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Off-Balance-Sheet Activities

Off-Balance-Sheet Activities. 陳秀蘭 楊雅智 翁明祥. Off-Balance-Sheet Activities. Outlines Definition, types How to be valued and effect on FIs Returns and Risks of OBS Activities Loan commitments Commercial letters of credit / Standby letters of credit When issued securities

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Off-Balance-Sheet Activities

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  1. Off-Balance-Sheet Activities 陳秀蘭 楊雅智 翁明祥

  2. Off-Balance-Sheet Activities Outlines • Definition, types • How to be valued and effect on FIs • Returns and Risks of OBS Activities • Loan commitments • Commercial letters of credit / Standby letters of credit • When issued securities • Futures and forwards Interest rate risk Foreign exchange risk Credit risk Catastrophe risk • Options, caps, floors, and collars • Swaps • Loans sold

  3. Off-Balance-Sheet Activities • Definition, types • How to be valued and effect on FIs • Dramatic growth and related regulations • Returns and Risks of OBS Activities • The Role of OBS Activities in Reducing Risk

  4. Off-Balance-Sheet Activities • In accounting terms – appear below the bottom line, frequently just as footnotes to financial statements • In economic terms – contingent assets and liabilities that affect the future, rather than the current shape of as FI’s balance sheet

  5. Off-Balance-Sheet Activities • Off-Balance-Sheet Asset - Contingent Gain - When an event occurs, this item moves onto the asset side of the balance sheet. • Off-Balance-Sheet Liability - Contingent Loss - When an event occurs, this item moves onto the liability side of the balance sheet.

  6. Change in the option’s price Change in price on underlying security Valuation of OBS Activities • Option features • Contingent asset / liability value (Delta Equivalent) = Notional value × Delta of an option Delta = ———————————————————— ex. An FI has an OBS asset of call option on bonds with a notional value of $100million and the delta is 0.25 Contingent asset value = $25million

  7. Valuation of an FI’s Net Worth Assets Liabilities Market value of assets A Market value of liabilities L Net worth *E ---------------------------------------------------------------------------------------------- Market value of Market value of contingent assets CA contingent liabilities CL *E = A + CA - L - CL

  8. Incentives to Do OBS Activities • Earn more fee income to offset declining margins or spreads on traditional lending business • Avoid regulatory costs or taxes since reserve requirements and capital adequacy requirements were not levied on off-balance-sheet activities • Hedge on-balance-sheet interest rate, foreign exchange, and credit risks

  9. Dramatic Growth in OBS Activities

  10. Regulations • 1983 Quarterly Call Report (Schedule L) List notional size and variety of OBS activities. • 1993 BIS Framework Impose capital requirements on OBS activities and explicitly recognize FI’s solvency risk exposure from pursuing OBS activities. • 1994 DSSSA Derivatives Safety and Soundness Supervision Act • 1994 GAO’s report

  11. Returns and Risks of OBS Activities • Loan commitments • Standby letters of credit and letters of credit • Futures, forward contracts, swaps, and options • When issue securities • Loans sold

  12. Loan Commitments • A certain maximum amount, at given interest rate terms, in a period of time • Up-front Fee • Back-end Fee • Example Maximum amount = $10million BR = Interest on the loan = 12% m = Risk premium = 2% t = Expected takedown rate = 75% f1 = Up-front fee = 0.125% ( of $10million ) f2 = Back-end fee = 0.25% ( of $2.5million ) b = Compensating balance = 10% R = Reserve requirements = 10%

  13. Loan Commitments The promised return (1+k) of the commitment is : 1 + k = 1+ ———————————— 1 + k = 1 + ————————————————————— 1 + k = 1.1566 or k = 15.66% compared to the cost of capital f1 + f2(1-t) + (BR+m)t t – [bt(1-R)] 0.00125+0.0025(0.25)+(0.12+0.02)0.75 0.75-[(0.1)(0.75)(0.9)]

  14. Loan Commitments • Interest Rate Risk • Takedown Risk This exposes the FI to future liquidity risk or uncertainty. • Credit Risk • Aggregate Funding Risk In credit crunches, spot loans may decline but loan- commitment-takedown not. However, cost of funds rise above than normal level in this time.

  15. Commercial Letters of Credit • A contingent payment guaranty for domestic and international trade • Letter of credit fee • Default risk on letter of credit

  16. Standby Letters of Credit • A contingent payment guaranty for CP issuing firm onto maturity • Standby Letter of credit fee • Default risk on standby letter of credit • The LC or SLC fees should exceed the expected loss from default risk, after adjusting for reclaiming and any monitoring costs.

  17. When Issued Securities • Commitment to buy and sell securities before issue • Sell the yet-to-be-issued securities in the secondary market at a small margin above the price expected to pay at the primary auction • Risk of mistake regarding the tenor of the auction

  18. Nonschedule L Off-Balance-Sheet Risks • Settlement Risk An FI is exposed to a within-day or intraday credit risk that does not appear on its balance sheet. • Affiliate Risk The failure of an affiliated firm or bank imposes affiliate risk on another bank in a holding company structure.

  19. The Role of OBS Activities in Reducing Risk • When used to hedge on-balance-sheet risks, OBS instruments can actually reduce overall insolvency risk. • Regulatory costs of hedging have risen, and caused FIs to underhedge, thereby increasing, rather than decreasing, their insolvency risk. • Noninterest fee income from OBS activities can potentially compensate for risk exposure for some FIs. • Optimum is always the point.

  20. Futures and Forwards • Interest rate risk • Foreign exchange risk • Credit risk • Catastrophe risk

  21. Interest Rate Risk Hedging with Forward • Change in bond values = Capital loss on bonds = Initial value of bond position = Change in forecast yield D = Duration of the bonds 1+R= 1plus the current yield

  22. Interest Rate Risk Hedging with Forward • Suppose an FI holds a 20-year, $1million face value bond • As interest rates rise, the FI makes a capital loss on these bonds =$970000 D= 9 years = 0.02(from 8% to 10% over the next three months) 1+R = 1.08

  23. Interest Rate Risk Hedging with Forward • Capital loss: Hedging: selling $1 million face value of 20-year bonds forward delivery in three months’ time

  24. Interest Rate Risk Hedging with Futures • Microhedging versus Macrohedging • Microhedging : Using a futures (forward)contract to hedge a specific asset or liability • Macrohedging : Hedging the entire duration gap of an FI

  25. Interest Rate Risk- Macrohedging with Futures • FI’s net worth exposure to interest rate changes =change in an FI’s net worth = duration of its asset portfolio =5 years = duration of its liability portfolio =3 years k = ratio of on FI’s liability to assets =0.9 A = size of an FI’s asset portfolio=$100million = shock to interest rates = (from 10% to 11%) • Loss on balance sheet: = -$2.091million

  26. Interest Rate Risk- Macrohedging with Futures • Gain off balance sheet on selling futures = change in dollar value of futures contract = duration of the bond to be delivered against the futures contracts = the number of contract bought or sold = the price of each contract = expected shock to interest rates 1+RF= 1 plus the current level of interest rates

  27. Interest Rate Risk- Macrohedging with Futures • How many futures ( )do we sell to fully hedge the interest rate risk • Assume the interest changes of the cash asset position match those of futures position =5years, =3years, k=0.9, A=$100m, =9.5years, =$970000 = = = 249.59contracts to be sold

  28. Foreign Exchange Risk Hedging with Forward • Example:All assets and liabilities are 1 year Assets Liabilities U.S loans $100m U.S CDs $200m U.K loans$100m Risk : The pound will depreciate against the dollar Hedge: Selling both the pound loan principal and interest forward

  29. Foreign Exchange Risk Hedging with Futures • Assuming perfect correlation between spot and futures prices Loan principal=£100m interest = £15m = spot exchange rate($/£)=$1.4713 per £1 = futures price($/£)=$1.4640 per £1 = $1.4213 per £1 = $1.4140 per £1 = -5cents = -5cents

  30. Foreign Exchange Risk Hedging with Futures • The size of each British pound futures contract is £62500 = £115000000/£62500 = 1840 contracts to be sold Loss on British pound loan £115m*($1.4713/£-$1.4213/£) = $5.75m Gain on futures contracts (1840* £62500)* ($1.4640/£-$1.4140/£)= $5.75m

  31. Foreign Exchange Risk Hedging with Futures • Assuming imperfect correlation between spot and futures prices = $1.4213 per £1 = -5cents = $1.4140 per £1 = -3cents let h be the ratio of to

  32. Foreign Exchange Risk Hedging with Futures • The number of futures contracts to be sold changes = £115m*1.66/£62500 =3054.4 contracts Loss on British pound loan £115m*($1.4713/£-$1.4213/£) = $5.75m Gain on British pound futures position (3054.4*£62500)* ($1.4640/£-$1.4340/£)=$5.75m

  33. Credit Risk Hedging with Forward • FIs are afraid of the decline in credit quality of a borrower • Solution: They could buy a credit forward to hedge against an increase in default risk on an loan after the loan rate is determined and the loan is issued

  34. Credit Risk Hedging with Forward • :the actual credit spread on the bond in maturity : the credit spread originally agreed to • MD : modified duration on the benchmark BBB bond • A : the principal amount of the forward agreement

  35. Credit Risk Hedging with Forward

  36. Catastrophe Risk Hedging with Futures • Who need to transfer the catastrophe risk Property-casualty insurers are allowed to hedge the extreme losses Example: Payoff= loss ratio*nominal value of futures 0.8*$25000=$20000 Insurer Investor 1.5*$25000=$37500

  37. Options , Caps ,Floors ,and Collars • Writing versus buying options • Calculating the fair value of the option by using the binomial model • Using options to hedge risks • Caps, floors, and collars

  38. Payoff function of a bond in an FI’s portfolio Payoff gain C A Bond price 0 X -C Payoff function from writing a call on a bond Payoff loss Writing Versus Buying Options -Writing a Call Option to Hedge the Interest Rate Risk on a Bond

  39. Payoff gain Payoff function of a bond in an FI’s portfolio 0 Bond Price X Payoff function from buying a put on a bond -C Payoff loss Writing Versus Buying Options -Buying a Put Option to Hedge the Interest Rate Risk on a Bond

  40. Calculating the Fair Value of the Option by Using the Binomial Model • $100 zero-coupon bond with two years maturity • P2=$80.45 →R2=11.5% • R1=10% • r1=13.82% or 12.18% with equal probability ⇒[E(r1)]=(0.5)(0.1382)+(0.5)(0.1218)=0.13 ⇒E(P1)=$100/1.13=$88.5

  41. (.25) $100 $87.86 (.25) (.5) $100 (.25) $80.45 (.5) $89.14 $100 t=1 t=2 Calculating the Fair Value of the Option by Using the Binomial Model • Binomial Model of Bond Prices:Two –year Zero-Coupon Bond (.25)

  42. (.25) $0=Max(0,0) Max[88.5-87.86,0]=0.64 (.25) (.5) $0=Max(0,0) (.25) ? (.5) Max[88.5-89.14,0]=0 (.25) $0=Max(0,0) t=1 t=2 Calculating the Fair Value of the Option by Using the Binomial Model • The Value of a Put Option on the Two-Year Zero-Coupon Bond ⇒(0.5)($0.64)+(0.5)($0)=$0.32 ⇒P=$0.32/1.1=$0.29

  43. Using Options to Hedge Interest Rate Risk on the Balance Sheet • With no Basis Risk

  44. Using Options to Hedge Interest Rate Risk on the Balance Sheet • DA= 5 , DL= 3 ,k=0.9 ,A=$100 million • Rate:10%→11% ⇒ △E= – $2.09 million • δ=0.5, D=8.82 ,B=$97,000

  45. Using Options to Hedge Interest Rate Risk on the Balance Sheet • With Basis Risk

  46. Using Options to Hedge Interest Rate Risk on the Balance Sheet • br=0.92

  47. Value($s) Value of C$ asset in U.S.dollar terms Payoff of put option on C$s X=$0.63/C$1 Exchange rate(US$/C$) $0.5821/C$1 $0.6367/C$ Using Options to Hedge Foreign Exchange Risk -Hedging FX Risk by Buying a Put Option on Canadian Dollars

  48. Using Options to Hedge Credit Risk • Credit spread call option -A call option whose payoff increases as a yield spread increases above some stated exercise spread.

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