Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
2 Financial Markets and Transformation Functions
Financing and Transformation Functions
financial deficit
units
(mainly
companies)
financial intermediaries
financial institutions
financial excess
units (mainly private households)
financial intermediation
lot size and spatial
transformation
transformation functions
of financial markets
risk transformation
issuing of financial assets
capital investment
Institutions:

Exchanges

OTC Markets

Bank Markets

Insurance Markets
period and liquidity
transformation
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
a) Lot Size and Spatial Transformation
Spatial transformation:
- Solvency at different places (monetary transactions, loans)
- Capital transfers between regions  financial balancing
Effects of the failure of a banking system?
Lot size transformation:
- Matching investments of a different size
- Pooling small deposits
- Splitting large deposits
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
b) Period and Liquidity Transformation
- Financing long-term investments with short-term funds (positive period
transformation) and vice versa (negative period transformation)
- Option to withdraw financial resources out of long-term projects prior to
maturity
Enabled by:

Secondary markets
Price and liquidity risks
Possibility of hedging with particular financial products

Intermediation
Counter party risk for the investor
Limited default risk of the financial intermediary by setting financing
rules
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Financial Rules to Limit the Risks that Arise from Period and Liquidity Transformation
Golden Banking Rule/Golden Rule of Finance:
Total maturity matching
Golden Rule of Balance Sheet
Basis: “Schichtenbilanz”
assets
liabilities
A1: Assets with a capital commitment of over F1: Financial resources invested longer than 4
4 years
years
A2: Assets with a capital commitment of 3 F2: : Financial resources invested 3 months to
months to 4 years
4 years
A3: Assets with a capital commitment up to 3 F3: : Financial resources invested less than 3
months
months
A1 ≤ F1
and
A1+A2 ≤ F1+F2
“Bodensatzregel” (Principles II and III of BAKred)
Rule 1: A1 ≤ F1 + 0,6 F2 + 0,1 F3
Rule 2: A2 ≤ (F1 + 0,6 F2 + 0,1 F3 - A1) + 0,4 F2 + 0,2 F3
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
c) Risk Transformation
Via secondary markets:

Portfolio diversification: (stock) exchange or funds

Limiting risk by using financial derivates
Via financial intermediaries:

Portfolio diversification and available net equity of a bank or insurance
company

Banks as “delegated monitor“ and “delegated contractor“
Implementation by banks: Risk management
40
Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Model Calculation
Arrow-Debreu-Model:
-
4 states with identical probability
-
2 financial assets (A1 and A2)
-
Utility functions U or V
-
Amount of investment: 100
state:
s1
s2
s3
s4
A1
x11 = 130
x12 = 130
x13 = 90
x14 = 90
A2
x21 = 160
x22 = 60
x21 = 160
x22 = 60
U x
U(Al)
11,40
11,40
9,49
9,49
U(A2)
12,65
7,75
12,65
7,75
E(U(A1)) = 10,44
 x
V
 x  5
E(U(A2)) = 10,20
x  100
otherwise
V(A1)
11,40
11,40
4,49
4,49
V(A2)
12,65
2,75
12,65
2,75
E(V(A1)) = 7,94
E(V(A2)) = 7,70
41
Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Risk Transformation by Diversification:
state:
s1
s2
s3
s4
A1
x11 = 130
x12 = 130
x13 = 90
x14 = 90
A2
x21 = 160
x22 = 60
x21 = 160
x22 = 60
Portfolio formation: Purchase α = 50% of A1 and (1 – α) = 50% of A2
½ A1 + ½ A2
xd1 = 145
xd2 = 95
xd3 = 125
xd4 = 75
U(α = 50%)
12.04
9.75
11.18
8.66
V(α = 50%)
12.04
4.75
11.18
3.66
E(U(α = 50%)) = 10,40
E(V(α = 50%)) = 7,90
(“naive” diversification, without success in this case)
Portfolio formation:
Purchase α = 86.52% of A1 and (1 - α) = 13.48% of A2
xd1 = 134,04
xd2 = 120.56
xd3 = 99.44
xd4 = 85.96
U(α = 86,52%)
11.58
10.98
9,97
9.27
V(α = 86,52%)
11.58
10.98
4.97
4.27
E(U(α = 86.52%)) = 10.45
E(V(α = 86.52%)) = 7.95
(optimal diversification for utility function U)
Instruments:
 Diversification via portfolio formation
 Buying shares in a fund
 Buying bank or insurance shares
42
Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Risk Transformation by Risk Splitting:
state:
s1
s2
s3
s4
A1
x11 = 130
x12 = 130
x13 = 90
x14 = 90
A2
x21 = 160
x22 = 60
x21 = 160
x22 = 60
xsl1 = 120
xsl2 = 120
xsl3 = 100
xsl4 = 100
10,95
10,95
10
10
“No-loss“ contract (e.g. on A1):
U(SL) = V(SL)
E(U(x)) = E(V(x)) = 10,47
Risk free asset:
U(RF) = V(RF)
xrl1 = 110
xsl2 = 110
xsl3 = 110
xsl4 = 110
10,49
10,49
10,49
10,49
E(U(x)) = E(V(x)) = 10,49
Hedging or financial engineering by:
 Contracting with a bank
 A particular fund construction

Buying financial assets on the capital market
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Prof. Dr. Hans-Peter Burghof, University of Hohenheim, Bank Management
Financial Engineering on the Capital Market:
E.g.: Combination of shares in A1 and a (long) put option
Wealth of the investor
in T
Portfolio
Desired
Minimum Wealth
in T
(e.g. 100)
A1
Put Option
Value of the Asset in T
State:
A1 (α of 100)
Put option with
strike P on α A1
Desired cash flow
130  120   
s1
s2
s3
s4
α130
α130
α90
α90
0
0
α(P – 90)
α(P – 90)
xsl1 = 120
xsl2 = 120
xsl3 = 100
Xsl4 = 100
12
13
 90   P  90   100  P 
100


100  13
 108, 3
12
Costs:
(risk free interest rate i = 10% and risk neutral valuation of the option)
100  92,31
Buying  shares of the asset A1 :
Buying a put option
1
1
1 12
1

108, 3  90   7,69
108, 3  90 

on share α of the asset : 2
1,1
1  i 2 13
Total costs :
92,31  7,69  100
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