What Information is Needed to Judge the Risk of Structured Financial Instruments?
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1 What Information is Needed to Judge the Risk of Structured Financial Instruments? Bernhard Nietert University of Marburg, Faculty of Business Administration and Economics
2 Introduction Theory Application Conclusion 1 Introduction to the problem Motivation Increasing important of Islamic Finance (Source: GLOBAL ISLAMiC FiNANCE & COMMERCE) Global market of Islamic financial products: 56 billion Expected growth over the next years to 350 billion 2
3 Introduction Theory Application Conclusion Structured financial products and the recent subprime crises Citibank: 11 billion USD loss Merrill Lynch: 8.4 billion USD loss Industriekreditbank and SachsenLB had to be bailed out by their owners Banking supervision could not prevent this crisis. 3
4 Introduction Theory Application Conclusion Questions First, measurement of the risk of structured financial instruments Second, information requirements of banking supervision Objective of presentation: to provide an answer to both questions 4
5 Introduction Theory Application Conclusion Contribution of the presentation compared to the literature New approach to measure risk: asset pricing theory as opposed to explicit risk measures New insights on risk drivers: cash flow and context 5
6 2 Theory 2.1 Definitions Structured financial instrument Consists of several basis products One of these products is a derivative 6
7 Derivative Financial instrument whose cash flow depends on the value of its underlying 7
8 Risk Future cash flows are not known today Example 1/4 10 State 1 5 3/4 0 State 2 t t + 1 8
9 2.2 Methodology Asset pricing theory Translates future risky cash flow into prices Test criterion Price of asset 1 in context 1< price of asset 1 in context 2 Context 1 must involve more risk Since lower price is associated with higher risk 9
10 Description of the context of an investor Definition Context describes the environment in which the investment is embedded Cash flow of the investment does not belong to its context 10
11 Example Financial market price cash flow in state 1 cash flow in state 2 (probability: ¼) (probability: ¾) Asset Asset Context Portfolio of old loans of a bank Loans?
12 Structured financial instrument Structured financial instrument? 0 20 Investment 12
13 2.3 Measuring Risk Two scenarios Structured financial products can be duplicated Structured financial products cannot be duplicated 13
14 2.3.1 Duplication possible What does duplication mean? price cash flow in state 1 cash flow in state 2 (probability: ¼) (probability: ¾) Asset Asset Structured financial instrument?
15 price cash flow in state 1 cash flow in state 2 (probability: ¼) (probability: ¾) Asset Asset Structured financial instrument? = = 20 15
16 Duplication means The financial market offers the same cash flow as the structured financial instrument. 16
17 Duplication means The financial market offers the same cash flow as the structured financial instrument. Duplication portfolio (= financial market) and structured financial instrument are identical from an economic point of view. Duplication possible 17
18 price cash flow in state 1 cash flow in state 2 (probability: ¼) (probability: ¾) Asset Asset Structured financial instrument? = = 20 18
19 Consequences 1 st consequence Price of structured financial product = price of duplication portfolio (Black/Scholes methodology): = 8 Identical price => structured financial instrument has the same risk as the duplication portfolio 19
20 2 nd consequence Risk preferences do not matter Structured financial instrument? 0 20 higher risk aversion lower risk aversion State probabilities (1/4 or 3/4) do not matter 20
21 3 rd consequence The portfolio of old loans of the bank does not matter. 21
22 2.3.2 Duplication impossible What does impossible duplication mean? modified financial market price cash flow in state 1 cash flow in state 2 (probability: ¼) (probability: ¾) Asset Structured financial instrument?
23 price cash flow in state 1 cash flow in state 2 (probability: ¼) (probability: ¾) Asset Structured financial instrument? = 20 > = 20 23
24 price cash flow in state 1 cash flow in state 2 (probability: ¼) (probability: ¾) Asset Structured financial instrument? = 10 > = 10 < 20 24
25 Duplication impossible means The financial market offers a different cash flow than the structured financial instrument. Financial market and the structured financial instrument are no longer identical from an economic point of view. Duplication impossible 25
26 Consequences 1 st consequence The price of the structured financial instrument cannot be derived from the financial market alone. Investors must value the cash flow discrepancy (Cox/Ingersoll/Ross methodology) 26
27 2 nd consequence Risk preferences do matter State probabilities (1/4 or 3/4) do matter 27
28 Graphical illustration 28
29 3 rd consequence The portfolio of old loans of the bank does matter. 29
30 Intuition Portfolio of old loans of a bank Loans? Structured financial instrument Structured financial instrument? 0 20 Sum of both positions Loans + structured financial instrument?
31 Graphical illustration price of the structured financial product with consideration of the portfolio of old loans - price of the structured financial product without consideration of the portfolio of old loans (stand alone price) 31
32 good risk 32
33 Counter-example Portfolio of old loans of a bank Loans? Structured financial instrument Structured financial instrument? 0 20 Sum of both positions Loans + structured financial instrument?
34 bad risk 34
35 Introduction Theory Application Conclusion 3 Application 3.1 Islamic financial products and interest rate risk Introductory example Structured financial instrument?
36 Introduction Theory Application Conclusion Definition If the price of a financial instrument changes when interest rates change, this product is subject to interest rate risk. 36
37 Introduction Theory Application Conclusion Dependence of the price of the structured financial instrument on interest rates Duplication possible 37
38 Introduction Theory Application Conclusion Duplication impossible price of the structured financial product with consideration of the portfolio of old loans - price of the structured financial product without consideration of the portfolio of old loans (stand alone price) High risk aversion Low risk aversion 38
39 Introduction Theory Application Conclusion Risk on markets without a riskless asset Price without Price with riskless asset High risk aversion Low risk aversion 39
40 Introduction Theory Application Conclusion 3.2 Consequences to banking supervision Information Duplication possible: information just on the cash flow of the structures financial product is required Duplication impossible: information on the cash flow of the structured financial product as well as the bank s old loan portfolio is required 40
41 Introduction Theory Application Conclusion Information on interest sensitivity is needed in both valuation scenarios (duplication possible or impossible). 41
42 Introduction Theory Application Conclusion Incentive Compatibility Duplication possible: cash flows are obvious Duplication impossible: there is no incentive that will result in true revelation (stand alone price is a bad proxy) 42
43 Introduction Theory Application Conclusion 4 Conclusion Huge losses with structured financial instruments Information required to judge the risk of these structured financial instruments Duplication possible: cash flow Duplication impossible: cash flow and bank s old loans Interest rate sensitivity 43
44 Introduction Theory Application Conclusion Banking supervision must actively gather this information. 44
45 Thank you for your attention! 45
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