B how competitive it is in bidding for different

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b. How competitive it is in bidding for different types of structured transactions. - 26 -
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Study Notes: Risk Management and Financial Institutions By Zhipeng Yan c. The profits being recorded from the trading of different products. - Getting too much of a certain type of business or making huge profits from relatively simple trading strategies, or the financial institution is unable to unwind trades at close to the prices given by its models, can be a warning sign. 6. Liquidity risk : as the quantity increases, the price paid by the buyer increases and the price received by the sell decreases. - The percentage bid-offer spread: s = (offer price – bid price)/mid-price - Liquidity-adjusted VaR = VaR + , where α 1 / 2 n i i i s α = i is the amount of money invested in the i th position. As the number of position, n, grows, VaR benefits from diversification but the liquidity adjustment does not. Consequently, the percentage difference between VaR and liquidity-adjusted VaR grows as n grows. 7. Liquidity black holes is created when a price decline causes more market participants to want to sell, driving prices well below where they will eventually settle. During the sell-off, liquidity dries up and the asset can be sold only at a fire-sale price. Reasons for herd behavior and the creation of liquidity black holes are: - The computer models used by different traders are similar. - All financial institutions are regulated in the same way and respond in the same way to changes in volatilities and correlations. E.g., when volatilities and correlations increase, market VaR and the capital required for market risks increase Æ banks tend to reduce their exposures. Since banks often have similar positions to each other, they try to do similar trades. Æ liquidity black hole. E.g., consider credit risk. During economic recessions, default probabilities are relatively high and capital requirements for loans under Basel II internal ratings based models tend to be high Æ banks may be less willing to make loans, creating a liquidity black hole for small and medium-sized businesses. Æ to solve this, Basel Committee requires that the probability of default should be an average of the probability of default through the economic or credit cycle, rather than an estimate applicable to one particular point in time. - There is a natural tendency to feel that if other people are doing a certain type of trade then they must know something that you do not. Chapter 17 Weather, Energy, and Insurance Derivatives 1. Weather derivatives (US department of Energy estimated that 1/7 of the US economy is subject to weather risk): we will see contracts on rainfall, snow and similar variables become more commonplace. - HDD: heating degree days – a measure of the volume of energy required for heating during the day.
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