Fin5440 2013notes

Risk Management in Banks
and Financial Institutions

Sreedhar T Bharath
Do not Duplicate without written permission of the author
Module 1: Introduction
New Theory of banking
In the past 25 years a new theory of the banking firm has
arisen that is making progress toward answering the
role of banks. The theory focuses on:

A. Information asymmetries, which occur when one party to a
transaction has more information than the other;

B. The problems that arise from information asymmetries; and

C. The institutional arrangements that have been developed to
solve or at least ameliorate these problems.
3
The ideal world
Suppose information were complete and costless. Then
we would probably not need banks. Issuers and
investors could find, negotiate, and transact with one
another directly (possibly over the internet).

But: Information about borrowers is not costless to
gather or analyze, and information in financial markets is
often incomplete. In particular, it is often prohibitively
expensive for investors (who are outsiders to the
borrowing firm) to stay informed about developments
inside the firm.
4
What kind of contract would arise without
monitoring? [Diamond (1996)]

Assume:

The firm needs to raise $1 million, henceforth referred to simply
as $1;
Investors required rate of return is 5%;
Everyone agrees that the firm has a profitable project to finance;
Only the firm (the borrower) will be able to observe how
profitable the project turns out to be.

In this case, think of a firm in a far-away locale that is borrowing
from an individual investor. A conflict of interest exists between the
firms insiders, who can appropriate resources to themselves, and
investors (outsiders to the firm).
5
The Project
The project costs $1 to finance. The project has
two possible outcomes:

High (H) which can be thought of as occurring
during good business conditions, with probability of
.8, in which it returns $1.4; and

Low (L) which can be thought of as occurring
during a recession, with probability of .2, in which it
returns $1.
6
How would an equity contract work in these
circumstances?
It would have to be some sort of profit sharing arrangement. Lets
assume it takes the form of a promise on the part of the firm to pay a
fraction o of the profits from the project to the investor.

Problem: The payoff to the firm and the investor are not portions of the
projects true value, V, but of the value reported by the firm, Z.
Therefore, the payoff to the firm is V- oZ. With no monitoring, the
value of Z that maximizes the payoff to the firm is zero. In other words,
the firm has an incentive to report that the project has turned out to
have a low value as low as zero.

So: Equity contracts do not work well if at all without monitoring.
7
Investors response
Obviously, the investor would like to be able to put some
kind of sanction on the firm when it appears it might be
under-reporting the projects value. Here we will
assume:

The investor can force the firm into bankruptcy and seize and
liquidate the assets of the firm;
But: Bankruptcy is expensive. So expensive, in fact, that the
investor recovers only percent of the value of the firms assets,
where 0 <= <= 1. (Diamond assumes that = 0 that the
bankruptcy consumes all of the firms assets, which is an
extreme assumption, but one that simplifies the example)

Therefore, the amount recovered by investors is: V
Bankruptcy costs are: (1-)V.
8
Investors Problem
The investor would like to set a face value on the loan, f, (principal +
interest) that will

(a) allow it to meet the required rate of return of 5%, and
(b) will somehow induce the borrower to repay the loan if it can.

From now on we will now refer to the investor as the lender because
the contract is a loan. Note that the only tools available to the lender
in the absence of monitoring are the power to force the firm into
bankruptcy, and the ability to set the face value of the loan.
9
Payoffs
With bankruptcy and liquidation now possible,
the payoffs are:

Outcome: L (1-P = .2) H (P = .8)

V: $1 $1.4
Return to firm: 0 V f
Return to lender: V f
10
How should the lender set f?
Expected return to lender =

.8f + .2V = $ 1.05 (the required rate of return);

Therefore:

f = ($1.05 .2V)/.8

This will depend on the expected recovery rate on the
assets in the event of a liquidation. The higher the
recovery rate, the lower the face value (and therefore
interest rate) has to be on the loan.
11
Setting f
Recovery rate, Face value of loan, f
1.00 $1.0625
0.50 $1.1875
0.25 $1.25
0.00 $1.3125

The last case, where the recovery rate is zero and
the contractual interest rate on the loan is 31.125%,
is the example given in the Diamond article.
12
How does this loan contract work?

For this loan contract to work, the lender must always
put the firm into liquidation if any offer is made to repay
less than the full face value of the loan regardless of
whether it thinks a bad outcome (L) has occurred or the
borrowers are simply not being truthful.

13

Look at the payoff structure to the transaction above. The only way
the borrower makes any money on the transaction is if the outcome
is good (H) and by being truthful (in which case it will get to keep an
amount equal to V f). This contract is incentive compatible it
has provided the borrower with the incentive to repay the loan if it
can.

14
What does this tell us about the kinds of
contracts that will arise when monitoring is not
possible?

They will be debt contracts with fixed face values;

Covenants of the debt contracts will be written tightly;

The debt contracts will be inflexible. If the covenants of the loan
are violated the firm will be placed into bankruptcy, period. No
other factors will be taken into account.

15
Loan contracts with monitoring
Why dont investors engage in monitoring?

If there a few large investors monitoring may make
sense. But if there are many potential investors, each
with only a relatively small amount to invest, it is likely
to be too costly, both individually and collectively.

For example, suppose the firm wants to borrow $1
million and there are 10,000 investors, each with
$100 to invest. If the monitoring cost is $200, no one
will monitor too expensive.

16
Loan contracts with monitoring
Why dont investors engage in monitoring?

There is a free rider problem. Why should an investor
monitor (and incur the expense) when he or she
knows that someone else is monitoring. In this case,
it is possible that insufficient monitoring will occur
(monitoring is a public good it has third party
effects).
17
Enter banks
Investors could delegate the monitoring function
to a single market participant (well call it a
bank), saving each investor the cost of doing it
on his or her own.

With monitoring, it may is no longer necessary
automatically to throw a firm into bankruptcy and
liquidation when the firm is unable to make pay
the full face value of the loan.
18
Enter banks
Recall: Without monitoring the lender could not
tell if the borrowers representation that a bad
outcome had occurred was the truth.

With monitoring, the bank can tell whether or not
the borrower is actually in a position to pay. The
lender knows the true value of the project. It can
accept a partial payment on a loan.
19
Monitoring
With monitoring, the lender can use the threat of
liquidation to induce the borrower to pay as
much as possible.

Specifically, the lender can now accept a
payment of $1 when V = $1 (the value of the
project in a Low outcome), which before would
have triggered a bankruptcy.

The borrower will be no worse off repaying $1
than going through liquidation.
20
Monitoring gains
Assuming that the recovery rate () is zero, with monitoring:

Expected return to the lender = .8f + .2($1) = $1.05,
where .2(1) is the expected savings in financial distress costs.

So: f = ( $1.05 - .2($1))/.8 = $1.0625

The lender can now either make a higher rate of return, or set a
lower loan rate (6.25%). The value of the monitoring is the expected
savings in distress costs.

Note that there are both private and social gains from monitoring:
the deadweight loss of bankruptcy costs is eliminated with
monitoring.
21
Quis custodiet ipsos custodes?
Who will monitor the monitors (banks)? Hasnt the
delegation of the monitoring function merely added
one more market participant that will have to be
monitored to the transaction?

Investors (depositors) will face every problem in
monitoring banks that they do in monitoring direct
credit extensions to nonbank borrowers. In effect,
monitoring of banks is not possible .

This has two implications.
22
Implications

A. Bank liabilities will generally take the form of debt
instruments with a fixed face value the kind of contract
shown above to be feasible when monitoring is not
possible. This provides the same incentives to banks as
faced by the firms that borrow from banks. The banks
are always better off paying a sufficient amount to avoid
bankruptcy and liquidation.

Banks in fact do fund themselves principally with debt
instruments. As of 3Q 2003, debt instruments (deposits,
subordinated debt, and other borrowed funds) represented about
91% of the total liabilities of banks insured by the FDIC.

23
Implications

B. Banks will be forced to diversify their assets.

If they do not, they will be just as risky as their loan
customer (in which case there is no point in using a
bank as an intermediary.)

24
Bank Diversification is crucial
Suppose the bank makes and monitors a single
loan, with the same distribution of returns as above.
When the project returns $1 in a Low outcome, the
bank can monitor and collect $1 without forcing the
borrower into liquidation.

25

However: The depositors would now force the bank
into liquidation. Why? Because they cannot monitor
the bank, they will deposit money into the bank only
under a tightly-written debt contract that provides for
automatic liquidation whenever the borrower (in this
case the bank) cannot pay the full face value of the
deposit otherwise they will not be able to earn the
required 5% return on their deposits. In other words,
depositors act just like lenders in a situation in which
monitoring is not possible.
26
The upshot is that undiversified bank lending (modeled
here as a loan to a single borrower) does not work.
Without diversification, the bank will be liquidated as
often as the borrower, and nothing is gained.

27
How do we know that diversification can solve this
problem?
Suppose:

Bank makes two loans, $1 million each.

The borrowers returns are independently distributed, but
otherwise just like that of the single borrower considered
above. Each loan has a .8 probability of returning $1.4
million, and a .2 probability of returning $1 million.

28
How do we know that diversification can solve this
problem?
Suppose:

The bank attracts $2 million in deposits from 20,000
depositors. The deposits are unmonitored debt. Let B
represent the face value (principal plus interest) of bank
deposits per loan. There are $2B in total deposits.

The bank lends to two borrowers under a debt contract
with a face value (principal and interest) of F ($ F
million). It collects F when the project returns $1.4
million, and monitors to collect $1 million when the
project is worth only $1 million. No liquidation is
necessary to enforce the loan contracts.
29
Outcomes
There are three possible outcomes:
1. Neither loan defaults.
2. One loan defaults.
3. Both loans default.
30
Distribution of payments to the bank
Prob. That payment
Probability is > or = this value
Neither loan defaults P
2
= 0.64 0.64
(both pay F)
One loan defaults 2P(1- P) = .32 0.96 = .64 + .32
(one pays $1, one pays F)
Both loans default (1 - P)
2
= .04 1.0 = .64 + .32 + .04
(both pay $1)
31
Notes on the table
Note that there are two ways that only one loan can
default. One is that loan A defaults and loan B pays in
full; the probability of which is (1 P)P. The other is that
loan A pays in full and loan B defaults, the probability of
which is P(1 P). The sum of the two possible
outcomes is 2P(1 P), which in the example is 2(.2)(.8)
= .32.

Assume that liquidating the bank consumes all of its
assets: = 0.

32
Can the bank survive the default of one loan, on
which it collects $1?
For simplicity, assume the units are in millions. If so, its
probability of collapse can be reduced to only .04 (see table of
outcomes above) the case when both loans default at once.

If it can, then:

Total payments to depositors
= $2B with probability .96
= 0 with probability .04.
33
Calculating B
Required rate of return on deposits = 5%, so the
expected repayment to depositors is $2(1.05)

In this case, .96($2)B = $2(1.05)

So: 2B = $2.1875 This is the most the bank should
promise to repay to depositors if it knows there is a .96
probability that, at worst, one loan will default (or,
alternatively, that there is only a .04 probability that both
loans will go bad at once).

34
Calculating B
Let R
B
be the promised interest rate of the deposits,
such that $2B = $2(1 + R
B
)

Then $2.1875 = $2(1 + R
B
),

and R
B
= 2.1875/2 1 = 9.375%

So: The bank must be able to pay $2.1875 when one
loan defaults (and the bank recovers $1 on that loan).
35
Calculating F
When one loan defaults and the other pays the full
face value, F, the banks earnings are 1 + F.

So: 1 + F must be equal at least to $2.1875.
Therefore, the bank should set a face value of each
loan of F = $1.1875. If the bank makes loans with
this face value in other words, if it charges an
interest rate equal to 18.75% on its loans, it will have
the ability and incentive to meet its deposit
obligations with a high (.96) probability.
36
Will the banks monitor?
Recall the value of monitoring one loan = 0.2
= saving of the expected bankruptcy costs

Cost of monitoring one loan = 0.0002 (200$
for 1 million $ of loan)

Pay off to bank from monitoring is 1+F-2.1875
when 1 loan defaults and the other does not.
This happens with 32% probability
37
Will the banks monitor?
Thus monitoring is worthwhile if
0.32(1+F-2.1875) >= 2 * 0.0002
i.e. F >= 1.18875

Thus as long as the interest rate on the loan
is greater than 18.875% the banker is willing
to invest 400$ in monitoring.
38
Bank profits
The two-loan banker must earn a small profit
in excess of the cost of monitoring. The need
to provide the bank an incentive to monitor
and to avoid bank failure when just one loan
defaults (by cross-subsidizing the losses from
the defaulting loan with the profit from the non
defaulting loan) leads to profits for the banker
who was delegated the monitoring of the
loan.

39
Bank profits
Prob. That payment
Probability is > or = this value
Neither loan defaults P
2
= 0.64 0.64
(both pay F)
One loan defaults 2P(1- P) = .32 0.96 = .64 + .32
(one pays $1, one pays F)
Both loans default (1 - P)
2
= .04 1.0 = .64 + .32 + .04
(both pay $1)

Profits
1.18875*2 2.1875 = 0.19

2.18875 2.1875 = 0.00125

0
Expected Profits for the bank = 0.64 *0.19 +0.32*0.00125+0.04*0
= 0.122
40
All parties are better off
Bankers rents = profits monitoring costs=
0.122 2 * 0.0002 = 0.1216

Borrower 18.875% from bank versus 31.25%
direct

Investors 5% return in both situations

41

Implications

(1) Banks can operate with a diversified portfolio with a low (though
nonzero) probability of default.

(2) This arrangement permits only a few agents (banks) to engage in
monitoring; thousands of depositors need not monitor on their own
(which is probably too costly for them to do anyway).

(3) Banks monitor loans, but will finance themselves with unmonitored
debt.

(4) Banks will diversify their assets (if permitted to do so by law).
Diversification makes bank deposits safer than bank loans.

(5) Laws that limit diversification remove much of the advantage of
banks as intermediaries, and makes deposit riskier. Banks subject
to such laws (such as restrictions on branching, which will limit the
geographic diversification of bank loan portfolios) will lobby for
deposit insurance.
42

Implications

Banks can operate with a diversified portfolio
with a low (though nonzero) probability of
default.

This arrangement permits only a few agents
(banks) to engage in monitoring; thousands of
depositors need not monitor on their own (which
is probably too costly for them to do anyway).
43

Implications

Banks monitor loans, but will finance themselves
with unmonitored debt.

Banks will diversify their assets (if permitted to
do so by law). Diversification makes bank
deposits safer than bank loans.

44

Implications

Laws that limit diversification remove much of
the advantage of banks as intermediaries, and
makes deposit riskier. Banks subject to such
laws (such as restrictions on branching, which
will limit the geographic diversification of bank
loan portfolios) will lobby for deposit insurance.
45
Module 2: Interest Rate Risk
Interest Rate Risk
The case of Homeside Lending

A look at Fannie Mae

Repricing Model

Duration and Convexity Models

On/Off balance sheet strategies
47
Homeside Lending
In early 1998 National Australia Bank, Melbourne,
anted up $1.2 billion to purchase all of HomeSide
Lending Inc., Jacksonville, FL, then the fifth-largest
mortgage banking company in the U.S.

In 1998, when NAB bought HomeSide, it had $100
billion in residential servicing rights (receivables) on
its books. In 1998, a record year for residential
originations, HomeSide produced $26 billion, a 23%
increase from the year before.

48
Homeside Lending
Prior to 1996 HomeSide was called BancBoston
Mortgage and was a subsidiary of First National Bank of
Boston. It was that year that the bank changed the name
of the company to HomeSide Lending

Traditionally, BancBoston Mortgage relied heavily on
correspondents for a majority of its loan volume. From
1994 to 2001 BancBoston/ HomeSide's correspondent
purchases comprised about 85% of its overall residential
loan production.

49
Homeside Lending
Correspondent lending: a firm such as HomeSide buys
closed loans from others, including both the underlying
mortgage and the servicing rights. It builds a servicing
portfolio and uses state-of-the art technology to drive
down costs and build economies-of-scale. Supposedly,
the larger a firm grows that portfolio the more it can
make per unit.

The problem with correspondent lending, is that a firm
relying mostly on loan purchases has to keep buying no
matter how intense the price competition becomes. If a
lender has no retail or wholesale channel, or a very small
one, it has to buy, buy, buy, to keep up. When loan
volumes fall dramatically, as they did in the post boom
years of 1999 and 2000, correspondent lenders bid
aggressively against each other for whatever product
was available. 50
Homeside Lending

HomeSide was also a buyer of "flow" and bulk servicing
rights, which means it bought servicing rights from other
lenders but not necessarily the underlying loans. The key
to doing this is to make sure you don't overpay, and then
to hedge that servicing asset aggressively.
51
52
53
55
56
57
Homeside Lending Interview in Australian Media
The ABC 7:30 report's Alan Kohler asked NAB chief
executive Frank Cicutto whether he felt any personal
responsibility for the loss.

Partial Details or Transcript:

Alan Kohler: In any case the core expertise of a bank like this, is risk management.
Isnt it the case that this shows that risk management at NationalBank failed with
regard to Homeside?
Frank Cicutto: Obviously the write-off speaks for itself. Its important to understand
the elements of your write-off. There was an interest rate modeling assumption
error and that accounted for part of it. The balance of the write-off and the majority
of the write-off was to mark the asset to market.
Alan Kohler: What do you mean by that?
Frank Cicutto: We mark the asset down to what we expect a realistic sale price to
be today. Its just like your house. It may have intrinsic value to an owner but in
essence the value in an open market is what a buyer would pay for it?

58
Alan Kohler: But how can such a loss in value sneak up on you like that?
Surely you must have seen something coming at the time.
Frank Cicutto: In July we announced that there was a hedge problem in
Homeside. At that time I took it quite seriously and sent in a team to look at
the issues at Homeside; engaged outside consultants to help us with that
review to determine the strategic options for Homeside.
Alan Kohler: But in a way the July announcements make things look a bit
worse, dont they? Because you actually announced a writedown in July
which made the market think, everyone think, that that was it. You wrote the
asset and nobody would have expected any more.
Frank Cicutto: Its important to understand that the provision taken in July
related to a hedge position. This is quite different.
Alan Kohler: A big part of the writedown seems to have been the result of a
mistake, though on interest rates.
Frank Cicutto: $400 million was as a result of an interest rate modeling
assumption error but that dates back to the fall of 1999 when the actual
software was changed in Homeside to model their assumptions.

Homeside Lending Interview in Australian Media
59
Stock Market Reaction
60
Homeside Lending: a US mortgage subsidiary of
NAB, purchased in 1998.

Failed to protect itself against a series of official
interest rate cuts in the US.

Result:
biggest ever corporate write down in Australias history
over A$4 billion lost by 2001
20% drop in NAB share price

Interest Rate Risk is a BIG risk endangering the
health of financial firms. Managing it is CRUCIAL for
survival

Takeaway from the Homeside Case
61
www.fanniemae.com
A look at Fannie Mae
62
Balance Sheets
Dollars in millions, except share stated values 2002 2001
Assets
Mortgage portfolio:
Mortgage-related securities:
Held-to-maturity.................................................................................................................................... 437,932 $ 509,155 $
Available-for-sale................................................................................................................................... 173,706 32,900
Total................................................................................................................................................. 611,638 542,055
Loans held-for-investment.......................................................................................................................... 185,652 165,917
Allowance for loan losses.............................................................................................................. (79) (48)
Unamortized premiums (discounts) and deferred price adjustments, net........................................... 337 (2,640)
Loans held-for-sale.................................................................................................................................... 145 40
Mortgage portfolio, net.................................................................................................................................. 797,693 705,324
Nonmortgage investments:
Held-to-maturity.................................................................................................................................... 23,050 38,671
Available-for-sale................................................................................................................................... 36,794 35,883
Cash and cash equivalents.............................................................................................................................. 1,710 1,518
Accrued interest receivable............................................................................................................................. 4,915 4,705
Acquired property and foreclosure claims, net................................................................................................ 1,033 684
Derivatives in gain positions........................................................................................................................... 3,666 954
Other............................................................................................................................................................ 18,654 12,209
Total assets....................................................................................................................................................... 887,515 $ 799,948 $
December 31,
63
Liabilities and Stockholders' Equity
Liabilities:
Debentures, notes and bonds, net:
Senior debt:
Due within one year.................................................................................................................................... 382,412 $ 343,492 $
Due after one year....................................................................................................................................... 458,600 413,582
Subordinated debt:
Due after one year....................................................................................................................................... 9,970 6,393
Total........................................................................................................................................................ 850,982 763,467
Accrued interest payable....................................................................................................................................... 8,379 8,529
Derivatives in loss positions................................................................................................................................. 5,697 5,069
Guaranty liability for MBS................................................................................................................................... 729 755
Other..................................................................................................................................................................... 5,440 4,010
Total liabilities.................................................................................................................................................. 871,227 781,830
Stockholders' Equity:
Preferred stock, $50 stated value, 100 million shares authorized - 53.6 million shares issued and outstanding in 2002
and 46 million shares issued and outstanding in 2001...................................................................................... 2,678 2,303
Common stock, $.525 stated value, $1.32 of dividends per share paid in 2002 and $1.20 of dividends per share paid
in 2001, no maximum authorization - 1,129 million shares issued.................................................................. 593 593
Additional paid-in capital..................................................................................................................................... 1,839 1,651
Retained earnings.................................................................................................................................................. 29,385 26,175
Accumulated other comprehensive loss................................................................................................................ (11,792) (7,065)
22,703 23,657
Less: Treasury stock, at cost, 140 million shares in 2002 and 132 million shares in 2001.................................. 6,415 5,539
Total stockholders' equity................................................................................................................................. 16,288 18,118
Total liabilities and stockholders' equity................................................................................................................... 887,515 $ 799,948 $
64
A simplified Balance Sheet
December 31, 2002
Billion Dollars
Assets:

Mortgage Portfolio 798
Investments 60
Cash,Rec & Other 11
Other 19

Total 888

Liabilities and S/Hs Equity:

Short-term bonds 382
Long-term bonds 468
Other Debt 22
EQUITY 16

Total 888

65
Question
What happens if the Mortgage Portfolio loses its
value by 16 billion dollars?

In other words, if the mortgage portfolio loses its
value by 2.005%, then FNMA will lose all its equity!
66
A Partial Look at FNMAs Income Statement
(2001-2002)
67
(2001-2002)

68
(2001-2002)

69
Interest Income: (In Billion $) In percent

Mortgage Portfolio 49 6.73 %
Investments 2 2.34
Total 51 6.35

Interest Expense:

Short Term 3 1.90
Long-Term 37 5.88
Total 40 5.15

Net Interest Income 11 1.20 E
Investment Spread

Other Income 2
Other Expenses 7
Income Before Taxes 6
70
Funds-Gap Analysis (The Repricing model)
Focus is on evaluating the impact of changes in interest-rates on net
interest-income.

The analysis is maturity based. Hence, it can be considered as the
worst asset-liability management tool.

There is one side benefit in learning the Funds-Gap Analysis. It is a
nice tool to demonstrate how changes in market yields cut through
the balance-sheet and affects the income statement. Specifically,
for example, it can show us the source of $6 billion accounting profit
FNMA reported for the year ending 2002.

To undertake the analysis, the first step is to partition the balance
sheet into four quadrants:
71
Funds-Gap Analysis
Assets

Rate Sensitive Assets (RSA)

Fixed Rate Assets (FRA)

Liabilities and S/Hs Equity

Rate Sensitive Liabilities (RSL)

Fixed Rate Liabilities (FRL)
72
What is a rate sensitive asset (or Liability)?
It is an instrument that will be re-priced within a SHORT period of
time.

What is the definition of SHORT?
Hence, if we define short, as 1 year, then RSA are those that
will be repriced within a year. Given this definition of short,
Funds Gap is defined as follows:

FUNDS GAP = RSA - RSL.

We can see that FUNDS GAP can be a zero, positive or
negative number.
Funds-Gap Analysis
73
Apply the Funds Gap Analysis to FNMAs
December 31, 2002 balance sheet
FUNDS GAP = RSA - RSL.

Funds Gap = $60 billion - $382 billion
= $-322 billion

What is the meaning of a negative Funds Gap?
To answer this question it helps to further classify the
balance-sheet as follows

74
Assets

RSA 60
FRA 490
FRA 322
FRA 16

Liabilities and S/Hs Equity

RSL 60
FRL 490
RSL 322
EQUITY 16

Hence, negative GAP amount shows the amount of fixed rate
assets (long-term assets) financed by rate sensitive (short-
term) liabilities.
Meaning of a negative Funds Gap
75
Funds-Gap Analysis
Another way to use the Funds Gap amount is
to view it as a proxy for the interest-rate risk
in the income statement.

Given the assets and liabilities over the last
year and given their respective returns, what
portion of the income reported for 2002 is due
to taking interest-rate risk?
76
Given the assets and liabilities over the last year and given
their respective returns, what portion of the income reported
for 2002 is due to taking interest-rate risk?

________________________________________________________
Amount * (Yield -Cost)% = Income
________________________________________________________

Rate Sensitive 60 * (2.34 - 1.90)% = 0.264

Fixed Rate 490 * (6.73 - 5.88)% = 4.165

GAP 322 * (6.73 - 1.90)% = 15.5526

Equity 16 * (6.73 - 0)% = 1.0768

21.0584
In other words, 15.5526 billion of 21.0584 billion dollars of income comes
from taking interest-rate risk.
77
What happens if the interest- rates remain at
these levels for the current year? What kind of
term structure is presumed here?

What happens if short-term rates increase by 4
% and long-term rates remain at these levels?
In other words, the term structure becomes
downward sloping?
78
Changed interest-rate Scenario

________________________________________________________
Amount * (Yield -Cost)% = Income
________________________________________________________

Rate Sensitive 60 * (6.34 - 5.90)% = 0.264

Fixed Rate 490 * (6.73 - 5.88)% = 4.165

GAP 322 * (6.73 - 5.90)% = 2.6726

Equity 16 * (6.73 - 0)% = 1.0768

8.1784
79
We could have obtained the same result using the following
ANI = Ar * Funds Gap

ANI = Ar * (RSA-RSL)

Hence,
ANI = .04 * (322) = (12.88)

New Income Level = 21.0584 12.88 = 8.1784
80
Funds-Gap Analysis
If changes in rates on RSAs and RSLs are
not equal, the spread changes. In this case,
ANII = (RSA A R
RSA
) - (RSL A R
RSL
)

81
Interest-Rate Risk
Variation in returns caused by unexpected changes
in interest rates.

Two components:
Price risk : Variation in market prices caused by
unexpected changes in interest rates.

Reinvestment Risk: Variation in the rate at which
intermediate cash flows can be reinvested.
82
Duration versus maturity
1.) 1000 loan, principal + interest paid in 20 years.
2.) 1000 loan, 900 principal in 1 year,100 principal in 20 years.

1000 + int
|-------------------|-----------------|
0 10 20

900+int 100 + int
|----|--------------|-----------------|
0 1 10 20

What is the maturity of each? 20 years
What is the "effective" maturity?
2.) = [(900/1000) x 1]+[(100/1000) x 20] = 2.9 yrs
1
2
Duration, however, uses a weighted average of the present values.
83
Duration
The average life of an asset or liability

The weighted-average time to maturity using
present value of the cash flows, relative to the
total present value of the asset or liability as
weights.
84
Frederic R. Macaulay, 1938 - Duration Measure.
D = E
n
t=1
[C
t
t/(1+r)
t
]
E
n
t=1
[C
t
/(1+r)
t
]

Where
D = duration
t = number of periods in the future
C
t
= cash flow to be delivered in t periods
n= term-to-maturity & r = yield to maturity (per period basis).

85
Example 1
Annual
Eurobonds pay coupons annually. Suppose the annual coupon is 8%. The
face value of the bond is $1000 and the current YTM is 8%.

t CF DF CF x DF (CF x DF) x t
1 80 0.9259 74.07 74.07
2 80 0.8573 68.59 137.18
3 80 0.7938 63.51 190.53
4 80 0.7350 58.80 235.20
5 80 0.6806 54.45 272.25
6 1080 0.6302 680.58 4083.48
1000.00 4992.71
D =
4992.71
1000
= 4.993 yrs .
86
Example 2
Semiannual
U.S. Treasury bonds pay coupon interest semiannually. Annual rate is
8%, face $1000, annual YTM is 12%

t CF
t
DF
t
CF
t
x DF
t
CF
t
x DF
t
x t
1/2 40 .9434 37.74 18.87
1 40 .8900 35.60 35.60
1-1/2 40 .8396 33.58 50.37
2 1040 .7921 823.78 1647.56
930.70 1752.40

D =
1752.4
930.70
= 1.88 yrs.
Note:
Treasury formula for bonds with semiannual coupon payments is (1 + 1/2 r)
x
where
x is the number of semiannual coupon payments. Thus at t = 1/2 the discount rate
is (1.06), at t=1 the discount rate is (1.06)
2
.
87
Features of Duration
Duration and Current Market Yields
As market yields increase duration of a bond decreases.

Duration and Coupon Rate
As coupon decreases duration increases.

Duration and Maturity
For securities that make only one payment at maturity (a
zero coupon), duration equals maturity. For all other
securities, it is shorter than term to maturity.
88
Economic meaning of Duration

Duration as a measure of Bond Price Volatility

Suppose we want to know how the price of the
bond (P) changes when yields (r) rise. We know
bond prices fall, but suppose we want to know a
direct measure of the size of this fall (i.e., its
degree of price sensitivity).
89
Duration is a measure of interest rate sensitivity or
elasticity of a liability or asset:

[dP/P] [dr/(1+r)] = -D

Or equivalently

dP/P = -D[dr/(1+r)] = -MD dr

where MD is modified duration.
Economic meaning of Duration

Always Remember: Duration is the approximate percentage change in
the price of a bond for a 100-basis-point change in interest rates.
90
Aside : Derivation of Duration
MD
r
P
P
P MD P
r
D
r
P
r
C
t
r r
P
r
C
P
N
t
t
t
N
t
t
t
=
c
c
=
+
=
c
c
|
|
.
|
\
|
+
=
c
c
+
=
=
=
1

1
) 1 ( 1
1
) 1 (
1
1
91
Example

Consider a 6% 25-year bond when the required yield is 9%. The price of this
bond for various level of interest-rate changes are given below:

Required Yield Price
8 78.5178
8.99 70.4318
9 70.3570
9.01 70.2824
10 63.4881

The true percentage price changes are:

Yield Change Actual percentage
Change in BPS Price Change
9 to 9.01 1 -0.11
9 to 8.99 -1 +0.11
9 to 10 100 -9.76
9 to 8 -100 +11.76
92
The Macaulay duration of the 25-year 6%
bond selling at 70.3570 to yield 9% is 11.10
years.
The Modified duration of this bond is 10.62.
93
Yield Actual Predicted
Yield Change Percentage Percentage
Change in BPS Price Change Price Change

9 to 9.01 1 -0.11 -.1062
9 to 8.99 -1 +0.11 +.1062
9 to 10 100 -9.76 -10.62
9 to 8 -100 +11.76 +10.62
94
95
96
Convexity
By precisely calculating the true A in bond prices, we would find that for
large interest rate increases, duration over-predicts the fall in bond prices
for large interest rate decreases it under-predicts the increase in bond
prices.

In actuality for rate increases the capital loss effect tends to be smaller than
the capital gain effect for rate decreases. This is the result of the bond
price-yield relationship exhibiting a property called convexity rather than
linearity as assumed by the basic duration model.

Convexity is a desirable feature. By buying a bond or a portfolio of assets
exhibiting a lot of convexity is similar to buying partial interest rate risk
insurance. Why?

High convexity means that for equally large changes of r up and down (eg
2%) the capital gain effects of a rate decrease more than offsets the capital
loss effect of a rate increase.
97
Can we measure convexity? Can we modify the duration model?

Duration is the slope of the price-yield curve. Convexity (curvature) is the
change in the slope of the price-yield curve.

Just as D (duration) measures the slope effect (dp/dr) let's introduce a new
parameter to measure the curvature effect (dp
2
/d
2
r) of the price-yield curve.

= - MD Ar + 1/2 CX (Ar)
2

CX reflects the degree of curvature in the price-yield curve at the current
yield level: The degree to which the capital gain effect exceeds the capital
loss effect for an equal change in yields up or down. Sometimes, we use the
symbol C for convexity
Convexity
A A
A
P
P
= D
r
(1+r)
+
1
2
CX ( r
)
2
98
Convexity
Measures how much a bonds price-yield curve
deviates from a straight line
Second derivative of price with respect to yield
divided by bond price

Allows us to improve the duration approximation for
bond price changes
r
P
P
CX
t t
r
CF
r r
P
N
t
t
t
2
2
1
2
2 2
2
1
Convexity
) (
) 1 ( ) 1 (
1
c
c
= =
(
+
+ +
=
c
c
=
99
Duration & Convexity Continuous Compounding

100
Duration & Convexity Continuous Compounding

101
(1/P)
(1/P)
Predicted percentage price change
Recall approximation using only duration:

100 100 A =
A
r MD
P
P

102
Numerical example with convexity
Consider a 20-year 9% coupon bond selling at
$134.6722 to yield 6%. Coupon payments are
made semiannually.

D = 10.98

The convexity of the bond is 164.106.

66 . 10
) 2 / 06 . 0 ( 1
98 . 10
=
+
= MD

103
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
A B C D E F G H
Bond Yield, Duration and Convexity
cashflow
time t Ct t*Ct PV(t.Ct) (t^2) (t+t^2) (t+t^2)*Ct PV((t+t^2)*Ct)
0 -134.6722 0 0 0 0
1 4.5 4.5 4.37 1 2 9 8.74
2 4.5 9 8.48 4 6 27 25.45
3 4.5 13.5 12.35 9 12 54 49.42
4 4.5 18 15.99 16 20 90 79.96
5 4.5 22.5 19.41 25 30 135 116.45
6 4.5 27 22.61 36 42 189 158.28
7 4.5 31.5 25.61 49 56 252 204.90
8 4.5 36 28.42 64 72 324 255.77
9 4.5 40.5 31.04 81 90 405 310.40
10 4.5 45 33.48 100 110 495 368.33
11 4.5 49.5 35.76 121 132 594 429.12
12 4.5 54 37.87 144 156 702 492.37
13 4.5 58.5 39.84 169 182 819 557.70
14 4.5 63 41.65 196 210 945 624.76
15 4.5 67.5 43.33 225 240 1080 693.21
16 4.5 72 44.87 256 272 1224 762.76
17 4.5 76.5 46.28 289 306 1377 833.11
18 4.5 81 47.58 324 342 1539 904.00
19 4.5 85.5 48.76 361 380 1710 975.19
20 4.5 90 49.83 400 420 1890 1046.45
21 4.5 94.5 50.80 441 462 2079 1117.57
22 4.5 99 51.67 484 506 2277 1188.35
23 4.5 103.5 52.44 529 552 2484 1258.62
24 4.5 108 53.13 576 600 2700 1328.22
25 4.5 112.5 53.73 625 650 2925 1397.00
26 4.5 117 54.25 676 702 3159 1464.81
27 4.5 121.5 54.70 729 756 3402 1531.54
28 4.5 126 55.07 784 812 3654 1597.08
29 4.5 130.5 55.38 841 870 3915 1661.32
30 4.5 135 55.62 900 930 4185 1724.17
31 4.5 139.5 55.80 961 992 4464 1785.54
32 4.5 144 55.92 1024 1056 4752 1845.38
33 4.5 148.5 55.99 1089 1122 5049 1903.61
34 4.5 153 56.00 1156 1190 5355 1960.17
35 4.5 157.5 55.97 1225 1260 5670 2015.02
36 4.5 162 55.90 1296 1332 5994 2068.13
37 4.5 166.5 55.77 1369 1406 6327 2119.44
38 4.5 171 55.61 1444 1482 6669 2168.93
39 4.5 175.5 55.41 1521 1560 7020 2216.59
40 104.5 4180 1281.41 1600 1640 171380 52537.74
104
47
48
49
50
51
52
53
A B C D E F G H I
r 3.00%
YTM 6.00%
Price 134.67 2958.12 =sum(D6:D45) 93785.58
sum(h6:h45)
Duration= 10.98 =D49/(B49*2)
Convexity= 164.1057
Modified Dur= 10.66278 =D51/(1+B47) =H49/((1+$B$47)^2*$B$49)/4
105
Numerical example
If yields increase instantaneously from 6% to 8%, the
percentage price change of this bond is given by:

First approximation (Duration):
10.66 .02 100 = 21.32

Second approximation (Convexity)
0.5 164.106 (.02)
2
100 = +3.28

Total predicted % price change: 21.32 + 3.28 = 18.04%
(Actual price change = 18.40%.)

106
Numerical example
What if yields fall by 2%?
If yields decrease instantaneously from 6% to 4%, the percentage
price change of this bond is given by:

First approximation (Duration):
10.66 .02 100 = 21.32

Second approximation (Convexity)
0.5 164.106 (.02)
2
100 = +3.28

Total predicted price change: 21.32 + 3.28 = 24.60%
Note that predicted change is NOT SYMMETRIC.

107
Takeaways: Duration and convexity
Price approximation using only duration:

New Bond Price ($) = P + [AP (Duration)]

Price approximation using both duration and convexity:

New Bond Price ($) = P + [AP (Duration)] + [AP (Convexity)]
| | r MD P P A + =
| | | |
2
) ( Convexity 5 . r P r MD P P A + A + =

108
Takeaways: Duration and convexity
Duration of a portfolio of securities equals the value-weighted average
of the durations of the securities.

109
Duration GAP Analysis
focus on managing NII or the market value of equity,
recognizing the timing of cash flows.

Interest rate risk is measured by comparing the weighted
average duration of assets with the weighted average
duration of liabilities.

If Asset duration > Liability duration

|interest rates Market value of equity will fall.

110
% Change in Price = - MD * % Change in Interest Rates

As managers, since our concern is to preserve (and maximize) the
value of equity of the firm, we have a vested interest in knowing
how changes in interest rates would affect the value of equity. The
following relationship provides an approximate answer to that
question.

NW Change
Total Assets
= - MDUR * % Change r
GAP

111
Where,

Hence, to apply the duration analysis, one
needs to figure out the average duration of
the firms assets (Dur
A
) and Liabilities
(Dur
L
).
GAP
A L L
MDUR =
( Dur - w * Dur )
1 + r

112
Aside : Derivation
Duration Gap:
From the balance sheet, E=A-L. Therefore, AE=AA-
AL. In the same manner used to determine the
change in bond prices, we can find the change in
value of equity using duration.
AE = [-D
A
A + D
L
L] Ar/(1+r) or
AE/A = |D
A
- D
L
w
L
](Ar/(1+r)) or

NW Change
Total Assets
= - MDUR * % Change r
GAP

113
MDUR
GAP
Summary
Positive MDUR
GAP

indicates that assets are more price
sensitive than liabilities, on average.

Negative MDUR
GAP

indicates that weighted liabilities are more
price sensitive than assets.

114
MDUR
GAP
Summary
MDUR
GAP
Change in
interest rates
Change in Market Values
Assets

Liabilities

Equity
+ Increase Decrease
>
Decrease Decrease
+ Decrease Increase
>
Increase Increase
- Increase Decrease
<
Decrease Increase
- Decrease Increase
<
Increase Decrease
0 Increase Decrease
=
Decrease None
0 Decrease Increase
=
Increase None

115
Application to FNMAs 2002 balance sheet
Step 1 :Calculate w
L

116
Step 1 : Calculate w
L

A = L + E gives
1 = (L/A) +(E/A) or
1-(E/A) = w
L
1- 0.021 = w
L
= 0.979

117
Step 2 : Calculate Duration Gap

118
Step 2 : If we assume that D
A
= 15 years then

D
A
- D
L
w
L

= -0.42

Solve for D
L
= 15.42/0.979 = 15.75 years

119
Step 3 : r at the end of 2002 was around 4.5%

MDUR
GAP
= -0.42/(1.045) = -0.3987

NWchange/Total assets = -(-0.3987)*(%change in r)

Hence, if interest rates fall by 1 percent FNMAs Net Worth
will lose value by 0.3987 percent of the assets
((0.3987/100)*888 billion) = 3.541 billion $.

120
Step 4 : Current market value of equity is roughly about = 64.33*
0.971667 = 62.5073 billion, hence, a 1 percent increase in interest
rates would cause FNMA to 5.66% of its equity value!

St ock P rice P er Common Share
$62.44
$86.75
$74.00
$64.33
$79.50
1998 1999 2000 2001 2002
December 31,

121
In order for this result to be credible the following must be true

1. We exactly know the Duration of assets and liabilities.

2. We exactly know the market value of assets.

3. Change in interest rates is a parallel shift.

4. Convexity plays no role.

5. Term structure is flat.

122
Summary
If you want to immunize your equity against interest-
rate risk set your
MDUR
GAP
= 0.

FNMA has a negative Duration Gap and you expect
interest rates to go down. What kind of asset/liability
strategy would you propose?

Try to make MDUR
GAP
as small as possible.

How do you do that?
Increase Dur
A
and decrease Dur
L
.

123
Risk management Strategies
On-Balance-Sheet Strategies
Increase Dur
A

Decrease Dur
L
.
Decrease w
L

Off-balance-sheet Strategies
Forward/Futures
Swaps
Options

Banc One case

124
Module 3: Market Risk
Market Risk
The case of Orange County
JP Morgan Risk metrics
VAR

126
Definition of market risk

The BIS (Bank of International Settlements) defines
market risk as the risk that the value of on- or off-
balance-sheet positions will be adversely affected by
movements in equity and interest rate markets,
currency exchange rates and commodity prices.

The main components of market risk are therefore
equity, interest rate, FX, and commodity risk.

127
Definition of market risk

128
Orange County
The story of how a municipality can lose $1.6 billion
in financial markets

In December 1994, Orange County stunned the
markets by announcing that its investment pool had
suffered a loss of $1.6 billion. This was the largest
loss ever recorded by a local government investment
pool, and led to the bankruptcy of the county shortly
thereafter.
Reproduced from Source : Philippe Jorion's Orange County Case: Using Value at Risk to Control
Financial Risk

129
Orange County
Loss due to unsupervised investment activity of Bob
Citron, the County Treasurer. He managed a $7.5
billion portfolio belonging to county schools, cities,
special districts and the county itself.

Citron delivered returns about 2% higher than the
comparable State pool

130
Orange County
This loss was the result of unsupervised investment
activity of Bob Citron, the County Treasurer, who was
entrusted with a $7.5 billion portfolio belonging to
county schools, cities, special districts and the county
itself.

Citron was viewed as a wizard who could painlessly
deliver greater returns to investors. Citron delivered
returns about 2% higher than the comparable State
pool

131

132
Orange County
Citron increased pool returns by investing in
derivatives securities and leveraging the portfolio to
the hilt.

The investment strategy worked excellently until
1994, when the Fed started a series of interest rate
hikes that caused severe losses to the pool. Initially,
this was announced as a ``paper'' loss. Shortly
thereafter, the county declared bankruptcy and
decided to liquidate the portfolio, thereby realizing the
paper loss. How could this disaster have been
avoided?

133
Portfolio Strategy
Bob Citron was implementing a big bet that interest
rates would fall or stay low.

The $7.5 billion of investor equity was leveraged into
a $20.5 billion portfolio.

Through reverse repurchase agreements, Citron
pledged his securities as collateral and reinvested the
cash in new securities, mostly 5-year notes issued by
government-sponsored agencies such as ``Fannie
Mae''.

134
Portfolio Strategy
The portfolio leverage magnified the effect of
movements in interest rates.

To increase bond return
Increase duration
Leverage the portfolio

100
1
100 A
+
=
A
r
r
D
P
P
Bond Return

135
Portfolio Strategy
Consider a 8% yield, 8% coupon 5 year note. The duration of this
bond is 4 years

Assume for instance that investors put $100 million in a portfolio. This
can be used to buy the 5-year note.

Next, the note can be pledged as collateral (in a reverse repo in
exchange) for cash.

The portfolio manager has the cash but is obligated to purchase back
the note at a fixed price in the future, and therefore is still exposed to
price movements.

136
Portfolio Strategy
In the meantime, the cash can be used to invest in
another $100 million 5-year note. This process can
be repeated a second time, for a total holding of $300
million. As the initial investment was only $100
million, the leverage ratio is 3:1. Therefore, any price
movement will be accentuated by a factor of 3. In
other words, the portfolio duration is now

million r
r
P
million r
r
P
100 $
1
12
300 $
1
4
A
+
= A
A
+
= A

137
Portfolio Strategy
Relative to the initial $100 million investment, the
duration is now of 12 years.

Note : The duration of a 8% yield, 8% coupon, 30
year note is 11.26 years

138
Portfolio Strategy
The risk of the 3:1 leverage portfolio is therefore
similar to that of a 30-year bond.

The duration was further amplified by the use of
structured notes. These are securities whose coupon,
instead of being fixed, evolves according to some
pre-specified formula. These notes, also called
derivatives, were initially blamed for the loss but were
in fact consistent with the overall strategy.

139
Portfolio Strategy
Citron's main purpose was to increase current income by
exploiting the fact that medium-term maturities had higher yields
than short-term investments.

On December 1993, for instance, short-term yields were less
than 3%, while 5-year yields were around 5.2%.

With such a positively sloped term structure of interest rates, the
tendency may be to increase the duration of the investment to
pick up an extra yield. This boost, of course, comes at the
expense of greater risk.

140
Portfolio Strategy

141
Portfolio Strategy
The strategy worked fine as long as interest rates
went down. In February 1994, however, the
Federal Reserve Bank started a series of six
consecutive interest rate increases, which led to a
bloodbath in the bond market. The large duration
led to a $1.6 billion loss.

142
Portfolio Strategy

143
Introduction to VAR
VAR is the maximum loss over a target horizon such that
there is a low, prespecified probability that the actual
loss will be larger.

a bank might say that the daily VAR of its trading
portfolio is $35 million at the 99% confidence level.

In other words, there is only one chance in a hundred,
under normal market conditions, for a loss greater than
$35 million to occur.

144
Introduction to VAR
This single number summarizes the bank's exposure to
market risk as well as the probability of an adverse
move. As importantly, it measures risk using the same
units as the bank's bottom line---dollars.

Shareholders and managers can then decide whether
they feel comfortable with this level of risk. If the answer
is no, the process that led to the computation of VAR can
be used to decide where to trim risk.

145
JP Morgan Riskmetrics
Every afternoon, J.P. Morgan takes a
snapshot of its global trading positions to
estimate its Daily-Earnings-at-Risk (DEAR),
which is a VAR measure that Morgan defines
as the 95% confidence worst-case loss over
the next 24 hours due to adverse market
movements.

Source : This section draws on material provided by JP Morgan at
www.riskmetrics.com

146
This definition of VAR
uses a 5% risk level (95%
confidence). You would
anticipate that losses
exceeding the VAR
amount would occur 5%
of the time (or losses less
than the VAR amount
would occur 95% of the
time).

147

148
Parameters for VaR analysis

(a) Confidence level or probability of loss associated
with VaR measurement. Generally range between
90% and 99%. RiskMetrics assumes 95% confidence

149

(b) Forecast horizon - Active financial institutions (e.g.,
banks, hedge funds) consistently use a 1-day forecast
horizon for VaR analysis of all market risk positions.
On the other hand, investment managers often use a
1-month forecast window, while corporations may
apply quarterly or even annual projections of risk.

150

(c) Base currency - typically the currency of equity
capital and reporting currency of a company. For
example, Bank of America would use USD to
calculate and report its worldwide risks, while the
United Bank of Switzerland would use Swiss francs.

151
VAR and DEAR

For a 10 day VAR, N = 10
For a monthly VAR, N = 21
For a weekly VAR, N = 5
For a 1 day VAR, N=1 and VAR = DEAR
N DEAR VAR =

152
VAR formulas (assuming 1 day horizon)

Equity positions

VAR
t
= V
t
* 1.65o
t

The market risk of the stock, VAR
t
, is defined as the
market value of the investment in that stock, V
t
,
multiplied by the price volatility estimate of that stocks
returns,1.65o
t

153
VAR formulas

Forex positions

VAR
t
, = V
t
* 1.65o
t

The market risk of the foreign exchange position, VAR
t
,
is defined as the market value of the forex position, V
t
,
multiplied by the forex volatility estimate of that
exchange rate changes,1.65o
t

154
VAR formulas
Fixed Income positions

VAR
t
, = V
t
* MD * 1.65o
t

The market risk of the fixed income position, VAR
t
, is defined as the
market value of the fixed income position, V
t
, multiplied by the
modified duration and yield volatility estimate due to interest rate
changes,1.65o
t

MD * 1.65o
t
is also called price volatility

155
VAR formulas and confidence levels
All the above formulas are applicable at a confidence level of 95%.
For 90% and 99% confidence levels, the corresponding scaling
factors are 1.28 and 2.33 respectively, instead of 1.65.

156
Application to real world data

157

158

159

160

161

162

163

164

165

166

167
Partial Volatility file
AUD.XS,0.659750,0.940,0.884248,NC
USD.Z05,2.346629,0.940,0.613691,4.805255
USD.SE,933.220000,0.940,1.747910,NC

3 Asset classes in the portfolio
Australian Dollar
US Govt Bonds 5 year maturity
US Stock Index

For simplicity, assume that the asset position in the books for all
the 3 classes is USD 1 million each.

168
Partial Correlation File
AUD.XS.USD.Z05,0.181986
AUD.XS.USD.SE,-0.192277
USD.Z05.USD.SE,-0.142311

169
Calculating the individual position VARs
Assume 95% confidence level.

AUD forex position
VAR = 1,000,000 * 1.65 * (0.884248/100)
= 14,590.092 USD

US govt bond position
VAR = 1,000,000 * 1.65 * (0.613691/100)
= 10,125.902 USD

US market Equity position
VAR = 1,000,000 * 1.65 * (1.747910/100)
= 28,840.515 USD

170
VAR of the portfolio
The VAR of the portfolio is =
=14,590.092 +10,125.902 + 28,840.515 USD
= 53,556.509 USD

True
False

171
Aggregating VAR Estimates
Cannot simply sum up individual VARs.

In order to aggregate the VARs from individual exposures
we require the correlation matrix.

Three-asset case:
VAR portfolio = [VAR
a
2
+ VAR
b
2
+ VAR
c
2
+ 2
ab

VAR
a
VAR
b
+ 2
ac
VAR
a
VAR
c
+ 2
bc
VAR
b

VAR
c
]
1/2

172
Aggregating VAR Estimates
VAR portfolio =

[(14,590)
2
+ (10,126)
2
+ (28,840)
2
+ 2*0.182 14,590
10,126 + 2*-0.192 14,590 28,840 + 2*-0.142 10,126
28,840]
1/2

VAR = 30,925.89 USD

Note that the principle of diversification reduces the VAR of
the portfolio

173
Historic or Back Simulation
Advantages:

Simplicity
Does not require normal distribution of returns
(which is a critical assumption for RiskMetrics)
Does not need correlations or standard deviations
of individual asset returns.

174
Historic or Back Simulation
Basic idea: Revalue portfolio based on actual prices
(returns) on the assets that existed yesterday, the
day before, etc. (usually previous 500 days).
Then calculate 5% worst-case (25
th
lowest value of
500 days) outcomes.
Only 5% of the outcomes were lower.

175
Monte Carlo Simulation
To overcome problem of limited number of observations,
synthesize additional observations.
Perhaps 10,000 real and synthetic observations.

Employ historic covariance matrix and random number
generator to synthesize observations.
Objective is to replicate the distribution of observed
outcomes with synthetic data.

176
Large Banks: BIS versus RiskMetrics
In calculating VAR, adverse change in rates defined as 99th
percentile (rather than 95th under RiskMetrics)

Minimum holding period is 10 days (means that RiskMetrics daily
VAR multiplied by \10.

Capital charge will be higher of:
Previous days VAR (or todays VAR )
Average Daily VAR over previous 60 days times a
multiplication factor > 3.

177
Back to Orange County
By liquidating the pool in December 1994, the county
locked in a loss of $1.6 billion.

Unfortunately, soon after the liquidation, interest rates
went back down by about 2.5 percent.

The liquidation entailed a huge opportunity loss, on
the order of $1.4 billion. This opportunity loss,
however, is in hindsight. Very few market observers
expected interest rates to go down so fast in 1995.
Reproduced from Source : Philippe Jorion's Orange County Case: Using Value at Risk to Control
Financial Risk

178

179
The county, fortunately, fared much better than had been
feared. Disaster was narrowly avoided as schools were paid
back just enough to avoid default; the county was able to extend
its debt over 20 years. Perhaps the greatest help came from the
private sector, in the form of a booming economy leading to
greater sales tax receipts and payments by the State.

Since then, the county has filed a recovery plan centered on a
$800 million bond issue, in which creditors would be fully repaid.
Some county expenses were cut, or transferred to other
agencies. Investors in the pool (cities, schools, agencies and the
county itself), however, are still facing a $800 million shortfall.
Source : Philippe Jorion

180
Back to Orange County- Recovery Plan
Source :Orange County Webpage

181
It is unlikely the $1.6 billion loss will ever be
recovered. So far, the county has settled a $2 billion
lawsuit against Merrill Lynch, its principal broker, for
$437 million. (Incidentally, this number is very close
to the fall in the market value of Merrill stock on the
day the bankruptcy was announced.) The county has
recovered so far $650 million, a far cry from the $1.6
billion loss.

182
Source : Merrill Lynch Webpage

183
Had a VAR requirement been imposed on Citron, he
would have been forced to tell investors in the pool:

"Listen, I am implementing a triple-legged repo strategy
that brought you great returns so far. However, I have to tell
you that the risk of the portfolio is such that, over the
coming year, we could lose at least $1.1 billion in 1 case
out of 20."

Source : Quoted from Phillippe Jorion, In Defense of VAR
1997--Derivatives Strategy

184
The advantage of such a statement is that this
quantitative measure is reported in units that anybody
can understand--in dollars. Whether the portfolio is
leveraged or filled with derivatives, its market risk can be
conveyed to a non-technical audience effectively.

It is fairly clear that, had such an announcement been
made, investors would have been more careful about
investing in the pool (or would have disciplined Citron). In
addition, it would have been harder for investors to claim
they were misled. Fewer lawsuits would have been filed.
Source : Quoted from Phillippe Jorion In Defense of VAR
1997--Derivatives Strategy

185
Module 4: Credit Risk
Credit Risk
The case of Worldcom

Calculating the return on a loan

KMV Merton Model

Credit Scoring models Altmans Z

JP Morgan Credit metrics

Loan Portfolios

187

1998

WorldCom merges with MCI Communications, a
deal worth $40 billion, the largest in history at
that time. At the end of 1998, debt was $32.8
billion. Share price $71.75

2000

Regulators block a proposed merger with Sprint.
At the end of 2000, the share price had decreased
to $14

The SEC inquires about accounting procedures
and loans to officers

Source : Moodys KMV Corporation

188

April 3, 2002

WorldCom cuts 3,700 jobs.

Standard & Poors, Moodys and Fitch all cut
WorldComs credit ratings

CEO Bernard Ebbers resigns; Vice Chairman John
Sidgmore becomes CEO. Share price is $2.47,
falling 27% from the previous week
Source : Moodys KMV Corporation

189

May 9-10, 2002

Moodys and Standard & Poors both cut WorldComs
rating to junk status

Market cap falls to $4.7 billion while liabilities remain
at about $31 billion, the same level of debt as 3 years
ago

May 13, 2002

S&P 500 Index removes WorldCom

S&P agency rating is BB

190
May 15-June 5, 2002

WorldCom negotiates with lenders and announces
cost-cutting moves

June 25, 2002

CFO is fired for improper accounting of some $4
billion in expenses

Market cap falls another 47% in one week

191
July 15, 2002 Default

On the brink of bankruptcy, WorldCom misses
three interest payments totaling $79 million

July 17, 2002

S&P downgrades WorldComs rating to D

July 21, 2002 Bankruptcy

WorldCom files for Chapter 11, surpassing Enron
as the largest bankruptcy ever in the U.S.

192

193
EDF credit measures are actual probabilities, not
credit scores. A company with a current EDF credit
measure of 2% has a 2% probability of defaulting
within the next twelve months. That is, out of 100
companies with a 2% EDF credit measure, we would
expect, on average, that 2 would default over the
next twelve months. Also, a company with a 2% EDF
credit measure is 10 times more likely to default than
a firm with a 0.20% EDF credit measure.

194
Credit risk- Return on a loan
Consider a simple loan to be paid back at the
end of the year. Let k be the annual interest rate
(including fees), and p be the probability of
default.

Assume for now that if the borrower defaults,
you get zero. Then the expected gross return is:
(1-p)(1+k)

195
In practice, recovery is not zero in the event of default.
Studies suggest, for example, that banks get about 60
cents on the dollar if a borrower goes bust. Thus, we can
alter the formula for the expected gross return to take
this into account:

196
We can write down a break-even relationship that
says the interest rate on the loan (k) has to be high
enough so that the loans expected return is greater
than the return required to compensate the bank for
funding the loan (call the required gross return 1+r).
To make things a little more general, let the recovery
rate be s (for salvage value):

197
Example
Suppose that you have made a 1-year loan for $100
with a contractual interest rate of 10%. The required
return for this borrower is 6%, the probability of
default is 7.3% and the recovery rate is 50%.
Compute the expected return on this loan. What is
the NPV of the loan?

198
Example
Now, suppose the loan has an interest rate of
12% and everything else stays the same.
How profitable is the loan now?

199

200
Quantitative Approaches to Measuring Credit Risk

The first approach (Altmans Z) is a statistical
measure of default probability based on
studies that link observable characteristics to
past defaults. These models are know these
days as credit scoring models.

Personal finance example ; FICO scores

201

The second approach is a ratings-based model
developed by JP Morgan in the mid 1990s, prior to its
merger with Chase. This model is called
CreditMetrics. It is based on the idea that gains and
losses on fixed income securities (loans and bonds)
occur, in large part, when companies are up and
down-graded by the ratings agencies. This approach
is a close cousin conceptually to the VAR models
described earlier for market risk.

202

The last model, developed by a consulting
firm called KMV, is an option-based
approach in which the value of loans (bonds)
depends on the market value of the issuing
firms assets.

203
The KMV- Merton Model

204
Options and Corporate Finance
Consider a firm that will liquidate in 1 year, with $10
million of 1-year zero coupon debt outstanding.

If the firm is worth less than $10 million in 1 year, the
debt holders receive everything and the stockholders
receive nothing. Otherwise, the debt holders receive
$10 million and the stockholders receive the residual.

205
Options and Corporate Finance : Equity and Debt Payoffs
Firm value
10 Firm value
10
Equity Debt
Equity: a call option on the firm
Debt: firm - call = risk-free bond - put
206
Black-Scholes Formula applied to the firm
t d d
t
t r X V
d
d N e X d N V V
A
A
A A
rt
A E
o
o
o
=
+ +
=
=

1 2
2
2
1
1
2 1
) ( ) / ln(
) ( ) (
V
E
market value of firms equity
X Book value of debt due at time t
r -- risk-free rate o
A
-- volatility of asset returns
N( ) -- normal cdf
1

207
The KMV- Merton Model
Equity volatility and asset volatility of the firm are
related by the following expression
2

208
Distance to Default

209
Distance to Default
Distance to Default in the Model

210
Expected Default Frequency
EDF = N(-DD) in the Model

EDF credit measures are actual probabilities, not
credit scores. A company with a current EDF credit
measure of 2% has a 2% probability of defaulting
within the next twelve months. That is, out of 100
companies with a 2% EDF credit measure, we
would expect, on average, that 2 would default
over the next twelve months. Also, a company with
a 2% EDF credit measure is 10 times more likely
to default than a firm with a 0.20% EDF credit
measure.

211
Expected Default Frequency

In the B-S Model, to calculate DD, we need V
A
and o
A

We can solve non linear equations 1 and 2
simultaneously to get these variables, setting t=1

We can also approximate by using r

With this we can get an estimate of EDF, the probability
that the firm would default over the next year

212
Expected Default Frequency - KMV

According to KMV, KMVs empirical default
distribution that is used to map distance-to-default
to EDF credit measures is built from publicly listed
defaults in the United States.

The empirical mapping is claimed to be more
accurate than the normal distribution

213
Application of the KMV Merton Model
Let us calculate EDF for Worldcom in 2001
Source : wrds.wharton.upenn.edu for stock prices

214
Application of the KMV Merton Model
Source : wrds.wharton.upenn.edu for stock prices
6
280
342
405
464
528
A B C D E F
DATE Shares o/s Price Return sigma(equity) Annualised Sigmaequity
20001229 2881195 14.06 0.0090 4.41% 69.99%
20010330 2886874 18.69 -0.0197 4.96% 78.72%
20010629 2896498 14.20 -0.0070 4.78% 75.92%
20010928 2965789 15.04 0.0387 4.74% 75.23%
20011231 2960671 14.08 -0.0243 3.80% 60.38%

215
Risk free rate data
Source : http://www.federalreserve.gov/releases/h15/data.htm
216
Risk free rate data

217
Data on Liabilities-COMPUSTAT

218
Quarterly Data
1
2
3
4
5
6
7
A B C D E F
End of End of
Year Quarter Stock Price ST_Liab LT_Debt Shares
2000 4 14.06 7200 12494 2881195
2001 1 18.69 8886 11682 2886874
2001 2 14.20 3264 22973 2896498
2001 3 15.04 1109 24568 2965789
2001 4 14.08 172 24533 2960671

219
Model Inputs
2
3
4
5
6
7
8
9
10
A B H I J K L
Raw Data Model Input Model Input Model Input Model Input
Beg of Beg of
Year Quarter Equity sigma(E) r(1yr) X PV(X)=Xe
-rT
2001 1 40516.805 69.99% 5.11% 13447.0 12777.1
2001 2 53948.458 78.72% 4.10% 14727.0 14135.4
2001 3 41130.271 75.92% 3.74% 14750.5 14209.0
2001 4 44605.466 75.23% 2.47% 13393.0 13066.2
2002 1 41686.247 60.38% 2.17% 12438.5 12171.5

220
Model Output
4
5
6
7
8
9
10
11
A G H I J K L M N O P
Starting Value Starting Value Model output1:A Model output 2:sigma(A)
A Sigma A
Iteration d1 d2 N(d1) N(d2) MV of Assets Volatility of assets Diff (Assets) Diff(Vol Assets)
1 53963.805 52.55% 3.004 2.479 0.999 0.993 53280.625 53.29%
2 53280.625 53.29% 2.946 2.413 0.998 0.992 53278.619 53.31% -2.006 0.02%
3 53278.619 53.31% 2.945 2.412 0.998 0.992 53278.572 53.31% -0.047 0.00%
4 53278.572 53.31% 2.945 2.412 0.998 0.992 53278.571 53.31% -0.001 0.00%
5 53278.571 53.31% 2.945 2.412 0.998 0.992 53278.571 53.31% 0.000 0.00%
1
2
3
A B
Beg of Beg of
Year Quarter
2001 1
13
14
B C D
Distance to Default 2.412
EDF 0.79373%

221
Model Output
17
18
19
A B
Beg of Beg of
Year Quarter
2001 2
29
30
B C D
Distance to Default 2.200
EDF 1.39201%
20
21
22
23
24
25
26
27
A G H I J K L M N O P
Starting Value Starting Value Model output1:A Model output 2:sigma(A)
A Sigma A
Iteration d1 d2 N(d1) N(d2) MV of Assets Volatility of assets Diff (Assets) Diff(Vol Assets)
1 68675.458 61.84% 2.865 2.247 0.998 0.988 68051.451 62.53%
2 68051.451 62.53% 2.826 2.201 0.998 0.986 68048.040 62.55% -3.411 0.02%
3 68048.040 62.55% 2.825 2.200 0.998 0.986 68047.937 62.55% -0.103 0.00%
4 68047.937 62.55% 2.825 2.200 0.998 0.986 68047.935 62.55% -0.002 0.00%
5 68047.935 62.55% 2.825 2.200 0.998 0.986 68047.935 62.55% 0.000 0.00%

222
Capital Structure Arbitrage
Assume a zero coupon bond for the debt of the firm

We know that
A = Z(A,t) + E(A,t)

where Z(A,t) is the zero coupon bond issued by the firm
and E(A,t) is the value of equity

Let us say the bond was underpriced in the market

An arbitrage strategy is to buy the underpriced bonds and
replicate a short bond position using equity to make a delta
neutral position

The portfolio is

223
Capital Structure Arbitrage
The portfolio is
Buy the bond Z(A,t)
short AE(A,t) in equity
Borrow Z(A,t) - AE(A,t) at risk free rate r

From Mertons model, E(A,t) = Black-Scholes, call option value.
Also, recall A = Z(A,t) + E(A,t)
224
JP Morgan Creditmetrics

225
JP Morgan Creditmetrics
Source : Creditmetrics Technical document

226
JP Morgan Creditmetrics vs. Risk metrics
Riskmetrics :
If tomorrow is a bad day how much will I
lose on tradable assets such as stocks,
bonds and equities?

Creditmetrics :
If next year is a bad year how much will I
lose on my loans and loan portfolio?

227
JP Morgan Creditmetrics : Application
Step 1 : Rating Migration

Consider a single BBB rated bond (Senior
Unsecured, $100 million, 6% annual interest)
which matures in five years. For the purposes of
this example, we make two choices.
The first is to utilize the Standard & Poors rating
categories and corresponding transition matrices.

The second is to compute risk over a one year
horizon.

228
Therefore we are interested in characterizing the
range of values that the bond can take at the end
of that period. Let us first list all possible credit
outcomes that can occur at the end of the year
due to credit events:

the issuer stays at BBB at the end of the year;
the issuer migrates up to AAA, AA, or A or down to BB,
B, or CCC; or
the issuer defaults.

229
Each outcome above has a different likelihood
or probability of occurring. We derive these from
historical rating data.

That is, for a bond starting out as BBB, we know
precisely the probabilities that this bond will end
up in one of the seven rating categories (AAA
through CCC) or defaults at the end of one year.

These probabilities are shown in the Table .

230

231
Step 2 : Valuation

We determine the values at the risk horizon for
these credit quality states. Value is calculated
once for each migration state; thus there are (in
this example) eight revaluations in our simple
one-bond example.

232
Step 2 : Valuation

These eight valuations fall into two categories.

First, in the event of a default, we estimate the
recovery rate based on the seniority classification of
the bond.

233
Step 2 : Valuation

These eight valuations fall into two categories.

Second, in the event of up(down)grades, we
estimate the change in credit spread that
results from the rating migration. We then
perform a present value calculation of the
bonds remaining cash flows at the new yield to
estimate its new value.

234
Step 2 : Valuation

First, in the event of a default, we estimate the
recovery rate based on the seniority classification of
the bond.

235
Step 2 : Valuation

Second, in the event of up(down)grades, we
estimate the change in credit spread that
results from the rating migration.

1. Obtain the forward zero curves for each rating
category. These forward curves are stated as of
the risk horizon and go to the maturity of the bond.

2. Using these zero curves, revalue the bond's
remaining cash flows at the risk horizon for each
rating category.

236
Step 2 : Valuation

1. Obtain the forward zero curves for each rating
category. These forward curves are stated as of
the risk horizon and go to the maturity of the bond.

237
Step 2 : Valuation

2. Using these zero curves, revalue the bond's
remaining cash flows at the risk horizon for each
rating category.

First, let us determine the cash flows which result from
holding the bond position. Recall that our example bond
pays an annual coupon at the rate of 6%. Therefore,
assuming a face value of $100, the bond pays $6 each at the
end of the next four years. At the end of the fifth year, the
bond pays a cash flow of face value plus coupon, which
equals $106 in this case.

238
Step 2 : Valuation

Now, let us calculate the value V of the bond at the
end of one year assuming that the bond upgrades to
single-A. This calculation is described by the formula
below:

239
Step 2 : Valuation

To calculate the value of the bond in a rating
category other than single-A, we would substitute
the appropriate zero rates from the table. After
completing these calculations for different rating
categories, we obtain the values in Table
below:

240
Step 2 : Valuation

241
Step 3 : Credit risk estimation

242

243
Calculation of percentile level as a measure of credit risk

Assuming Normal Distribution

5 percent VAR = 1.65 * o = $4.93

1 percent VAR = 2.33 * o = $6.97

244
Calculation of percentile level as a measure of credit risk

Assuming Actual Distribution

6.77 percent VAR = 93.23% of actual distribution
= $107.09-$102.02=$5.07

1.47 percent VAR = 98.53% of actual distribution
= $107.09-$98.10=$8.99

You can find the 1% VAR by interpolation (linear)

245

246
JP Morgan Creditmetrics : Loan Portfolios
Add a second bond : a A rated 3 year bond, 5% annual
coupons Senior unsecured, to the earlier portfolio of 5 year
BBB bond.
Step 1 : Rating Migration

247
Step 2 : Valuation

248
Step 2 : Valuation

249
Step 2 : Valuation

250

Mean = $213.63
Standard Deviation = $3.35

251

99% VAR under Normal Distribution = 2.33 * $3.35 = $7.81
million. The loan portfolio face value is $ 200 million.

Compare this against a 99% VAR for a $100 million BBB
loan of $6.97 million

252
99% VAR under Actual Distribution :
99% Worst loan value for the portfolio is $ 204.40 million.
Thus, the unexpected change in portfolio from its mean
value is $213.63 million - $204.40 million = $9.23 million.

Compare this against a 99% VAR for a $100 million BBB
loan of $14.80 million

253
Module 5: Off Balance Sheet
Banking
Cash Flow Schematic for a Static Pass-Through
Principal and
Interest -
Servicing Fee
Principal and
Interest on
Loans
and Interest
Principal
Payments to Make Up Shortfalls Created by
Delinquencies and Defaults Insurance Fee
Paid to Credit
Enhancer
Grantor Trust
Collection Account
Investors Who
Hold
Certificates
Credit
Enhancer
Originator/Serv
icer
Borrowers
Loans
Revenue from
sale of certificates
Revenue from Sale of Certificates
255
The incentives and mechanics of Pass-through Security
Creation

The creation of a GNMA pass-through security

Bank originates 1,000 new $100,000 mortgages, $100 million total size
. Each has 30 year maturity, 12 % coupon. FHA insured. Financed by
deposits and equity.

Bank faces capital adequacy requirements. Risk adjusted value of
residential mortgages is 50% of face value, and the risk-based capital
requirement is 8%, bank capital needed to back the mortgage portfolio:
Capital requirement= $100 mill. X .5 X .08 =$4 million

Bank also faces reserve requirements of 10%. Needs $96 million in
deposits after reserves, and the $4 million in equity capital.
256
Balance sheet may look like:

Assets Liabilities

Cash Reserves $10.66 Demand Deposits $106.66
Long-term mortgages 100.00 Capital 4.00

Bank also has to pay insurance premium to FDIC (assuming 27
basis points)

$106.66 million X .0027 = $287,982
These amount to 3 levels of regulatory taxes (incentive enough?):
1. Capital requirements
2. Reserve Requirements
3. FDIC insurance premiums.
257
Two more problems:
Duration mismatch (core DD generally have a duration of less than 3
years, whereas mortgages depending on prepayment assumptions
normally have durations of at least 4.5 years)
Illiquidity exposure. May lead mortgage asset fire sales if large
unexpected DD withdrawals happen.

Bank can deal with the above by a variety of tools, lengthening
durations, swaps, etc.. BUT regulatory burden stays,
By contrast:
creating GNMA pass-through securities can largely resolve the
duration, and illiquidity risk problems and reduce the burden of
regulatory taxes.
Bank packages the loans and places them with a third party,
removing them from the B/S. Next gets the GNMA guarantee for a
fee, and arranges to service the mortgages for a fee.
258
The GNMA pass-through securities are issued and sold in the
capital markets. These are desirable to investors as they are
FHA/VA insured against default by homeowners, and GNMA
insured against default by the originating bank or the trustee.

The relevant rates:
Mortgage coupon rate 12%
minus
servicing fee 0.44
minus
GNMA insurance fee 0.06
equals
GNMA pass-through bond coupon 11.50%
Barring prepayment, the investor receives a constant stream of
monthly payments.
259
Post-securitization Balance Sheet of the FI:

Assets Liabilities

Cash reserves $10.66 Demand Deposits $106.66
Cash proceeds from
mtge securitization 100.00 Capital 4.00

Dramatic change.
1. Illiquid mortgages replaced by cash.

2. Duration mismatch has been reduced.
260
Dramatic change.

3. Regulatory taxes reduced, e.g. capital requirements reduced as cash
has 0 risk-adjusted asset value.

4. Reserve requirements and insurance (FDIC) fees will also be reduced if
FI retires some DD.

5. More importantly, The FI can generate new mortgages with the new
cash and securitize those. Act like a broker.

6. Fee income becomes more important. BUT, prepayment risk may
reduce demand for MBSs.
261
Example of a GNMA pass through
Bank has 1000 new mortgages
Average size of each mortgage = $100,000
30 years, 12% interest rate
Bank servicing fee = 44 basis points
GNMA insurance fee = 6 basis points

262
Payment to bank from the mortgage pool
n = number of payments = 12 * 30 = 360
r = interest rate = 12%/12 = 1% per month
PV = 100,000,000$ = 1000 * 100,000
PMT = ?

263
C C
C
0 1 2 3
i%
Present Value of an Annuity
264
Present Value of an annuity

265
Payment to bank from the mortgage pool
PAF (1%,360) = 1/(0.01) { 1- (1/(1+.01)
360
)}
97.21833
PMT = 100,000,000/97.21833 = $1,028,612.60

This is the amount received from the borrowers
by the bank

266
Payment to GNMA, Servicing fee to bank
Since the payment retained is 44+6 = 50
basis points, the payments passed through
provides a return of 11.50% to bond holders

The PMT passed through using the same
formula as above but with r = 11.50%/12 is
$990,291.43

267
Payment to GNMA, Servicing fee to bank
The difference between the 2 payments is
38,321.17 $

This shared in the ratio 44/50 and 6/50 between
the bank and GNMA

The bank gets $33,722.63 (over the entire life of
the mortgage in PV terms) and GNMA gets
$4,598.54

268
Assumptions underlying these calculations
Mortgage rates remain constant over time

There are no prepayments
Refinancing
Housing turnover

269
Fixed-Rate Mortgage Amortization
Each monthly mortgage payment has two
separate components:
payment of interest on outstanding mortgage
principal
pay-down, or amortization, of mortgage principal

The relative amounts of each component
change throughout the life of the mortgage.

270
Suppose a 30-year $100,000 mortgage loan is financed
at a fixed interest rate of 8%.
Monthly payment =
( )
76 . 733 $
12 08 . 1 1 1
12 08 . 000 , 100 $
12 30
=
+

In the first month,

Interest payment = $100,000 .08/12 = $666.67
Principal payment = $733.76 $666.67 = $67.09
New principal = $100,000 $67.09 = $99,932.91
In the second month,
Interest payment = $99,932.91 .08/12 = $666.22
Principal payment = $733.76 $666.22 = $67.54
New principal = $99,932.91 $67.54 = $99,865.37

271
Mortgage amortization can be described by
an amortization schedule, which states the
scheduled principal payment, interest
payment, and remaining principal owed in
any month.

272

273
274
Outline
Prepayment Modelling
Price Quotes

275
276
Fixed-Rate Mortgage Prepayment & Refinancing
277
Fixed-Rate Mortgage Prepayment & Refinancing
278

279
PSA Mortgage Prepayment Model (Model 1)
Mortgage prepayments are typically
described by stating a prepayment rate,
which is the probability that a mortgage will
be prepaid in a given year.

Conventional industry practice states
prepayment rates using a model specified by
the Public Securities Association (PSA).
Prepayment rates are stated as a percentage of a
PSA benchmark.

280
Prepayment Model
The prepayment rate is called the prepayment
speed or speed.

Investors and issuers apply different
prepayment models in analyzing MBS. Most
models, though, are compared to a benchmark
model or rate.

The benchmark model is the one provided by
the Public Securities Association (PSA).

281
PSA Mortgage Prepayment Model
In the PSA model, the rates are conditional on the
age of the mortgages in the pool. They are
conditional prepayment rates (CPRs).

For seasoned ( > 30 months old) mortgages, the
CPR is a constant (6% annually for 100% of the PSA
benchmark (100 PSA)).

For unseasoned (< 30 months old) mortgages, the
CPR rises steadily in each month until it reaches an
annual rate of 6% (for 100 PSA) in month 30.

282
By convention, the probability of prepayment
in a given month is stated as a single monthly
mortality (SMM).
SMM = 1 (1 CPR)
1/12

283
Estimation of CPR for month (t): (30 year
mortgage)

CPR for month 5:
If t then CPR
t
s =
|
\
|
.
| 30 06
30
, .
If t then CPR > = 30 06 , .
CPR
SMM
=
|
\
|
.
| =
= =
. .
[ . ] .
/
06
5
30
01
1 1 01 000837
1 12
Prepayment Model

284

285
Prepayment Model
PSAs model can be defined in terms of different
speeds by expressing the standard model (100%
PSA) in terms of higher or lower percentage:
150% or 50%.

Example: In a period of lower rates, the PSA
model could be 150% and in a period of higher
rates it could be 50%.

286
Prepayment Model
The estimated monthly prepayment is

Example: IF CPR = 6%, beginning-of-the-month
balance = $100M, scheduled principal for month =
$3M, then the estimated prepaid principal for the
month would by $0.499M:
SMM
Monthly prepaid principal M M M
= =
= =
1 1 06 005143
005143 499
1 12
[ . ] .
. [$100 $3 ] $0.
/
Monthly prepayment SMM Beginning of month balance Sch prin for month = [ . ]

287
The average life of a mortgage in a pool is
the average time for a single mortgage in the
pool to be paid off, either by prepayment or
by making scheduled payments until maturity.
For a pool of 30-year mortgages,
Prepayment Schedule Average Mortgage Life (years)
50 PSA 20.40
100 PSA 14.68
200 PSA 8.87
400 PSA 4.88

288
PSA Example
1
2
3
4
5
A B C D E
Mortgage Portfolio $100.0000000 million $
Coupon 9.0000000% 0.7500000% permonth
Maturity 360.0000000 months
Prepayment 100.0000000% PSA

289
PSA Example
7
8
9
10
A B C D E F
Month OpenBalance Payment Principal Interest CPR
0 $100.00000
1 $100.00000 $0.8046226 $0.0546226 $0.7500000 0.002000
2 $99.92870 $0.8044884 $0.0550231 $0.7494653 0.004000
7
8
9
10
A G H I J
Month SMM Prepaid principal Cash flows Closing balance
0 100
1 0.000167 $0.0166729 $0.8212955 $99.92870
2 0.000334 $0.0333524 $0.8378408 $99.84033

290
PSA Example
First Months CF:
M
M
pmt 8046 . 0 $
12 / 09 .
)) 12 / 09 (. 1 /( 1 1
100 $
360
=
(
+
=
payment mortgage monthly pmt =

291
First Months CF:
Interest M M =
|
\
|
.
| =
.
$100 $0.
09
12
75
Scheduled principal M M M = = $0. $0. $0. 8046 75 0546
Estimated prepaid principal
CPR
SMM
prepaid principal M M
:
. .
[ . ] .
. [$100 $. ] $.
/
=
|
\
|
.
| =
= =
= =
1
30
06 002
1 1 002 0001668
0001668 05462 01667
1 12
CF M M M M
1
75 0546 01667 821295 = + + = $0. $0. $0. $0.
PSA Example

292
Second Months CF:
M
M
mt p 804488 . 0 $
12 / 09 .
)) 12 / 09 (. 1 /( 1 1
9287 . 99 $
359
=
(
+
=
Beginning Balance for month
M M M
2
0546 01667 9287
:
$100 $0. $0. $99. =
PSA Example

293
Second Months CF:
Interest M M =
|
\
|
.
| =
.
$99. $0.
09
12
9287 749465
Scheduled principal M M M = = $0. $0. $0. 804488 749465 055023
Estimated prepaid principal
CPR
SMM
prepaid principal M M
:
. .
[ . ] .
. [$99. $. ] $.
/
=
|
\
|
.
| =
= =
= =
2
30
06 004
1 1 004 0003339
0003330 9287 055023 033352
1 12
CF M M M M
2
7494 055023 033352 837840 = + + = $0. $0. $0. $0.
PSA Example

294
Price Quotes
The prices of MBS are quoted as a percentage
of the underlying mortgage balance.
The mortgage balance at time t (F
t
) is quoted as
a proportion of the original balance. This is
called the pool factor (pf):

pf
F
F
t
t
=
0

295
Price Quotes
Example: A MBS backed by a mortgage pool
originally worth $100M, a current pf of .92, and
quoted at 95 - 16 (Note: 16 is 16/32) would have
a market value of $87.86M:

F pf F
M M
t t
=
= =
( )
(. ) ($100 ) $92
0
92
Market Value M M = = (. ) ($92 ) $87. 9550 86

296
Price Quotes
The market value is the clean price; it does not take
into account accrued interest, ai. For MBS, accrued
interest is based on the time period from the
settlement date (two days after the trade) and the
first day of the next month.
Example: If the time period is 20 days, the month is
30 days, and the Coupon = 9%, then ai is $.46M:
ai M M =
|
\
|
.
|
|
\
|
.
| =
20
30
09
12
46
.
$92 $0.

297
Price Quotes
The full market value would be $88.32M:

The market price per share is the full market value
divided by the number of shares. If the number of
shares is 400, then the price of the MBS based on a
95 - 16 quote would be $220,080:
Full Mkt Value M M M = + = $87. $0. $88. 86 46 32
MBS price
M
M = =
$88.
$0.
32
400
2208

298
Value and Return
The value of a MBS is equal to the PV of
securitys CFs; thus, the value is a function of
the MBSs expected CFs and the interest rate.
In addition, for MBS the CFs are also dependent
on rates: a change in rates will change the
prepayment of principal and either increase or
decrease early CFs.
V f CFs R
MBS
= ( , )
CF f R = ( )

299
Value and Return
With CF a function of rates, the value of MBS is
more sensitive to interest rate changes than a
similar corporate bond. This sensitivity is known
as extension risk.
if R lower discount rate V
M
+ |
like any other bond
if R Increases prepayment V
Earlier CFs
M
+ |
|
:

300
Value and Return

if R higher discount rate V
M
| +
if R Decreases prepayment V
Earlier CFs
M
| +
+
:
Extension Risk

301
Stripped Mortgage Backed Securities
Stripped MBS were introduced by FNMA in
1986. Like CMOs, they are a derivative
product. They are formed by redirecting the
collaterals CFs into interest-only (IO) and
principal-only (PO) securities:

IO class receives just the interest on the
mortgages.
PO class receives just the principal.

302
Example of IOs and POs

Interest and
Scheduled Principal
Loan #1
Interest and
Scheduled Principal
Loan #2
Interest and
Scheduled Principal
Loan #3
Interest and
Scheduled Principal
Loan #4
Pooled Monthly Cashflow:
Interest
Scheduled Principal
Prepayments
Passthrough: $1 million par
Each loan: $250,000
Rule for Distribution of Cash Flow:
Pro Rata Basis
$250,000
$250,000
$250,000
$250,000
Each loan is $250,000
Total Pool Amount: $1 Million
Stripped Mortgage-Backed Security
Rules for Distribution of Cash Flows
Across Classes
Class
X
Y
Interest
All
None
Principal
None
All
303
PO Class:
The yield on PO bonds depends on the speed of the prepayment. The
faster the prepayment, the greater the yield.
Example: PO investors who paid $75M for a mortgage portfolio with a
principal of $100M would earn a higher yield if the $100M principal
were paid early (e.g., first years) than if it were spread out.
. 0 : int <
A
A
| +
| | | +
R
V
relation rate erest and price inverse
V rate discount lower R
V return prepayment R if
PO
PO
PO

304
IO Class:
IO investors receive interest on the outstanding principal. As a result,
they want prepayment to be slow.
For example, IO investors holding an IO claim on $400M, 7.5%
mortgage would receive $30M if the principal were paid immediately:
($400)(.075) = $30M. By contrast, if the principal were paid off by equal
increments over four years, the return would be $75M:
Year M M
Year M M
Year M M
Year M M
total M
1 075 0
2 075 5
3 075 0
4 075 7 5
75
($400 )(. ) $30.
($300 )(. ) $22.
($200 )(. ) $15.
($100 )(. ) $ .
$
=
=
=
=

305
Note: Since a rate decrease augments speed, it lowers the return on
an IO bond, causing its value to decrease. Whether IO bonds decrease
in response to a rate decrease depends on whether this effect
dominates the effect of lower discount rates on increasing value.
if R prepayment return V
R lower discount rate V
V
R
or
V
R
Thus it is possible that there is a
direct relation between value and
return for an IO bond
IO
IO
IO IO
+ | + +
+ |
> <
A
A
A
A
0 0
,
.

306

Example: Collateral: $100M, Maturity = 357,
Coupon = 8.25%, PT Rate = 7.5%, PSA = 165
Seasoning of the pool = 3 months
1
2
3
4
5
6
A B C D E
Mortgage Portfolio $100.0000000 million $
Coupon 8.2500000% 0.6875000% permonth
Maturity 357.0000000 months
Prepayment 165.0000000% PSA
Pass Through Rate 7.5000000% 0.6250000% permonth
Seasoning 3.0000000 months

307

Notes :
Month 0 is really month 3 because of the seasoning period.
Payment for month 1 is based on r = 8.25%/12; n = 357.
Payment for month 2 is based on r = 8.25%/12; n = 356.
Interest is for the IO and is based on (Open balance)*(7.5%/12)
Principal = Payment (Open balance * 8.25%/12)
CPR = (PSA/100)*(0.06*(month+3)/30) if month <=27;
= (PSA/100)*(0.06) if month > 27;
The rest of the calculations are as in the PSA model
7
8
9
10
A B C D E F G
Month OpenBalance Payment Principal Interest CPR SMM
0 $100.00000
1 $100.00000 $0.7527165 $0.0652165 $0.6250000 0.013200 0.001107
2 $99.82418 $0.7518834 $0.0655922 $0.6239012 0.016500 0.001386
7
8
9
10
A H I J K L
Month Prepaid principal Cash flows Closing balance PO IO
0 100
1 $0.1105990 $0.8008155 $99.82418 $0.17582 $0.6250000
2 $0.1382165 $0.8277098 $99.62038 $0.20381 $0.6239012

308
Option Models
Since the mortgages are insured against
default risk, the only risk investors are
exposed to is prepayment risk.

The risk premium for such risk is known as
the option adjusted spread (OAS).

309
Option Models
Use option pricing theory to figure fair yield
spread of pass-throughs over Treasuries.

Fair price on pass-through decomposable
into two parts
P
GNMA
= P
TBOND
- P
PREPAYMENT OPTION

Y
GNMA
= Y
TBOND
+ Y
OPTION

Option-adjusted spread between GNMAs and
T-bonds reflects value of the call option.

310
Option Model Approach : Example
We make the following simplifying assumptions

i) Borrowers only prepay due to refinancing
mortgages at a lower rate

ii) The current zero coupon yield curve for T bonds is
flat and the discount rate on Tbonds = 8%

iii) The mortgage coupon rate is 10% on an
outstanding mortgage pool with an outstanding
principal balance of $1,000,000. The mortgages have
a 3-year maturity and pay principal and interest only
once at the end of each year.

311
We make the following simplifying assumptions

iv) Mortgage loans are fully amortized and there is no servicing
fee

v) The current mortgage rate (y) is 9%. Interest rate movements
over time change maximum of 1% up or down each year. The
time path of interest rates follow a binomial process.

vi) Because of prepayment penalties and other refinancing costs,
mortgagees don't begin to prepay until mortgage rates, in any
year, fall 3% or more below the mortgage coupon rate for the
pool (10% in our example)

vii) With prepayments present, cash flows in any year can be
either the promised debt service, the promised debt service +
repayment of outstanding principal, or cash flow = 0 if all
mortgages have been prepaid or paid off in the previous year

312
Also, assume that the time path of mortgage interest rates over 3
years with the associated probabilities (p) is as given below
0
1 2 3
Period
9. 0 %
p=. 5
p=. 5
10 %
8%
p=. 25
p=. 25
p=. 25
p=. 25
11 %
9%
7%
12 %
10 %
8%
6%
p=. 12 5
p=. 12 5
p=. 12 5
p=. 12 5
p=. 25
p=. 25
Mor t gag e
co upon
ra t e

313
Step 1: Calculate PMT assuming no prepayment and servicing fee

Step 2: Calculate P
GNMA
assuming no prepayments, no default risk
and current mortgage rate y = 9%

P
GNMA
= $1,017,869

114 , 402 $
10 .
)) 10 (. 1 /( 1 1
000 , 000 , 1 $
3
=
(
+
= mt p
3 2
) 1 ( ) 1 ( 1 y
PMT
y
PMT
y
PMT
P
GNMA
+
+
+
+
+
=

314
Step 3a: Calculate OAS by the following formula

P =
E CF
1
1 + r
1
+ OAS
+
E CF
2
1 + r
2
+ OAS
2
+
E CF
3
1 + r
3
+ OAS
3
where P = Price of Mortgage Pass-through
r1 = Discount rate on 1-year, zero-coupon Treasury bond
OAS = Option adjusted spread on mortgage pass-through
As discussed, we divide the required yield on a GNMA pass-through
with prepayment risk into the required yield on T-bond plus a
required spread for the prepayment call option given to mortgage
holders
Since the term structure is flat, r1 = r2 = r3 = 8%
We still need E(CF
1
), E(CF
2
), E(CF
3
)

315
Step 3b: Calculate E(CF
1
), E(CF
2
), E(CF
3
)

We first set up the amortization table for the 1,000,000 loan

The next few slides are a refresher on how to construct an
amortization table that you learned in your core course.

316
1
), E(CF
2
), E(CF
3
)

We now set up the amortization table for the 1,000,000 loan

Note : Rounded off in the last year to have the balance to be zero

5
6
7
8
9
B C D E F G
Year Beg. PMT INT Prin End.
Balance Pmt Balance
1 $1,000,000 $402,114 $100,000 $302,114 $697,886
2 $697,886 $402,114 $69,789 $332,325 $365,561
3 $365,561 $402,117 $36,556 $365,561 $0

317
1
), E(CF
2
), E(CF
3
)

Calculate E(CF
1
)

In year 1 there is no prepayment since rates have to fall to 7%
for a prepayment to occur
Therefore E(CF
1
) = $402,114

318
1
), E(CF
2
), E(CF
3
)

Calculate E(CF
2
)

In year 2 there is prepayment when rates fall to 7%. This
happens with 25% probability (see tree). 75% of the time there in
no prepayment and the cash flow is $402,114.
The remaining 25% of the time, there is a principal repayment
and the cash flow is $402,114 + $ 365,561 = $767,675
Therefore E(CF
2
) = 75% * $402,114 + 25% * $767,675
Therefore E(CF
2
) = $493,504.3

319
1
), E(CF
2
), E(CF
3
)

Calculate E(CF
3
)

In year 2 there is prepayment when rates fall to 7%. This
happens with 25% probability (see tree). So in year 3 there is a
25% chance of 0$ cash flow. 75% of the time there in no
prepayment and the cash flow is $402,114.
Therefore E(CF
3
) = 75% * $402,114 + 25% * $0
Therefore E(CF
3
) = $301,585.5

320
Step 3a: Calculate OAS by the following formula

P =
E CF
1
1 + r
1
+ OAS
+
E CF
2
1 + r
2
+ OAS
2
+
E CF
3
1 + r
3
+ OAS
3
Solve for oas using a financial calculator (IRR function)
This gives 1+0.08+oas = 1.0896
oas = 0.0096 = 0.96%

Why is the yield less than 9%?
Can the yield be > 9% ?

3 2
) 08 . 0 1 (
5 . 585 , 301
) 08 . 0 1 (
3 . 504 , 493
08 . 0 1
114 , 402
689 , 017 , 1
oas oas oas + +
+
+ +
+
+ +
=

321
Average Life
Average Life is the weighted average of the MBSs
or collaterals time periods, with the weights being
the periodic principal payments divided by the total
principal.
Example: The original average life of the 30-year, $100M,
9%, 100 PSA mortgage portfolio is 12.077 years.
Av Life .
($71, ) ($88, ) ($135, )
$100, ,
. . =
+ + +
=
1
12
1 295 2 376 360 281
000 000
12 077

322
Prepayment Risk and
Average Life
Prepayment Risk can be measured in terms of
how responsive a MBSs or collaterals average
life is to changes in prepayment speed (change in
PSA) or equivalently to changes in rates (since
rate changes are the major factor affecting
speed).
Prepayment risk measure:
prepayment risk
Av life
PSA
Av life
R
= ~
A
A
A
A

323
Prepayment Risk and
Average Life
A MBS or its collateral would have zero
prepayment risk if

One of the more significant innovations in finance
occurred in the 1980s with the development of derivative
MBS which had different prepayment risk features,
including some derivatives with zero prepayment risk or
equivalently with
prepayment risk
Av life
PSA
= =
A
A
0
A
A
Av life
PSA
= 0 .

324
Mortgage Derivatives
There are two general types of MBS
derivatives:
Collateralized Mortgage Obligations
(CMOs)
Stripped Mortgage-Backed Securities

Both redirect the CFs to various security
classes.

325
COLLATERALIZED MORTGAGE OBLIGATIONS
To address the problems of prepayment risk, many
MBS issuers began to offer collateralized mortgage
obligations (CMOs).

Introduced in the mid-1980s, these securities are
formed by dividing the cash flows of an underlying
pool of mortgages or a MBS issue into several
classes.

Each class has a different claim on the mortgage
collateral and with each sold separately to different
types of investors.

326
COLLATERALIZED MORTGAGE OBLIGATIONS
The different classes making up a CMO are
called tranches or bond classes.

There are two general types of CMO tranches
sequential-pay tranches
planned amortization class tranches.

327
Sequential-Pay Tranches
A CMO with sequential-pay tranches, called a
sequential-pay CMO, is divided into classes with
different priority claims on the collateral's principal.

The tranche with the first priority claim has its
principal paid entirely before the next priority class,
which has its principal paid before the third class, and
so on.

Interest payments on most CMO tranches are made
until the tranche's principal is retired.

328
Sequential CMOs
Sequential CMOs carve a mortgage pool into
a number of tranches (slices).
For example, A, B, C, and Z-tranches.
Each tranche is entitled to a share of
mortgage pool principal and interest on that
share of principal.
However, cash flows are distributed
sequentially, so as to create securities with a
range of maturities.

329
Analysis of Structured Security Classes
Sequential Pay Classes (SEQ)
GNMA bonds
placed in trust as
collateral

FI
Principal Payments
Interest Payments

Borrower
GNMA
pass
through
bonds
GNMA
Guarantee

I-bank or
other FI

Trust
Issued by FI
Purchase GNMA
bonds
Class
A
Class
B
Class
C
CMO created with 3 classes
330
Residual
Interest

CMO
Issuer

A Class
SEQ

B Class
SEQ

C Class
SEQ

Principal Payments
Interest Payments

Borrower
331
MBS
Class
A
Class
B
Class
C
Simplest Case: Security has 3 classes -- A, B, C
Class Cash Flow Allocation
A
- Receive interest payments due each month (based on current principal balance of class A)
while the class is outstanding
- All principal repayments would go first to the investors of the A class security
- Considered relatively short-term instrument with respect to the underlying whole loans or MBS

B
- Receive interest payments due each month (based on current principal balance of class B)
- B class investors would receive no principal repayment until A class had been fully repaid its
par value
- Considered intermediate term instrument

C
- Receive interest payments due each month (based on current principal balance of class C)
- C class investors would receive no principal repayment until all A class and B class investors
had been paid in full
- Considered relatively longer-term instrument

332
Sequential-Pay Tranches - Example
Suppose we form the following sequential-
pay tranches from the following mortgage
portfolio : $100M mortgage portfolio, Maturity
= 357 months, Coupon = 8.125%, Pass
through rate (PT rate) = 7.5%, and
prepayment speed = 165.

Tranche Par PT Rate
A M
B M
C M
$48. .
$9 .
$42. .
625 7 5%
7 5%
375 75%

333
Principal payment is first made to A, then to B, and so on.
Principal payment includes both scheduled principal payment
and prepaid principal.
7.5% is based on the remaining balance in the class.
Each tranche has a maturity, average life, and window (number
of months that principal is paid) that differs from each other and
the underlying collateral:

Tranche Maturity Window Av Life
A
B
C
Collateral
.
.
.
.
.
81 80 349
100 19 7 50
357 257 1512
357 357 8 78

334
By forming sequential-pay tranches, we obtain some tranches
with average lives greater than the collaterals and some that
are smaller.

Recall, average life is similar to duration.

The lower the average life of a tranche, the lower the sensitivity
of its value to rate changes and the lower its prepayment risk.

Note: Creating sequential-pay tranches does not eliminate
prepayment risk, but it does reduce it.

335
Accrual Bond Class:

With many sequential-pay CMOs, there is an
accrual bond class or Z-bond.

This tranche does not receive current interest;
rather the interest is deferred. The interest not paid
to Z is used to pay down the principal on the other
bonds.

The creation of a Z-bond serves to reduce the
average life of the other classes.

336
Accrual Bond Class:

Suppose we replace tranche C with a Z bond. The interest that
was paid on C now is used to pay the principal on the other
classes. This serves to reduce each tranches maturity, window,
and average life.
Tranche Av Life
with Z w o Z
A
B
Z
.
/
. .
. .
.
2 51 349
503 7 50
12 71

337

338
Valuation
Mortgage = (Nonprepayable) Stream of Monthly Payments -
Prepayment Option.

Modeling the mortgage involves modeling the prepayment option.

If all borrowers prepaid according to a strategy that minimized the
mortgage value (maximized the option value), mortgage cash flows
would be a function of interest rates and could be valued by
replication and no arbitrage

Alternatively, if prepayments (option exercises) were uncorrelated
with the market and independent across different loans in a given
pool, a well-diversified pool would just experience the average
prepayment, with little variance, by the law of large numbers, and
MBSs would have nearly fixed cash flows which could be valued as
a package of zeroes.

339
Valuation
What makes valuation hard is that prepayments are random and
subject to both market and non-market risks:

market: a mortgage could prepay because rates fall (the
prepayment option gets deep in the money)

non-market: a mortgage could prepay even when rates are high
because the mortgagor sells the property or the property is
destroyed (the mortgagor may be forced to exercise the option when
it is out of the money)

non-market: a mortgage might not prepay even when rates fall
because the mortgagor faces transaction costs, or cannot refinance
because the property has lost value (the mortgagor fails to exercise
a deep-in-the-money option)

340
We can value non-market risks at their true expected value if
they can be diversified away through pooling.

Market risks can be hedged, and thus valued by no arbitrage
(risk-neutral expected value).

Practically, however, we need to know the average prepayment
along every interest rate path throughout the life of the mortgage
to be able to value the mortgage exactly. Realistic valuation
problems are very difficult.

As an example, consider simple prepayment assumptions to
illustrate some basic effects.

Valuation

341
Tranche CMOs - Example
Consider a 2 year, 5.5% semi annual mortgage pool with 100$
of principal

Amortization Schedule for the Pool Assuming no prepayments
Date Beginning Scheduled Interest Principal Ending
Balance Payment Balance
0.5 100 26.74 2.75 23.99 76.01
1 76.01 26.74 2.09 24.65 51.36
1.5 51.36 26.74 1.41 25.33 26.03
2 26.03 26.74 0.72 26.03 0

342
Divide this pool into three tranches
Tranche A gets the first $30 of principal
Tranche B gets the next $30 of principal
Tranche C gets the last $40 of principal

A 30 B 30 C 40
Date A Int A Prin B Int B Prin C Int C Prin
0.5 0.83 23.99 0.83 0 1.1 0
1 0.17 6.01 0.83 18.64 1.1 0
1.5 0 0 0.31 11.36 1.1 13.97
2 0 0 0 0 0.72 26.03

343
WSJ strip rates
6 months = 5.54% 0.9730
1 year = 5.45% 0.9476
1.5 year = 5.47% 0.9222
2.0 year = 5.50% 0.8972
Recall the price of a zero can be
derived from the STRIPs rates as
Valuation of the tranches assuming no prepayment

With no prepayment, each tranche would just be a stream of four
fixed cash flows, which could be valued as a package of zeroes:

A: (0.83+23.99)*0.9730 + (0.17+6.01)*0.9476 = 30.00

B: 0.83*0.9730+ (0.83+18.64)*0.9476 + (0.31+11.36)*0.9222 =
30.01

C:1.10*0.9730+1.10*0.9476+(1.10+13.97)*0.9222+
(0.72+26.03)*0.8972 = 40.01

Note that the values of the tranches sum to the value of the pool:
30.00 + 30.01 + 40.01 = 100.02

345
Cash Flows to Tranches Assuming 50% Prepayment at Time 0.5,
and 25% Prepayment at Time 1.5

Pool
Date Beginning Scheduled Interest Principal Prepayment Ending
0.5 100.00 26.74 2.75 23.99 38.00 38.00
1 38.00 13.37 1.05 12.33 0.00 25.68
1.5 25.68 13.37 0.71 12.66 3.25 9.76
2 9.76 10.03 0.27 9.76 0.00 0.00
Tranches
A 30.00 B 30.00 C 40.00
Date A Int A Prin B Int B Prin C Int C Prin
0.5 0.83 30.00 0.83 30.00 1.10 2.00
1 0.00 0.00 0.00 0.00 1.05 12.33
1.5 0.00 0.00 0.00 0.00 0.71 15.92
2 0.00 0.00 0.00 0.00 0.27 9.76

346
Valuation Assuming 50% Prepayment at Time 0.5, and 25%
Prepayment at Time 1.5, with Certainty

With deterministic prepayments, each tranche would just be a
stream of four fixed cash flows, which could be valued as a
package of zeroes:

A: (0.83+30.00)*0.9730 = 29.99
B: (0.83+30.00)*0.9730 = 29.99
C: (1.10+2.00)*0.9730 + (1.05+12.33)*0.9476
+(0.71+15.92)*0.9222 + (0.27+9.76)*0.8972 = 40.01

Again, the values of the tranches sum to the value of the pool
(allowing for rounding error):
29.99 + 29.99 + 40.01 = 100.00

347
Assume the risk neutral probabilities are 0.5 for the up and down
moves and the 6 month rates as follows.

348

349

350

351
Tranche A, assuming optimal prepayments

352
Tranche B, assuming optimal prepayments

353
Tranche C, assuming optimal prepayments

354
Z-Bond
Another way to structure CMO tranches involves a Z
Tranche or Z bond--a security that receives no principal,
or interest, until all previous tranches are paid off.

Pool assuming No Prepayments
Date Beginning Scheduled Interest Principal Ending
0.5 100.00 26.74 2.75 23.99 76.01
1 76.01 26.74 2.09 24.65 51.36
1.5 51.36 26.74 1.41 25.33 26.03
2 26.03 26.74 0.72 26.03 0.00
Tranches
A 30.00 B 30.00 Z 40.00
Date A Int A Prin B Int B Prin Z Int Z Prin Z Balance
0.5 0.83 25.09 0.83 0.00 0.00 0.00 41.10
1 0.13 4.91 0.83 20.87 0.00 0.00 42.23
1.5 0.00 0.00 0.25 9.13 1.16 16.20 26.03
2 0.00 0.00 0.00 0.00 0.72 26.03 0.00

355
Z-Bond
Tranches with Z Bond Assuming 50% Prepayment at
Time 0.5, and 25% Prepayment at Time 1.5

Pool
Date Beginning Scheduled Interest Principal Prepayment Ending
0.5 100.00 26.74 2.75 23.99 38.00 38.00
1 38.00 13.37 1.05 12.33 0.00 25.68
1.5 25.68 13.37 0.71 12.66 3.25 9.76
2 9.76 10.03 0.27 9.76 0.00 0.00
Tranches
A 30.00 B 30.00 Z 40.00
Date A Int A Prin B Int B Prin Z Int Z Prin Z bal
0.5 0.83 30.00 0.83 30.00 1.10 2.00 38.00
1 0.00 0.00 0.00 0.00 1.05 12.33 25.68
1.5 0.00 0.00 0.00 0.00 0.71 15.92 9.76
2 0.00 0.00 0.00 0.00 0.27 9.76 0.00

356

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