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Bernd Scherer
Capital Markets
May 2010
Dr. Bernd Scherer
Professor of Finance, EDHEC Business School
Member of EDHEC Risk
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Prof. Dr. Bernd Scherer
Sessions
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Prof. Dr. Bernd Scherer
Teaching Format
• The course will comprise a total of 30 hours split roughly into 10 sessions of
3 hours.
• The lecture notes are thought as a guidance to the literature. Lecture notes
can not replace studying the suggested literature, neither is reading the
literature a substitute for the course.
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Course Assessment
• The exam will be a take home exam, where students have to answer a set
of questions and hand in their solutions two weeks after they received the
questions.
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1. Financial System
– How does the financial system promote efficiency?
3. Financial Structure
– What are the basic facts of financial structure around the world?
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Literature
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Financial
Intermediaries
Indirect
finance
Lenders/Savers Borrower/Spender
Financial
Households Corporates
Corporates Markets Governments
Governments Households
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• Ultimate investors sell financial assets to savers; they use the proceeds to
buy real assets (buying real assets is the same thing as investment).
• A financial asset is a legal contract that gives its owner a claim to payments,
usually generated by a real asset. Examples include currency ($), stocks,
bonds, bank deposit, bank loans, options, futures, etc.
• The FS is the place where savers (or, more generally, economic agents with
a surplus of funds relative to their immediate need for those funds) meet
investors (or, more generally, economic agents with a deficit of funds
relative to their immediate need for those funds).
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Prof. Dr. Bernd Scherer
• Across Time
– By a house today rather than have to wait until to the rest of your life when you
will have save all the money.
– Go to university and pay back your fees after graduation allows you to develop
skills early in life.
• Across Space
– Channel investments to places with higher marginal returns
– Example: Provide capital to Russian oil firms either via stocks and bonds (direct
finance) or bank loans (indirect finance)
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Often one party of a deal lacks the information to make a good decision
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Value Maximization
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Fisher Separation –
Production and Consumption
• Endowment: y1 y0
y1
y0
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Fisher Separation –
Production and Consumption with Capital Markets
y0
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• Examples:
– Bonds: Coupon bond must equal the sum of implicit zero bonds
– Currency: If we know USD/EUR and EUR/YEN exchange rate we also know the
right value
– Capital structure arbitrage: When credit spreads move so should stock prices
– Derivatives: Option price equals value from replicating strategy
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Prof. Dr. Bernd Scherer
• Prices in financial markets will be set such that the optimal forecast - using
all available information - equals the securities equilibrium return (investors
get a fair compensation for risk, no more).
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• Read the entrails: prices (stock / bond) impound all available information –
example: if the firm’s bonds are offering a much higher than average yield,
one can deduce that the firm is most probably in trouble
• The do-it-yourself alternative: investors will not pay others for what they
can do equally well themselves (e.g. diversify, create leverage)
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3. Financial Structure
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5. The Financial System is the most heavily regulated part of the economy
– Why are financial markets so regulated?
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• The Problem: Fixed transaction costs crowd out low volume business. If you
have only 1000 Euros invest you can not get diversify across international
assets, commodities, hedge funds in your portfolios. Lower income
population gets cut out! How can financial intermediaries help to reduce
TC?
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Prof. Dr. Bernd Scherer
• The original lemon paper (AKERLOF, 1970): Potential buyers of used cars can
not evaluate the true value of a car. There is asymmetric information (seller
knows the true quality of his car) .
– Buyer suspects car is bad (lemon) and offers a low price
– Lower prices crowd out the seller of good cars
– Only bad cars are on offer – market does not function
• Adverse selection costs in finance (MYERS & MAJLUF, 1984) arise because two
types of firms might raise capital
• Firms that need to finance positive-NPV projects (starting the project is good for
existing investors, new investors get required rate of return)
• Firms whose claims are overvalued (raising capital transfers wealth from new investors
to existing investors!)
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Prof. Dr. Bernd Scherer
• Outside investors cannot distinguish between overvalued firms and those with
positive-NPV projects
– New investors would have, on average, a lower than required return
– Potential investors understand this, and offer to pay LESS so that the earn
their required rate of return on average
– underinvestment (positive-NPV projects are not realized because
necessary capital can only be raised at additional cost)
• The lemon problem explains why marketable securities are not the
primary source of funding (Fact #2)
• It also explains why there is a pecking order (prefer internal funds over
bonds over equity as the degree of information release is different)
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Numerical Example
• Suppose the management knows the intrinsic value of its assets (a) as well
as the NPV of a new project (b). These values are not known to capital
markets. In order to fund the project the company needs an amount of I.
• Let P and P* be the market value of the old stockholders’ shares before and
after issuance. Note that P does not need to equal a. In fact we have argued
that companies are reluctant to finance new projects if their stocks are
undervalued P < a.
• The total value of the firm after issuance is the sum of the money raised
from new shareholders and the market value of old stockholders’ shares (I
+ P*). Note that any price drop due to adverse selection is already included
in P*.
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Prof. Dr. Bernd Scherer
Numerical Example
• Old shareholders now own only a fraction of company assets. The company
will issue new stock if the old shareholders’ participation on assets after
issuance, namely I + a + b, is larger that the 100% participation in a. The
condition for issuance becomes
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Prof. Dr. Bernd Scherer
Numerical Example
• In this setting, issuing equities is not good idea for old stockholders. While
the value of the company would eventually increase to 120 (90 + 10 + 20),
they get only a share of 71.4% (50/70), which totals 85.71.
• Not issuing equities and giving up the positive NPV project gives them 100%
in the intrinsic value of 90. The result of this form of adverse selection is
underinvestment.
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• C. Financial intermediation
• Banks build expertise in evaluating good and bad firms, acquire funds from
depositors and start lending to good firms.
• Similar model for cars (used car dealership, guarantees on used cars, BMW sells
used BMWs)
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• D. Collateral
– Collateral (positive equity) protects the lender in times of default.
– Example: Mortgage market
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• Definition: Engage in activities that are undesirable for the purchaser of the
issued security
– Bondholders are hurt if management increases business risks.
– This helps shareholders and hurts bondholders. Why?
• Venture capital: manager and owner are the same person, solves
defrauding equity investors, but what about bondholders?
• Debt Contracts
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Prof. Dr. Bernd Scherer
• Collateralization
• Covenants
– Discourage undesirable behaviour (loan money must only be used for particular
project, business risk must remain the same)
– Encourage desirable behaviour (no further leverage allowed, no external funding
of pension plans)
– Keep collateral value (required maintenance until loan is paid off)
– Information provision
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Liquidity
• Liquid assets are more valuable than illiquid assets. If you buy an illiquid asset and
transform into a liquid assets you made a profit!
• Information is the key to liquidity. If the owner knows more than the buyer he will
have difficulties to sell at a fair price. Result: adverse selection.
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Conflicts of Interest
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Depository Institutions
• Key function: asset transformation: transform low liquidity left side of balance sheet
(assets) into high liquidity right side (deposits)
– Deposit insurance
– State guarantees
– Reputation, risk management, financial capital
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Investment Banks
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Fund Management
• Mutual funds are FSF that pool the resources of individuals and firms and invest those
funds in a large, diversified portfolio of financial assets.
• Money market mutual funds, Bond funds, Stock funds, Pension funds
• Hedge funds: These are pooled investment vehicles like mutual funds but they are
very lightly regulated. Hedge funds usually raise funds from wealthy investors and also
from pension funds, University endowments and state funds. They avoid most
regulations on disclosure requirements and are unrestricted in the kinds of assets that
they can hold. Also, hedge funds face no restrictions on short positions.
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1. Bank Management
– Understand the general principles of bank management
2. Banking Regulation
– Understand the credit crisis and the current debate on bank regulation
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Literature
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1. Bank Management
Assets Liabilities
Assets Liabilities
• Transform deposits into longer term loans, hold 10% cash buffer reserve
requirement. Money is created in the banking system!
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Liquidity Management
Assets Liabilities
• After a 10 million outflow in deposits the bank has still enough reserves (10 million >
10% x 90 million)
Assets Liabilities
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Prof. Dr. Bernd Scherer
Liquidity Management
• What happens if reserves are not high enough? Example: 10 million reserve loss.
Assets Liabilities
Assets Liabilities
• The bank has a reserve requirement of 9 million, (10% from 90 million), but no
reserves. What can it do?
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Deposits 90
Required Reserves 9
Borrowing 9
Loans 90
Bank Capital 10
Securities 10
2. Sell securities. Liquidity crisis becomes a solvency crisis when assets need to be sold
on fire sales terms.
3. Borrow from the Central bank using securities as collateral (not all securities qualify!)
• Banks will hoard cash (excess reserves) when the costs of from making up
for deposit outflows are high.
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• Deposits
• Ensure funding is not too volatile: Short term funding might cease in a crisis
(difficult to rollover) while long term funding is expensive.
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Bank Capital
• Lower bank capital yields higher returns for bank owners (ROE); trade-off
versus safety
• Bank need to hold capital for regulatory reasons as bank default imposes an
externality on the economy.
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2. Banking Regulation
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Deposit Insurance
• Suppose a bank looks troubled. Short term finance will not get rolled over and the
creditors withdraw funds, deposits, nobody wants to trade with that bank; bank needs
to sell illiquid securities at fire-sale prices and liquidity crisis becomes solvency
problem.
• Deposit insurance also creates an adverse selection problem. Bad risks are likely too
benefit from deposit insurance so its difficult to price.
• Too big to fail (banks take on even bigger risks and morph into “too big to save”)
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• Example: 100 million AAA bonds and 100 million B bonds and 100 million US treasury bonds
amount to risk weighted assets of 200 million. For this the bank needs at least 16 million in
capital from which at least 4 million must be tier 1
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– VaR is the maximum of today’s and the last 60 days trailing VaR, k is a multiplier set by
the regulator and SRC is a specific risk charge (to account for idiosyncratic risks)
• Total capital needed is now 8% on credit risk weighted assets plus market risk weighted
assets)
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• Three Pillars
– Regulatory requirement (risk based capital charges)
– Supervisory review (expanded role for supervisors)
– Enforcing market discipline (disclosure rules, that yield to large shareholder
and depositor scrutiny)
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Why Regulation?
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• The crisis started off as a solvency crisis. Falling (less strongly rising) house prices
meant that subprime borrowers could no longer borrow against rising house as a
result of rising interest rates.
– tightening standards rising foreclosures, falling value of collateral, …
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• Investors did not know how the losses (everybody knew were there) were distributed
among banks. CDS made it difficult to figure out which banks took the hit – a massive
adverse selection problem stopped the interbank market as a source of liquidity.
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• Paulson Plan – provide liquidity. Fed, ECB pumped massive liquidity into the
financial system
– Banks took the cash and hoarded it. Nobody wanted to lend to a failing
institution
• Collapse of AIG, Lehman – It became clear this was a solvency crisis, Banks
had to be recapitalized (stress test) to start lending again.
– Invest directly into banks
– Takeover failed institutions (Fannie and Freddie are US government
companies)
– Expand liability insurance
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• Debasing of Currencies
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Literature
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Understanding Returns
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Understanding Returns
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• Given that financial assets just represents claims against real assets we can plot
financial assets against real assets to see whether the former are inflated.
Bubble
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• Expected Productivity of Capital Goods (goods that are used to produce other goods)
– Mines, roads, canals, machinery, power stations, patents
– The higher the productivity the higher the interest rate (=slope of production function)
• Time Preferene
– The greater the preference for current consumption, the higher the interest rates in the economy
• Risk Aversion
– Rising risk aversion leads to a larger equity risk premium
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P P P P
ln n = ln n n−1 ... 1
P0 Pn−1 Pn−2 P0
P P P P
= ln n + ln n−1 + ln n−2 + ⋯ + ln 1
Pn−1 Pn−2 Pn−3 P0
= rn + rn−1 + rn−2 + ⋯ + r1
Var (∑ )
r = Var ( rn ) + Var ( rn−1 ) + ⋯ + Var ( r1 )
i =1...n i
= nVar ( r )
= nσ 2
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Prof. Dr. Bernd Scherer
Basics of Long Term Risks and the Central Limit Theorem (CLT)
• The CLT says that for independent (no autocorrelation in first or second
moment) and identically (can be non-normal as long as they have finite
variance) distributed random variables
– their sum is normal
– their product is log-normal
• If you look at diversified (little „factor risk) stock market investments over a
long period of time the distribution of log returns is likely to be close to
normal; this is not the case for short term risks on concentrated portfolios!
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• Investors with long horizon overpay for something they dont need (receive)
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Calculate the probability that an asset looses more than 10% in value by
year end.
– Change your return calculations from discrete to continuous returns and calculate
expected value and volatility.
– For example
P P µ = 9.71%
ln ( 1 + R ) = ln 1 + 1 − 1 = ln 1
P0 P0 σ = 19.48%
– Convert the target return of -10% in a continuos return of ln(1-10%)
– Calculate the standardised difference between continuous mean and target return
−10.54% − 9.71%
= −1.04
19.48%
– Calculate the coresponding value from the cumulative standard normal; in EXCEL: Normdist(-
1.04; 0; 1; 1)=14.9%
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• The key to investment risk is the positive correlation with consumption; assets
that pay off well if consumption is down (your marginal utility from extra wealth is
high) should require a lower risk premium (recession hedges).
r −c
= γ ⋅ σ ( ∆c ) ⋅ corr ( ∆c, r )
σ
• This is a genral asset pricing model as we do not need the covariance of asset
returns with a market portfolio
• For realistic values of risk aversion, consumption volatility and correlation the
derived SHARPE-ratio is inconsistent (factor 100) with the observed SHARPE-ratio
– Main culprit: consumptioni too smooth: too low volatility and correlation
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Risk Premium
Stocks - T.Bills Stocks - T.Bonds
60.00%
1928-2009 7.53% 6.03%
1960-2009 5.48% 3.78% 40.00%
Standard Error
Annual Return
Stocks - T.Bills Stocks - T.Bonds 0.00%
1928
1933
1938
1943
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
2003
2008
1928-2009 2.28% 2.40%
1960-2009 2.42% 2.71% -20.00%
t-value
Stocks - T.Bills Stocks - T.Bonds -60.00%
Years
1928-2009 3.31 2.51
1960-2009 2.26 1.39
2000-2009 -0.24 -0.59
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Styles
• Sorting equities on stock specific charactersitics turned out to earn superior risk
adjusted returns not explained by the market portfolio in the CAPM.
– The most popular characteristics are value and size
– FAMA/FRENCH use these portfolios to create a portfolio based asset pricing model
• Although the empirical evidence is far from clear it is more likely that these return
advantages are a compensation for risk.
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20
15
VALUE SIZE
(HML) (SMB)
Mean 0.403 0.237
10
Volatility 3.590 3.336
SIZE
t-value 3.558 2.249
Sharpe-ratio 0.389 0.246 5
Skewness 1.838 2.187
Kurtosis 15.557 22.233
Minimum -13.450 -16.850 0
JB-Test (p-value) 0.000 0.000 1930 1940 1950 1960 1970 1980 1990 2000
TIME
Table 1: Summary for monthly returns on investment styles, 1927 to 2009
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• Consider the following game. One coin is beeing tossed. If it turns out head the
player doubles his initial holding and can decide to continue or stop playing. If it
turns out number the player looses everything. What is the expected value of the
game?
• The expected value of this game is infinite. However most player would offer very
little to participate in this lottery. This is called St. Petersburg Paradox.
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Log-Utility
• This utility function exhibits constant relative risk aversion (The optimal percentage
allocation into the risky asset remains the same whatever the level of wealth)
10
8
U til ity
4
0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000
Wealth
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Example
• An investor with log-utility can participate into a lottery. He will win 100 with
50% likelihood and he will win 1000 also with 50% likelihood. What is his
expected utility?
U = 0.5 ln ( 100 ) + 0.5 ln ( 1000 ) = 5.76
• How much would you have to pay the investor to not engage into this bet?
In other words: what safe profit does the investor need to give up his right
to participate in the lottery?
• We need to pay 316.23 for sure. This is called the security equivalent.
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• Unter the following assumptions SAMUELSON has shown that the optimal allocation into equities
does not depend on the investment horizon
– Investoren exhibit CRRA
– Equiyt returns show no patterns, i.e. No mean reversion or aversion
– Investors do not have human capital
• 4 Period Example (Market goes up 33% or falls 25% with equal probability)
237.04
177.78
133.33 133.33
100.00 100.00
75.00 75.00 0.25 ⋅ ln ( 177.78 ) + 0.5 ⋅ ln ( 100 ) + 0.25 ⋅ ln ( 56.25 ) = 4.605
56.25
42.19
Periode 0 1 2 3
Nutzen 4.605 4.605 4.605 4.605
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Table 1: Inflation beta for FAMA/FRENCH factors, commodities and cash for 1926:7 to
2009:12. For each return series I run a BOODOKH/RICHARDSON (1993) OLS regression
with overlapping data
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• Stylized evidence
for alternative
time horizons
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• In the US, there is substantial empirical evidence that high inflation is associated with
a high equity risk premium and declining stock prices.
• The Proxy Hypothesis: This view, more fully put forward by Fama (1981), argues that
the relationship between high rates of inflation and future real economic growth
rates is negative.
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2. Access to Equity
3. Stock Portfolios
4. Equilibrium Returns
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1. Equity Valuation
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D1
Po =
k −g
P1
−1 = ?
Po
D2
D (1 + g )
P1 = 1
k −g 1 (1 + g )
=P
D1
k −g
P1 P (1 + g )
−1 = o −1 = g
Po Po
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Earnings
• Let us redefine
∞ ∞ ∞
Dt Et It
Po = ∑ t = ∑ (1 + k ) −∑
(1 + k ) (1 + k )
t t
t =1 t =1 t =1
• The value of the firm is the present value of earnings minus the present
value of the fraction of earnings that needs to get reinvested to keep the
business going.
– Do not double count earnings!
– In an expanding industry net investments are positive
• Let us break up the firm into two parts: (a) the present value of current
earnings as a perpetuity (no growth) and the present value of growth
opportunities.
E1
Po =
+ NPV of future investments
k
• How do value and growth stocks differ?
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Do Dividends Matter?
1. The naive view: yes as it affects the cash flows to be discounted in the
DDM. Earlier cash flows are more valuable.
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• CAPE compares share prices with average earnings during the past decade,
rather than to the most recent year's earnings.
– This evens out bumps in earnings multiples caused by the profit cycle, and has proved to be a
great market timing vehicle - highs and lows for this metric have overlapped almost perfectly
with highs and lows for the market.
50 20
2000
45 18
1981
40 16
1929
35 14
1966
25 Price-Earnings Ratio 10
22.04
20 8
1921 You are here
15 6
10 4
Long-Term Interest Rates
5 2
0 0
1860 1880 1900 1920 1940 1960 1980 2000 2020
Year
http://www.econ.yale.edu/~shiller/data.htm
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2. Access to Equity
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Types of Equity
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Shareholder Value
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Private Equity
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Going Public
• Efficient stock markets allocate capital to its best use and therefore create
growth
• Benefits
– Lower capital costs due to better access to markets, increased liquidity and the fact that
owners can now diversify better
– employees can sell their stocks
– External monitoring
• Disadvantages
– Expensive: 10% in lawyer, investment banking and underwriting fees + 15% underpricing (see
next section) = 25%
– Information revealed to competition
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• This requires that conditional expected returns are non-negative so that the
uninformed at least break even.
• In other words, all IPOs must be underpriced in expectation. This does not
remove the allocation bias against the uninformed – they will still be crowded
out by informed investors in the most underpriced offerings – but they will no
longer (expect to) make losses on average, even adjusted for rationing.
• Beatty and Ritter (1986) argue that as repeat players, investment banks have an
incentive to ensure that new issues are underpriced by enough lest they lose
underwriting commissions in the future. Investment banks thus coerce issuers
into underpricing. Of course, they cannot underprice too much for fear of losing
underwriting market share.
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3. Stock Portfolios
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• Suppose you are given two assets with the following scenarios and
respective scenario probabilities
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1
= [(10 − 5.83)(5 − 0.67) + ... + (−15 − 5.83)(−3 − 0.67)] = 80.5
6
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• This is the right approach if investors only care about standard deviation to
measure risks.
— Returns are multivariate normal
— Preference (utility functions) only care about variance
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Diversification I
20
18
16
Portfolio Standard Deviation
14
12
10
4
What is the return on this portfolio?
2
0
100%
95.00%
90.00%
85.00%
80.00%
75.00%
70.00%
65.00%
60.00%
55.00%
50.00%
45.00%
40.00%
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Weight in Aset B
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5
Portfolio Return
0
0 5 10 15 20 25
Portfolio Risk (Standard Deviation)
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Risk Contributions
Cov ( ri , rp ) Cov ( ri , ∑ i =1 wi ri )
n
wi σi2 + ∑ i ≠`j w j σi j
βi = = =
σp2 σp2 σp2
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σp2 = n ( n1 ) σ 2 + n ( n − 1)( n1 ) ρσ 2 = + (1 − n1 ) ρσ 2
• Assume equal return 2 2 σ2
correlation volatility n
• Restriction on correlations:
σ2
+ (1 − n1 ) ρσ 2 > 0, σn > − (1 − n1 ) ρσ 2
2
weighted random variables σp2 = n
can not have negative
variance ρ > − n 1−1
µ S
• What is the maximum Sharpe Sp = 1
= 1
Ratio? ( σ2
n + (1 − n1 ) ρσ 2 ) 2
( n1 + (1 − n1 ) ρ )2
1
lim S p = 1 S
n →∞ ρ 2
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4. Equilibrium Returns
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Prof. Dr. Bernd Scherer
• Result
– All investors hold the market portfolio (in varying proportions with cash due to their risk
aversion)
– Practically investors should hold a money market fund and an index fund (ETF)
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Prof. Dr. Bernd Scherer
• THE CML represents the best risk reward combination available to all
investors
E (rm ) − c
E (r ) = c + ⋅ σr
E r , E (rm )
( ) σ m
Market portfolio
E (rm ) − c
c
σm
σr , σm
• The slope of the CML is the famous SHARPE ratio named after Nobel price
winner Bill SHARPE. Interestingly it is most of the time misapplied to
individual investments!
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Prof. Dr. Bernd Scherer
• The risk premium on the market portfolio is the great unknown in CAPM
calculations
• We can think of the risk premium on the market portfolio be driven by the
index of risk aversion (within the economy) denoted by A as well as the
riskiness of the market portfolio (its variance)
E (rm ) − c = Aσ 2
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Prof. Dr. Bernd Scherer
• This makes sense as the diversifiable risk diversifies away and the risk
contribution to the market portfolio equals its beta (the sum of betas add
up to 1)
121
Prof. Dr. Bernd Scherer
4. Regress the time series of security excess returns against the time series of
market excess return (include an intercept or your result will be biased)
– At this stage you can add Bayesian procedures to deal with parameter instability or mean
reversion in betas if you wish
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Prof. Dr. Bernd Scherer
• Diversification Advice
– Diversify your portfolio to get rid of unsystematic risks
– Best to hold a combination of cash and market portfolio
• Investment advice
– The CAPM provides a breakeven return
– Ensure that you have good reason to believe the market is out of equilibrium and
inefficient enough not to have returned to the fair price.
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Prof. Dr. Bernd Scherer
• Capital Costs
– Calculate the beta of a project to calculate the required hurdle rate (costs of
equity, i.e. return requirement for the provider of equity capital)
• Regulation
– Calculate the fair return for a regulated entity
• Court
– Calculate the stocks return in the absence of insider trading, information release,
etc.
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Prof. Dr. Bernd Scherer
Empirical Evidence
• Small Caps earn more than they should under the CAPM; this lead to new
model that added a small CAP and a value premium (FAMA/FRENCH model)
Size Decile 10
Small Cap Stocks
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Prof. Dr. Bernd Scherer
5. Execution Costs
• Components
• Approaches to Reduce Execution Costs
126
Prof. Dr. Bernd Scherer
• Market impact
– Bid, ask spread widening as larger orders are placed
– VWAP (volume weighted average price as benchmark for trading desk
– Issues with VWAP: close to useless if the trade in question represents a large trading volume,
does not take opportunity costs into account
• Opportunity Costs
– Loss or gain in performance as a result of failure to trade a decision
– Very important for high frequency trading with rapid information decay
127
Prof. Dr. Bernd Scherer
• Internal Crossing
– Not always possible, difficulty to set fair transaction price
• External Crossing
– Might take too long (opportunity costs)
• Principal trade
– Trade though a dealer that guarantees price. Dealer acts as a principal, i.e. acts
on firm price.
– Fast, but with large hidden execution costs
• Agency trade
– Trader works the order against a trading benchmark
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Prof. Dr. Bernd Scherer
1. Futures
2. Options
3. Principal Protection
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Literature
130
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1. Futures
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Prof. Dr. Bernd Scherer
• Forward contract
– Parties agree to exchange an item at a delivery price agreed now.
– The forward price is defined as the delivery price that equates the market value of the
contract with zero.
– The face value of the contract is the quantity specified times the forward price.
– The buyer (seller) of a forward is called long (short)
– Forward contracts are bespoke agreements betweeen two parties (traded OTC)
• Futures contract
– Exchange traded contracts
– Exchange specifies exact underlying (quality, etc), contract size, delivery point
– Easy to close out, i.e. To terminate the position befor delivery date.
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Prof. Dr. Bernd Scherer
Margin Account
• EXAMPLE DJIA 3 month Futures, Futures price 10220 (allows you to buy 10 „shares“ of
the DJIA portfolio)
– Initial margin: USD 4000, i.e. 4%
– Maintenance margin: USD 3000, i.e. 3%
• Daily realization of profits and losses minimizes the probability (and severity) of
counterparty default.
• Futures markets are used by individuals whose credit rating is costly to be chsecked
• Forward marketis OTC between counterparties with high and easy to verify credit
ratings.
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Prof. Dr. Bernd Scherer
Financial Futures
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• Assume the gold price to be 300 USD, storage costs are 2% and interest
rates are 8%.
• Return on stored gold is
S1 − S 0
rgold = −s
S0
• Return on synthetic gold (buy futures and invest PV of futures price into
cash)
S1 − F
rgold = +c
S
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Prof. Dr. Bernd Scherer
• Let S be the spot price (of wheat for example) and Cj the storage costs of
the j-th producer. As usual F is the Future price.
Cj < F −S
⇒ carry the wheat (store and sell later )
¨spread
• The future and forward markets create an economic structure where the
most cost efficient distributor would do the physical storage.
• Example: Suppose you are a distributor of corn (you store it!). The spot pice
is 3 USD/bushel and the futures price for 1 month delivery is 3.10
USD/bushel. Your costs of carrying (storing) corn is 0.15. WHat should you
do.
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Prof. Dr. Bernd Scherer
• Speculators
– Provide liquidity. For every hedger there must be a speculator to take the opposite
position
– Price discovery. Speculators ensure that relevant information enters the price
Example: US housing market: If speculators would have been able to sell short
thet bubble might not have developed and popped earlier with less severe
consequences
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Prof. Dr. Bernd Scherer
• General arbitrage condition (futures price can not exceed spot price by
more than cost of carry, cost of carry can vary over time)
F −S ≤C
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Prof. Dr. Bernd Scherer
Backwardation
• Backwardation means: spot prices are higher than futures prices, and/or
prices for near maturities are higher than for distant.
– Backwardation occurs if convenience yield exceeds storage cost (inventories are low)
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Prof. Dr. Bernd Scherer
• The hedge ratio is the number of futures used to hedge a unit exposure to the
risk of spot price. With basis risk, how do we choose optimal hedge ratio?
– Basis risk arises from mismatch of underlying asset (an investment bank shorts index futures
to hedge the risk in underwriting a large stock issue) or mismatch of maturity (roll over short
contracts to hedge long term risks) Basis risk leads to imperfect hedge. Use linear regression
(minimizes basis risk)!
∆S = a + b∆F + e
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Prof. Dr. Bernd Scherer
2. Options
• Binomial Trees
• BLACK/SCHOLES Formula
• Greeks (Sensitivities)
• Delta Hedging
• Where do we find option payoffs?
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Prof. Dr. Bernd Scherer
Options
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Prof. Dr. Bernd Scherer
• Example
Call = max [S − X , 0]
Put = max [X − S , 0]
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Prof. Dr. Bernd Scherer
Payoffs
• Insure a portfolio with a protective put (buy put option to cut off the
downside
• It looks like stock plus put (left picture) give you the same payoff than cash
plus call with same strike (right picture).
– Arbitrage: If two assets A and B, have same future payoffs with certainty, then they should sell
for the same price now.
– Option pricing theory is about relative pricing (makes no statement whether the stock is priced
correctly)
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Prof. Dr. Bernd Scherer
Put-Call Parity
• IBM stock currently sells for $34 per share. There are call and put
options available with a strike price of $36 and an expiration date
of one year. The price of the IBM call option is $5, and the risk-free
interest rate equals 4%. What is the price of the put option?
36
P + 34 = 5 +
1.04
Bond ¨
PV of strike
P = 5 + 34.62 − 34 = 5.62
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Prof. Dr. Bernd Scherer
• Assume a two period example. The share price of 100 today can move to 115 or fall to
95. What is the value of a call on the stock price with strike 100, i.e. the value of
max[S-100,0] today?
• Suppose we buy 0.75 shares and sell 1 option. Whatever happens to the stock price
we would arrive at
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Prof. Dr. Bernd Scherer
• The option value is simply the discounted expected value of final payoffs
under risk neutral probabilities.
– The risk neutral probabilities are pseudo probabilities that fix the likelihood of up and down
movements such that the expected rate of the return on the stock equals the risk free rate.
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Prof. Dr. Bernd Scherer
ր 132.25 ր 32.25
115 cup
ր ց ր ց
100 109.25 ⇒ c 9.25
ց ր ց ր
95 cdown
ց ց
90.25
0
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Prof. Dr. Bernd Scherer
Calculations
m ⋅ cup,up + (1 − m )cup,down
cup = = 19.76
1+r
cdown = 4.41
c = 11.508
up = e σ t , down = e −σ t
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Prof. Dr. Bernd Scherer
Delta Hedging
∑ d ( St − St ) + ∑ n =1 rn −1 ( dt St − C 0 )
T T
( max [ ST − K , 0 ] − C 0 ) −
n =1 t
n −1 n
n −1 n −1
n −1
Payoff from long call rebalanced interest earned on
minus cos t from long call delta equivalent proceeds from
short stock
Call-Delta
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Prof. Dr. Bernd Scherer
Delta-Hedged Gains
Using a Call on IBM on January 3, 2006
Closing Price DTM Call Hedging Interest
Call Price ($) 2.95 Date DTM St Volatility Delta Profits Payments
Risk Free Rate (r ) 0.05 3-Jan-06 17 82.06 0.194 0.753
Date of Maturity 20-Jan-06 4-Jan-06 16 81.95 0.191 0.750 -0.08 0.01
Strike Price (K ) 80 5-Jan-06 15 82.50 0.189 0.809 0.41 0.01
6-Jan-06 14 84.95 0.191 0.953 1.98 0.01
9-Jan-06 11 83.73 0.257 0.860 -1.16 0.02
10-Jan-06 10 84.07 0.239 0.905 0.29 0.01
11-Jan-06 9 84.17 0.211 0.944 0.09 0.01
12-Jan-06 8 83.57 0.192 0.944 -0.57 0.02
13-Jan-06 7 83.17 0.187 0.940 -0.38 0.02
17-Jan-06 3 83.00 0.167 0.993 -0.16 0.01
18-Jan-06 2 83.80 0.153 1.000 0.79 0.02
19-Jan-06 1 83.09 0.164 1.000 -0.71 0.02
20-Jan-06 0 81.36 -1.73 0.02
Delta-Hedged Gain
Dollar Gain ($) -0.20 Terminal Call Cost Hedging Interest Profit π
As a % of Spot Price S 0 -0.24% Payoff ($) C 0 ($) Profits ($) Payments ($) ($)
As a % of Call Price C 0 -6.81% 1.36 2.95 -1.22 0.17 -0.20
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Prof. Dr. Bernd Scherer
• Assumptions
– Returns are lognormal and distribution is known
– No transaction costs, continuous hedging feasible
– Known and constant interest rates
– No early exercise, no dividends
• Don’t worry if you don’t like the assumptions. Most have been relaxed and
effectively dealt with in derivatives research.
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Prof. Dr. Bernd Scherer
BLACK&SCHOLES Equation
S : stock price
X : strike
σ : volatility (annualized )
r : interest rate
t : maturity
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Prof. Dr. Bernd Scherer
Some Interpretation
c = S − e −rt X
• For (σ = 0) the option price will be a weighted average of stock and zero bond
100
Probability the stock ends in the money log + 0.08 ⋅ 0.5 + 21 ⋅ 0.32 ⋅ 0.5
110
d1 = = −0.1547
0.3 ⋅ 0.5
d2 = d1 − 0.3 ⋅ 0.5
N (d1 ) = 0.4384
N (d2 ) = 0.3568
c = 100 ⋅ 0.4384 − 110 ⋅ e −0.08⋅0.5 ⋅ 0.3568 = 6.13
p = c − S + e −rt = 11.82
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Prof. Dr. Bernd Scherer
Sensitivities – Delta
• The delta expresses the share equivalent of an option: How much does the option
price move if the (underlying) stock moves?
– Rule of thumb: The delta of an ATM call is about 0.5
– The delta of a deep in the money option is one (used as directional market play with little notional
exposure)
dc dp
∆c = = N (d1 ) = 0.4384, ∆p = = N (d1 ) − 1 = −0.5616
dS dS
• If deltas are known we can aggregate them and calculate the directional exposure
of an options portfolio.
• We can also calculate an options elasticity …
dc S
εc = = delta ⋅ leverage
dS c
• … or its beta
dc S
βc = βS = delta ⋅ leverage ⋅ stock − beta
dS c
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Prof. Dr. Bernd Scherer
Sensitivities – Delta
• We can plot the delta of an option to see how the sensitivity changes when yhe
underlying price changes.
D e lta
0.5
0.4
0.3
0.2
0.1
Busted 0
60 80 100 120 140
Stock Price
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Prof. Dr. Bernd Scherer
0.01
0.008
0.006
0.004
0.002
0
60 70 80 90 100 110 120 130 140
Stock Price
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Prof. Dr. Bernd Scherer
dc d 2c
∆c ≈ ∆S + 12 2 ∆S 2 + O
dS dS
158
Prof. Dr. Bernd Scherer
Implied Volatility
• Implied volatility contains a risk premium over expected future realized volatility due
to the impossibility to delta hedge correctly.
• Option prices rise as the world gets riskier
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Prof. Dr. Bernd Scherer
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3. Portfolio Insurance
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Prof. Dr. Bernd Scherer
• How are options sold? How do you make most money as an investment banker?
• Sell risks that clients (wrongly) dont perceive as risks! Exploit clients behavioural biases!
• Capital guarantee in high return currency that is thought to appreciate
• Sell digital payouts on dual events that never ever happenend before
• Etc. ...
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Prof. Dr. Bernd Scherer
• Buy and forget products (no dynamic trading, but beware the credit risk!)
– Good choice if you believe realized volatility will be higher than implied volartility
• Derived from Put-Call parity: Equity plus put (protective put) equals cash plus
call (fiduciary call), Typically perceived as too expensive. Variations exist
– Capital guarantee in foreign currency
– Averaging option rather than end of period price
– Sell protection, ..
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Prof. Dr. Bernd Scherer
CPPI
• CPPI offers principal
protected exposure
by dynamically
allocating the initial
investment between Constant Proportion Portfolio Insurance (“CPPI”) offers principal protected exposure by
a risky and riskless dynamically allocating the investments of a portfolio between two assets: a risky asset (such as
asset an equity index or fund) and a riskless asset (such as a government bond). As the value of the
• Hence, exposure risky asset increases, the allocation to the risky assets increases; as the value of the risky asset
towards the risky decreases, the allocation to the riskless asset increases. At any given time, the minimum portfolio
asset is variable value (the “floor”) must equal the present value of the minimum amount guaranteed at maturity.
• The more the To determine the amount allocated to the risky asset, the excess of the portfolio value over the
market increases,
the more client floor (the “cushion”) is multiplied by a predetermined figure (the “multiple”).
participates in
future market
increases
• The more the
market decrease, Graphical Representation For example, an investor with a €100
Example
the more client
reduces his portfolio value, a floor of €90 and a
Assumptions multiple of 5 will allocate €50 (5 * (€100 -
exposure to the
Initial Portfolio
market Value = 100
Cushion = 10
Risky €90)) to the risky asset and €50 to the
(excess of Portfolio Assets = 50
Floor = 90 Value over the Floor) riskless asset.
(Cushion x
• The dynamic nature Multiple = 5 Multiple)
Floor = 90
of the CPPI means (present value
The floor, initial cushion and multiple are
of the
that the final minimum defined according to the investor's risk
participation level guaranteed Riskless Assets =
cannot be pre-
payoff at
maturity)
50 tolerance and are exogenous to the
(Portfolio Value
specified less Risky Assets) model.
Calculate Allocations
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Prof. Dr. Bernd Scherer
CPPI
In theory, the allocation between risky and riskless assets is calculated continuously as the
value of the risky asset changes. An increase in the cushion allows for more funds to be
allocated away from the riskless asset into the risky asset. A decrease in the cushion indicates
there is less safety margin and that more funds will be allocated into the riskless asset. If the
CPPI level approaches the price of the riskless asset (=floor), the cushion will tend towards zero
and the investment will be fully allocated into the riskless asset.
This ensures that the minimum guarantee is paid out to the client at maturity.
Portfolio Value = 100 Determine Floor and Cushion of the Portfolio Value = 95
Portfolio Value
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Prof. Dr. Bernd Scherer
CPPI
• Performance of
CPPI Portfolio vs.
Underlying Risky
Asset
90
• Whenever the Price of safe Asset (Floor)
80
market increases,
the more client 70 Portfolio Value Risky Asset Performance Minimum Guarantee at Maturity Floor
participates in future 60
market increases
125%
Risky Assets Riskless Assets
• The more the market
100%
decrease, the more
client reduces his
exposure to the 75%
market
50%
25%
0%
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Prof. Dr. Bernd Scherer
• First scenario
• As the cushion
approaches zero, the
CPPI
allocation to the risky
asset approaches
zero. In continuous
Risky Assets
time, this dynamic Return: -20%
rebalancing keeps the Risky
Risky
portfolio value from Assets = Assets =
20
falling below the floor. 25
At this point all the Floor = 90 Risk-
Risk- Calculate Floor
Risk- New less
investment is fully less (thus, no Only =
less Allocations Assets =
allocated into the Assume no Assets = cushion left) 90
Assets = change
90
riskless asset. This 70
70
ensures that the
minimum guarantee is
paid out to the client Portfolio Value = 90 Portfolio Value = 90
Portfolio Value = 95
at maturity
Risky Assets
Return: -40%
Risky
• Second Scenario Assets =
Shortfall
167
Prof. Dr. Bernd Scherer
CPPI
168
Prof. Dr. Bernd Scherer
CPPI Costs
• Costs arise from rebalancing, i.e. buying high and selling low. These costs
become larger if wither volatility or multiplier becomes larger
• Costs are path dependent, i.e. they differ from path to path
Volatility Risks
• CPPI is short vega, i.e. it will under-perform its projections if market volatility
increases heavily
Performance Measure
• Skewed distribution makes average return less likely than median return
• Performance is path dependent
169
Prof. Dr. Bernd Scherer
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3. Swaps
171
Prof. Dr. Bernd Scherer
Literature
• BRITTON –JONES (1999), Fixed Income and Interest Rate Derivative Analysis ,
Butterworth-Heinemann
172
Prof. Dr. Bernd Scherer
Zerobonds
• Natural fixed income building blocks, even though they are hardly traded in the
market
173
Prof. Dr. Bernd Scherer
Forward Rates
• Forward rate is an interest rate which is specified now (t=0) for a loan that will
occur at a specified future (T1) date over the period T2-T1
Time 0 T1 T2
(1+ f ( 0,T ,T ) )
T2 −T1
Payment - -1 1 2
( 1 + s ( 0,T2 ) )T2
f ( 0,T1,T2 ) = T2 −T1 −1
( 1 + s ( 0,T1 ) )T1
s ( 0, T1 ) f ( 0, T1 , T2 )
s ( 0, T2 )
174
Prof. Dr. Bernd Scherer
Example
s ( 0, 2 ) = 2.6%
175
Prof. Dr. Bernd Scherer
• From the current spot rates we can derive the path of furure spot rates (as implied
by the current spot rates)
• What happens if next periods spot rates ae eaual to this periods forward rates
(ecpectations hypothesis? All bonds earn (over next period) the same, i.e. the
curren spot rate.
B ( 1, 2 ) = 1 (
1+ f ( 1,2 ) , B 0, 2
) = 1
( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) )
s ( 0,1 )
dB = B ( 1, 2 ) − B ( 0, 2 ) = 1+ f ( 1,2 ) − ( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) ) =
1 1
( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) )
dB s ( 0,1 )
= 1
( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) ) ( 1+s ( 0,1 ) )( 1+ f ( 1,2 ) )
= s ( 0,1 )
B
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Prof. Dr. Bernd Scherer
Couponbonds
177
Prof. Dr. Bernd Scherer
Example
Maturity 1 2 3 4
B(0,T) 0.98 0.95 0.92 0.89
Maturity 1 2 3 4
B(0,T) 0.98 0.95 0.92 0.89
B(0,T)C 2.94 2.86 2.77 91.91
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Prof. Dr. Bernd Scherer
C1 Cn 100
−BC ( 0,Tn ) + + ... + + =0
( 1 + y ( 0,Tn ) ) ( 1 + y ( 0,Tn ) )n ( 1 + y ( 0,Tn ) )n
• Why is the yield of a ten year zero bond higher thqn the yield of 10 year coupon
bond if the term sructure is rising?
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Prof. Dr. Bernd Scherer
Par Bonds
• Par Bonds sind Kuponanleihen, die zu pari (100) notieren, d.h. die Rendite des
Par Bonds entspricht seiner yield to maturity.
• Wie berechnet man den Kupon eines Par Bonds, bei gegebenen Nullkupon-
anleihen?
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Prof. Dr. Bernd Scherer
BC ( 0, 2 ) = C ⋅ B ( 0,1 ) + (C + 100 ) ⋅ B ( 0, 2 )
BC ( 0, 2 ) − C ⋅ B ( 0,1 )
B ( 0, 2 ) =
(C + 100 )
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Prof. Dr. Bernd Scherer
Example
BC = CB
100 1 0 0 B ( 0,1 ) B ( 0,1 )
=
( ) =
( ) + ( )
98 3 103 0 B 0, 2 3B 0,1 103 B 0, 2
99 4 4 104
B ( 0, 3 ) 4B ( 0,1 ) + 4B ( 0,2 ) + 104B ( 0, 3 )
B = BC C−1
0,009708738 100
0 0 0,970873786
= -0,000282779 98 = 0,923178433
0,009708738 0
-0,000362537 -0,000373413 0,009615385 99 0,879074915
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Prof. Dr. Bernd Scherer
Duration
• Question: what happens to the price of a coupon bond if interest rates are
changing?
C1 C2 Cn 100
BC ( 0,Tn ) = + + ... + n +
( 1 + y ( 0,Tn ) ) ( 1 + y ( 0,Tn ) )2 ( 1 + y 0,Tn
( ) ) ( 1 + y ( 0,Tn ) )n
dBC ( 0,Tn )
= −1C 1 ( 1+y( 10,T ) )2 − 2C 2 ( 1+y( 10,T ) )3 − 3C 3 ( 1+y( 10,T ) )4 − ... − nC n 1
( 1+y ( 0,Tn ) )n +1
dy ( 0,Tn ) n n n
dBC ( 0,Tn ) 1 + y ( 0,Tn ) 1C 1 (1+y ( 0,T ) )1 + 2C 2 ( 1+y( 0,T ) )2 + 3C 3 (1+y( 0,T ) )3 + ... + nC n ( 1+y( 0,T ) )n
1 1 1 1
= − n n n n
dy ( 0,Tn ) BC ( 0,Tn ) C
( 0,Tn )
B
<0
183
Prof. Dr. Bernd Scherer
Duration
y ( 0, Tn )
184
Prof. Dr. Bernd Scherer
Duration Types
dBC
∆B$C = ∆y = D$C ∆y
dy y =y
dBC 1 DC
DCmod = ⋅ C = $
dy y=y B BC
185
Prof. Dr. Bernd Scherer
3. Swap Market
Main Issues
• Definition of swaps
• Applications of swaps
• Fixed for fixed currency swaps
• Fixed for floating interest rate swaps
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Prof. Dr. Bernd Scherer
Definition
• A swap is a transaction where at the time of the contract’s initiation the two
parties agree to exchange two cash-flow streams of equal present value. The
deal is structured as a single contract, with a right of offset.
• Example: Fixed for Floating Swap (receive a fixed rate and pay a floating rate) is
equivalent to a long position in a fixed bond and a short position in a floating
rate note. Swap spread creates equal present value.
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Prof. Dr. Bernd Scherer
Application of Swaps
188
Prof. Dr. Bernd Scherer
• Suppose you want to swap a 7 year 18 million HC loan into a FC loan. The current
exchange rate is S = HC/FC = 1.8
• Why would a company want to do this? Get better loan in HC (better known by
domestic banks, less monitoring and screening costs).
189
Prof. Dr. Bernd Scherer
1 1
∑ i =1 1.44 ( 1 + 0.08 )i
7
PVDC = + 18 = 18mDC
( 1 + 0.08 )7
1 1 FC
⋅ = [ ]
S 1.8 DC
1 1
∑ i =1 0.7 ( 1 + 0.07 )i
7
PVFC = + 10 = 10mFC
( 1 + 0.07 )7
190
Prof. Dr. Bernd Scherer
1
V = PVHC ( r1, r2 ,... ) − PVFC ( r1* , r2* ,... )
S
191
Prof. Dr. Bernd Scherer
Time t1 t2 t3 t4 … tn
Cash Flow 1
B ( 0,t1 )
−1 1
B ( t1 ,t2 )
−1 1
B ( t2 ,t3 )
−1 1
B ( t3 ,t4 )
−1 … 1
B ( tn −1 ,tn )
−1
Discount
B ( 0, t1 ) B ( 0, t2 ) B ( 0, t3 ) B ( 0, t4 ) … B ( 0, t3 )
Factor
192
Prof. Dr. Bernd Scherer
• Valuation
1
FRN ( t0 + dt ) = B ( t0 + dt , t1 ) 1 + − 1
value
B ( t0 , t1 )
after
known
reset Coupon
• Suppose a floating rate note starts to contain some credit risk. It has been issued
with Libor + 0 bps, but the credit risk rises to Libor plus 50bps.
– How is the FRN affected?
– Can you use the formula above?
– Is the impact large or small?
193
Prof. Dr. Bernd Scherer
V = BTC − FRN T
1
194
Prof. Dr. Bernd Scherer
• Learn how to price fixed income options / fixed income contingent claims
• Which capital market products contain fixed income options?
• What can we use fixed income options for?
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Prof. Dr. Bernd Scherer
• Suppose interest rates for 6 and 12 month maturity are 10%. Suppose
further rates fall to 8% or increase to 12% during the next 6 month. Whats
the value of a call options (strike 95.5) on a zerobond with 6 month
maturity in?
1
2 ր 12% 1
2 ր 94
10% 1 ⇒ 95 1
2 ց 2 ց
8% 96
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Prof. Dr. Bernd Scherer
• The call payoffs are given by max[B-X,0], i.e the payoff is either 0 (if B=94)
oder 0.5 (if B=96). The investor has two traded instrumentds to replicate
the payoff from this call:
– One year zerobond that costs 90 and pays off either 94 or 96 in 6 month
– Six month zero bond that costs 95 and pays off 100 for sure
• Find a portfolio of these two bonds that replicates the payoff from our call
option.
φ1100 + φ2 94 = 0
φ1100 + φ2 96 = 0.5
100 94 φ1 0
= ⇒ φ2 = 0.25, φ1 = −0.235
100 96 φ2 0.5
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Multi-period valuation
• The real worl is not binomial and sometimes we need the whole interest rate
path to evaluate options (early exccise).
• We asssume we already calibrated an interest rate tree (i.e. A tree that correctly
prices a set of reference options in a risk neutral world)
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Prof. Dr. Bernd Scherer
• Interest rate and price trees – calculate value of a 3 period zero bond from
belows interest treee
• First we calculate the values of a 3 year zero bond in period 2 (trivially its 100 in
period 3)
100
1
ր 14% 1
ր = 87.72
2
12% 1
2
12% 1 1.14
1 1
2 ր 2 ց 2 ր
ց 100 2
10% 1 10% ⇒ 10% 1 = 90.01
2 ց 1
2 ր 2 ց 1
2 ր 1.1
8% 1 8% 1 100
2 ց 6% 2 ց = 94.34
1.06
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Prof. Dr. Bernd Scherer
• In the „up“ state of year 1the risk free rate is 12% (see previous slide). Given
that the binomal tree represents the risk neutral world (all calims can be
replicated arbitrage free), the expected return also eaquals 12%.
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Prof. Dr. Bernd Scherer
• New price-tree
1
2 ր 87.72
1
79.95 1
2 ր 2 ց
10% 1 1
90.01
2 ց 2 ր
85.76 1
2 ց 94.34
• We can now calculate todays value for the three year zero bond
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Prof. Dr. Bernd Scherer
Exercise
• We want to value the option to buy a one year zero bond at a strike of 90 in two
years from now. Assume the previous interest rate tree.
1
2 ր 0
1
?1
2 ր 2 ց
?1 1
0.01
2 ց 2 ր
?1
2 ց 4.34
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Prof. Dr. Bernd Scherer
HO/LEE - Model
• Recombining interest rate tree for the die „short rate“, Allows us to price
long bonds, opttions,etc.
• (2,2) denotes the state of the world where rates rose twice in a row.
1
2 ր ...
( 3, 3 )
1 1
2 ր 2 ց
( 2, 2 )
1
2 ր 1
2 ց 1
2 ր ...
( 1, 1 ) ( 3, 1 )
1 1 1 1
2 ր 2 ց 2 ր 2 ց
( 0, 0 ) ( 2, 0 ) ...
1 1 1 1
2 ց 2 ր 2 ց 2 ր
( 1, -1 ) ( 3, -1 )
1 1 1
2 ց 2 ր 2 ց ...
( 2, -2 )
1 1
2 ց 2 ր
( 3, -3 ) ...
1
2 ց
s ( ti , j ) = s ( 0, 0 ) + ( ∑ tt =1 at )dt + j σ
i
dt
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Prof. Dr. Bernd Scherer
1
2 ր ...
1
s + (a1 + a 2 + a 3 ) + 3σ 1
2 ր 2 ց
s + ( a1 + a 2 ) + 2σ
1
2 ր 1
2 ց 1
2 ր ...
1
s + a1 + 1σ 1 1
s + ( a 1 + a 2 + a 3 ) + 1σ 1
2 ր 2 ց 2 ր 2 ց
s s + ( a1 + a 2 ) + 0σ ...
1 1 1 1
2 ց 2 ր 2 ց 2 ր
s + a 1 − 1σ 1 1
s + ( a 1 + a 2 + a 3 ) − 1σ 1
2 ց 2 ր 2 ց ...
s + ( a 1 + a 2 ) − 2σ 1 1
2 ց 2 ր
s + (a1 + a 2 + a 3 ) − 3σ 1 ...
2 ց
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Prof. Dr. Bernd Scherer
Example tree
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Prof. Dr. Bernd Scherer
100
92.5925926
87.3515024 100
83.9918293 94.3396226
82.3449307 90.7111756 100
88.9325251 96.1538462
94.2684766 100
98.0392157
100
0.5 ⋅ 94.33 + 0.5 ⋅ 96.15
t=0 t=1 t=2 t=3 t=4 1 + 5 /100
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Prof. Dr. Bernd Scherer
100
96.2963
94.5838803 100
92.8884448 98.1132
94.8054713 94.3396226 100
98.2030449 100.0000
101.922711 100
101.9608
100
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Prof. Dr. Bernd Scherer
Option Valuation
0
0
0.25917479 0
0.7152017 0.54945055
1.24274878 1.15384615
2.03546691 max ( 98.03 − 95, 0 )
3.03921569
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Prof. Dr. Bernd Scherer
Problems
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Prof. Dr. Bernd Scherer
• Callable bonds: gives the issuer the right to buy back the bond at a given
price (for example at par, i.e. at 100)
• Suppose you are a pension fund with 30 year duration liabilities. You buy a
30 year duration mortgage bond. Is this a good hedge?
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Prof. Dr. Bernd Scherer
• Caps are interest rate call options on interest rate (hedges against rising
rates). Payoff:
Cap = max [ r − cap, 0 ]
• Can you value a cap with cap = 5 for the below tree?
1
2 ր8
1
71
2 ր 2 ց
61
1
2 ր 2 ց 1
2 ր6
51 1
51
2 ց 2 ր 2 ց
41 4
1
2 ց 2 ր
31
2 ց3
• Caps help limit exposure to rising rates yet allow the borrower to benefit
when rates fall;
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213
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Literature
214
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1. Credit Risk
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Prof. Dr. Bernd Scherer
• Default risk: risk an obligor does not repay parts of his financial obligation
• Credit deterioration risk: risk that the credit quality of the debtor
decreases.
– Downgrade to a lower rating category
– Spread widening leads to mark to market losses
– Forced selling due to rating constraints; can no longer be used as collateral
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Prof. Dr. Bernd Scherer
Credit Risk
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Prof. Dr. Bernd Scherer
• Rating agencies (the biggest are MOODYS, S&P, FITCH) create ratings on bonds in
accordance with their default probability.
• AAA represents the best rating (smallest likelihood to default in a given period), AA
represents the second best rating, …
• One way to measure credit risk is to model the transition between rating caegories.
This is usually done with a transition matrix where it is assumed that transition
probabilities follow a MARKOV process (see next slides).
• The probability for a AAA bond stay AAA in one year time is 90.82%. It will
migrate to BB (within a year) with a 0.07% probability.
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Prof. Dr. Bernd Scherer
T
P0,n = P ⋅ P ⋅… ⋅ P ⋅ P = PT
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Prof. Dr. Bernd Scherer
• Assume we know the price of two zero bonds. One without credit risk B(0,T)
and one with credit risk BAA(0,T). In a risk neutral world we would expect
• Here, qAA denotes the risk neutral probability to default any time between
time 0 and time T in Konkurs
• In this example qAA denotes the second element of the last column in Q0,T (T-
Period transition matrix with risik neutral probabilities)
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Prof. Dr. Bernd Scherer
• We need to transform the real world transition matrix P via a choice of Π to Q. The
matrix Π contains risk premia to adjust real world to risk neutral probabilities
Qt,t+1 =I+Πt ( P-I)
Π(1) 0
1
1 0 Π( 2) 0 0
I= ,Π = 0 ⋱ 0
0 ⋱ t
Π( k ) 0
1
0
0 0 0 1
– For period one we fit k risk premia to k rating categories according to the above
– As in bootstrapping we continue to work ourselve through the term structure for all
further periods
– With these estimates we can then price credit derivatives (see later section)
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Prof. Dr. Bernd Scherer
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Prof. Dr. Bernd Scherer
B( 0,2)
B( 0,1)
= 0.9648
0.9271
= 0.9609
• What is the price for a 5 year BB corporate bond in one year, i.e. with 4 years
remaining live?
C
BBB (1,5) = 4.4 + 0.9527 ⋅ 4.4 + … + 104.4 ⋅ 0.7858 = 100.79
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Prof. Dr. Bernd Scherer
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• Still asymmetric
226
Prof. Dr. Bernd Scherer
Normal(0,0073082; 0,0030345)
-10 -5 0 5 10 15 20
Portfoliorendite (mal 1000)
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• We can apply the BLACK/SCHOLES model to price the value of firm equity, where
V represents the firms assets, D its outstanding debt, r the risk free rate, T
time to maturity, and σV the volatility of assets. The value of equity is given by
E 0 = V0N ( d1 ) − De −rT N ( d2 )
d1 =
ln (VD ) + ( r + 1 σ2
2 V )T
, d2 = d1 − σV T
σV T
V0 dV
σe = σ
E 0 dE V
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Prof. Dr. Bernd Scherer
Credit Correlation
• Credit (default) correlation describes the tendency for two companies to default at
the same time.
– Similar industry, leverage
– Similar business risk
• Non-zero default correlation is the reason why credit risk does not completely
diversify away (and we real world and risk neutral default probabilities are not the
same)
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Prof. Dr. Bernd Scherer
• Define t1 and t2 as the time to default for company 1 and company 2. Both
can (and will) be highly non-normal with cumulative distribution Q1 ( t1 ) and
Q2 ( t2 ) . These could be taken from a migration matrix.
−1
xi = N (Qi ( ti ) ) .
inverse of
cummulative
standard
normal
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Prof. Dr. Bernd Scherer
This allows us to first draw x i and then work out ti . For example if we draw
232
Prof. Dr. Bernd Scherer
x i = ai M + 1 − ai2 zi
Default happens if
N −1 (Qi (T ) ) − ai M
Qi (T | M ) = N
1 − ai2
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Prof. Dr. Bernd Scherer
0 10 20 30 40
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Prof. Dr. Bernd Scherer
• CDS buyer makes a periodic payment to the seller of the default swap. The
default swap seller promise to make a payment in the event of default of a
reference bond or loan.
• This is more like a put option rather than a swap.
Periodic
Premium
CDS
CDS
Buyer
Seller
Contingent
payment
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Prof. Dr. Bernd Scherer
CDO Structure
• Cash flows can be structured to cater risk aversion with the claim to create
value (departure from neoclassical finance and wrong)
• Offers high upside limited liability exposure to low rated bonds
• Success of CDO depends on selling the risky equity tranche
– Long call on underlying asset pool
AAA,3%
AA, 4%
A, 5%
BBB, 9%
Equity, 15%
237
Prof. Dr. Bernd Scherer
• Mostly B rated assets have been transformed into higher rated assets
under the critical assumption of low correlation (i.e. zero systemic risk)
238
Prof. Dr. Bernd Scherer
Credit Indices
239
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Single Tranching
240
Prof. Dr. Bernd Scherer
• Regulatory Arbitrage
• Hedging
• Yield Enhancement
241
Prof. Dr. Bernd Scherer
• The question is how much capital should be required, and the key concept
is risk-based capital.
242
Prof. Dr. Bernd Scherer
• The theory is simple: for any asset hold an amount of capital proportional
to its risk. The tricky thing is putting this into practice:
– The potential complexity of financial transactions far exceeds the
ability of regulators to specify rules for every one.
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Prof. Dr. Bernd Scherer
Basel I: example
244
Prof. Dr. Bernd Scherer
• Regulatory capital arbitrage happens because, all other things being equal,
banks would like to hold less rather than more capital. The reason is that, in
general, bank profits are proportional to the amount of assets that they
hold.
– One main source of banking profits is interest margin: the spread
between the interest charged on loans and the interest paid on
deposits and other sources of funding. For any given interest margin,
profits will be strictly proportional to loan volume (assets).
– The same logic applies to banks’ principal investment and trading
businesses; for any given strategy, doubling the size of the position will
double the expected profit. So to increase profits, you have to increase
assets. If a bank wants to increase its assets, it can do so either by
increasing its leverage (lowering its capital as a percentage of assets) or
increasing its capital; the former is preferable, because the latter
requires issuing new shares, which dilutes current shareholders. (Also,
issuing new shares results in lower earnings per share, lowering the
stock price.)
245
Prof. Dr. Bernd Scherer
• Our bank earlier had $100 in mortgages, for which it had to hold $4 in
capital.
• The bonds are divided into a set of tranches ordered by seniority (priority),
so the incoming cash flows first pay off the most senior tranche, then the
next most senior tranche, and so on.
• If these are high-quality mortgages, all the credit risk (at least according to
the rating agencies) can be concentrated in the bottom few tranches
(because it’s unlikely that more than a few percent of borrowers will
default), so you end up with a few risky bonds and a lot of “very safe” ones.
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Prof. Dr. Bernd Scherer
• Getting sufficiently high credit ratings for the senior tranches, the bank can
lower the risk weights on those assets, thereby lowering the amount of
capital it has to hold for those tranches.
– The risky tranches will require more capital, but it is possible to do the math so that the lower
capital requirements on the senior tranches more than outweigh the higher requirements on
the junior tranches.
• The passive side of the CDO will have a lower risk weighting than the
active side of a CDO (up to 50% in some cases)
• All this is possible because the rules setting capital requirements are lumpy
while there is an infinite range of actual financial assets.
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Prof. Dr. Bernd Scherer
• Recall from session 2: Basel II introduces VaR based methods as well as a finer grid
on credit risk (recall Basel I was very crude). Below are two reasons Basel II failed
– In VaR, the riskiness of any asset is determined by a model based on the historical
attributes of the asset. In theory, this is an improvement, because it gets around the
problem of lumpy fixed percentages, and tailors the risk weight to the unique
characteristics of the asset itself.
248
Prof. Dr. Bernd Scherer
• Basel I: 100% risk weight for non OECD, i.e. regulatory capital amounts to
• Basel II: BBB risk weighting is 50%, AAA banks have 20% risk weight, Residual risk
from CDS hedge (contractual risks, enforceability, …) is 15%
= 19600
1000000 ⋅ 15% ⋅ 50% + (
1-15% ) ×20%
BBB risk weight
CDS risk weight
after hedge
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Prof. Dr. Bernd Scherer
250
Prof. Dr. Bernd Scherer
• Example: Government bond yields 4%, CDS premium is 2%, Corporate bond
trades at 7%. Is there arbitrage?
– Only works for par bonds, what happens when interest rates change.
What happens to interest rate sensitivity close to default?
– Counterparty risk?
251
Prof. Dr. Bernd Scherer
• Start with risk neutral default probabilities (for example from transition
matrix)
⋅ 0.02
0.9604 = 0.0192
survive default
to T −1 in T
252
Prof. Dr. Bernd Scherer
Probability to PV of e−0.05⋅2
Time Expected Discout
survive year expected
(T) Payment Factor
T Payment
1 0.9800 0.9800s 0.9512 0.9322s
2 0.9604 0.9604s 0.9048 0.8690s 0.9604 ⋅ s ⋅ 0.9084 = 0.8690s
3 0.9412 0.9412s 0.8607 0.8101s
4 0.9224 0.9224s 0.8187 0.7552s
5 0.9039 0.9039s 0.7788 0.7040s
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Prof. Dr. Bernd Scherer
PV of
Prob to default in Recovery Expected Discount
Time (T) Expected
year T Rate Payoff Factor
Payoff
0.5 0.0200 0.4 0.0120 0.9753 0.0117
1.5 0.0196 0.4 0.0118 0.9277 0.0109
2.5 0.0192 0.4 0.0115 x 0.8825 = 0.0102
3.5 0.0188 0.4 0.0113 0.8395 0.0095
4.5 0.0184 0.4 0.0111 0.7985 0.0088
0.0192 ⋅ ( 1 − 0.4 ) ⋅ 1
0.0511
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Prof. Dr. Bernd Scherer
PV of
Prob to default Expected Discount
Time (T) expected
in year T Accrual Factor
accrual
0.5 0.0200 0.0100s 0.9753 0.0098s
1.5 0.0196 0.0098s 0.9277 0.0091s
2.5 0.0192 0.0096s 0.8825 0.0085s
3.5 0.0188 0.0094s 0.8395 0.0079s
4.5 0.0184 0.0092s 0.7985 0.0074s
0.0426s
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Prof. Dr. Bernd Scherer
• Banks buy protection against default (is this decision done by risk manager
or speculator)
256
Prof. Dr. Bernd Scherer
CDO Pricing
• The value of the CDO must be the sum of the bond values (asset side of the
balance sheet)!
• CDO pricing is about pricing the relative value of different stakes (tranches).
Each tranch holds options against other tranches. Industry practice of rating
based discount rates is wrong!
• Example: 5 years n-th to default basket. Assume 100 bonds with 2% default
probability over 5 years.
– With zero default correlation the likelihood that one or more bonds default is
86.74% (1-0.98^100), while the likelihood that 10 or more default is 0.0034%
– First to default is valuable, while 10th to default is not
– If correlation increases the likelihood of one or more declines while the
likelihood of 10 or more increases
– For perfect correlation there will be no difference between 1st and nth to default
257
Prof. Dr. Bernd Scherer
1. Spot Market
2. Forward Market
4. International Diversification
258
Prof. Dr. Bernd Scherer
Literature
259
Prof. Dr. Bernd Scherer
• Key Questions
– How is the market for trading spot exchange organized?
– How are spot exchange rate quoted?
• Motivating Problem
– You work for a large multinational firm that has its headquarters in Paris.
The multinational firm has subsidiaries in 2 countries—Japan and Canada.
All foreign sales are made through these subsidiaries. Each month, the
subsidiaries remit to the Paris office their income over the month. This
income is in the local currency of the country in which the subsidiary is
located (JPY and CAD). The exchange rates that are quoted to you are in
terms of the USD; that is, USD/JPY and USD/CAD.
• How do you find the rates in terms of EUR. If the inflows are JPY 100 m and
CAD 10 m, what is their total value in terms of EUR?
260
Prof. Dr. Bernd Scherer
Definition
• The spot rate is the amount of home currency one pays/receives in
exchange for one unit of foreign currency today.
St ST
Example
– If one needs USD 100 to buy a copy of the textbook, then the exchange rate
is USD 100/textbook.
– If one receives USD 2000 when selling a computer, then the exchange rate
USD 2000/computer.
261
Prof. Dr. Bernd Scherer
Quotation
• Example
– 30.000 USD/car—is the price for a car with the ”item” being bought or sold, in this case
a car, in the denominator
– 2.03 USD/GBP is the price for one British Pound, i.e. you need to pay 2.03 USD for one
GBP. Where is the exchange rate today?
262
Prof. Dr. Bernd Scherer
USD as FC USD as HC
263
Prof. Dr. Bernd Scherer
Market Organization
264
Prof. Dr. Bernd Scherer
Market Statistics
• Size:
– The daily volume of trading on the exchange market (including the currency
futures, options, and swaps markets) is more than USD 1800 billion.
– It is about five to ten times the daily volume of international trade in goods and
services.
• Location
– The major markets are, in order of importance, London, and New York, with less
important markets being Singapore, Zurich, Hong Kong, and Frankfurt.
• Currencies
– The most important markets, per currency, have been USD/EUR and the USD/JPY;
together they represent over half of the world trading volume.
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Prof. Dr. Bernd Scherer
• Spot Market
– the exchange market for payment (of home currency) and delivery (of foreign
currency) ”today”.
– In practice, ”today” means the same day only when you buy or sell notes or coins
(and this part of the market is very small).
– For ’electronic’ deposits, delivery is within two working days for most currencies,
and one day between Canada and the US
• Forward Market: exchange market for contracts signed today but payment
and delivery take place at some future date.
– The forward market consists of many sub-segments corresponding to different
delivery dates, with each sub-segment having its own price.
– The most active forward markets are for 30, 90, 180, 270, and 360 days, but
bankers nowadays quote rates up to ten years forward.
Note that months are indicated as 30 days.
A 30-day contract is settled one month later than a spot contract, and a 180-day
forward contract is settled six months later than a spot contract—each time
including the two-day delay convention.
You can always obtain a price for non-standard maturities, too, for instance 64 days
(two months and four days), or for a specific date.
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Prof. Dr. Bernd Scherer
• We first look at the simple (but unrealistic) case where there are no transactions
costs; then, we consider the case with bid-ask spreads.
• See TABLE 1:
– One needs USD 0.83 to buy one AUD; thus, the exchange rate is USD/AUD 0.83.
– The fourth column treats the USD as the HC and the other currency as the FC.
– The third column treats the USD as the FC and the other currency as the HC. Thus, the
numbers in the third column are the inverse of the numbers in the fourth column.
267
Prof. Dr. Bernd Scherer
Cross Rates
• All the quotes in the third and fourth columns of TABLE 1 are in terms of the USD.
But one may also wish to make spot transactions between other currencies
without going through the USD. The rate at which one can exchange two non-
USD currencies directly is called the cross rate.
HC
268
Prof. Dr. Bernd Scherer
• To calculate the cross rate between two non-USD currencies simply note:
FC 1 FC 1 USD
= ⋅
FC 2 USD FC 2
269
Prof. Dr. Bernd Scherer
– The spread is the ”market-maker’s” commission for executing the trade. This
spread compensates the market-maker for taking a position that she may not
desire.
– Markets where the trading volume is small will typically have larger spreads; this is
because in these markets it is more difficult for the market-maker to get out of an
undesirable position.
– Bid ask spreads are rising when volatility is rising. Why?
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Prof. Dr. Bernd Scherer
• The spot ask exchange rate is the amount of HC one requires to buy one unit of
the FC today, and the spot bid exchange rate is the amount of HC that one
receives when selling one unit of the FC today.
• TABLE 3: FX Spot bid and ask
– If you live in the U.K. and are planning a holiday to the U.S and wish to buy USD, then
the you have to pay GBP/USD 0.4927. This is the ask rate for USD (the currency in the
denominator).
– If you have some dollars left over after your holiday, when you sell them you will
received the bid rate, GBP/USD 0.4917, which is less than what you paid to purchase
dollars.
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Prof. Dr. Bernd Scherer
• The spot bid-ask quotes in TABLE 3 are in terms of FC. To get the inverse quotes,
that is the quotes in terms of USD/FC, we need to invert the bid-ask quotes. To
get the inverse bid quote we invert the FC/USD ask quote; to get the inverse ask
quote, we invert the FC/USD bid quote.
• The reason why we invert the USD ask quote to get the inverse bid quote is that,
to preclude arbitrage, the bid quote must always be smaller than the ask quote.
• Thus, to get the inverse bid quote to be the smaller number we need invert the
(larger) direct ask quote; similarly, the inverse ask quote will be larger than the
inverse bid quote only if it obtained by inverting the (smaller) direct bid quote.
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Prof. Dr. Bernd Scherer
Example
• Table 4: Foreign exchange spot bid and ask rates as of 11 September 2007
• In Table 4, the sixth column (bid per US$) is obtained by inverting the ask quotes in
the fifth column; the eighth column is obtained by inverting the quotes in the third
column. Consequently, the bid per quotes in column 6 are smaller than the
corresponding ask quotes in column 8.
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Prof. Dr. Bernd Scherer
Summary
• Currencies are not traded on an organized exchange; instead trading takes place
via banks (market-makers) and brokers.
• The market for currencies is very deep—over USD 1.8 trillion is traded daily,
– with most of the trade being in the spot and forward markets, and
– a majority of this being unrelated to trade in goods and services.
• Quotes for spot exchange rate are typically against the USD (direct).
– Indirect quotes can be obtained by inverting the appropriate direct quote.
– Cross rates can be obtained by computing the effective rate if one transacted via the
USD.
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Prof. Dr. Bernd Scherer
• Key Questions
– Understanding forward exchange contracts.
– Relation between spot and forward exchange rates.
– Valuation of forward contracts
• Motivating Problems
1. Suppose you work for Sony (Japan) in the division that exports computer games to
Britain. You receive GBP 100 m for these exports at the end of each quarter. You are
worried about the possibility of a decrease in the JPY value of the GBP. How can you
hedge your position against such a decrease?
2. You work in the treasury office of BC Gas in Vancouver, Canada. It is 6 AM, and you
have yet to see your first cup of coffee. The Chief Financial Officer has told you, Marie,
that there is a cash shortfall, and that to buy gas you need to borrow USD 10 m, for 1
month. How do you decide where to finance this loan—in the US or the Canadian
money market.
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Prof. Dr. Bernd Scherer
• Definition: The forward exchange rate between two currencies, is the price
agreed upon today (t) at which one currency can be exchanged for the
other currency at a certain future date (T).
t T
• Some Observations
– The rate at which the transaction will take place is determined today;
thus, there is no uncertainty about the price (it is not random).
– The actual transaction (settlement) takes place at a future date, T, in
contrast to a spot transaction, which is settled on the same date (t).
– There is no exchange of cashflows today.
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Prof. Dr. Bernd Scherer
Example
– The spot and forward rate will typically not be the same.
– If the forward rate for the FC (the currency in the denominator) is larger than the spot
rate, then the FC is said to be trading at a premium otherwise, it is at a discount. From
the last column, we see that the Euro is at a premium relative to the USD.
– If the FC is at a forward premium, then the HC is at a discount, and vice versa.
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Example (continued)
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Hedging FC Cash-Flows
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Example
• Suppose that you live in the US and intend to vacation in London (UK) twelve
months from today. You expect to spend GBP 1 M (monetary unit ☺ ) on your
vacation. You are worried, however, that if there is an increase in the value of the
GBP, you will either have to cut back on what you spend, or you will need
additional USD to keep the same expenditure in GBP. How can you use forward
contracts to hedge your position?
• Your position is short forward GBP. You can hedge this by going long forward GBP
(buying GBP forward). From the data below, we see that the price for buying 12-
month forward GBP would be: USD/GBP = 2.0080.
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Prof. Dr. Bernd Scherer
Invest in HC
( 1 + rt,T )
1 1 ⋅ ( 1 + rt ,T )
Ft,T
Exchange in FC Change into HC
( 1 + rt*,T )
1
st 1
St ⋅ ( 1 + rt*,T )
Invest in FC
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Prof. Dr. Bernd Scherer
CIP (cont.)
( 1 + rt,T )
Ft,T = St ⋅
( 1 + rt*,T )
– Hedging transforms foreign cash into home cash (taxman might view capital gains from
a forward position different than interest rates)
– This is a pure arbitrage argument. It does not imply that the forward rate is
determined by the spot rate.
– Holds extremely close in empirical data (do not confuse with UIP! See later)
• Memory tip
EUR ( 1 + rtEUR
,T )
Ft,T = St USD
⋅
( 1 + rtUSD
,T )
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Prof. Dr. Bernd Scherer
• From the above, in frictionless markets (no transactions costs, no taxes etc.): Can
you save money by borrowing in one currency rather than another?
• No, according to CIP, once you hedge exchange rate risk, borrowing cost will be
the same across currencies.
1
S
( 1 + rt*,T ) Ft,T = (
1 + rt,T )
t
borrowing at hom e
borrowing abroad
• If you are not allowed to use forward contract you can replicate them via the
local money markets
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Prof. Dr. Bernd Scherer
1 1
Vt +1 = St +1 ⋅ − Ft ,T ⋅
1 + rt*+1,T 1 + rt*+1,T
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Summary
• The value of a just-issued forward contract is zero. After this it moves with the
discounted P&L.
• Covered Interest Parity implies that one cannot profit by borrowing in one
currency and lending in another. With frictions, one can always save money: it
will always be cheaper to borrow in one currency rather than another, even
after hedging against exchange rate risk.
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Main Issues
Question Answer
2. Can one forecast accurately the future spot exchange rate using past No
values of the exchange rate (weak form of predictability).
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Motivating Problems
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• The real exchange rate is defined as the nominal exchange rate, deflated by the
domestic and foreign price level.
Pt* HC FC
et = St
Pt FC HC
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Prof. Dr. Bernd Scherer
• Suppose that the current price of gold is USD 330 and the Pound exchange rate is
USD/GBP is 1.65. Then, to preclude arbitrage opportunities the gold price in Sterling
must be:
[USD ] 330
= [GBP ] 200
[ GBP ]
USD 1.65
• That is, the price of the gold in the US must be the same as Britain, after translation
into USD.
• Another way of stating this is that the relative price of gold in the US and in Britain
must equal the exchange rate.
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Prof. Dr. Bernd Scherer
Pkt = St ⋅ Pkt*
• Clearly, if CPP holds for all goods produced in an economy then we need not care
about fluctuations in nominal exchange rates.
• Answer: While CPP may hold for easily traded and homogenous commodities such as
gold and silver, it is unlikely to hold for other commodities such as cars or houses
which are difficult to trade across countries.
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• Question
– Even if CPP does not hold, is the general price level in one country related to the price
level in another country, after being translated into a common currency? That is, is one
country more expensive than another?
• Definition
– The absolute version of the Purchasing Power Parity (PPP) hypothesis states that the
price of a representative basket of goods at time t in a particular country, should equal
the price of a representative basket of goods in another country, translated into a
common currency:
Pt = St ⋅ Pt*
• Empirical evidence
– shows that there are large violations of Absolute PPP because the prices of identical
goods in the two baskets may vary across countries (violations of CPP); The
composition of the representative baskets might be different across countries.
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• Tests of relative PPP seem to do better when inflation is high (when economic
agents are more responsive to price changes). But even in these studies, there
are substantial period-by-period deviations from relative PPP.
• Relative PPP is also more likely to hold in countries where wages are indexed (for
example, Israel in the 1970s).
• Conclusion:
– Relative PPP may have some power in the long run (several years rather than several
months), and in times of high inflation,
– but in the short run there are large deviations that tend to persist for aslong as 3-6
years.
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USD
= PPorsche
USD EUR
PPorsche [USD ] St
EUR
• If Euro appreciates by 10% (exchange rate pass through) versus USD will Porsche
be 10% more expensive?
– Accept smaller profit margins?
– Cost reduction as imports become less expensive?
– Price elasticity of demand < 1?
– Cost reactions and efficiency gains
• Less than 100% exchange rate pass through exposes a firm to economic currency
exposure (risk)
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• Local Production
• Flexible Sourcing
• Diversification across markets (currencies)
• Lowering price elasticity (product differentiation, create monopolistic positions)
• Hedging with financial instruments
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• Question
– Even if the level of prices is not the same across two countries, are changes in the price
level in one country related to changes in the exchange-rate adjusted price level in
another country?
• Definition
– According to the relative PPP hypothesis, changes in the price of a representative
basket of goods at time t in a particular country, should equal the changes in the
exchange-rate adjusted price of a representative basket of goods in another country:
Pt +1 St +1 Pt*+1
= ⋅ *
Pt St Pt
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Prof. Dr. Bernd Scherer
Pt +1 St +1 Pt*+1 St +1 Pt*+1
ln = ln ⋅ = ln + ln
Pt St *
Pt S *
Pt
t
S
ln t +1 = πt +1 − π *
+1
St
t
percentage change percentage change
percentage change in domestic prices in foreign prices
in exchange rate
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Prof. Dr. Bernd Scherer
• There are large, frequent, and persistent deviations from PPP, implying that there
is real exchange rate risk;
– that is, changes in the nominal spot rate are not completely offset by changes in prices
at home and abroad.
• Hence, changes in the nominal spot rate will have an impact on the competitive
position of firms.
• Also, changes in the nominal spot rate will have an impact on the returns realized
from investing in foreign-currency denominated securities.
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Autocorrelation Models
• Autocorrelation models are similar to regressions where one regresses the left-
hand side variable on its lagged values.
S S
ln t +1 = a + b ln t + εt +1
St St −1
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Prof. Dr. Bernd Scherer
Filter Rules
• Conclusion: While there is some persistence in exchange rates, of the more than
580 filters tested
– less than 10% of the rules produced profits that are significant at the 10% level before
transaction costs; and,
– only 0.3% of the rules were profitable after transaction costs.
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Prof. Dr. Bernd Scherer
• The conjecture that the future spot rate is equal to the current forward rate is
called the Unbiased Expectations Hypothesis (UEH)
E ( Sɶt +1 | Ωt ) = Ft ,t +1
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Prof. Dr. Bernd Scherer
S t +1 − S t Ft ,t +1 − St
= +
St a b St + εt +1
• Conclusion: Over 75 empirical studies test this regression, and reject it.
– The average value of b in these studies is -0.88. What regression coefficient would you
expect. What does this tell you?
– The R2 value is also very small, so there is little evidence of predictability in forward
exchange rates.
– What do theses results tell you about the likely success of carry strategies? How would
you optimally design those funds?
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Prof. Dr. Bernd Scherer
• None of these explanations get much support in the data—and this is an ongoing
area of investigation.
– Recent work finds that sign of slope coefficient depends on whether USD at
discount/premium
– slope coefficient is not negative in emerging countries.
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Prof. Dr. Bernd Scherer
• Fisher Closed: Nominal rates should react one to one to an increase in expected
inflation to protect the real rate investors require (no money illusion)
rt +1 = ρ + E ( πt ,t +1 )
• Fisher Open: The real rate of return is the same across the world. If not
investments continue. In other words, the differential in nominal interest equals
the differential in inflation rates
rt +1 − rt*+1 = E ( πt ,t +1 ) − E ( πt*+1 )
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Prof. Dr. Bernd Scherer
• Example: Nominal interest rates in Europe are 1% higher than in the US. What
does this imply for inflation differential, forward contracts and expected
exchange rate movements?
St +1 −St
UEH St PPP
Ft ,t +1 −St
E ( πt ,t +1 ) − E ( πt*+1 )
St
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Prof. Dr. Bernd Scherer
St + 1 − St
= a + b ( rt,t +1 − rt ,t +1 ) + c ( πt ,+1 − πt ,t +1 )
* *
St
+ d ( mt ,+1 − mt*,t +1 ) + e ( gt ,+1 − gt*,t +1 ) + εt +1
• For the case of US versus Japan, the R2 statistic is 0.0098; and for the case of US
versus Germany, the R2 is 0.0118;
• None of the slope coefficients in either regression is significant even at the 10%
level.
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Prof. Dr. Bernd Scherer
• Correlation between exchange rates and explanatory variables is small and not
significant
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Prof. Dr. Bernd Scherer
• Would you sell a forecast or apply it a set of assets? How do the economics
compare? What is your prior on forecasting services?
• Forecasting services using technical models to predict the future spot rate have a
superior record compared to those analyzing fundamental variables.
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Prof. Dr. Bernd Scherer
• When the profits from intervention are measured for eight central banks, it was
found that seven central banks actually made substantial losses from currency
trading.
• Studies undertaken by the Dutch central bank and the Canadian central bank find
that intervention has been modestly profitable, though there have been long
periods during which the banks incurred substantial losses.
• Conclusion: Thus, the evidence is mixed and one cannot conclude that central
banks can predict the future spot rate, even though they have access to private
information about monetary and exchange-rate policy.
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Prof. Dr. Bernd Scherer
Summary
• The overall evidence suggests that it is quite difficult to predict future exchange
rates accurately.
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315
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Pt +1 − Pt + dt +1 P + dt +1
rt,t +1 = = t +1t −1
Pt Pt
= rtFC
,t +1 + st ,t +1 + rt ,t +1 ⋅ st ,t +1
FC
≈ rtFC
,t +1 + st ,t +1
– The approximation is good when the returns are small, and is exact for
continuously compounded returns
– Currency risk is always on TOP OF asset risk
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Prof. Dr. Bernd Scherer
rt ,t + 1 = rtFC
,t + 1 + ( 1 − h ) ⋅ st ,t + 1
• Will currency hedging always decrease risks, i.e. what is the optimal hedge ratio?
d var ( rt ,t + 1 )
= −2 ( 1 − h ) var ( st ,t + 1 ) − 2 cov ( rtFC
,t + 1 , st ,t + 1 ) = 0
dh
∗
cov ( rt ,t + 1 , st ,t + 1 )
FC
h = 1+
var ( st ,t + 1 )
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Prof. Dr. Bernd Scherer
• But, the volatility of non-US equity markets has also been higher than that of the
US market. The variance of returns on non-US stocks in local currency terms are
only slightly lower than returns measured in USD because even though the
exchange rate has high volatility, its correlation with stock returns is quite low.
• Because the correlation among international stock markets is less than one
there are substantial gains from diversifying internationally. But, investors
typically invest only in domestic stocks and do not diversify internationally.
318
Prof. Dr. Bernd Scherer
• Average returns in merging markets have been high and very variable relative to
returns in developed markets.
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321
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• Global Diversification
323
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324
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Summary
• The data seems to suggest that there are large gains from diversifying one’s
portfolio internationally.
• However note that observed portfolios are heavily weighted toward domestic
assets. It is a puzzle why investors do not diversify internationally – If its so great
why don’t investors do it?
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Prof. Dr. Bernd Scherer
1. Volatility Returns
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Literature
327
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• Example: Delta hedged long call (20% volatility), i.e. long call with delta
equivalent short position in the underlying
• If implied volatility jumps (to 30%), is the holder of the above strategy
guaranteed to make a profit?
• Note a delta hedged position leaves the investors still with three exposures
– Theta: Time decay, i.e. option sensitivity to the passage of time
– Gamma: Sensitivity of the option delta to changes in underlying
– Vega: Option sensitivity to changes in implied (expected future)
volatility
• In the next few slides we will show this is a grossly imperfect volatility
position
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Prof. Dr. Bernd Scherer
• Example: 100 Calls with 0.1 years maturity, Strike 100 and implied volatility
of 20%
100 ⋅ C = 100 ⋅ 2.52 = 252
delta = 100 ⋅ dC
dS = 51.2
2
gamma = 100 ⋅ ddSC2 = 6.3
vega = 100 ⋅ ddC
σ2
= 3152
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Prof. Dr. Bernd Scherer
• Vega is a function of the underlying stock price (deep ITM and OTM) “cease” to
have option value and hence have almost no vega.
35
100 ⋅ 31.52 ⋅ ( 0.09 - 0.04 ) = 157.6
30
25
15
10
0
70.00 80.00 90.00 100.00 110.00 120.00 130.00 140.00
-5
Strike/Underlying
331
Prof. Dr. Bernd Scherer
• Sell 110% out of the money call at 30% implied volatility. Realized volatility is 27%
(prima facie good) but rises towards the end when option was at the money (and
hence had large gamma). Position lost money. Why?
332
Prof. Dr. Bernd Scherer
500%
• A dynamically hedged position
might loose its exposure to
400%
volatility and hence works no
longer as a hedge. How will a
300% static long straddle (long call
Straddle Return
-100%
Spot Price (S) at Maturity T
333
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334
Prof. Dr. Bernd Scherer
• Intuition: Vega of out of the money puts became increasingly smaller, i.e.
we need to increase the weight on OTM Calls and Puts to avoid Vega decay.
But by how much?
∑ K >K * ( K1 )C
2
OTM
(K ) + ∑
K <K * ( K1 )P
2
OTM
(K )
CALL PUT
335
Prof. Dr. Bernd Scherer
Example
• 13 Options with strikes between 70 and 130, 0.0833 years to maturity, 20% volatility
and 5% risk free rate.
16
12
Vega
0
70 80 90 100 110 120 130
Spot Price (S )
336
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Example (continued)
337
Prof. Dr. Bernd Scherer
Example (continued)
0.16
2.5
0.14
2.3 0.12
0.10
2.1
Weight
Vega
0.08
1.9
0.06
1.7 0.04
0.02
1.5
70 90 110 130
Asset Price 0.00
70.00 90.00 110.00 130.00
Stri ke
• Price of a variance swap depends on the price of out of the money puts. If smile is
steep, variance swaps are very expensive.
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341
Prof. Dr. Bernd Scherer
• Low correlation is not enough (coin flipping also has zero correlation but no
risk premium)
• Only return streams that are yet un-spanned extend the efficient frontier
further to the left.
342
Prof. Dr. Bernd Scherer
• The more pronounced the smile the more expensive the variance swap
(bigger spread below). Why (relate this to the pricing of variance swaps)?
343
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Discrete
Returns
Log
Returns
344
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345
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346
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• Run CAPM regressions to look for risk adjusted out (under) performance.
Are variance swaps priced (spanned) by systematic risk factors?
347
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Efficient Frontiers
348
Prof. Dr. Bernd Scherer
Contrary to popular advice (go long variance swapss to protect downside, the reults show that
investors should go short variance swaps (to collect a risk premium) and go short equities to hedge
the risk from sort variance swaps.
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Literature
351
Prof. Dr. Bernd Scherer
Financial Operational
• Instruments: • Instruments:
– insurance contracts – standard procedures
– derivatives – safety installations
– capital structure – etc
• Aim: • Aim:
– structuring cash flows – continued operations
depending on certain and loss prevention
outcomes
352
Prof. Dr. Bernd Scherer
Conventional answer:
Public company
Entrepeneurial firm
353
Prof. Dr. Bernd Scherer
Buying Assets
Capital „fairly 60 Capital
Assets
100 100 priced“ 100
derivative Hedge
40
354
Prof. Dr. Bernd Scherer
Source: Bodnar et al. (1998): Wharton/CIBC World Markets 1998 Financial Risk Management
Survey of 2000 publicly traded US firms. 399 respondents.
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Prof. Dr. Bernd Scherer
• Direct costs
– Lawyers, management time
– Firm specific assets
356
Prof. Dr. Bernd Scherer
bc
d a
Bankruptcy costs. The costs of corporate bankruptcy (direct and indirect) indicated by bc rise if the asset
value (a) falls below the value of corporate debt (d). Costs are measured at time of bankruptcy. Asset
volatility will increase the value of this option. Source: Scherer (2005)
357
Prof. Dr. Bernd Scherer
Taxes (1/2)
• The second convexity arises from corporate tax schedules. For example:
firms either pay taxes if they make profits (the more the higher profits
are) or they don’t (irrespective of the size of losses).
• Carrying losses backward and forward is typically limited. Hence there is
a natural kink of the tax function creating convexity. If earnings (e) are
100 in one year and -100 next year the tax base is on average zero (the
company left its owner with zero profits after two years), while the
company did pay 35 in taxes after year one.
• Shareholder value is created if we manage to reduce the governments
contingent claim in a company.
• In summary: a rise in earnings volatility induced by corporate leverage
will reduce the expected value of the tax shield, as this can only be used
if interest payments can be offset against profits.
358
Prof. Dr. Bernd Scherer
Taxes (2/2)
0 e
Non linear tax schedule. The value of total tax payments ( τ ) increases with earnings (e), but it does not
become negative when earnings turn negative. Instead it remains zero. This resembles a long call option
on corporate earnings. Source: Scherer (2005)
359
Prof. Dr. Bernd Scherer
• Liquidity (cash on hand) is valuable to firms, because raising cash in the future
might be expensive. Reasons are
– direct transaction costs (investment banking and lawyers‘ fees)
– adverse selection (Myers & Majluf, 1984)
• Adverse selection costs arise because two types of firms might raise capital
– firms that need to finance positive-NPV projects (starting the project is good
for existing investors, new investors get required rate of return)
– firms whose claims are overvalued (raising capital transfers wealth from new
investors to existing investors!)
360
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• A firm is said to be in financial distress when its income is not sufficient to cover
its fixed expenses.
• The state of financial distress can lead to bankruptcy, which of course involves
liquidation costs and other direct costs.
• Large, uncovered exposures combined with adverse exchange rate movements
may send a firm into insolvency and bankruptcy, or may at least contribute to
such an outcome.
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Prof. Dr. Bernd Scherer
• Many firms sell products for which after-sales service is needed and the firm
typically offers product warranties.
• Thus, a buyer’s decision to purchase such products will depend on her
confidence to continue to receive after-sales service.
• Such firms will sell more, and will therefore be worth more, the lower the
probability of going out of business.
• Thus hedging, by reducing the volatility of cash flows, decreases the probability
of coming uncomfortably close to bankruptcy.
364
Prof. Dr. Bernd Scherer
• Risk averse employees are likely to demand higher wages if their future job
prospects are very uncertain.
• In the event of bankruptcy, a forced change of job will generally entail monetary
or nonmonetary losses to the employee. Thus, the employee will want to
protect himself, ex ante, by requiring higher wages when working for a firm that
is more likely to be in financial distress.
• Note that this source of wage risk premium seems to hinge on imperfections in
the labour market. However, ultimately, the validity of this rationale for
corporate hedging can still be traced to imperfections in the market for risks. If
uncertainty of personal income were fully diversifiable or hedgeable, there
would not be a risk premia in wages.
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Prof. Dr. Bernd Scherer
• Loan covenants can trigger repayment if the firm’s income falls below a stated
level. To the extent that refinancing is difficult or costly, it is useful for the firm
to reduce income volatility by hedging.
• Costs associated with refinancing include transaction costs, and especially the
indirect or agency costs of refinancing when a firm is in financial distress.
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Prof. Dr. Bernd Scherer
• Agency costs are the costs that arise from the conflict of interest between
shareholders, bondholders and the managers of the firm.
– These agency costs can affect the firm’s wage bill, its choice of investment projects,
and its borrowing costs.
• Hedging, by reducing the volatility of a firm’s cashflows, can reduce the conflict
of interests between different claimants to the firm’s cashflows and can
– increase its debt capacity, and
– reduce its cost of capital.
368
Prof. Dr. Bernd Scherer
Regulation
D ∂c
Debt Vega = >0
∂σ
Equity
Equity holders have an incentive to engage
in high risk investments
D V
Explains the severe regulation of financial institutions,
Incentive increases with leverage
such as banks and insurance, in particular
- risk management
- asset liability management
Taking risk particularly simple with - restrictions on derivative use
financial instruments
369
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Regulation
370
Prof. Dr. Bernd Scherer
• Information costs
– risk management has potentially a multitude of objectives
– optimal strategies may be complex
• Transaction fees
– trading costs
– complex products are difficult to price: low transparency
371
Prof. Dr. Bernd Scherer
Optimum amount of
hedging
Cost
Firm value
PV(bankruptcy costs)
Extent of Extent of
hedging hedging
372
Prof. Dr. Bernd Scherer
• What should the CEO do? How can he compare across business?
• What should the CEO do at bonus time? Whose profits are more
valuable?
373
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RAROC
377
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dh = σ ⋅ dz
In order to manage the firm risks that arise from the hedging error, the firm puts a
risk buffer in form of cash, C , aside. The buffer earns the riskless rate on cash r and
the firms assets, S , after one period are given by
S = C ⋅ (1 + r ) + h
378
Prof. Dr. Bernd Scherer
(1 + m ) E ( S − )
While we can get these insurance costs down to zero if we hold large amounts of
cash, cash itself comes with agency costs (management waste) diluting the
shareholder claim S − = max [ −S , 0 ] to
(1 − d ) E ( S + )
The present value of the firm is equal to the firms operating profit less the value of
deadweight costs (these costs depend on volatility with no beta exposure, i.e. it is
not only systematic risks that matter!!!)
firm − value = µ − [ d ⋅ E ( S + ) + m ⋅ E ( S + ) ]
deadweight costs
379
Prof. Dr. Bernd Scherer
We can calculate the deadweight costs by taking their expectation with respect to
the risk neutral distribution.
E (S + ) =
σ
1+r ((
n
C ⋅ (1 + r )
σ )
+
C ⋅ (1 + r )
σ
N (
C ⋅ (1 + r )
σ ))
E (S + ) =
σ
1+r ((
n
C ⋅ (1 + r )
σ )
−
C ⋅ (1 + r )
σ (
N −
C ⋅ (1 + r )
σ ))
where n ( ) and N ( ) are the standard normal and cumulative standard normal
distributions.
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Prof. Dr. Bernd Scherer
Cash will decrease monitoring costs but increase agency costs. As these two effects
offset we need to find the cash allocation where
∂E ( S + ) ∂E ( S − )
d =m
∂C ∂C
∂E ( S + ) ∂E ( S − )
d −m =0
∂C ∂C
1 − q ) (
d ( 1 + r ) − mq ( 1 + r ) = 0
prob of pay off from
pay off more cash
d
q =
m +d
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Prof. Dr. Bernd Scherer
q = F ( −C * ( 1 + r ) )
d
d +m
=N ( −C * ( 1+r )
σ ) | transform into standard normal
1−
d
d +m
=N ( C * ( 1+ r )
σ ) | use symmetry
C * ( 1 +r )
σ = N −1 ( mm+d )
C * = N −1 ( mm+d ) σ 1+1 r
Firms will hold a low cash portion if the agency costs of cash are high relative to the
monitoring costs from insurance and the other way round. If hedging were
complete, σ = 0 , no cash would be needed.
382
Prof. Dr. Bernd Scherer
If we substitute the term for C * into the expression for firm − value we get the
following
firm − value = µ − kR
R= σ
2 π ( 1+r )
2
k = (d + m )e −2[ N ( d +m ) ]
1 −1 m
R is the value of a put option to insure against hedging error. In other words: The
risk capital needed equals the price to insure against a loss. How can we see this?
We simply calculate
0 − 1 ( h )2
E ( max [ −h, 0 ] ) = ∫ -∞ h⋅ 1
1
σ( 2 π )2
e 2 σ2 ⋅ dh = σ
2π
383
Prof. Dr. Bernd Scherer
Capital Allocation
Capital allocation should aim at maximizing the net present value of the financial
firm
µ − kR
∆µ − k ∆R > 0 or
∆µ
∆R
>k
Steps:
384
Prof. Dr. Bernd Scherer
Capital Allocation
∆µ
The expression ∆R
> k looks similar to RAROC. However the differences are:
Note all this analysis is incremental, i.e. for small projects only!
385
Prof. Dr. Bernd Scherer
70
60
50
Deadweight Costs
40
30
20
10
0
0
0
0
40
80
12
16
20
24
28
32
36
40
44
48
52
56
60
Cash Cushion
386