2017 Week 1 FRM Part I - (Topics 1-7) · 2019-06-14 · 1 Fixed Income Investments Kaplan Schweser...
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1 Fixed Income Investments Kaplan Schweser 2017 FRM Part I 10-Week Online Class Week 1 ©2017 Kaplan, Inc. About the Online Weekly Class This online class consists of 10 weeks of live (and on- demand) discussions of 2017 FRM Part I concepts and practice exam questions During this class we will cover most of the Learning Objectives (LOs) in the Part I curriculum Please feel free to submit questions 2
Transcript of 2017 Week 1 FRM Part I - (Topics 1-7) · 2019-06-14 · 1 Fixed Income Investments Kaplan Schweser...
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Fixed Income Investments
Kaplan Schweser2017 FRM Part I
10-Week Online ClassWeek 1
©2017 Kaplan, Inc.
About the Online Weekly Class
This online class consists of 10 weeks of live (and on-demand) discussions of 2017 FRM Part I concepts and practice exam questions
During this class we will cover most of the Learning Objectives (LOs) in the Part I curriculum
Please feel free to submit questions
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©2017 Kaplan, Inc.
About the Online Weekly Class (continued)
In addition to the 10 weeks of scheduled instruction, you have or will receive:
Downloadable slides before each class
Ask Your Instructor email access
Part I Candidate Resource Library
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©2017 Kaplan, Inc.
FRM Exam Format
Offered by the Global Association of Risk Professionals (GARP). www.garp.org.
Part I exam: 100 multiple-choice questions Part II exam: 80 multiple-choice questions Both exams 4 hours in length Paper-based Both parts offered on third Saturday in May and November Possible to sit both on the same day but risky Approximately 200–250 hours of study time per part Results available approximately 1–2 months later
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FRM Part I Knowledge Domains
Foundations of Risk Management: 20%
Quantitative Analysis: 20%
Financial Markets and Products: 30%
Valuation and Risk Models: 30%
4-hour exam with 100 multiple-choice questions
Equates to roughly 2 ½ minutes per question5
©2017 Kaplan, Inc.
Calculations and Types of Questions
20–30% numerical questions No formula sheet Do not spend too much time on lengthy calculations Look for logical answers Types of questions:
Short single best response Long single best response Multipart questions Questions with tables or graphs
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Calculator Policy
The following calculators are allowed in the exam room:
Texas Instruments BA II Plus (or Professional)
HP 12C (or Platinum or Anniversary versions)
HP 10B II (or 10BII Plus or 20B)
We run our courses using the TI BA II Plus (or Professional)
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Pass Rates
To earn a passing result, your objective should be to answer at least 70% of the questions correctly
Recent Part I Exam pass rates:
Nov 2014: 48.8%
May 2015: 42.9%
Nov 2015: 49.2%
May 2016: 44.5%
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FRM Prep Time Distribution
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Distribution of FRM Preparation Time – May 2011
©2017 Kaplan, Inc.
Recommended Question Practice Earlier months: SchweserNotes end of topic questions (concept checkers) SchweserPro QBank (easier than exam but good for coverage!)Later months: Additional QBank questions for retention SchweserNotes—Self-Test questions at end of each book Two Schweser Practice Exams (8 hours) Schweser Mock Exam (4 hours) GARP FRM Practice Exams (free to paid candidates)
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Word of Caution
No matter how much question practice you do from all of the preceding sources, real exam questions will look and feel different!
Best way to prepare is to focus on understanding the concepts!
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Foundations of Risk Management
Basic risk types, measurement tools, and management tools
The role of risk management in corporate governance
Enterprise risk management (ERM)
Financial disasters and risk management failures
The capital asset pricing model (CAPM)
Risk-adjusted performance measurement
Multifactor models
Data aggregation and risk reporting
Ethics and the GARP Code of Conduct
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Fixed Income Investments
Topic 1
Risk Management:A Helicopter View
©2017 Kaplan, Inc.
What is Risk?
Risk
Uncertainty regarding future
Not necessarily related to size of results
More related to variability of results
Book 1, LO 1.1
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What is Risk? Risk Management
Process of activities to mitigate potential losses
Expected
Unexpected
Risk Taking
Activities that:
Increase opportunities for gains
Introduce opportunities for losses
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Book 1, LO 1.1
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Risk Management is a Process
1. Identify risks
2. Quantify exposure
3. Perform cost/benefit
4. Develop risk mitigation strategy
5. Assess/amend
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Book 1, LO 1.2
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Risk Management Challenges
Correct identification of risks
Efficient mitigation/transfer of risks
Prevention of the “fraud” factor
Instruments may “back-fire”
Mainly entity specific, not “systemic” risk reduction
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Book 1, LO 1.2
©2017 Kaplan, Inc.
Measuring and Managing Risk Quantitative Approaches: Value at Risk (VaR)
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Book 1, LO 1.3
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Value at Risk (VaR)
Definition: An estimate of the maximum (or minimum) expected loss at a specified level of probability over a specified time period
Example: The 1-day, 1% VaR of a portfolio is $2.6m. This means that we feel there is a 1% chance the portfolio will lose at least $2.6m in one day. Alternatively, we are 99% confident that the portfolio will lose no more than $2.6m in one day.
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Book 1, LO 1.3
©2017 Kaplan, Inc.
Measuring and Managing Risk
Qualitative Approaches
Scenario Analyses
Stress Testing
Enterprise Risk Management (much more later)
Integrative approach
Entity-wide assessment
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Book 1, LO 1.3
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Expected vs. Unexpected Losses
Expected Loss
Normal course of business
Generally stable and predictable using past history
Bad Debt Expense, Loan Loss Reserves, etc.
Unexpected Loss
Beyond normal course of business
Difficult to predict and be prepared for
Correlation risk, negative macro-economic impacts
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Book 1, LO 1.4
©2017 Kaplan, Inc.
Risk vs. Reward
Risk drives return, not other way
Often forgotten when times are too good
Overly cautious when times are bad
Key is to connect return to risk
Benefits (rewards) should be adjusted for risk taken
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Book 1, LO 1.5
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Risk Classes Market Risk
Credit Risk
Liquidity Risk
Operational Risk
Legal/Regulatory Risk
Business Risk
Strategic Risk
Reputation Risk23
Book 1, LO 1.6
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Risk Classes
Market risk is the risk that declining prices or volatility of prices in the financial market will result in a loss
Interest Rate Risk
Equity Price Risk
Foreign Exchange Risk
Commodity Price Risk
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Book 1, LO 1.6
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Risk Classes
Credit risk is the possibility of default by the counterparty to a financial transaction
Default Risk
Bankruptcy Risk
Downgrade Risk
Settlement Risk
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Book 1, LO 1.6
©2017 Kaplan, Inc.
Risk Classes Liquidity risk is the possibility of sustaining significant losses due to
the inability to take or liquidate a position at a fair price
Funding and Trading Liquidity Risk
Operational risk is the risk of loss due to inadequate monitoring systems, management failure, defective controls, fraud, or human errors
Technology failures
Fraud
Natural disasters
Human error26
Book 1, LO 1.6
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Risk Classes
Legal and Regulatory Risk
One party not “legally” able to enter transaction
Lawsuits
Change in a general law or specific regulation
Business Risk
Uncertainty associated with the business
Could be economic or implementation difficulties
Measured by variability in revenues or operating income27
Book 1, LO 1.6
©2017 Kaplan, Inc.
Risk Classes
Strategic Risks
Usually associated with “new” market or business opportunity
Change in focus or activity
Reputation Risk
Perceived trustworthiness
Deals unfairly in transactions
Questionable business deals
“Rumors”28
Book 1, LO 1.6
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Fixed Income Investments
Topic 2
Corporate Risk Management:A Primer
©2017 Kaplan, Inc.
Hedging Advantages vs. Disadvantages
Hedging involves taking an offsetting position in an investment to neutralize any potential gains or losses.
Advantages Potential for lowering variability in earnings
Positive impact on cost of capital
Positive managerial reputation
Increased certainty of operational input costs
Variety of instruments with differential costs available
Book 1, LO 2.1
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Hedging Advantages vs. Disadvantages
Disadvantages: Theoretical and Practical
M&M—Hedging does not impact value of firm
CAPM—Systematic risk, not idiosyncratic risk, is what’s important
However, there are explicit and implicit costs involved in purchasing protection as well as the elimination of upside potential
If the benefits outweigh the costs, then it is appropriate for the firm to hedge
Book 1, LO 2.1
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Should Company Hedge?
Board should communicate risk appetite (more later)
What risks willing/unwilling to take?
How much exposure can company handle?
Accounting versus economic exposures
Liquidity and tax impacts need consideration
Risk Mapping
Identification (e.g., currency exposure)
Timing of exposure on operations32
Book 1, LO 2.3
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Hedging Approaches
Must consider cost/benefit tradeoff
Pricing Risk
Forwards/futures to minimize input/output fluctuations
Foreign Currency Risk
Operational exposure hedges
Balance sheet hedges
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Book 1, LO 2.4
©2017 Kaplan, Inc.
Hedging Approaches
Interest Rate Risk
Swaps
Geographic specific funding
Static vs. Dynamic
Time horizon and cost/benefit tradeoff must be considered
Static has lower cost, but may have lower effectiveness
Dynamic may have higher effectiveness, but costly
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Book 1, LO 2.4
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Risk Management Instruments
On-Exchange
Standardized
Highly Liquid
No counterparty credit risk
Off-Exchange
Customized
Low Liquidity
Counterparty credit risk35
Book 1, LO 2.5
Fixed Income Investments
Topic 3
Corporate Governance and Risk Management
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Best Practices
Corporate Governance
Board should be majority independent
Board should be representative of shareholders
Board should be cognizant of agency cost matters
Board should consider a Chief Risk Officer (CRO)
Book 1, LO 3.1
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Best Practices
Risk Management
Economic, not accounting, performance is the key
Requires incorporating risk-adjusted performance
Board should have risk committee separate from audit committee
Book 1, LO 3.1
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Audit Committee
Traditionally responsible for accuracy of financial reports
Ensures financials are representative of underlying business operations and results
Requires knowledge of relevant accounting principles
Largely independent of management, but must work with management to ensure legal, compliance, and risk managementstandards are met
Book 1, LO 3.6
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Risk Governance
Risk governance: methods in which risk-taking is permitted, optimized, and monitored within an organization
An effective risk governance environment exists when there is clear accountability, authority, and methods of communication
The goal of risk governance is to increase the value of the organization from the perspective of shareholders and/or stakeholders
Book 1, LO 3.2 & 3.4
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Board Risk Governance
Risk Advisory Director
Board member knowledgeable on Corporate Governance and Risk Management
Educates and Communicates
Risk Management Policies
Risk Management Reports
Risk Appetite
Internal Controls
Best risk governance and management practices
Book 1, LO 3.2 & 3.4
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©2017 Kaplan, Inc.
Board Risk Governance
Risk Management Committee
Responsible for understanding and communicating various risk exposures
Identifies, measures, and monitors financial and non-financial risks
Makes connections to audit functions and management activities
Provides periodic reports and raises “flags” if risk exposures are beyond norms or expectations
Book 1, LO 3.2 & 3.4
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Board Risk Governance
Compensation Committee
Independent of management
Ensures appropriate risk exposure taken by management
Designs compensation schemes that account for risks taken
Deferred compensation components to ensure long-term results are “real”
Stock-based components that do not induce excessive risk taking
Clawbacks if problems subsequently come to light
Book 1, LO 3.2 & 3.4
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Risk Appetite and Strategy
Risk appetite refers to propensity to tolerate risk
Board must ensure that appetite and strategy are aligned and that management understands connection
Logical connections must be made between risk appetite and strategy
Once in place, continual identification, evaluation, and adjustments of risks is required
Book 1, LO 3.3
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Interdependence of Units
Functional units are interdependent
Once units become independent, relevance of communication becomes poor and risks increase
Continuous recognition of interdependence allows for increased return given risks taken and brings operation to more closely resemble an integrated enterprise
Book 1, LO 3.5
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Topic 4
What is ERM?
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Enterprise Risk Management
Relatively “new” concept—lack of single definition
Enterprise risk management (ERM): attempts to coordinate risk
management duties to maximize efficiency and value added while
reducing hedging and other transaction costs
It is an integrative approach to evaluate exposures at the entity, not
solely unit, level
Recognizes interdependence among entity units
Book 1, LO 4.1
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ERM Benefits and Costs
Costs: implementation of firm-wide risk aggregation is
capital and labor intensive
Benefits
Increased organizational effectiveness
More effective risk transfer and reporting
Improved business efficiency and performance
Book 1, LO 4.2
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Who is the Chief Risk Officer (CRO)?
Relatively new role created in response to innovative
financial instruments and increased capital market
integration
Responsible for all risks facing firm typically reporting to
CEO or directly to Board
Heads of risk functions (market, credit, etc.) report to CRO
Book 1, LO 4.3
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Who is the Chief Risk Officer (CRO)?
Critical skills possessed by successful CRO
Leadership
Power of persuasion
Able to protect firm assets
Possesses relevant technical skills
Able to communicate and educate relevant parties on risk exposure
and management techniques
Book 1, LO 4.3
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ERM Components
Corporate Governance
Line Management
Portfolio Management
Risk Transfer
Risk Analytics
Data Technology and Resources
Stakeholder Management
Book 1, LO 4.4
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Fixed Income Investments
Topic 5
Risk Management, Governance, Culture, and
Risk Taking in Banks
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Methods to determine optimal level of risk exposure:
Target default probability or credit rating
Bank should not always aim to earn highest credit rating possible
Sensitivity or scenario analysis
Analyze adverse impacts from shocks (e.g., interest rate movements)
Optimal level of risk depends on focus of the bank’s activities (e.g., lending, deposits, derivatives), so it will differ among banks
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Optimal Level of Risk
Book 1, LO 5.1
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Taking on an optimal amount of risk maximizes shareholder value while satisfying constraints imposed by bank regulators
Too little risk: Bank may not generate sufficient returns for shareholders, which may decrease value
Too much risk: Bank may become distressed (could result in losses for counterparties), which may also decrease value
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Risk-Taking Implications
Book 1, LO 5.2
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If taking incremental risk does not change the value of a bank, then investing in risk management is destroying value Due to fixed costs of having risk management department
If taking incremental risk results in excessive total risk (and a decrease in bank value), then investing in risk management is adding value Due to risk management policies preventing the bank from taking
on excessive risk
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Risk-Taking Implications (continued)
Book 1, LO 5.3
©2017 Kaplan, Inc.
Risk measures do not exist for entire banks although they do for certain banking activities
Risk measures are far from perfect and can result in inaccurate computations
In practice, many risks are nearly or entirely impossible to hedge (e.g., terrorism risk), and some hedges are imperfect
Some risk takers within the bank (e.g., traders) are motivated to maximize compensation by taking excessive risks
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Risk Management Challenges and Limitations
Book 1, LO 5.4
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Risk managers may not be given necessary information to properly assess bank risks
Firm-wide value at risk (VaR) is not likely to account for all of the bank risks (e.g., operational risks)
Aggregation of market, credit, and operational risks needs to consider correlation between risks (in practice, there is usually insufficient data and any errors may lead to insufficient capital)
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Risk Management Challenges and Limitations (continued)
Book 1, LO 5.4
©2017 Kaplan, Inc.
Governance: Difficult to demonstrate that a bank’s governance has a significant impact on its risk profile and performance (very limited data)
Incentive structure: Incentives must be designed so they do not merely reward managers for performance based on their respective business units alone
Risk culture: Companies where managers were perceived as honest and trustworthy were more profitable and were given higher valuations
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Bank Risk Profile and Performance
Book 1, LO 5.5
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Financial Disasters
Topic 6
©2017 Kaplan, Inc.
Drysdale Securities and Chase
Drysdale Securities was able to borrow $300 million in unsecured funds from Chase Manhattan by exploiting a flaw in the system for computing the value of collateral
When the value of positions deteriorated, Drysdale went bankrupt and Chase was forced to absorb the majority of the losses
Book 1, LO 6.1
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Drysdale Securities and Chase (continued)
Crisis resulted from:
System flaw regarding accrued interest on government bonds
Drysdale's willingness to exploit this flaw by taking oversized positions
Failure of Chase to understand transaction risks
Book 1, LO 6.1
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©2017 Kaplan, Inc.
Drysdale Securities and Chase (continued)
Corrective actions:
More accurate valuation models were developed
Chase and other firms began using a risk control function
Book 1, LO 6.1
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Kidder Peabody
The head of the government bond trading desk at Kidder Peabody, Joseph Jett, reported substantial artificial profits
After the false profits were detected, $350 million in previously reported gains had to be reversed
Book 1, LO 6.1
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©2017 Kaplan, Inc.
Kidder Peabody (continued)
Crisis resulted from:
System flaw regarding PV of forward contracts on government bonds
Jett's willingness to exploit this flaw
Firm's inability to realize stated trading strategy was not capable of producing reported profits
Book 1, LO 6.1
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Kidder Peabody (continued)
Corrective actions:
Systems must accurately value trades
Trading supervisors must understand and verify trading strategies
Book 1, LO 6.1
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Barings Bank
Hidden trading losses induced Nick Leeson to abandon hedging strategies in favor of speculative strategies
He initiated a long-long futures position in hopes of profiting from an increase in the Nikkei 225
This exposed Barings to enormous market risk and event risk
In early 1995, an earthquake hit Japan. The Nikkei plunged, creating huge losses for Leeson and Barings.
Book 1, LO 6.1
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Barings Bank (continued)
Between 1993 and 1995, Leeson's actions resulted in losses of approximately $1.25 billion and forced Barings Bank into bankruptcy
A lack of operational oversight and his dual roles as trader and settlement officer allowed him to conceal his activities and losses
Book 1, LO 6.1
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Allied Irish Bank
A currency trader for Allied Irish Bank, John Rusnak, hid $691 million in losses
Rusnak bullied back-office workers into not following up on trade confirmations for imaginary trades
Book 1, LO 6.1
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Allied Irish Bank (continued)
Crisis resulted from:
Rusnak's manipulation and deception
OTC market structure that did not require immediate cash settlement
Corrective actions:
Trading and settlement functions should be separated
Book 1, LO 6.1
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Union Bank of Switzerland (UBS)
In 1997, UBS’s equity derivatives business lost between $400 and $700 million
In 1998, UBS lost an additional $700 million due to its stake in Long-Term Capital Management
1997 losses resulted from: (1) British law tax changes; (2) large Japanese bank warrants, which were inappropriately hedged; (3) incorrect valuation of long-dated options on equity baskets; and (4) inappropriate modeling of other long-dated options
Book 1, LO 6.1
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Société Générale
In January 2008, it was discovered that one of Société Générale’s junior traders, Jérôme Kerviel, was involved in unauthorized trading activity that resulted in losses of $7.1 billion
Reasons that explain how Kerviel’s unauthorized trading activity went undetected include: the incorrect handling of trade cancellations, the lack of proper supervision, and the inability of the bank’s trading system to consider gross positions
Book 1, LO 6.1
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Metallgesellschaft
Metallgesellschaft Refining and Marketing implemented a strategy designed to insulate customers from price volatility in the petroleum markets for a fee
The company offered customers forward contracts to buy fixed amounts of heating oil and gasoline at a fixed price over a 5- or 10-year period
Book 1, LO 6.1
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Stack-and-Roll Hedging Strategy
Metallgesellschaft hedged exposure using a stack-and-roll hedging strategy
In this strategy, the firm buys a bundle of futures contracts with the same expiry date, known as a stack
Just prior to delivery, the firm liquidates the stack and buys another stack of contracts with longer expirations, known as a roll
Book 1, LO 6.1
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Cash Flow Timing Differences
The crisis at Metallgesellschaft resulted from cash flow timing differences
Cash flows on short forward contracts occurred over the distant future (5 to 10 years)
Cash flows on long futures contracts occurred daily (marked to market)
The sizes of the positions were so large that it prevented the company from liquidating its positions without incurring large losses
Book 1, LO 6.1
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Metallgesellschaft Losses
The company used short-term futures to hedge because alternatives in the forward market were unavailable
Metallgesellschaft's open interest in unleaded gasoline contracts was 55 million barrels compared to an average of 15 to 30 million barrels per day
In December 1993, Metallgesellschaft cashed out its positions and reported losses of approximately $1.5 billion
Book 1, LO 6.1
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Long-Term Capital Management
Long-Term Capital Management (LTCM), a hedge fund founded in early 1994, generated stellar returns in its first few years of operation
With positions in equity, fixed income, and derivatives markets all around the globe, LTCM had grown enormously
At the beginning of 1998, it had $125 billion of assets on $4.7 billion of equity capital, yielding leverage of 28 to 1
Book 1, LO 6.1
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LTCM Strategies
Most of LTCM's investment strategies could be classified as relative value, credit spreads, and equity volatility
Their relative value strategies involved arbitraging price differences among similar securities and profiting when the prices converged
Book 1, LO 6.1
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The Problem
In 1998, Russia unexpectedly defaulted on its debt
This economic shock triggered investor concern about already faltering economies in the Pacific Rim, causing the yields on corporate debt (both high and low quality) to increase sharply
In other words, the flight to quality increased, rather than decreased, credit spreads, causing huge losses for LTCM
Book 1, LO 6.1
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LTCM Losses
Falling prices resulting from LTCM's forced liquidation of their large positions created additional marked to market losses and margin calls, which forced even more liquidations
Ultimately, the Federal Reserve Bank of New York orchestrated a bailout in which 14 leading banks and investment houses invested $3.65 billion for a 90% stake in LTCM
Book 1, LO 6.1
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Banker's Trust
Banker's Trust (BT) was hired by Procter & Gamble and Gibson Greetings to reduce their funding costs
Banker's Trust developed derivative structures that were intentionally complex and prevented their clients from understanding the inherent risks
In taped phone conversations, BT's staff bragged about how badly they fooled clients
Book 1, LO 6.1
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Banker's Trust (continued)
Crisis resulted from:
BT's greed and deception
Client's inability to fully understand the transactions
Book 1, LO 6.1
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Banker's Trust (continued)
Corrective actions:
Tighter controls for dealing with clients
Matching trades with a client's needs
Exercise caution regarding communication that could eventually be made public
Book 1, LO 6.1
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JPMorgan, Citigroup, and Enron
Enron collected cash by selling oil for future delivery, and, in turn, agreed to buy back the delivered oil at a fixed price
The agreement was essentially a loan where the company paid cash at a later date to receive cash at the beginning of the agreement
The advantage for Enron was that the company did not have to account for these transactions as loans on its financial statements
Book 1, LO 6.1
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JPMorgan, Citigroup, and Enron (continued)
JPMorgan Chase and Citigroup were the main counterparties in these transactions
It was revealed that the investment banks fully understood Enron’s intent when entering into these loan-type transactions
As a result, JPMorgan and Citigroup agreed to pay a $286 million fine for assisting with fraud against Enron investors
Book 1, LO 6.1
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Topic 7
Deciphering the Liquidity and Credit Crunch 2007–2008
©2017 Kaplan, Inc.
Key Factors Leading to the Housing Bubble
Main factors that led to the housing bubble were:
Cheap credit: Large capital inflows from abroad plus the Fed’s lax interest rate policy lead to a low interest rate environment in the U.S., making mortgages less expensive for borrowers.
Decline in lending standards: The originate-to-distribute model allowed banks to offload risk to investors, which led to falling lending standards because banks had less incentive to exercise care when approving and monitoring loans.
Book 1, LO 7.1
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Banking Industry Trends and the Liquidity Squeeze
The originate-to-distribute model and asset-liability maturity mismatches were two key banking industry trends that led to the mortgage crisis and resulted in the liquidity squeeze
Book 1, LO 7.2
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©2017 Kaplan, Inc.
Collateralized Debt Obligations
Banks create collateralized debt obligations (CDOs) to unburden themselves of risk
First, the bank will bundle a number of debt instruments, such as bonds and loans
Then, this portfolio is sliced into various tranches
Finally, the different tranches are sold to investors with varying appetites for risk
Book 1, LO 7.3
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Collateralized Debt Obligations (continued)
The super senior tranche, which is the safest tranche and first to be paid out (but pays the lowest interest rate), is sold to investors that have low risk tolerance
The most junior or equity tranche is typically (but not always) retained by the CDO issuer to give the bank incentive to monitor the loans carefully
Mezzanine tranches are between senior and equity tranches
Book 1, LO 7.3
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Credit Default Swaps
Credit default swaps (CDSs) are essentially insurance contracts that pay off in the event of the default of a bond or tranche
The protection buyer pays the protection seller a set fee at fixed intervals and, in exchange, receives protection in the form of a payment if the debt instrument experiences a credit default
Book 1, LO 7.4
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Growth of Securitization and Structured Products
The originate-to-distribute model refers to the process through which banks create securities based on an underlying pool of mortgages, bonds, or other loans and then sell the securities to investors
By originating and selling the securitized assets, the banks transfer the default risk of borrowers to the investors
Book 1, LO 7.5
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Growth of Securitization and Structured Products (continued)
Banks, via structured investment vehicles (SIVs), used commercial paper and repurchase agreements (repos) to roll over short-term financing for investing in long-term assets
The banks’ mismatches in asset-liability maturities exposed the banks to funding liquidity risk
Book 1, LO 7.5
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Consequences of the Financial Crisis
The financial crisis led to a worldwide liquidity crisis because institutions had:
1. taken on too much leverage.
2. generated large maturity mismatches between assets and liabilities.
3. become too interconnected.
Book 1, LO 7.6
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Funding Liquidity and Market Liquidity
Funding liquidity refers to the ability of an institution to settle its obligations when they are due
Market liquidity refers to the ease with which an asset can be sold without having to lower the price to attract a buyer
Book 1, LO 7.7
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Loss Spiral and Margin Spiral
Loss spiral refers to the forced sale of an asset by a leveraged investor to maintain margin or leverage ratio requirements
A margin spiral refers to the forced sale of an asset as a result of an increase in margins or, equivalently speaking, a decline in the leverage ratio
Book 1, LO 7.7
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Network Risk
Network risk arises as a result of an increase in counterparty credit risk, which forces contracting parties to seek additional protection and liquidity enhancement
In the absence of a clearinghouse that could facilitate multilateral netting arrangements, an increase in counterparty credit risk can produce systemic effects, as evidenced by the recent global financial crisis
Book 1, LO 7.8
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