Description
The presentation explains answer to the question whether derivatives destabilize the markets.
Do Derivatives De-stabilize the markets?
-By Group RJH(P)
The need for a Derivatives market
• The derivatives market performs a number of economic functions: • They help in transferring risks from risk adverse people to risk oriented people • They help in the discovery of future as well as current prices • They catalyze entrepreneurial activity • They increase the volume traded in markets because of participation of risk averse people in greater numbers • They increase savings and investment in the long run
Certain Figures pre-crisis
• Leverage Levels Bear Stearns – 33:1 Lehman Brothers – 28:1 • Balance Sheet total of top 15 financial institutions stood at $20 trillion • US GDP - $14 trillion • CDS market - $45 trillion • CDO market - $40 trillion • World GDP - $40 trillion
Collateralized Debt Obligation
• First issued in 1987, major growth since 2001 due to introduction of Gaussian Copula models by David X Li. • CDOs are structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. • CDOs securities are split into different risk classes or tranches. • Interest and principal payments are made in order of seniority
More on CDOs
• Basically three types of tranches Senior, mezzanine and equity. • The senior tranches offers low payments with low risk whereas the equity tranches offer higher coupon payments with high default risk. • Pooling BBB mezzanine tranches to form AAA tranche.
Creation of ABS CDO
Equity tranche (5%) not rated Equity tranche (5%) not rated
Portfolio
Mezzanine tranche (20%) BBB Senior Tranche (75%) AAA
Mezzanine tranche (20%) BBB Senior Tranche (75%) AAA
Synthetic CDO
• Normal ones are known as cash CDO. • Long in corporate bond has same credit risk as short on corresponding CDS. • Synthetic CDO has a portfolio consisting of short positions in CDS. • Default losses on CDS are allocated to tranches.
Try to figure this out!!!
Credit Default Swap
• A contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange,
receives a payoff if a credit instrument goes into default.
Explanation of CDS
• Suppose, A Inc. were long a Lehman Brothers’ CDS, and were probably
paying a healthy quarterly premium to the seller (B Inc.) of the CDS. When
Lehman filed for bankruptcy, this created a credit event. When the Lehman bonds were finally auctioned off, they settled for 8.625% - or 8.625 cents
per dollar. In this case, A Inc. - which was long Lehman’s CDS, was obliged to
get [$1.000 - $0.08625] = $0.91375 per dollar (from B Inc.). The converse is true too. If Lehman’s financial health improved [instead of deteriorating], A Inc. could stop paying the premiums, and B Inc. would keep all the money that they had collected in premiums. Alternately, A Inc. could buy a
“cheaper” CDS where the premiums are lower.
Origin & its purpose at inception
• CDS are insurance like contracts • Mainly used for municipal bonds and corporate debt • It can be bought and sold from both ends - the insured and the insurer • It was used to transfer the risk
Growth of CDS market
45 40 35 30 25 20 15 10 5 0
45
in trillion $
0.0097
1997
0.1
6.4
2000
2004
2007
Reasons for rapid growth
• Development of a secondary market for both the sellers of protection and the buyers of protection • Economy was booming • Risk of defaults of big corporations was expected to be very low • Used to convert corporate bonds to risk free bonds • Lack of regulation • Change of usage
• From protection to speculation • Seems easy money for banks
Size of CDS market
The cost paid for rapid growth
• CDS market expanded into structured finance, such as CDOs • Use of CDS for speculation and betting • Creating CDS between parties without any connection to the underlying asset • Lack of regulation • Lack of transparency
Note of Caution
• Top 25 commercial banks were holding more than $13 trillion in CDS • All the financial markets were interlinked and interdependent • Out of $45 trillion, $20 trillion was invested on speculative bets
Factors that built the asset bubble
• Low interest rate structure • Global savings imbalances • ‘Search for yield’ in financial markets + cheap credit = a general increase in the appetite for risk • Inverted yield curve ( a predictor of the recessions of 2000, 1991, and 1981) • November 2006: US Commerce Department reports that new home permits dropped 28% from the year before
Factors that built the asset bubble
• • • • Lax Monetary Policy Hedge funds not regulated by the SEC Lack of regulation on leveraging Pushing Americans to live beyond their means (e.g. Home Equity)
Criticalities
• Purchasers were banks, individual investors, pension funds and hedge funds • Risk spread throughout the economy • Potential to generate higher returns in a good market; greater losses in a bad one, thus magnifying the impact of any downturn • No one knew how much bad debt they had on their books and no one wanted to admit it (prior to FAS 157)
Sub-Prime Concentration
• Sub-prime lending became very significant in the US in the middle part of this decade • 2006: Loans were about 1/5th of new housing lending in the US • Amounted to an estimated 15 per cent of the stock of housing loans outstanding • they were vulnerable to rising default rates as lending standards slipped and as the overheated housing market turned down, from late 2006 onward
How the bubble burst
Rise in Interest Rates CDS defaults Drop in LTV
Credit crisis of 2008
Defaults leading to lower asset prices FAS 157 enforced MTM
Higher mortgage payments
Possible factors for the crisis
• At the outset it looks like derivatives was the cause but reasons could be: – Undefined risk limits – Trying to outguess the markets – Lack of diversification – Blind trust in models – Lack of trade monitoring – Inception profit recognition mechanisms – Financing long term assets with short term liabilities – Lack of market transparency – Skewed incentives and greed – Rating shopping – Imperfect information
THANK YOU
doc_354959389.pptx
The presentation explains answer to the question whether derivatives destabilize the markets.
Do Derivatives De-stabilize the markets?
-By Group RJH(P)
The need for a Derivatives market
• The derivatives market performs a number of economic functions: • They help in transferring risks from risk adverse people to risk oriented people • They help in the discovery of future as well as current prices • They catalyze entrepreneurial activity • They increase the volume traded in markets because of participation of risk averse people in greater numbers • They increase savings and investment in the long run
Certain Figures pre-crisis
• Leverage Levels Bear Stearns – 33:1 Lehman Brothers – 28:1 • Balance Sheet total of top 15 financial institutions stood at $20 trillion • US GDP - $14 trillion • CDS market - $45 trillion • CDO market - $40 trillion • World GDP - $40 trillion
Collateralized Debt Obligation
• First issued in 1987, major growth since 2001 due to introduction of Gaussian Copula models by David X Li. • CDOs are structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. • CDOs securities are split into different risk classes or tranches. • Interest and principal payments are made in order of seniority
More on CDOs
• Basically three types of tranches Senior, mezzanine and equity. • The senior tranches offers low payments with low risk whereas the equity tranches offer higher coupon payments with high default risk. • Pooling BBB mezzanine tranches to form AAA tranche.
Creation of ABS CDO
Equity tranche (5%) not rated Equity tranche (5%) not rated
Portfolio
Mezzanine tranche (20%) BBB Senior Tranche (75%) AAA
Mezzanine tranche (20%) BBB Senior Tranche (75%) AAA
Synthetic CDO
• Normal ones are known as cash CDO. • Long in corporate bond has same credit risk as short on corresponding CDS. • Synthetic CDO has a portfolio consisting of short positions in CDS. • Default losses on CDS are allocated to tranches.
Try to figure this out!!!
Credit Default Swap
• A contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange,
receives a payoff if a credit instrument goes into default.
Explanation of CDS
• Suppose, A Inc. were long a Lehman Brothers’ CDS, and were probably
paying a healthy quarterly premium to the seller (B Inc.) of the CDS. When
Lehman filed for bankruptcy, this created a credit event. When the Lehman bonds were finally auctioned off, they settled for 8.625% - or 8.625 cents
per dollar. In this case, A Inc. - which was long Lehman’s CDS, was obliged to
get [$1.000 - $0.08625] = $0.91375 per dollar (from B Inc.). The converse is true too. If Lehman’s financial health improved [instead of deteriorating], A Inc. could stop paying the premiums, and B Inc. would keep all the money that they had collected in premiums. Alternately, A Inc. could buy a
“cheaper” CDS where the premiums are lower.
Origin & its purpose at inception
• CDS are insurance like contracts • Mainly used for municipal bonds and corporate debt • It can be bought and sold from both ends - the insured and the insurer • It was used to transfer the risk
Growth of CDS market
45 40 35 30 25 20 15 10 5 0
45
in trillion $
0.0097
1997
0.1
6.4
2000
2004
2007
Reasons for rapid growth
• Development of a secondary market for both the sellers of protection and the buyers of protection • Economy was booming • Risk of defaults of big corporations was expected to be very low • Used to convert corporate bonds to risk free bonds • Lack of regulation • Change of usage
• From protection to speculation • Seems easy money for banks
Size of CDS market
The cost paid for rapid growth
• CDS market expanded into structured finance, such as CDOs • Use of CDS for speculation and betting • Creating CDS between parties without any connection to the underlying asset • Lack of regulation • Lack of transparency
Note of Caution
• Top 25 commercial banks were holding more than $13 trillion in CDS • All the financial markets were interlinked and interdependent • Out of $45 trillion, $20 trillion was invested on speculative bets
Factors that built the asset bubble
• Low interest rate structure • Global savings imbalances • ‘Search for yield’ in financial markets + cheap credit = a general increase in the appetite for risk • Inverted yield curve ( a predictor of the recessions of 2000, 1991, and 1981) • November 2006: US Commerce Department reports that new home permits dropped 28% from the year before
Factors that built the asset bubble
• • • • Lax Monetary Policy Hedge funds not regulated by the SEC Lack of regulation on leveraging Pushing Americans to live beyond their means (e.g. Home Equity)
Criticalities
• Purchasers were banks, individual investors, pension funds and hedge funds • Risk spread throughout the economy • Potential to generate higher returns in a good market; greater losses in a bad one, thus magnifying the impact of any downturn • No one knew how much bad debt they had on their books and no one wanted to admit it (prior to FAS 157)
Sub-Prime Concentration
• Sub-prime lending became very significant in the US in the middle part of this decade • 2006: Loans were about 1/5th of new housing lending in the US • Amounted to an estimated 15 per cent of the stock of housing loans outstanding • they were vulnerable to rising default rates as lending standards slipped and as the overheated housing market turned down, from late 2006 onward
How the bubble burst
Rise in Interest Rates CDS defaults Drop in LTV
Credit crisis of 2008
Defaults leading to lower asset prices FAS 157 enforced MTM
Higher mortgage payments
Possible factors for the crisis
• At the outset it looks like derivatives was the cause but reasons could be: – Undefined risk limits – Trying to outguess the markets – Lack of diversification – Blind trust in models – Lack of trade monitoring – Inception profit recognition mechanisms – Financing long term assets with short term liabilities – Lack of market transparency – Skewed incentives and greed – Rating shopping – Imperfect information
THANK YOU
doc_354959389.pptx