Version 2013-11-21
Lecture Synopsis:
Bo Sjö’s part of Financial Markets and Institutions Risk Management
I will regularly update this document with reading instructions, and suggestions for end-of-chapter
questions from the book.
About the course
The course is mixing “The History of Financial Crises” and “The Risk management of Financial
Institutions”. Given the recent financial crises, which is not over yet, this course is very up to date
with the present situation. You will get both an historical perspective and learn about the (perhaps)
insufficient tools that exists to control manage risk.
The text book by Anthony Saunders and Marcia Million Cornett is the best you can get in the area.
The authors really know what they are talking about. There is nowadays quite a number of
textbooks. The problem is that most of them too trivial and do not deal with risk management issues.
However, there a few topics you need to know before you enter into world of financial institutions. A
course in Corporate Finance is good pre-requisite, but not necessary. We will go through some basic
stuff that will help you to understand what people are talking about when they talk about financial
crises.
Background topics (not in the textbook)
Understand the balance sheet
Understand valuation of financial assets, the time value of money and risk
Debt instruments, different types of bonds
Bond valuation
What are interest rates and yields?
The Flow of funds – demand and supply of loanable funds => interest rates
The yield curve and theories of the terms structure of interest rates
Duration – a measure of interest rate sensitivity of price of bonds (or debt)
This material will come up in Lecture 2 and Lecture 3.
Lecture 1
Ch. 1 is an introduction to my part of the course. Overview of financial markets and their role in the
economy. What are financial institutions (FI:s)? Why do FI:s exist? In what ways are they special
compared to other institutions and non-financial firms? What is meant by i) asset transformation and
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ii) delegated monitoring? (For the latter I add material in my lectures). These are critical questions.
An overview of different risks are coming up in Ch. 7.
Risk management principles, i) identify, ii) measure iii) decide about hedging
Lecture 2
Financial markets - orientation
Ch. 2-6 presents different financial institutions. Identify the major types of financial institutions,
which are they? What do they do? We go through these chapter briefly in class. The material is
meant for self-studies. It is important to understand the different institutions and what they do on
the markets. We are not interested in US markets per se, we are interested in the role of different
institutions since they operate in all economies. These institutions often have different regulations,
though they share many risks factors.
Ch. 7 presents a number of different risks. These risks are dealt with in the textbook, but we have
time only for the big risks. Name and explain the different risks talked about in Ch 7. Most of these
risks are highly relevant for the current crisis in EU, of course you should be able to explain this. Of
course, we will look deeply into interest rate risk, which comes in two shapes. Refinancing and
reinvestment risk
Most of the risks mentioned in Ch 7 can be understood by looking at a stylized balance sheet of an FI
(or a bank to put it simply). Notice that most of time we talk about the real balance sheet in real
economic values, not the accounting balance sheet based on book values. It is important to
understand the difference between the real economic balance sheet and the accounting one since
economic decisions are and should be based on the former.
Lecture 3
Capital Markets and Money Markets, Money Market instruments,
Interest rates, The flow of funds theory, the basics of supply and demand for loanable funds (or
bonds) and what is causing interest rates to change.
Zeroes, coupon bonds, zeros, face values, valuation of bonds, default risk premiums
Bond ratings, the most important factors behind the rating
Yield curves, implicit forward rates, theories of the yield curve and the terms structure of interest
rates.
Memo + Appendix 8B p 227-233
Lecture 4 etc
Ch 8 Interest Rate Risk I (Repricing Model)
The repricing model, buckets, rate sensitive assets and liabilities, NII = GAP r
P 204-210, p 216-218,
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Ch 9 Interest Rate Risk II (Duration)
Book value accounting, market value accounting, marking to market.
Duration, modified duration, interest rate risk and duration and expected losses and gains in interest
rate sensitive assets and liabilities, Duration gap, interest rate risk management with duration, how
to measure the effect on assets, liabilities and equity. What is duration? What can you do with
duration? Immunization, Difficulties with the duration measure convexity
Ch. 9 p 234-264
Ch. 10 Market Risk (VaR)
Market risk, calculating market risk exposure, VaR, back simulation, monte carlo simulation
DEAR, VaR (basis points).
Briefly explain the Historic (Back simulation) model and its weaknesses
Briefly about BIS regulation
Ch 10. P 283-290, 296-300, 308-310.
Ch. 11 Credit Risk Individual Loan Risk
Types of loans, secured loan, unsecured loan, commercial paper, whole sale and retail loans, the
contractually promised return on a loan, LIBOR, k = 1 +(r +m), expected return on a loan E(r) = p(1+k)
+ (1-p) x 0, or E(k) = E(r), credit ration and fig 11-4
Measuring credit risk, Qualitative models & borrower specific factors – reputation, implicit contract
Quantitative models, credit scoring models, linear discriminant models (=Altman’s z-score model)
RAROC models
Ch 11: p. 317-333, 335, 337-341, 349-352.
Ch. 12 Credit Risk: Loan Portfolio and Concentration Risk
Two simple models, migration analysis and loan mix, concentration risk and concentration limits. .
Loan portfolio diversification geographical (domestic and international) and economic sectors. Avoid
concentration risk, set limits.
Micro and macro hedging of credit risk, credit default insurance (or derivatives) individual loans or
loan portfolio.
p. 369-371 (We don’t do portfolio theory in this class)
Ch 13. Off-balance Sheet Risk
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Contingent assets and liabilities, definition of OBS, examples of typical OBS activities (Table 13-1) and
OBS risk comes from trading in derivatives, types of derivatives (Table 13-3) + memo on derivatives.
The accounting problem (a valuation problem). Definition of TARP
Ch. 13 p 396-402, 411-412
Ch 17 Liquidity Risk + Ch 19 Deposit Insurance
Causes of liquidity risk, (economic problems => affects banks, interest rate risk and market risk or
credit risk => changes asset values => expectation of insolvency => less credibility => bank run,
systemic risk, bank panic deposit drains, bank runs, how to deal with Liquidity risk: Discount window
borrowing, deposit insurance and government intervention (buy bad debt from banks)
Problems with the solutions.
Ch 19 causes of depository fund insolvencies
Too big to fail and uninsured depositors, moral hazard. Te discount window,
Ch 17: p. 515-516, 529-531. Ch 19: p 578-582 (to how to calculate the premium), 589, 594-595.
EU financial crisis (My power points)
The basic problem, the basic solution from a macroeconomic perspective.
http://en.wikipedia.org/wiki/Eurozone_crisis
http://www.businessinsider.com/the-european-economic-crisis-explained-in-just-two-charts-2013-7
Discuss the basic cause of the problem. Discuss its principal solution, by using some equations, see
combination of austerity and supply side politics.
Ch 22 Futures and Forwards
Spot, futures and forward contracts. FRA:s, Forward contract and hedging interest rate risk.
Calculate how many futures are necessary to hedge interest rate risk exposure.
Ch 22: p 696-712
Ch. 23 Options Caps Floors and collars
Definition of caps floors and collars.
Ch. 26 Securitization
Definition and example of securitization, Bowie bonds, CMO:s
To be updated the26th of November.
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