Slideshow for Review Session in 04-13

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Slideshow for Review Session in 04-13

• Conceptual Overview of the Course
• Coverage and Structure of Final Exam

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• Concept of the Teachable Moment A time when
  students become eager to fit the individual
  elements of a course together.
• An analogy exists between the elements of any
  university course and the pieces of a jigsaw
  puzzle
• How do you assemble a jigsaw puzzle? My
  procedure

a. Identify and turn over the individual pieces
b. Collect them into subpuzzles that show
distinct colors or shapes.
c. Assemble the subpuzzles, starting with the
easiest.
d. Link the subpuzzles together until the picture
comes fully into view.
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A. SUBPUZZLES MEGATHEMES

• The easiest subpuzzle is usually the border. In
  this course, the concept of an FSFs Economic
  Balance Sheet constitutes the border of the
  puzzle.
• How to use financial-engineering concepts to
  calculate and manage the opportunity-cost value
  and risk exposure of FSF net worth emerges as the
  biggest subsection and connects directly various
  pieces to the border.
• Capital is a shield whose protective strength is
  set to give differential comfort required by
  different stakeholders.

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1. The baseline of the border links a series of
alternative measures of net worth

• TNW (GAAP vs opportunity cost principles)
• Enterprise-contributed NW (adds EI to TNW)
• Government-contributed risk capital FG
• Economic Capital (ENW)MVTNW EI FG
• Market-value vs Fair-value estimates of ENW
• SStock markets estimate of ENW, includes
  valuation errors.
• Unacceptably rough model of S projected
  earnings/RE

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VALUE-CREATION SUBTHEMES

• Focusing only on Accounting Numbers is Foolish
• Focusing only on Explicit Cost and Revenues or
  Tangible Balance-Sheet Positions is Inadequate

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• Capital may be viewed instructively as a
  derivative security that is written on a value
  difference. This value difference capitalizes
  the present discounted value (PDV) of projected
  flows of future net income Revenues - Costs.
• To create and maintain value, managers must
  manage information and frame deals to make
  skillful use of the profit generators and profit
  killers.
• Opportunity-cost accounting (market-value
  accounting, MVA) information systems are needed
  internally for optimal management of profit
  generators and profit killers. Externally, MVA
  helps customers, regulators, and taxpayers to
  protect their stake in a firms risk taking.
• FSFs are in the business of taking and pricing
  calculated risks. It is not enough to recognize
  and manage each type of risk. Risk must be
  analyzed on an integrated firm-wide basis.
• Financial engineering, derivative instruments and
  information technology are the cutting edge of
  financial change.
• We saw that the IRR on swap positions may be
  measured by the same concepts of duration,
  convexity, and pvbp used for bank capital itself.

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2. PORTFOLIO-MANAGEMENT SUBPUZZLE

• FSFs can embrace Value-Creating Exposures to
  credit risk or interest-rate risk even when these
  risks are large or highly concentrated, as long
  as their financial engineering department can
  diversify or transfer these risks in
  profit-preserving ways.
• External Substitutes for Internal
  Diversification Swaps Loan Sales and
  Syndications Securitizations Insurance Futures.

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3. Financial Engineering

• What is meant by Financial Engineering? Synthetic
  Replication? Loophole sources of efficiency
  gains?
• How do derivatives resemble and differ from loan
  syndications and whole loan sales? From
  traditional intermediation?

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FINANCIAL-ENGINEERING SUBTHEMES

• The Importance of Pricing the explicit and/or
  implicit credit enhancements that are
  incorporated into most debt and derivative
  contracts.
• Importance of pricing and hedging the optionality
  conveyed to loan and deposit contracts that
  increases the convexity of an FSFs exposure to
  interest-rate risk.
• Value-at-Risk, though attractive in theory,
  requires information on the variance,
  correlation, and stability of returns on
  balance-sheet positions that cannot be reliably
  assembled.

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4. Synthetic-Replication Subpuzzles

• Allows us to conceive of exotic and complicated
  instruments as combinations of familiar and
  easy-to-value instruments
• Two examples of usefulness
• Identifying sources of value-added in
  Collateralized Mortgage Obligations (CMOs)
• Explaining why Banc Ones hedging strategy failed
  to protect its stock price from interest-rate
  risk.

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5. REPUTATIONAL-RISK SUBPUZZLES

• Reputational Risk is as important as any other
  kind of risk

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• The key point is that EI includes the reputation
  of the firm for honest and fair dealing. In hot
  firms, the spin imparted to the facts by a
  charismatic leadership confuses analysts and is
  usually a big part of enterprise-contributed
  intangibles. Enron in its heyday exemplified
  this confusion
• FG expresses the capitalized value of subsidies
  to risk-taking provided by the Financial
  Safety-Net, especially from deposit insurance.

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Reputational Risks are handled by internal
control policies. Reputational risks are hard to
enumerate and even harder to quantify.

• FSF managers express interest in controlling
  unethical behavior by their employees. Seeking
  short-run gain by unethical means is very risky
  and usually unprofitable for the firm in the long
  run (slippery dealing can seldom be permanently
  hidden).
• Similar dangers arise from pushing exciting new
  technology on customers without first
  establishing adequate safeguards against hacking

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Megatheme B. Linking the subpuzzles to the
capital-structure border requires understanding
the full range of opportunities for managing the
linkage between balance-sheet net worth and S.

• Earnings flow through to N and S from individual
  deals as incremental balance sheets
• To manage enterprise risk, managers synthetically
  slice, dice, extend, reassemble and aggregate the
  risks of individual deals
• Best measure of management performance over the
  long run is sustainable increment in ENW. S will
  catch up or revert to this value eventually.

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• Mean and volatility of opportunity-cost measures
  of N provide an appropriate focus for risk
  management and express the benefits and costs of
  using operational measures and targets that can
  be generated by financial engineering DN, DN,
  pvbp (N), VaR arbitraging RBCR implicit vs.
  explicit risk tolerance of authorities
• Interest-rate risks and credit concentration
  risks set by customer-initiated book of business
  may be diversified or hedged. Adjustments use
  modern methods of risk transfer asset sales
  securitization, derivative contracts, futures,
  and forward hedges.

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Swaps Markets provide convenient and increasingly
effective ways to

• Take offsetting positions that hedge risks that
  managers choose not to retain
• Establish positions in companies, industries, and
  regions that lie outside the firms natural
  customer base
• N of on-market swaps is zero, but for most swaps
  Dswap is seldom zero
• i-rate swaps
• Total-return swaps
• Credit swaps

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• Logical link between fixed-rate securities and
  variable-rate securities.
• Modified Duration of RVPF and RFPV Swaps
• or
• Relation between and pvbp pvbp
• (-D) (F) (.0001)
• How does the DF of a coupon swap differ from the
  DF of a total-return swap?

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Exercise

• Suppose at date t two parties agree to an
  on-market total-return swap that has a notional
  amount of 10,000 and a tenor of 3 years. The
  fixed-rate instrument is designated as a 7
  annual coupon three-year Treasury Bond. The
  variable rate coupon is set at LIBOR plus 2.
  Each side settles once a year. Both parties
  project the relevant value of LIBOR to equal 7,
  6, and 7 at the three settlement dates and
  project that the bond yield will remain unchanged.

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• Suppose Citigroup takes the other side of each
  partys swap obligation. How does the
  intermediated interest-rate swap differ from a
  forward contract between the counterparties to
  deliver and receive the projected amounts?
• Do counterparty projections enter the formula for
  calculating the duration of either the RFPV or
  RVPF sides of the swap?

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• Assume that the market yield on 3-year Treasury
  Bonds is 6.5. Find the modified duration and
  pvbp at t of the RVPF side of
• a swap of PV and PF coupons only
• ANS. D(PFRVcoupons) DV - DF DF D of a
  3-year unit annuity DV 1.
• pvbp -D ( 10,000) (.0001)
• a total-return swap.
• ANS. By convention, (RVPF)

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• What side of the swap would help to hedge the
  interest-rate risk exposure of an institution
  that finances fixed-rate mortgages with
  variable-rate deposits?
• -- Duration of Hedgeable Position is? _________
  (positive)
• Hedge must therefore be ___________ (RVPF).

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T/F (explain)

• A swap dealer cannot control its risk of ruin.
• The risk factor in bank dealing in derivatives
  comes from the difficulty of establishing
  internally transparent systems for management and
  control. It is inconceivable for a well-managed
  dealer bank not to recognize the dangers of
  carrying an unbalanced derivatives book. Risk
  management includes measuring, pricing,
  supporting, and laying off risk.
• RF Payments due on a total-return swap are fixed
  once the deal is made.
• Which two choices are false? Assuming that
  applicable PV obligations and tenor are each the
  same, the duration of a RVPF total-return swap is
  (higher than, lower than, the same as) the
  duration of an ordinary RVPF interest-rate swap
  when the coupon rate applicable to the FR side
  equals the market yield on the date the
  counterparties initiate the contract.

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II. Coverage and Structure of Exam

• Exam focuses on FSF capital structure, financial
  engineering, and ethics. It poses three types of
  questions
• Essay Question on the Value of Active Risk
  Management
• Short-Answer Questions
• Calculation Exercises

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• Although the final will focus on the material
  contained in 04-9 to 04-13, foundational elements
  developed earlier cannot be ignored. In
  preparing for the exam, the major question to ask
  yourselves is what elements of the first part of
  the course are truly foundational.

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• Conceptual questions will draw on magacepts,
  megathemes, and minicases.
• Calculation Exercises
• Calculate different measures of net worth from a
  hypothetical series of disclosures.
• Capital shields for different creditors.
• Durations and pvbp of swaps and how to size a
  swap to get the desired degree of hedging.
• Re-test your knowledge of Basel I capital
  requirements.

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Issues Treated in Ethics Questions

• Apply tests for fraud or negligent
  misrepresentation to facts of a minicase (such as
  managers rewarding analysts for issuing inflated
  opinions of a stocks prospects) or some type of
  abusive FSF behavior (such as predatory lending).
• Evaluate facts of some situation(s).
• Evaluate likely effectiveness of various
  penalties or reforms.