Summary Class notes - Part 3: Financial Market and Products

Course
- Part 3: Financial Market and Products
- N/A
- 2016 - 2017
- Tilburg University (Tilburg University, Tilburg)
- FRM - Level 1
250 Flashcards & Notes
1 Students
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Summary - Class notes - Part 3: Financial Market and Products

  • 1473717600 Reading 1 - Introduction

  • How big is the derivatives market?
    Huge, bigger than the stock market when measured in terms of underlying assets (USD >600 trillion). But of course this is not the value of the respective derivatives, the gross value is estimated at USD 25 trillion. The total transactions is bigger on exchanges, but the size of the OTC is bigger (due to larger deals).

    Derivatives play a key role in transferring a wide range of risks in the economy from one entity to another. A derivative is a financial instrument whose value depends on (or derives from) the values of other, more basic, underlying variables.
  • How about their role in the crisis?
    They've brought a lot of good things, like more liquidity. But consciously or unconsciously also speculation for some investors. Derivatives played a huge role in the securitization of risky mortgages. 

    Post-crisis more attention to capital (also investment banks) and liquidity (not only short-term). As well as more valid proxies for funding rates instead of using "the risk-free rate".
  • What about exchange markets?
    They trade standardized contracts that have been defined by the exchange; tenor, notional. The products are primarily futures, which are to arrive-contracts. Greatest characteristic is that is uses an exchange clearing house for settlements. The advantage of this arrangement is that traders do not have to worry about the creditworthiness of the people they are trading with (unlike OTC). The clearing house takes care of the credit risk by requiring each of the two parties to deposit funds/margin.

    Exchange evolved from open outcry system to electronic system, which increased frequency of trades and algorithmic trading without human intervention.
  • What about Over-The-Counter (OTC)?
    Not alle derivatives trade on exchanges, the OTC market is actually much bigger. In OTC traders have to find each other, sometimes via a platform. Two parties can either present it to a CCP (central counterparty) or clear the trade BILATERALLY. The CCP functions as a clearing house.

    Bilateral trades involves an agreement to cover all transactions, termination, settlement and collateral. Banks often trade as market makes for the commonly traded instruments, so they are always prepared to quote a bid and offer price. Disadvantage is counterparty risk, default risk on the counterparty.

    Largely unregulated, although increasing in recent years (ICE). Reasons; transparency, improve market efficiency, reduce systemic risk. Example: US - - > all trades at SEFs (Swap Execution Factilities), a platform by bid and offer. CCP usages. Central registry.
  • What are forward contracts?
    An agreement to buy are sell an asset at a certain future time for a certain price, trade in OTC market. Buy is long and Sell is short. There is a relation between spot and forward market, resulting in arbitrage (will follow in later readings). 

    Example: they can be used to hedge FX risk. Pay EUR 1 mio in the future, can lock in the current FX rate by entering a long FX forward (buy other currency). If you will receive money at a future date you can short this to lock in the current FX rate.
  • What about futures contracts?
    Like a forward contract, a futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price. Important difference is that it is traded on an exchange and has standardized features. The exchange mechanism also guarantees that the contract will be honored. Lots of commodities trade a futures, but also bonds and stock indices.
  • What about options?
    Trade both on exchanges and OTC. Call options, right to buy. Put options, right to sell. Most important that it is more like an insurance, the option HOLDER does not have the obligation to exercise the option. Difference between American (always) and European (at maturity). Generally on exchanges traded in amounts of 100 SHARES. The bid-offer spread on options is usually greater than on the underlying stock, depends primarily on volume of trading.

    Characteristics:
    - Call value decreases when strike price increases (option other way around)
    - Call and put value increase when time to maturity increases
    - More in future readings

    Offer price is what client pay (what the bank offers). Bid price is what a clients get if he sells (what the bank is willing to pay).

    Shorting an option is like writing it.
  • What type of traders exist?
    Derivatives attracted many different type of traders, which made it such a success. There is always someone willing to take the other side. Because the derivatives market is in the end a zero-sum game.

    Types:
    - Hedgers: use derivatives to reduce risk that they face from potential future market movements.
    - Speculators: use them to bet on the future direction of a market variable.
    - Arbitrageurs: take offsetting positions (long and short) to lock in a profit.
  • What about hedgers?
    Most important, hedging doesn't mean that the company will always do it better, its purpose is to reduce risk. This means that it could have prevented a large loss, but it could have prevented a gain as well. Hedging means giving up the upward potential to get rid of the downward risk. It could very well be that a company would have done better without hedging.

    Only for options a company sort of insures itself and can keep upside potential, but this is at a premium with upfront costs.
  • What about speculators?
    These investors TAKE a deliberate position in the market. Don't forget to take into account the interest rate when comparing spot and forward/future market.

    Options are a very good product as they provide a form of leverage. Good outcomes are usually very good while bad outcomes results in the whole initial investment being lost. But also futures provide the leverage as there is only a small fee/margin required. However, the risks with futures is bigger as potential loss is much bigger.
  • What about arbitrageurs?
    Involves locking in a riskless profit by simultaneously entering into transactions in two or more markets. In the absence of transaction costs, everything should be entirely equal. But not realistic so not possible for small investors. Large investment banks can do this however at low costs due to a bigger scale. 

    Due to its nature an arbitrage opportunity can't last for long, due to supply and demand. Only small arbitrage opportunities are observed.
  • What about hedge funds?
    Less regulated, lock in investments for a longer time (unlike mutual funds). Usually speculating or arbitrage positions. Must:
    - Evaluate risks
    - Decide which are acceptable
    - Devise strategies (usually based on derivatives)

    Strategies:
    - Long/short (over- or undervalued)
    - Convertible arbitrage (long in undervalued bond, short the equity)
    - Distressed securities (speculate on bankruptcy)
    - Emerging markets (less liquid)
    - Global Macro (anticipate on macroeconomic trends)
    - Merge Arbitrage (bet on deal regarding M&A)
  • What about its dangers?
    Very versatile instruments, which can be weapons of mass destruction in case it is in the wrong hands (Jerome Kerviel, Nick Leeson). This emphasizes the need fro proper risk controls and limits that are monitored daily to make sure that derivatives are used for their intended purpose. Be aware of high correlation. When times are good there is a tendency to ignore risk managers (CRO of Lehman was removed from the executive board in 2007). 

    Think of: what can go wrong? Follow up with: how much will we lose?
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WHat about regulation?
High quality and independence, widely accepted. The NRSRO or ECAI gives competitive advantage. Criteria:
- Objectivity
- Independence
- International access and transparency
- Disclosure
- Resources
- Credibility
Varies over the cycle, battle with capital Basel, can lead to more short-term and procyclical ratings. Whcih may lead to capital volatility.

Difficulty: low frequency events in terms of statistical prove!! Conflict of interest remains and cautious on over reliance.
What about their performance?
Very good track record, both short and long term. Baa (BBB) and Ba (BB), dividing line between speculative and investment grade has the most significant change in case of a notch change. Consistent with yield, i.e. lower rating is higher yield. 

Reliable guide based on methodology, technology and culture together with the transparency they provide.
How about the rating process?
Many of the same tools that are normally applied by equity analysts. Difference is long-term horizon instead of short-term forecast. Many areas:
- Business risk
- Industry charactersitics
- Competitive positioning
- Management
- Financial risk
- Financial characteristics (and policies, profit, capital. cash flow, flexibility)
Industry usually leading, mostly an upper limit for industry is defined.         

Sovereigns is more dispersion due to more social factors that should be included. Accounting implications are filtered out. Level and predictability of cash flows very important. Cross-group approves to keep consistency on ratings, sectors. Usually then a surveillance procedure is initiated that follows material developments.
How about growth?
Primarily structured finance. Letter cases. Also give an outlook: negative, stable, positive or developing/evolving. S&P uses Credit Watch, Moody's Rating Review Watch List and Fitch just the media to update.

In general they are more like academic research centers than businesses. Sometimes rating agencies give unsolicited or agency-initiated ratings. Which are disclosed in reports!!
Three big players
- Moody's (publicly owned), 39%
- S&P part of McGraw-Hill, 40%
- Firth is a part of FIMALAC (French congolomerate), 15%  
Fitch primarily smaller issuances. As of 60s they became more important as bank debt financing was not longer the sole provider of debt capital.Diversifying funding base.

A.M Best and Dominion are number 4 and 5.
Introduction
Rating agencies specialise in evaluating the creditworthiness of debt securities issued by corporate, financial, structured finance, municipal, and sovereign obligors by evaluating the issuers themselves. Considering the probability of repayment.

Some critics due to oligopolistic and uncontrolled world powers. But they don't make recommendations, they express an informed rating opinion. Being independent, objective and transparant. Although paid as of 1970s issuer-based instead of member-based.

Useful due to convenience and relatively low cost. But regulation only NRSRO (national recognised statistical rating organisation) or ECAI (external credit assessment institutions).
WHat about price-behavior of MBS?
If no prepayments, the positively convex. Higher CPR has lower BPV (no positive convexity). It is NEGATIVELY convex for lower rates (due to at par, called). Interest-only pool can have negative BPV or duration which is quite unusual.
What about MBS valuation and trading?
Using Monte-Carlo vs. using a tree. Difference is that the tree assumes independence, while a burnout would be dependent. MC helps on dependence but drawbacks are: computationally complex and impossible to price Bermudan.

Can use empirical hedge-ratios. Higher coupons prepay faster, thereby more like shorter-term securities meaning lower interest rate sensitivity.

OAS, option-adjusted spread. Relative value measure for MBS. Blend of relative and left-out factors. Rely on mean reversion. Usually a relative combined with a supporting story can be convincing.
What about prepayment modelling?
Interest rate is just a single reason. Four major components of prepayment:
- Refinancing (interest rate reason to reduce costs). Cash-out refinancing is benefiting from higher credit rating or higher property value by prepayment and consequently refinancing a higher amount.

Incentive function: (WAC-R)*WALS*A - K. K estimate of the fixed cost of refinancing, A is the annuity factor and WALS is the weighted average loan size.
Higher loan balance prepays more quickly. S-curve modelled. CPR(I) = T + 1/(a+ E^(-b). High creditworthiness or spread at origination characteristics prepay more quickly.

Burnout, eventually prepayment will be determined by borrowers with a lower propensity to refinance and CPR will be lower. This phenomena of less responsive to incentive is called burnout. Consider also media-coverage or government action.

- Turnover (relocate (summer), bigger home, divorce). Usually not right away, average assumption reached at 30 months. High interest rate could mean a lock-in effect.

- Defaults (mortgage modifications, guarantors)

- Curtailments (partial prepayments, primarily when older and balance lower)
What about other products?
Pass-through MBS. Planned amortisation class (PAC), has a fixed prepayments schedule. In order to do so the rest of the pool consists of companion or support bonds that absorb the prepayment uncertainty. IO and PO, interest only and principal only, basically strips the pool in two segments that receive one payment.