly after origination, often to Fannie and Freddie Many of these firms have little at stake, financial or reputational, in the communities where they operated This lead to riskier behavior

Interest Rates and Mortgages

With the economy appearing to be more stable and with interest rates at such low levels, these factors fed a boom in the housing market. After all, the rates on a mortgage hadn't been any lower before so one might think that "rates will never be lower"

Euro

´1999: Fixed exchange rates b/n countries ´2002: Domestic currencies phased out, euros begin circulating ´Euro appreciated vs. USD in early 2000's ´European Sovereign Debt Crisis in 2010's led to Euro weakening

FX markets

´2019 Stats ´US Exports: $1.64 Trillion ´US Imports: $2.5 Trillion ´ ´Need markets to do currency transactions ´ ´Importance to hedge FX risks ´ ´Role of FX markets: ´facilitate foreign trade ´raising capital in foreign mkts ´transfer of risk b/n participants ´speculation on currency values

Technology Risk

´: Risk that tech investments do not produce anticipated cost savings. ´The major objectives of technological expansion are to allow the FI to exploit potential economies of scale and scope by: ´Lowering operating costs. ´Increasing profits. ´Capturing new markets.

Financial Institutions in FX Transactions

´A financial institution's overall net foreign exchange exposure in any given currency is measured as, ´Net exposurei = (assetsi,denom in for curr− liabilitiesi, denom in for curr) + (FX boughti − FX soldi) = Net foreign assetsi + Net FX boughti = Net positioni ´Net long position: benefits if foreign currency appreciates, loses if USD appreciates ´Ex. US banks are net long Canadian dollars. They have bought more CAD than they have sold ´If CAD appreciates vs. USD, then the bank benefits ´Net short position profits if foreign currency depreciates, loses if USD depreciates ´Ex. US banks are net short Euros. If Euro appreciates, then bank loses

Option markets

´An option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a prespecified price for a specified time period. ´Call Option ´Put Option ´ ´Terms ´Exercise or strike price ´Premium ´Spot price Underlying asset

Free-Floating Yuan

´Chinese yuan fixed peg to USD until 2005. ´US and others argued yuan was undervalued, boosting Chinese exports ´Yuan also called renminbi ´2005 to 2008 yuan shifted to "managed" floating system tied to euro and USD ´2008 yuan back to fixed peg to USD ´US again argued currency artificially weak ´2010 top finance leaders talk and agree to avoid currency devaluations ´In 2010's China allows more trading of yuan ´Aug 2019, US labels China as currency manipulator (label ended Jan '20 w/ trade deal) https://www.wsj.com/articles/why-the-u-s-labeled-china-a-currency-manipulator-and-what-it-means-11565105936 ´

Forward Markets

´Commercial banks & investment banks major participants ´Profit from spread on price buy and sell underlying asset for ´ ´Contract details are unique/tailor made by parties involved ´Counterparty/default risk ´Traded over-the-counter (OTC) ´ ´Recent changes: ´Increased trading in secondary markets ´Easier to take offsetting position ´Increase in standardization (now more similar to future contracts than before)

Credit options

´Credit Options ´Credit spread call option: Payoff increase as default risk premium or yield spread increases above exercise spread ´Ex. Bank can buy this to protect if a loan is in trouble ´Digital default option ´Pays stated amount if a loan default ´No payment made if no default before expiration date

Dollarization

´Definition: Use of a foreign currency in parallel to, or instead of, the local currency ´Can involve USD or other currency ´Ex. British Virgin Island's official currency is USD ´Ex. Panama's currency (Balboa) has exchange rate of 1:1 with USD ´Promotes fiscal discipline, more financial stability and lower inflation ´Sometimes doesn't last ´Ex. Argentina peso pegged 1:1 to USD until 2001 ´USD grew stronger, Argentina had big deficits ´Peso interest rates went to b/n 40% & 60% ´Went to floating peg in 2001

Option market

´Difference in American and European Options? ´ ´Terms: ´In the Money ´Exercise would generate positive cash flow ´Call: market price>strike price; Put: strike price>market price ´Out of the Money ´Exercise would generate negative cash flow ´Call: market price< strike price; Put: strike price<market price ´At the Money ´Exercise price equals asset price ´market price= strike price

futures markets

´Floor brokers place trades for the public. ´Professional traders trade for their own accounts. ´Position traders take a position in the futures market based on their expectations about the future direction of the prices of the underlying assets, and trade for their own account. ´Day traders take a position within a day and liquidate it before day's end. ´Scalpers take positions for very short periods of time, sometimes only minutes, in an attempt to profit from active trading. Electronic trading is becoming more popular for derivative trading and many pits have closed. If you're curious: Talking w/ hand signals https://www.youtube.com/watch?v=M6mWd3EjtsQ ´Options for liquidating futures position: ´Liquidating before delivery date ´Have broker take offsetting trade position ´99% of futures positions done this way ´Liquidating on delivery date (depends on how contract says to settle) ´May settle in cash based on final price vs. futures prices ´OR, deliver underlying asset. Ex. Treasury bond actually sold at futures price ´ ´Types of Futures Contracts Traders ´Hedgers ´Speculators ´Arbitrageurs ´

History of FX markets

´Gold standard until WWII ´In WWII, Britain and others depleted gold reserve ´Bretton Woods Agreement (1944-1971) ´FX rates trade within narrow bands ´Overvalued USD and others, undervalued other currencies ´Smithsonian Agreement of 1971 ´Increase bands for currencies to trade ´USD devalued ´Smithsonian Agreement II of 1973 ´FX rates move to free floating ´Central banks and gov't can influence this ´System mostly still in place today

FX exchange transactions

´Impact of currency appreciation ´Impact on Imports: ´Ex. $1USD worth 0.78 British Pound sterling OR $1.2821 = ₤ 1 ´An American company import British tea that cost ₤100,000 ´This cost $128,210 for the tea ´Suppose the dollar appreciates, so $1= ₤ 0.80 or $1.25 = ₤ 1 ´Tea still costs ₤100,000 but now this is $125,000. ´Impact on Exports: ´Ex. $1USD worth 0.78 British Pound sterling OR $ 1.2821 = ₤ 1 ´An American company exports American computers to Britain that cost $100,000 ´This cost ₤78,000 for the British company ´Suppose the dollar appreciates, so $1= ₤ 0.80 or $1.25 = ₤ 1 ´Computers still costs $100,000 but now this is ₤80,000. When a currency appreciates: •How does it impact costs of imports and exports? •How does this change demand in countries? •Is this always "good" or "bad"?

foreign exhcnage currency depreciation

´Impact on Imports: ´Ex. $1USD worth 0.78 British Pound sterling OR $1.2821 = ₤ 1 ´An American company import British tea that cost ₤100,000 ´This cost $128,210 for the tea ´Suppose the dollar depreciates, so $1= ₤ 0.74 or $1.3514 = ₤ 1 ´Tea still costs ₤100,000 but now this is $135,140. ´Impact on Exports: ´Ex. $1USD worth 0.78 British Pound sterling OR $1.29 = ₤ 1 ´An American company exports American computers to Britain that cost $100,000 ´This cost ₤78,000 for the British company ´Suppose the dollar depreciates, so $1= ₤ 0.74 or $1.3514 = ₤ 1 ´Computers still costs $100,000 but now this is ₤74,000. When a currency depreciates: •How does it impact costs of imports and exports? •How does this change demand in countries? •How does this relate to a country who devalues its currency?

Other risks and interactions among risks

´In reality, all of the previously defined risks are interdependent. ´Example: liquidity risk is correlated with interest rate and credit risks. ´When managers take actions to mitigate one type of risk, they must consider effects on other risks. ´Event risks. ´Changes in regulatory or tax policy ´Ex. Dodd Frank Act in 2010 ´Ex. Tax Cuts and Jobs Act of 2017 reduces corporate taxes ´Sudden and unexpected changes in financial market conditions due to war, revolutions, and sudden market collapses. ´Theft, malfeasance, and breach of fiduciary trust. ´Macroeconomic risks include increased inflation, inflation volatility, and unemployment.

Margin Requirements

´Initial margin ´Deposit a portion of value of contract when open position ´Ex. 5% of value of underlying asset ´Amount of the margin varies according to the type of contract traded and the quantity of futures contracts traded. ´Minimum margin levels are set by each exchange. ´ ´Maintenance margin ´Minimum level of funds in margin account ´www.cmegroup.com/clearing/margins ´ ´What if you fall below maintenance margin? ´Margin call: Add more funds to bring back to initial margin or liquidate position

Regulation

´Items regulated: ´Price reporting requirements, anti-fraud & anti-manipulation regulation, position limits, audit trail requirements, margin requirements, min capital requirements ´Main regulators: ´SEC ´Commodities Futures Trading Commission (CFTC) ´FASB for accounting standards ´Requires mark-to-market valuation of derivatives ´Federal Reserve, FDIC, and Comptroller of the Currency ´Oversees banks and their ability to use derivatives ´Encourage use of derivatives for hedging and not speculation for banks ´Changes from Wall Street Reform and Consumer Protection Act (aka Dodd Frank) (201) ´Goal for OTC derivatives to traded on exchange (more transparent, liquid, limit default risk) ´New authority for SEC and CFTC over OTC market ´Required regulators to create new rules to address concerns: ´Ex. CFTC limits on position size https://www.wsj.com/articles/cftc-votes-to-pass-final-rule-on-position-limits-11602789715?mod=lead_feature_below_a_pos1

FX Trading

´Market is OTC and trades 24 hours a day ´Ex. of derivatives trading ´Futures ´Standardized contracts for size, currencies, and contract expirations once per quarter ´Profits/losses settled daily ´Many contracts sold before maturity/ no delivery of currency (under 1% actually delivered) ´Forwards ´Customized contracts ´Any currency, dates, size ´No daily settlement ´Delivery occurs in over 90% of forwards

fx risk hedging

´Off-balance-sheet hedging ´No changes on the balance sheet ´Involves taking position in forward or other derivative ´ ´Ex. A US bank has assets of loans made in the US of $81.25M and loans made in the UK of ₤ 62.5M (currently worth $81.25M) ´Bank still takes $ and converts to ₤, then issues loans in ₤ ´Now it also enters a forward agreement ´Bank agrees to sell ₤ and receive $ in one year ´At end, banks is repaid in ₤ for the loan. Then fulfills forward and pays ₤ and gets $ ´Return is locked in regardless of exchange rate movements ´Transactions mostly done among dealers in OTC. ´Increasing use of electronic brokerage. Electronic brokers automatically quote best price ´Historically traditional method requires contacting multiple dealers and getting their price info and searching for best price ´Trading happens 24/7 ´Largest US banks are major players ´Smaller banks often use relationships with large banks for FX transactions

FX risk

´On-balance-sheet hedging ´Make changes to assets and liabilities on the Balance sheet to protect profits ´Pros: Can ensure positive profits/returns. ´Cons: End return can still vary. Also, loans and profits in other countries may be less favorable abroad than domestically ´ ´Ex. A US bank has instead has assets and liabilities of $81.25M as well as assets and liabilities of ₤ 62.5M (currently worth $81.25M) ´For UK loans, bank takes ₤ from issuing CDs and directly loan in ₤ . ´At end, the profits in ₤ from UK transactions is fixed ´However, the value of the fixed profits in ₤ , will vary once repatriated into $ depending on FX rates Return is at least positive (versus prior scenario where it could be negative)

options on futures contract

´Options on Futures Contract ´Call Buyer: Right to enter futures contract to buy asset at strike price. ´Put Buyer: Right to enter futures contract to sell asset strike price. ´Motivation: ´Ex) Option where a T-bond is physically delivered vs. Option where a futures on a T-Bond delivered ´Futures contract may be more liquid and easier to get pricing info on than actual T-bond itself ´Futures contract has no issues about what the exact bond terms are or accrued interest ´Other options on futures: Interest rates, currencies, stock indexes

Types of options

´Options on individual stocks ´Typically involves 100 shares of stock ´American options ´Note various strike prices and expirations ´Note how premiums vary with strike & expiration ´What leads to call premium being more? ´What leads to put premium being more? ´In the money Out of the money ´Options on stock indexes ´Typically involves a multiplier ´Ex. Multiplier of 100 for Dow Jones and strike price is 182. Mean $ amount involved with exercise of option is 182*100=$18,200 ´Other multiplies: 500 for S&P 500, 100 for S&P 100, 500 for NYSE Composite ´Settled in cash

PPP purchasing power parity

´PPP explains how inflation rate changes lead to FX changes ´Assumes real rate of interest is same in countries ´Fisher effect: Nominal Rates ≈ Real Rates + Inflation ´If true then, 〖Nom〗_US-〖Nom〗_CAD=〖Infl〗_US-〖Infl〗_CAD ´Change in the exchange rate between two countries' currencies is proportional to the difference in the inflation rates in the two countries

Hedging FX Risk

´Risks from FX movements ´2019 Foreign currency-related losses of $22.56 Billion ´https://www.wsj.com/articles/exchange-rates-deal-22-56-billion-blow-to-companies-earnings-11571346541 ´Ex. A US bank has assets of loans made in the US of $81.25M and loans made in the UK of ₤ 62.5M (currently worth $81.25M). They have liabilities from US customers depositing $162.4M in CDs ´For UK loans, bank takes $ and converts to ₤, then issues loans in ₤, and at the end of loan converts back to $ ´If ₤ depreciates, then it gets less when it converts ₤ to $ at the end and profits suffer ´ ´ ´ ´Two methods for hedging ´On-balance-sheet hedging ´Off-balance-sheet hedging

Credit Card Loss Rates & Personal Bankruptcy Filings

´Spike in bankruptcies in 2005 due to Bankruptcy Reform Act being passed making it harder to declare bankruptcy ´People rushed to file before it took effect ´ ´Rates differ by amount of credit risk ´https://creditcards.usnews.com/articles/average-apr ´ ´For banks, which type of risk can they reduce by diversifying? ´Firm-specific credit risk? ´Or, systemic credit risk?

Foreign Exchange transactions

´Spot FX transaction ´Immediate exchange at "spot" rates ´Forward FX transaction ´Exchange of currencies at specified exchange rt on date in future ´Can help hedge FX risk ´About 2/3 of FX trading uses forwards and 1/3 uses spot

Swaps Markets

´Swaps are not standardized contracts. ´Swap dealers (usually financial institutions) keep markets liquid by matching counterparties or by taking positions themselves. ´Dealers bears counterparty risk and gets a fee for this (similar to a clearinghouse for futures) ´Alternatively, a direct swap only involves 2 parties and no intermediary ´Historically very little regulation but changed since 2009 ´ICE started central clearinghouse in 2009 ´More standardization of contracts & exchange trading now ´OTC swaps now have margin requirements (but no clearinghouse use)

Interest rate parity theorem (Chapter 9 slide 22)

´The interest rate parity theorem ´Theory that the domestic interest rate should be equal to the foreign interest rate minus the expected appreciation of the domestic currency ´Implication is you should get same returns doing either: ´Investing directly in US ´OR, using a forward on FX rates and investing in a foreign country

Measuring Sovereign Risk

´The trade policy of the foreign government. ´The fiscal stance (deficit or surplus) of the foreign government. ´Government intervention in the economy. ´The foreign government's monetary policy. ´Capital flows and foreign investment. ´Inflation. ´The structure of the foreign country's financial system.

Credit Default Swaps

´Total return swaps involve swapping an obligation to pay interest at a specified fixed or floating rate for payments representing the total return on a loan (interest and principal value changes) of a specified amount. ´Used to hedge credit exposure ´Also, contains an element of interest rate risk as well as credit risk. ´ ´In a pure credit swap, the financial institution lender will send (each swap period) a fixed fee or payment (like an insurance premium) to the counterparty, but if the FI lender's loan or loans do not default, it receives nothing back from the counterparty. ´If loan defaults, counterparty makes payment to cover losses from default ´Similar to buying credit insurance ´ ´Players: ´Banks often buy and insurance companies often sell CDS ´CDS lets bank hold onto loan w/o bearing default risk (assuming CDS fulfills obligations) ´$16.44 Trillion in notional value in March 2008. Dropped to $7.42 T by March 2016

Option Markets

´Trading Process similar to those for futures contracts ´Tell broker what you want ´Can place market or limit order ´Brokers send order to exchange for execution ´Different exchanges have different type of options that trade there ´Trades done using open-outcry auction or electronic trading ´Options Clearing Corporation is clearinghouse that takes opposite position in each option and guarantees options ´Alternatively, can trade OTC but comes with some risk ´ ´Volume Market Share ´NASDAQ and CBOE each have about 1/3 https://markets.cboe.com/us/options/market_share

Future markets

´Trading on Organized Exchanges ´Ex. Chicago Board of Trade, NY Mercantile Exchange, ICE Futures U.S. ´Trading introduced in 1972 ´Types of futures contracts ´Financial futures (interest rates, currency, stock indexes) ´Commodities ´Energy ´Metals ´Other (e.g. weather) ´Terms of contracts ´Exchanges set terms and CFTC (Commodity Futures Trading Commission) approves them ´Contract size, delivery month, trading hours, min price fluctuation, daily price limits, process used for delivery

Operational Risk

´is the risk that existing technology or support systems may malfunction or fail.