Basis risk exists because the value of an item being hedged may not always keep the same price relationship to contracts purchased or sold in the futures market.

Cross-Hedging leads to basis risk because it is hedging with a traded futures contract whose characteristics do not exactly match those of the hedgers risk exposure. For instance an S&L that wishes to hedge its assets for more than 1 year may wish to hedge in the treasury note rather than the mortgage-backed security futures market, because trading in distant futures contracts is more active in the former. However, mortgage rates and Treasury not rates, although closely related, do not always move together. As the spread between the rates changes, so does the basis risk.

Call option: Intrinsic value=Spot-Strike; Time value=Premium-Intrinsic value

Put option: Intrinsic value=Strike-Spot; Time value=Premium-Intrinsic value

The option premium varies positively with the price variance, time to the options expiration and the level of interest rates. The more price variability a stock has, the greater the chance that the buyer can exercise the option for a larger profit. However, the buyer never exercises the option and takes a loss. Thus, options with greater price variance tend to have higher premiums. Similarly, given a longer period of time, bigger cumulative price changes can be expected. Thus, options have greater value and greater premiums when they have a longer time to expiration. Because the purchase of an option allows the buyer to conserve capital until the option is actually exercised and the underlying stock or commodity is purchased, call options on stocks have a higher value when interest rates are high. If a buyer purchases a call option instead of a stock and then invests the money saved the buyer still shares in the price appreciation but earns more on the invested funds when interest rates are high. Thus buyers are willing to pay more for options when interest rates are high, particularily if the option has a long time to maturity.

For puts the same is true except that when interest rates are low the premium is higher as they would hedge against the option losing value which would happen if interest rates rose.

If you were to hedge in the futures market by selling T-Bond futures, you would be safe if rates rose, because the loss on the bonds in the portfolio would be offset by the gain on the short sale of the T-bond futures. 

Same is true for notes.

A line of credit is an agreement under which a bank customer can borrow up to a predetermined limit on a short-term basis.

A letter of credit is a contractual agreement issued by a bank that involves three parties: the bank, the bank’s customer, and a beneficiary. The bank guarantees payment for goods in a commercial transaction and the buyer of the goods arranges for the bank to pay the seller of the goods once the terms of the purchase agreement are satisfied.

Solution:  The bank has a negative GAP because its rate sensitive liabilities are greater than its rate sensitive assets. If liabilities reprice more frequently than the assets then the average duration of the liabilities is less than the average duration of assets. The bank, therefore, has a positive duration GAP.

Solution:  A bank with a negative maturity GAP or positive duration GAP should sell futures on interest rates to reduce interest rate risk.  As interest rates increase the bank’s cash flow (or value) decreases. The short position in interest rate futures, however, increases in value when interest rates increase, offsetting the loss in value experienced by the bank.  Conversely, a bank exposed to a drop in rates should take a long position in interest rate futures.

What are the major differences between large banks and small banks on the income statement? Why are there differences between the two groups of banks? For example, why is the net interest income higher for small banks?

The major differences between large banks and small banks on the income statement is that small banks holder a higher proportion of investment securities and loans than large banks. Large banks hold a higher proportion of assets held in trading accounts, federal funds sold and repurchased, trading account gains and fees and other noninterest income. The differences can be attributed to differences in lending practices of large and small banks. The interest income is higher for small banks than large banks because they have more investment securities which are more important to small banks than large banks as large banks generate a larger proportion of income from non-interest activities.

(A) Small banks’ interest and fee income on loans is GREATER than large banks because the differences can be attributed to differences in the lending practices of large and small banks. Recall from chapter 13 that small banks tend to make more real estate and agricultural loans, whereas large banks tend to make more commercial and industrial loans. (B) The interest earned on investment securities is higher and more important for small banks than large banks because small banks hold proportionally more investment securities. Small banks pay more interest on their deposits than large banks because of their greater reliance on deposits as a source of funds. Large banks pay more than small banks for federal funds purchased and securities sold under repurchase agreements as well as other borrowed money. Small banks tend to earn greater net interest income as a percentage of assets than large banks because small banks generate more interest income.

·         Bank failure can result from the depletion of capital caused by losses on loans or securities – from over-aggressive profit seeking. But a bank that only invests in high-quality assets may not be profitable.

·         Failure can also occur if a bank cannot meet the liquidity demands of its depositors (i.e., liquidity risk) – a run on the bank occurs. If assets are profitable, but illiquid, the bank also has a problem.

·         Bank insolvency very often leads to bank illiquidity.

Example: a large number of depositors withdraw their funds simultaneously, such as occurred in the 1920s and 1930s.

• Liability management supplements assets management but does not replace it as a source of bank liquidity. Asset management still remains the primary source of liquidity for banks, particularly smaller banks. If used properly, liabilities management allows banks to reduce their secondary reserve holdings and invest these funds in higher-yield assets, such as loans or long-term municipal bonds.

Smaller banks have limited access to liability management because they do not have direct access to the wholesale money markets where liability management is practiced.

How do banks decide on the proper amount of primary and secondary reserves to hold?

Hold enough “primary reserves” to satisfy reserve requirements.

Hold minimum primary and secondary reserves consistent with bank safety.

What are risk-based capital standards? What are they designed to do?

Capital is measured against risk-weighted assets. Risk-weighting is a measure of total assets that weighs high-risk assets more heavily than low-risk assets. The current standards define two forms of capital: Tier 1 capital or “core” capital includes common stock, common surplus, retained earnings, non-cumulative perpetual preferred stock, minority interest in consolidated subsidiaries, minus goodwill and other intangible assets. Tier 2 capital or “supplemental” capital includes cumulative perpetual preferred stock, loan loss reserves, mandatory convertible debt, and subordinated notes and debentures. The minimum capital requirements are: Ratio of Tier 1 capital to risk-weighted assets must be at least 4%. Ratio of Total Capital (Tier 1 plus Tier 2) to risk-weighted assets must be at least 8%. Capital levels are also used by regulators to determine the level of regulatory scrutiny a bank should receive and whether a bank should have any limits placed on its activities. They are designed to require high-risk banks to hold more capital than low-risk banks.

A bank can become insolvent by suffering losses on its loans or investment portfolio (i.e., credit risk or interest rate risk), resulting in a depletion of its capital.

 Interest rate risk ex.:

 Credit Risk ex.: In late 1980s and early 1990s, many banks failed because of loan defaults.

What is maturity GAP?  What is duration GAP?  What are the strengths and weaknesses of each as a measure of interest rate risk?

Maturity gap is an interest rate risk measure comparing the value of assets that will either mature or be repriced within a given time interval to the value of liabilities that will either mature or be repriced during the same time period. One advantage is that it is relatively easy to compute and it makes good intuitive sense. A disadvantage banks should recognize, however, that their management of interest rate risk will be less precise because maturity GAP ignores reinvestment risk on intermediate cash flows.

Duration Gap is the measurement of the sensetivity of a portfolio to interest rate changes. One advantage of duration gap is that it is the most precise way to manage interest rate risk. A disadvantage is that it is costly and complex to use therefore only the largest banks find it feasible to measure duration gap.

Unlike other business failures, bank failures reduce the money supply and disrupt the financing of a variety of other business activities.  Bank failures also tend to be contagious if liquidity is not promptly and decisively injected into troubled institutions to restore the confidence of the depositing public.

What is Glass-Steagall?  What did it do? What did the Financial Services Modernization Act (Gramm-Leach-Bliley) do?

CAMELS: is what examiners assess the overall quality of a bank’s condition using the CAMELS

—1 (Best) to 5 (Worst) in each of 6 areas:

                                                a.            Capital Adequacy            

                                                b.            Asset quality

                                                c.             Management

                                                d.            Earnings

                                                e.            Liquidity

                                                f.             Sensitivity to Market Risk