Special Topics in Banking & Finance Ch 2

8/9/2019 Special Topics in Banking & Finance Ch 2

1/33

Special Topics In Banking &Finance

Dr. Karim Kobeissi

Arts, Sciences and Technology University in

Lebanon


2/33

Chapte r 2 : inanc ia l C r i ses


3/33

Ke yword : AssetsAn asset is a resource with economic value that an

individual, corporation or country owns or controls

with the epectation that it will provide !uture "ene#t $• Assets can "e classi#ed as either:

!. Debt instr"ments

– %amples include "onds and deposits$

– They speci!y that the issuer must repay a fxed amountregardless o! economic conditions$

or

2. #$"ity instr"ments

– %amples include stocks or a title to real estate propertyconsisting o! land or "uildings'$

– They speci!y ownership e(uity ) ownership' o! variable pro#ts or returns, which vary according to economicconditions$


4/33


5/33

.2 Futures 3ontracts• A '"t"re contract is a #nancial contract obligating the "uyer

to purchase an asset or the seller to sell an asset', such as a

physical commodity or a #nancial instrument, at a

predetermined !uture date and price$

• Futures can "e used either to hedge to lock in a certain

price and reduce risk' or to speculate on the price

movement o! the underlying asset$ For eample, a producer

o! corn could sell a !uture contract to hedge$


6/33

/2 Forwards 3ontracts• A customi+ed contract "etween two parties to "uy or sell an

asset at a speci#ed price on a !uture date$ A !orward

contract can "e used !or hedging or speculation, although

its non2standardi+ed nature makes it particularly apt !or

hedging$

• 4nlike standard !utures contracts, a !orward contract can "e

customi+ed to any commodity, amount and delivery date$


7/33

02 5ptions 3ontracts• A "uyer purchase an option contract to hold the right o!

carrying out a certain transaction in a predetermined

period o! time and price 2 hence the name$ For eample,let6s say you purchase an option on shares o! Intel I7T3'with a strike price o! 819 and an epiration date o! April .$

This option would give you the right to purchase .99shares o! Intel at a price o! 819 on April . the right to do

this, o! course, will "e valua"le only i! Intel is trading a"ove819 per share at that point in time'$

• The seller has the obligation to sell the "nderlying

asset to the "uyer at a speci#ed price "y a speci#ed date$ ;eanwhile, the "uyer o! an options contract hasthe right, "ut not the o"ligation, to complete thetransaction "y a speci#ed date$


8/33

12 Swaps 3ontracts• A swap is a derivative in which two counterparties echange

cash =ows o! one party6s #nancial instrument !or those o!the other party6s #nancial instrument$

• Swaps are use!ul when one company wants to receive apayment with a varia"le interest rate, while the other wantsto limit !uture risk "y receiving a #ed2rate payment instead$#ach gro"p has their o(n priorities and re$"irements,

so these e)changes can (or* to the advantage o'both parties$ For eample, one company may have a "ondthat pays the >ondon Inter"ank 5?ered @ate >IB5@', whilethe other party holds a "ond that provides a #ed paymento! $ I! the >IB5@ is epected to stay around 0, then the

contract would likely eplain that the party paying thevarying interest rate will pay >IB5@ plus /$ That way "othparties can epect to receive similar payments$ The primaryinvestment is never traded, "ut the parties will agree on a"ase value perhaps 8. million' to use to calculate the cash=ows that theyCll echange$


9/33


10/33

Fa c t o r s 3 a u s i n g Fi n a n c i a l 3 r i s e s;any theories have "een developed over the years regarding the

underlying causes o! #nancial crises$


11/33

Factors 3ausing Financial 3rises con'

Financial crises are o!ten preceded "y asset and credit

"ooms that eventually turn into "usts decrease in

values'$ ;any theories !ocusing on the sources o! crises

have recogni+ed the importance o! "ooms in asset and

credit markets$ owever, eplaining why asset price

"u""les or credit "ooms are allowed to continue and

eventually "ecome unsustaina"le and turn into "usts

has "een challenging$ This naturally re(uires answering

why neither #nancial market participants nor policy

makers !oresee the risks and attempt to slow down the

epansion o! credit and increase in asset prices$


12/33

ynam cs o nanc a r ses n vance%conomies• Stage 5ne: Initiation o! Financial 3risis

– ;ismanagement o! #nancial innovations such as

swaps, !orwards'

– Asset price "oom and "ust

– Spikes sharp increases' in interest rates

– Increase in uncertainty

• Stage two: Banking 3risis


13/33

Jynamics o! Financial 3rises in Advanced%conomies

•

Stage three: Je"t Je=ation a theoryo! economic cycles, which holds that

recessions and depressions ared"e to the overall level o' debt

shrin*ing +deating%: the creditcycle is the ca"se o' the

economic cycle-$


14/33

ig"re ! Se$"ence o' #vents in inancial Crises in Advanced #conomies


15/33

ALL>I3ATI57 The ;other o! All Financial 3rises: The MreatJepression

• ow did a #nancial crisis disclose during the Mreat

Jepression and how it led to the worst economic

downturn in 4$S$ historyD

• This event was "rought on "y:

– Stock market crash

– Bank panics

– 3ontinuing decline in stock prices

– Je"t de=ation


16/33

ig"re 2 Stoc* -rice Data D"ring the reatDepression -eriod

Source: Dow-Jones Industrial Average (DJIA). Global Financial Data;www.globalfinancialdata.com/index_tabs.php?actiondetailedin!o"id##$%.

Figure 0 3redit Spreads Juring the Mreat


17/33

Figure 0 3redit Spreads Juring the MreatJepression

Source: Federal Reserve Bank o! St$ >ouis F@%J data"aseEhttp:NNresearch$stlouis!ed$orgN!red/NcategoriesN//.

A li ti Th Gl b l Fi i l C i i f 2007 2009


18/33

STA# /0#: 101T1AT1/0 / 10A0C1AL C1S#:

!% inancial innovations emerge in the mortgage mar*ets

– S"bprime : loan arrangements !or "orrowers with a poor credit history, typically

having un!avoura"le conditions such as high interest rates$

– Alt3A mortgages : the "orrowers "ehind these mortgages will typically have

clean credit histories, "ut the mortgage itsel! will generally have some issues that

increase its risk pro#le$

– 4ortgage3bac*ed sec"rities: de"t o"ligations that represent claims to the cash

=ows !rom pools o! mortgage loans, most commonly on residential property$

– Collaterali5ed debt obligations: A structured #nancial product that pools

together cash =ow2generating assets and repackages this asset pool into separate

tranches that can "e sold to investors$ A collaterali+ed de"t o"ligation 3J5' is so2called "ecause the pooled assets O such as mortgages, "onds and loans O are

essentially de"t o"ligations that serve as guarantee !or the 3J5$ The tranches in a

3J5 vary su"stantially in their risk pro#le and the highest rated tranches, re!erred

to as super senior tranches are the ones that are paid o? #rst and so have the least

risk$

Application: The Global Financial Crisis of 2007-2009

A li ti Th Gl b l Fi i l C i i f 2007 2009


19/33

2% 6o"sing price b"bble 'orms

– Increase in li(uidity !rom cash =ows moving towards the 4nited States$

– Jevelopment o! su"prime mortgage market !ueled housing demand

and housing prices$

&% Agency problems +a conict o' interest bet(een a company7s

management and the company7s stoc*holders% arise

– G5riginate to distri"uteH model is su"Pect to "roker management'

and mortgage investor stoc*holders' pro"lem$

– 3ommercial and investment "anks had weak incentives to assess the

(uality o! securities$

– Borrowers had little incentive to disclose in!ormation a"out their a"ility

to pay$

Application: The Global Financial Crisis of 2007-2009


20/33


21/33

A li i Th Ml " l Fi i l 3 i i ! /99Q


22/33

STAM% T@%%: J%BT J%F>ATI57

.' Assets and commodities prices decrease

/' The economy enter a recession stage /992/99R'

Application: The Mlo"al Financial 3risis o! /99Q 2/99R con'


23/33


24/33

ig"re 9 Stoc* -rices and the inancialCrisis o' 2;;

Source: Dow-Jones Industrial Average JIA'$ Mlo"al Financial JataE www$glo"al#nancialdata$comNindeUta"s$phpDaction)detailedin!o&id)...

http://www.globalfinancialdata.com/index_tabs.php?actionhttp://www.globalfinancialdata.com/index_tabs.php?actionhttp://www.globalfinancialdata.com/index_tabs.php?action


25/33

ig"re Credit Spreads and the 2;;inancial Crisis

Source: Federal Reserve Bank o! St$ >ouis F@%J data"aseE http:NNresearch$stlouis!ed$orgN!red/NcategoriesN//.

D i ' i i l C i i # i


26/33

Dynamics o' inancial Crises in #merging4ar*et #conomies

• Stage one: 1nitiation o' inancial

Crisis

– -ath one: mismanagement o' ?nancial

liberali5ation:•


27/33

Dynamics o' inancial Crises in #merging 4ar*et#conomies +con%

– -ath t(o: severe ?scal imbalances:

• Movernments in need o! !unds sometimes !orce"anks to "uy government de"t$

•


28/33

Dynamics o' inancial Crises in #merging 4ar*et

#conomies +con%

•

Stage t(o: c"rrency crisis – Jeterioration o! "ank "alance sheets

triggers currency crises:

• Movernment cannot raise interest rates doing

so !orces "anks into insolvency'

• and speculators epect a devaluation$

•

Foreign and domestic investors sell thedomestic currency Foreign echange crisis'$

D i ' i i l C i i # i 4 * t


29/33

Dynamics o' inancial Crises in #merging 4ar*et#conomies +con%

• Stage three: "ll3ledged +developed%

inancial Crisis: – The de"t "urden in terms o! domestic

currency increases net worth decreases'$

–

Increase in epected and actual in=ationreduces #rmsC cash =ow$

– Banks are more likely to !ail Banking 3risis':• Individuals are less a"le to pay o? their de"ts

value o! assets !all'$• Je"t denominated in !oreign currency increases

value o! lia"ilities increase'$

ig"re < Se$"ence o' #vents in #merging 4ar*et


30/33

ig"re < Se$"ence o' #vents in #merging 4ar*etinancial Crises


31/33

ALL>I3ATI57 Fi i l 3 i i ; i .RR1 .RR


32/33

ALL>I3ATI57 Financial 3rises in ;eico, .RR1O.RRE%ast Asia, .RRQO.RRE and Argentina, /99.O/99/ con'

• %ast Asia: Financial li"erali+ation in the early.RR9s: – >ending "oom, coupled with weak supervision and lack o!

epertise$

– Banks accumulated losses and their net worth declined$• 4ncertainty increased stock market declines and

!ailure o! prominent #rms'$

• Jomestic currencies devaluated "y .RRQ$

• @ise in actual and epected in=ation$

ALL>I3ATI57 Fi i l 3 i i ; i .RR1 .RR


33/33

ALL>I3ATI57 Financial 3rises in ;eico, .RR1O.RRE%ast Asia, .RRQO.RRE and Argentina, /99.O/99/ con'

• Argentina: Movernment !orced "anks to a"sor"large amounts o! de"t due to #scal im"alances$

• @ise in interest rates a"road$

• 4ncertainty increased ongoing recession'$

• Jomestic currency devaluated on anuary , /99/

• @ise in actual and epected in=ation$

Special Topics in Banking & Finance Ch 2

Documents

Transcript of Special Topics in Banking & Finance Ch 2