Banks are highly regulated organizations. They are at risk from regulatory and legislative changes that increase the costs of doing their business and may even prohibit them from undertaking it at all. They may breach regulatory requirements and be fined, face losing their license or suffer loss of reputation.
Sunday, November 29, 2009
Banks use models to estimate the value of instruments such as options and to assess the level of risk that the bank is exposed to in its trading activities. These models are complex and errors in these models pose a risk to banks. They may overpay for financial instruments or underestimate the level of market or trading risk being taken.
Thursday, November 26, 2009
This is the risk that the settlement of a transaction with a counterparty fails. A bank that exchanges US$ with another bank for yen has a potential settlement risk due to the time difference between the USA and Japan; it will deliver the US$ before it receives the equivalent in yen.
Sunday, November 22, 2009
Banks are usually funded with relatively liquid, short-term deposits which are lent out long term as loans. Loans are inherently illiquid. Companies and individuals rarely borrow unless they have a financing need. Banks face the risk that a large portion of their depositors will demand their funds back at the same time. Management has to determine the appropriate balance between holding low yield, but liquid, assets such as government securities that can be readily sold and higher yielding, but illiquid assets such as loans.
Thursday, November 19, 2009
The price of a bond changes as interest rates change. Specifically, price moves in the opposite direction to the change in interest rates. That is, if interest rates increase, the price of a bond will decline; if interest rates decrease, the price of a bond will increase. This is the reason a bond will sell above its par value (i.e., sell at a premium) or below its par value (i.e., sell at a discount). The risk that the price of a bond or bond portfolio will decline when interest rates increase is called interest rate risk.
The sensitivity of the price of a bond to changes in interest rates depends on the following factors:
? The bond’s coupon rate
? The bond’s maturity
? The level of interest rates
Specifically, the following relationships hold:
? All other factors being constant, the lower the coupon rate, the greater the price sensitivity of a bond for a given change in interest rates.
? All other factors being constant, the longer the maturity, the greater the price sensitivity of a bond for a given change in interest rates.
? All other factors being constant, the lower the level of interest rates, the greater the price volatility of a bond for a given change in interest rates.
Consequently, the price of a zero-coupon bond with a long maturity is highly sensitive to changes in interest rates. The price sensitivity is even greater in a low interest rate environment than in a high interest rate environment. For money market instruments, since their maturity is less than one year, the price is not very sensitive to changes in interest rates.
The price sensitivity of a bond to changes in interest rates can be estimated. This measure is called the duration of a bond. Duration is the approximate percentage change in the price of a bond for a 100-basis- point change in interest rates. For example, if a bond has a duration of 8, this means that for a 100-basis-point change in interest rates, the price will change by approximately 8%. For a 50-basis-point change in interest rates, the price of this bond would change by approximately 4%.
Given the price of a bond and its duration, the dollar price change can be estimated. For example if our bond with a duration of 8 has a price of $90,000, the price will change by about 8% for a 100-basis- point change in interest rates and therefore dollar price change will be about $7,200 (8% times $90,000). For a 50-basis-point change, the price would change by about $3,600.
The concept of duration applies to a bond portfolio also. For example, if an investor has a bond portfolio with a duration of 6 and the market value of the portfolio is $1 million, this means that a change in interest rates of 100 basis points will change the value of the portfolio by approximately 6% and therefore the value of the portfolio will change by approximately $60,000. For a 25-basis-point change in interest rates, the portfolio’s value will change by approximately 1.5% and the portfolio’s value will change by approximately $15,000.
Monday, November 16, 2009
This is the risk that the prices of financial instruments, such as equities, in which a bank has a position falls. This could result in the bank suffering unrealized losses on any open positions it has.
Sunday, November 15, 2009
A foreign bank that borrows US$ and lends it out in its local currency is exposed to exchange risk. The main risk here is that the US$ appreciates against the local currency leaving it with a liability that in local currency terms it is greater than the value of its matching asset.
Saturday, November 14, 2009
Bank balance sheets are made up of a mix of fixed and floating rate assets and liabilities whose composition is continually changing over time. A bank that makes a lot of fixed rate loans, such as car loans, funded with floating rate deposits is exposed to the risk that interest rates rise. This will push up its cost of funds while the returns on its assets will remain largely unchanged.
Friday, November 13, 2009
Credit risk is the risk that a counterparty that owes, or potentially owes, a bank money fails to meet its obligations. For most commercial banks this is the most important risk to manage and price. A triple-A US company, such as General Electric, has very different risk characteristics than a small manufacturing company in an emerging market. The challenge for banks is to determine a pricing structure for its products that is competitive but compensates for the underlying risks.
Thursday, November 12, 2009
Many people see banks and other financial services companies as conservative risk-averse organizations. Nothing could be further from the truth. Banks and insurance companies are in the business of managing and pricing risk. In essence they seek opportunities where the market price for accepting risk is higher than their own assessment of its likely cost.