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Week 8 Lecture Summary - Letters of Credit Commitment by a...

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Lecture 8 – Off-Balance Sheet (OBS) Risk Lecture Summary Off-Balance Sheet Risk OBS Activities - Financial guarantees - Derivatives OBS Items - Below the line on BS - ‘contingent assets and liabilities that affect the future’ - Economic solvency should consider both market value of on-balance and off balance sheet - ± (² ³ ´) µ (¶² ³ ¶´) - Result in positive/negative future cash flows; also fees from OBS – noninterest income Why increase OBS activities? - Increases in fee income - Avoidance of regulatory costs or taxes Loan Commitments - Contractual commitment to make a long to a stated amount at given I.R o Size, type of loan, period o Up-front fee % and back-end fee % o Interest Rate Risk (fixed, variable) o Take-down Risk (liquidity risk) o Credit Risk (rating may decline) o Aggregate funding risk (demand likely to be greatest when borrowing and funding conditions difficult)
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Unformatted text preview: Letters of Credit - Commitment by a bank on behalf of a buyer that payment will be made to a third party - A “guarantee” Derivative Contracts - Futures, forwards, swaps, options and credit derivatives o Use by FIs for hedging o FIs act as dealers o Counterparty risk (default on payment obligations) o OTC markets (high counterparty risk), Organised exchanges (low counterparty risk) o Credit derivatives – CDSs, CDOs Valuing OBS Items - Where option-like features; use contingent claim/option pricing theory models - ¶²·(¸¹·¶´) ±·º·¸»·¼½¾¿¸À·Á·Â¸¾¿¸ÀÃÄ·ÅÃÄÆÇ- Holder of loan commitment has option to borrow- Buyer of letter of credit has an option to default- For swaps, futures and forwards convert into an equivalent value of underlying assets Role of OBS - Hedging exposures - Fee income - Expanded use of derivatives poses risks to the financial system...
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