Ch 13 fully revised 2011

Ch 13 fully revised 2011 - 1 Chapter 13 Off-Balance Sheet...

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Chapter 13 Off-Balance Sheet Risk 1
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Overview This chapter: Off-Balance Sheet Activities (OBS). OBS activities and FI solvency. Returns and risks of OBS activities. h Types of OBS activities and their risks. The role of OBS activities in reducing risks. 2
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Off-Balance Sheet Risks OBS activities are often designed to reduce risks through hedging with derivative securities and other means. However, OBS risk can be substantial. OBS mortgage-backed securities were instrumental in the financial crisis . 3
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Off-Balance Sheet Activities An item is called an off-balance-sheet activity if, when a contingent event occurs, the item moves onto the balance sheet of the FI. Hence, OBS activities have a direct impact on the future profitability and solvency of a FI. They produce both negative and positive future cash flows. OBS activities have both risk-increasing and risk- reducing attributes; it depends on how they are used (speculation versus hedging). 4
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Off-Balance Sheet Activities OBS activities are often designed to reduce risks through hedging with derivative securities and other means. However, as recent events demonstrate, risks from OBS activities can be substantial. Infamous cases: Barings Metallgesellschaft Banker’s Trust Orange County, CA Sumitomo Corp. Amaranth Advisors Société Générale 5
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Earlier, we showed that the value of a FI’s net worth (E) is equal to the difference of the market values of its on-balance sheet assets (A) and liabilities (L). However, a more accurate picture of the FI’s economic solvency should consider the market value of both its on-balance sheet items and its OBS activities: E = (A – L) + (CA – CL) CA = market value of contingent assets. CL = market value of contingent liabilities. 6
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Valuation of Off-Balance Sheet Activities Since OBS items are contingent assets and liabilities, their valuation is difficult and often highly complex. Because many OBS items involve option features, the most common methodology has been to apply contingent claims/option pricing theory models of finance. 7
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For example, one relatively simple way to estimate the value of an OBS position in options is by calculating the delta of an option. h Delta of an option: Change in the option’s price/change in price of underlying security = dO/dS. h Delta equivalent or Contingent asset value = Delta × Face value of option 8
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Incentives To Increase OBS Activities Early 1980s, losses on loans to less developed countries and reduced margins because of increased competition from banks and nonbanks. This
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Ch 13 fully revised 2011 - 1 Chapter 13 Off-Balance Sheet...

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