Decline in value of investment securities happens when treasury futures contract of the same maturity as the investment iv. How does the use of swaps to establish an interest-rate position economize on the need for capital?Purchasing $100 million in securities would cost $4 million in equity capital but “balloon” the balance sheet by $100 million if the capital-to-asset ratio was 4%. A bank could purchase swaps that earn the same amount on $100 million and only have to set aside ~$20,000 for the chance that the other party in the swap agreement doesn’t meet its obligations. Reduction in interest rate risk so this is no longer an issue, you only have to pay the 20,000 to cover default riskv. In the early ‘00s, why did banks stock up on MBSs? What danger did this expose them to?Commercial lending had been weak since the dot-com bubble burst, and banks had a lot of deposits since low interest rates had allowed consumers to refinance their mortgages, so they turned to MBSs because they were higher yielding than treasuries but almost as safe. -This exposes them to interest rate risk as the value of MBSs fall as interest rates rise (they are fixed rate). -It also introduces extension risk - along with being able to prepay when rates are low, people can prolong payments when rates are higher which increases the duration of MBSs making their value much more sensitive to interest rates. MBS- bonds comprising bundles of mortgages (make up 28% of American commercial bank assets) ●Interest rates are rising- problem for banks with large mortgage assets ●Commercial lending has been weak since the technology burst so deposit rich banks have been putting money into MBS, which yield more than treasury but are almost just as safe vi. Item 18.3 seems to suggest that banks will be taking losses as interest rates rise and it implies that they are selling off some MBSs as a result. Do you agree that they will be making losses? If not, why not? Why then do you think that they are selling off MBSs? They won’t be making losses because they have likely prepared for the situation by funding the assets properly and hedging their positions. -If they expect rates to climb, they could be taking positions in the market to try to maximize their gains. Value of MBS (like treasuries) falls if interest rates increase- MBS also has extension risk- (unlike bonds) there’s no fixed maturity ●Need not matter if banks have funded their investments carefully and hedged their exposure
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C. Read “The Collapse of Barings: A fallen star” (Item 18.2) and answer the following questions:The Nikkei 225, more commonly called the Nikkei, the Nikkei index, or the Nikkei Stock Average, is a stock market index for the Tokyo Stock Exchange.i. Explain the arbitrage strategy that Nick Leeson was supposed to be pursuing.Leeson was supposed to using the differences in price of the Nikkei-225 futures contracts listed on the Osaka Securities Exchange in Japan and the Singapore Monetary Exchange by buying securities in one market and simultaneously selling them in the other.
Derivative, Nick Leeson, Credit default swap, Tokyo Stock Exchange
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